Before you decide, please understand the advantages and disadvantages of both.
July 22, 2021
4 minute reading
Opinions expressed entrepreneur The contributors are their own.
Direct real estate investment and investment real estate investment trusts (REITs) are the two most popular real estate investment methods. Choosing one over the other requires exploring their advantages and disadvantages.
Advantages of direct real estate investment
Direct real estate investment means buying a specific real estate, residence or business and earning subsequent income from it. Income may come from property rentals, appreciation, or profits from commercial activities conducted on the property. Through direct investment, you have greater control and decision-making power. For example, you can choose the property and quantity to buy, and decide the rent and tenants. In addition, there is appreciation. Both real estate and stock markets fluctuate, but the price of real estate usually rises over time, and eventually you can sell it at a higher price.
Another great advantage of investing in physical assets is that you can enjoy a variety of tax deductions to offset the purchase cost. For example, the ordinary and necessary costs of managing and maintaining property are deductible. In addition, depreciation has a large tax deduction. In this case, you can gradually reduce your taxable income by deducting the cost of purchasing and improving the property throughout its useful life.
Disadvantages of direct real estate investment
Lack of liquidity is one of the main disadvantages of direct real estate investment. If you are in urgent need of funds, you may not be able to sell physical assets quickly. Another disadvantage is financing. The purchase of physical property requires higher initial capital, and many investors turn to mortgages or other types of financing. However, if market conditions deteriorate or you cannot find a good tenant, you will be at risk of loan default.
Another disadvantage of direct real estate investment is the high level of so-called sweat assets. It takes a lot of time and effort to solve tenant problems and maintain emergency situations. In addition, if there is any accident in the property, you are responsible for it.
Advantages of REITs
On the other hand, for REIT, investors do not need to purchase any physical assets. REIT is a company whose role is similar to a mutual fund for real estate investment. It owns or operates income-generating real estate or real estate-related assets, and pools funds from multiple investors. Basically, investors have the opportunity to earn income from real estate without having to own or manage property.
REITs provide high total returns, capital appreciation potential and liquidity. REITs are legally obliged to pay shareholders at least 90% of their taxable income, and dividend yields may usually exceed 5%. At the same time, the increase in the value of the underlying asset is conducive to potential capital appreciation. In terms of liquidity, REITs stocks are like stocks. As an investor, you can buy and sell them on the exchange as needed.
Disadvantages of REITs
Heavy taxation is one of the main disadvantages of REITs. Most REIT dividends have higher tax rates because they are not considered “qualified dividends.” In addition, REITs may be extremely sensitive to interest rate fluctuations. Generally speaking, there is a negative correlation between REIT prices and Treasury bond yields: an increase in one leads to a decrease in the other, and vice versa.
Another disadvantage of REITs is the lack of diversification. Usually, they focus on specific types of properties, such as offices or shopping malls or hotels. Therefore, in the event of an economic downturn, investors in REITs may face higher specific property risks.
Whether to choose a type of real estate investment depends on whether the investor wants to own and manage tangible property and its initial capital.