Investors seeking exposure to real estate can look for investment properties to purchase and rent out, or they can buy shares of a real estate investment trust (REIT). Becoming a landlord offers greater leverage and a better chance of realizing big returns, but it comes with a long list of hassles, such as collecting rent and responding to maintenance issues. REITs provide a much simpler way to invest in real estate and earn consistent income through dividends, but they confer less control, and their upside tends to be lower than that of rental properties.
Landlord Pros
Becoming a landlord offers several advantages. Perhaps the biggest advantage is leverage. Investors with good credit can buy rental property with as little as 20% down, financing the rest. Therefore, the investor's cash outlay on a $100,000 property is only $20,000. If the value of the property increases by 20% in the first year, an amount not unheard of in a hot real estate market, then the investor enjoys a 100% return.
Although mortgage payments must be made on the financed amount, a smart real estate investor earns enough money in rental income to cover the mortgage, with money left over as profit. This allows the investor to earn money from both property appreciation and rent payments from tenants.
Landlord Cons
Being a landlord is a much more hands-on investment than owning shares of a REIT. Many people who have gotten into the business of purchasing rental properties have quickly learned that the time required to manage all of their properties becomes another full-time job. A person considering buying rental properties should brace themselves for a huge time commitment, or be prepared to pay a professional property manager to handle the minutiae involved, such as advertising vacancies, collecting rent and dealing with delinquent tenants.
Then there are the myriad expenses involved with owning property. Depending on how the lease agreement is written, a landlord could be financially responsible for everything from a leaky faucet to a broken refrigerator. This can eat into an investor's profit quickly. Moreover, dealing with frantic late-night phone calls every time a tenant's toilet does not flush properly can impede quality of life.
REIT Pros
Perhaps the biggest advantage of buying REIT shares rather than rental properties is simplicity. REIT investing allows for sharing in value appreciation and rental income without being involved in the hassle of actually buying, managing and selling property. Diversification is another benefit. Building a diversified portfolio of one's own rental properties requires a hefty budget and a lot of time and expertise. Investing in the right REIT offers done-for-you diversification in one simple purchase. Furthermore, while rental properties are potentially lucrative investments, they can be highly illiquid, particularly when the real estate market turns soft. REIT shares, on the other hand, can be redeemed for cash in one five-minute phone call.
REIT Cons
REITs lack the leverage advantage offered by financing rental properties. Because a REIT is required by law to distribute 90% of its profits to investors, that leaves only 10% to grow the company by investing in additional properties. Consequently, REIT share prices rarely grow as fast as, say, Silicon Valley tech companies, which rarely pay dividends and usually invest every penny of their profits into growth and innovation.
REIT investing offers less control than being a landlord. When an investor buys rental properties, the investor can see, touch and smell each property before owning it. The investor can research the local rental market and examine data on how similar properties have fared recently. Buying REIT shares means ceding that control to someone else. This can be ideal for investors not wanting to make such decisions, but those who prefer a hands-on approach might be better off as landlords.
FAQs
Perhaps the biggest advantage of buying REIT shares rather than rental properties is simplicity. REIT investing allows for sharing in value appreciation and rental income without being involved in the hassle of actually buying, managing and selling property. Diversification is another benefit.
What is the downside of REITs? ›
Non-traded REITs have little liquidity, meaning it's difficult for investors to sell them. Publicly traded REITs have the risk of losing value as interest rates rise, which typically sends investment capital into bonds.
What are 3 drawbacks to owning rental real estate? ›
The drawbacks of having rental properties include a lack of liquidity, the cost of upkeep, and the potential for difficult tenants and for the neighborhood's appeal to decline.
Are REITs safer than rentals? ›
But especially today, REITs offer far better return prospects and much lower risk because their valuations are so heavily discounted. Investing in REITs provides both a margin of safety and future upside potential. This explains why I am buying REITs instead of rental properties.
What is the 2% rule in real estate? ›
The 2% rule is a rule of thumb that determines how much rental income a property should theoretically be able to generate. Following the 2% rule, an investor can expect to realize a positive cash flow from a rental property if the monthly rent is at least 2% of the purchase price.
Do REITs do well in a recession? ›
REITs historically perform well during and after recessions | Pensions & Investments.
What is the biggest risk of owning a rental property? ›
An extended vacancy is undoubtedly one of the biggest financial risks involved in investing in rental homes since it's essentially lost money. If you can't consistently rent your space, you're still responsible for paying the property's expenses — without generating income to offset the cost.
Is renting ever better than owning? ›
Long-term renting is currently cheaper than homeownership in 46 of the 97 major cities we researched. 69% of renters believe that renting is the best financial decision for them right now. Renters will spend an average of $1.26 million over the course of 30 years while homeowners will spend $1.30 million.
How stressful is rental property? ›
However, don't jump into the rental property game without seeing that there are negatives and it can get very stressful. People often overlook things like times of vacancy, residents who don't pay rent, and maintenance issues. Real Estate provides no shortage of opportunities for stress.
What is bad income for REITs? ›
In terms of tax, a REIT's income may be considered “bad” under rules governing the trusts contained in Sections 856 of the Internal Revenue Code. An overabundance of such income can cost a REIT its tax-favored status.
The FTSE Nareit All REITs index, which tracks the performance of all publicly traded REITs in the U.S., had an average annual total return (dividends included) of 3.58% during the five-year period that ended in August 2023. For the 10-year period between 2013 and 2022, the index averaged 7.48% per year.
Can you lose money investing in REITs? ›
Can You Lose Money on a REIT? As with any investment, there is always a risk of loss.
What is a better investment than real estate? ›
With stocks, it's possible to build a broad portfolio of companies and industries at a fraction of the time and cost of owning a diverse collection of properties. Perhaps the easiest way to get that diversification: Purchase shares in mutual funds, index funds or exchange-traded funds.
Do REITs outperform the market? ›
REITs are also attractive thanks to their market-beating returns. During the past 25 years, REITs have delivered an 11.4% annual return, crushing the S&P 500's 7.6% annualized total return in the same period. Image source: Getty Images. One reason for REITs' outperformance is their dividends.
Do REITs increase in value? ›
During periods of economic growth, REIT prices tend to rise along with interest rates. The reason is that a growing economy increases the value of REITs because the value of their underlying real estate assets increases.
