Whenever I see discussions in articles and forums about real estate, inevitably someone will throw out the option of investing in REITs as a way to diversify into real estate within one’s portfolio of investments. Whenever I see that tossed in as a proxy for direct real estate investments I always sigh a little bit, as the reality is they are quite different investments. I know there are proponents for each type of investment, but is one really better than the other? Like many questions in life and real estate, the answer to that question is “It depends.” I know, vague answers like that are not the concrete information most people are looking for, but what is right or optimal for one investor might be totally wrong for the next person. That’s why I always strongly encourage other investors to figure out their own strategy that works around their interests, their time availability, their capital to work with, their tax situation, and all the other factors which go into figuring out the ideal portfolio of investments for an individual. That being said, I figure the best way to approach it is to go over what REITs are and how and what types of income they produce for an investor and from there you can decide on whether it is right for your portfolio.
REITs are Real Estate Investment Trusts which own and manage large pools of income-producing real estate such as office space, retail, industrial complexes, apartments, hotels, self-storage, and the like. The REIT is sold to investors in shares, similar to how a mutual fund invests in a multitude of companies and your money is pooled with other investors to buy parts of those companies. So when you buy shares of a REIT you are really purchasing units of a security rather than a direct piece of real estate. The IRS requires REITs to pay out at least 90% of their income to shareholders to avoid certain tax implications on the REIT itself, so this contributes to pass through of much of the profit of the company. Dividends from a REIT are passed on to the shareholder in primarily 3 ways:
1. Ordinary dividends – This accounts for most of the income received from a REIT investment. These dividends are considered “nonqualified dividends” for tax purposes and therefore taxed at the shareholder’s individual ordinary income tax rate.
2. Return of capital – Part of the dividend may be constructed as a return of shareholder capital. Importantly, this reduces the shareholder’s cost basis in the investment but also has the effect of creating a tax-deferred gain between the reduced cost basis and the price at which you eventually sell your shares.
3. Capital gains – If an asset within the REIT is sold at a profit this profit can pass through to shareholders at their capital gains tax rate.
With these things in mind, the easiest way I find to analyze REITs compared to direct property ownership is to break it down into analyzing some of the different components of each.
• ENTRY COSTS – REITs have a definite advantage here, as you can invest in a REIT with a minimal amount of money whereas purchasing directly held property will generally require at a minimum thousands of dollars if not hundreds of thousands of dollars.
• DIVERSIFICATION POTENTIAL – Again, REITS do allow for easier diversification compared to investing in property directly as you can spread around money into REITS exposed to various real estate asset classes or geographic locations.
• TIME INVESTMENT – REITS are passive by nature and therefore require negligible time commitment other than picking which REIT to invest in versus a variable amount of time commitment with direct ownership which could require an hour a month or be a full-time job for some people.
• LIQUIDITY – Since REITS are traded on the exchange markets, the liquidity is an obvious advantage over directly held real estate which could take months or years to get out of.
• CORRELATION TO STOCK MARKET – Even though the underlying investments of a REIT are individual properties, the structure of a REIT as a security behaves much more similarly to the patterns of the stock market as compared to the trends of the real estate market. From this standpoint, investing in a REIT does not help you diversify away from the volatility of the stock market.
• CONTROL – Again, since REITs are passive investments you do not have control over the investment itself other than deciding whether to be an investor or not. On the other hand, you have ultimate control (and responsibility) over directly owned real estate.
• LEVERAGE – Although the REIT itself will likely utilize leverage in purchasing the underlying property assets, you as the individual shareholder in the REIT cannot utilize leverage in your purchase of shares like you could with directly owned real estate. For example, if you invest $2,500 in a REIT your returns will be based solely off of that $2,500. If you invest $50,000 in a directly held property using 75% leverage you can purchase a property worth $200,000 and part of your returns from the property (appreciation, depreciation, amortization) are magnified due to the effect of leverage.
• SPECIAL TAXATION CONSIDERATIONS (1031 EXCHANGE) - As mentioned, your REIT investment is a security and therefore does not qualify for a 1031 Exchange. With directly owned real estate you have the option to sell (exchange) one property and buy another property in a tax-deferred manner. See our recent article on 1031 Exchange for more information on that topic.
• TAX EFFICIENCY – This is really my favorite part of the comparison and one of the primary components of why I feel so strongly about real estate in general. As the adage goes, it doesn’t matter how much you make but how much you keep. In my opinion, the effects of taxation HAVE to be a central part of your investing strategy as without taking that into account you are not addressing the biggest threat to your wealth growth and preservation. In comparing the tax efficiency of REITS to that of direct ownership, owning real estate directly has the advantage here. By utilizing depreciation on directly held property, you will very likely come out with a passive loss on paper at the end of the year even though you received cash flow each month. For some, this passive loss can be used to offset other passive gains. Even without utilizing those passive losses, there really is no comparison between potentially tax free cash flow from direct property ownership versus taxation of REIT income at primarily ordinary income rates.
• USE FOR PRETAX OR POSTTAX CAPITAL – Given the taxation structure discussed, it is worth mentioning that you should also consider which pool of money you want to invest into either a REIT or directly owned property. An argument can be made that since much of the income from a REIT will be taxed at your ordinary income tax rate that this might be a better investment for retirement account investments. On the other hand, some people feel that putting a tax advantaged investment (real estate!) into another tax advantaged vehicle (retirement account) detracts from some of the tax efficiency of real estate to begin with as you don’t get to utilize the depreciation effect and potential passive (paper) losses as you would if using post-tax money.
Hopefully breaking down the components to consider will help you consider what is right for your situation and if you would benefit from investing in REITs or directly held properties. As a reminder, I am not a tax professional or advisor, so none of my comments should be construed as professional advice. I strongly advise you to utilize the services of your own tax strategist in helping you make investment decisions that are beneficial for your own situation.
I’d love to hear your thoughts on REITs versus direct property ownership as sometimes the subtle aspects to consider are not appreciated until you hear directly about another investor’s own anecdotal experience.