Last Updated on November 6, 2019 by Mark Ferguson
Many people say that investing in REITs (real estate investment trusts) is a great way to invest in real estate. Investing in REITs is much easier than investing in real estate, and I have invested in REITs in the past. However, I do not think investing in a REIT is anything close to investing in real estate. With a REIT, you miss out on several things, including the ability to buy below market value, depreciation, control, and better financing options. I no longer invest in REITs because I make so much more from buying investment properties directly.
What is a REIT?
REIT stands for Real Estate Investment Trust. REITs are like mutual funds, but they have different rules and must be used primarily for real estate. An individual investor can buy one or many shares of a REIT, which makes the barriers to investing in them smaller than buying a house. 75% of funds invested in a REIT must be in real estate and must pay 90 percent of the earnings back to investors as a dividend. REITs often specialize in land, apartments, malls, office space, and even single-family homes.
REITs usually pay out a great dividend because they must pay out 90% of earnings to the shareholders. The average dividend paid out on a REIT is 5%, while the average dividend on a stock is 1.9%. While the dividends on REITs are usually higher than stocks, the dividends can be taxed differently. They may be taxed as ordinary income instead of qualified dividends, which are taxed lower.
REIT’s may not see the capital appreciation that stocks have either because they are forced to issue 90% of the profits to the shareholders instead of reinvesting the money into growing the company or fund.
What are the advantages of REITs compared to direct real estate investments?
Here are some of the pros of investing in a REIT:
- REITs are more liquid than real estate. Both REITs and the stock market are more liquid than real estate. Selling houses takes time…and costs a lot of money. In fact, you can safely assume it takes 8 to 10 percent of the selling price to pay agents, closing costs, and title companies (or attorneys). If you need your money right away, real estate may not be the best investment.
- REITs make more money than real estate. Some argue that REIT’s rate-of-return have historically ranged from 9 to 12 percent, while real estate has returned 8 percent. It is true that housing prices may increase by 8%, but that is not what the return on direct real estate investing is. I have made much more than 8% on my investments thanks to leverage, buying below market value, forced appreciation, and cash flow (more on this later).
- REITs offer more diversification. REITs allow an investor to invest in hundreds of properties at one time, which could be less risky than buying a few houses outright. I agree that a REIT offers more diversification, but you also have no control over what is bought and how it is managed.
- REITs are easier to invest in than real estate. REITs are easier to invest in. They take less money, less time, and less management than buying a house. However, you can get a property manager to greatly reduce the time it takes to manage rentals.
What are the pros of investing in real estate over a REIT?
Since 2010, I’ve bought 21 rentals, and since 2001, I’ve flipped over 180 houses. Flipping houses is actually more of a job than investing, and in my opinion, is not a good comparison to investing in a REIT. Rental properties are a much better comparison. I have made at least 15 percent cash-on-cash returns on rent income alone, but there are many other ways to make money with rental properties:
- Buy below market value. I can buy a house tomorrow for $100,000 that is worth $130,000. This is not easy to do, and it takes work to learn how to get great deals, but it is virtually impossible to do this with REITs.
- Forced appreciation. I can make repairs, add bedrooms, and add leases to my properties to increase their value without depending on market increases.
- Tax advantages. Direct investment in real estate has many tax advantages. I can depreciate the structure of the property, almost all expenses are depreciated or deductible, you can defer taxes with a 1031 exchange, and more!
- Cash flow. I make money on my rentals every month because the rent I receive is more than all the expenses including the mortgage. I get this money coming in every month similar to a REIT dividend, but my cash flow is much more than 5%.
- Leverage. I can use loans to buy real estate. Real estate is one of the easiest assets to leverage, and that increases my returns and allows me to make money from assets that are much more valuable than my investment.
My rental properties versus my REITs
When I invested in REITs, I made a decent percentage. I averaged close to 10% some years, which means my $30,000 turned into $33,000 a year later. That’s not a bad return, but I have always been an investor who wants better than a decent return.
I bought my first rental for $97,000 using $30,000 for the down payment, closing costs, and repairs. The house was worth at least $130,000 after I bought it. I rented it out for $1,050 a month, and my mortgage payment with taxes and insurance was about $450 a month. After all expenses including property management, I was making about $350 a month. I was also saving about $1,400 in taxes a year from depreciating the property, and I was paying down the mortgage by about $ $1,200 a year. In my first year I made:
Equity gain: $33,000
Cash Flow: $4,200
Debt paydown: $1,200
Tax savings: $1,400
I made more than 100 percent on my money. I would not make this every year because I got a great deal to begin with, but I would still make $6,800 a year based on these numbers, and they get better every year.
- The rents will go up (they were up to $1,500 a month 9 years later).
- The mortgage paydown increases over time (with every payment you pay less interest and more principal).
- The property can increase in value. I actually sold this property recently for $275,000 (these are not typical returns)!
I did not even mention the capital appreciation of the property. Because I used leverage to buy it, any increase in value is multiplied. If the property increased in value by 10%, it is now worth $143,000, not $130,000 because I used $30,000 in cash to buy it. That is an increase of 40% on my investment!
REITs are much easier to invest in than real estate. However, you can make much more money with real estate if you are willing to put in the time and effort to learn how to invest the right way. You cannot use leverage with REITs, can’t buy them below market value, and you do not have the same tax advantages of buying real estate directly. I am so happy I stopped investing in REITs and started buying rental properties directly.