REITs and residential properties are both in the real estate sector, but the similarities end there.
When investors invest in residential property, they often intend to flip the property within a few months, which can be very risky, tax-inefficient and will not yield long-term profits. Investing directly in real estate can also be done as long term investments where the individual investor manages the properties and receives rent and later capital gains when they sell properties for a profit.
Buying residential real estate directly tends to have more tax advantages than a REIT does. With a REIT, capital gains must be recognized each year. Directly investing in real estate also gives the individual investor the opportunity to raise the value of the property through their own efforts such as renovations and property improvements.
REIT’s are professionally managed and generally invest in commercial real estate, where investing decisions are thought over very carefully and the real estate property is bought with the intention to hold for several years to rent out to long-term tenants.
Individual investors can invest in REITs by purchasing shares either directly or through a mutual fund, similar to how one would invest in stocks. The advantages are that the investor can have a part ownership in a diversified portfolio of real estate projects while at the same time holding a liquid asset. Shares in a REIT can be bought and sold on the open market just like stocks. With a REIT, the investor also does not have to actively manage any properties.
REIT’s are businesses and are focused on creating profits for investors, and when they don’t perform they are not only losing their own money, but the capital of thousands of investors. As a result, REITs limit speculation and tend to invest in more stable properties with promising futures. Speculation is often left for the individual investor.
Although REITs are historically not very risky, they are not perfectly insulated investments. When the housing market weakens, consumer spending declines and business do not need to expand. When businesses do not need to expand, they will decrease their spending on office space, which will negatively affect REITs.
Another risk is being exposed to overbuilding, which drives down rents and hurts profitability. When too much space is bought with not enough tenants to rent, the low amount of rent may not cover mortgage payments and administration costs. This will considerably dip into profits. On the contrary, 100% occupancy could mean the REIT is not managing their rent rate appropriately and need to raise the rent.
There are advantages and disadvantages to investing in REITs and residential real estate. For someone who wants to have more control of their assets and work to improve their value, investing in residential real estate can be a good choice. For someone looking for a passive real estate investment, with the added benefits of portfolio diversification and liquidity, a REIT is a good option to consider.