Investors may acquire real estate in the pursuit of income and capital appreciation. In addition, real estate may offer the opportunity to earn revenue through rent paid by tenants and increases in the asset's value. However, some investors may prefer not to be actively involved with the day-to-day responsibilities that direct ownership requires. Those individuals may instead pursue the potential benefits of real estate by investing in a Real Estate Investment Trust or REIT.
Many investors firmly believe in the value and advantages of real estate. However, like any venture, real estate offers opportunities and risks. That remains true whether one participates via direct purchases of assets or through fractional ownership of a REIT. Which approach is appropriate for any individual depends on that person's circumstances, risk appetite, and goals.
Advantages and Disadvantages of Direct Real Estate Ownership
Buying real estate can potentially provide income and add to the accrual of wealth. Suppose that you buy a house to live in. Later, you decide to move into another place, but instead of selling the first house, you keep it and rent it to someone else. This act is one of the most common entry points into property management and real estate investing.
As a landlord, you can earn income from the rent that the tenant pays you to live in the home. You may also enjoy tax benefits due to the expenses that accompany your ownership. The house is possibly increasing in value as you own it, which is expanding your accumulated wealth. These are clear advantages, but what's the downside? The downside is that when the sink backs up over the weekend, the tenant will call you for help. Or when the tenant leaves, and you discover damage to the house that you must repair before renting to a new tenant. There is much responsibility associated with being a landlord.
Perhaps you decide to increase the scope of your investments, and you buy an entire apartment building with an onsite manager to handle these issues. Or you invest in a retail center where the tenants don't live in the units; they just conduct business there during set hours. Those changes may cut down the number of late-night calls, but ultimately you are still responsible when something goes wrong on your property. If you have a mortgage, you must also keep track of the payments, taxes, interest rate, and value fluctuations to ensure that you are always on top of the investment.
Suppose that you need to sell your property quickly, for some reason—real estate is an illiquid investment. That just means that you may not be able to find a buyer as soon as you would like (sometimes you can, but there is no certainty) at the price you want.
Advantages and Disadvantages of Choosing a REIT for Investment
Real Estate Investment Trusts pool funds invested by multiple shareholders to purchase real estate or related assets. In many cases, these trusts invest in and operate commercial property that the individual shareholders might not be able to access individually. There are equity REITs, mortgage REITs, and hybrids. Any REIT must have at least 100 shareholders (although they can have many more) but cannot allow a concentration of more than 50% of the ownership to be held by any five or fewer investors.
Equity REITs purchase and operate property in pursuit of income. For example, the REIT might own multi-family housing, office buildings, hotels and restaurants, shopping centers, industrial facilities, or other types of assets, including farmland.
Mortgage REITs earn income by owning mortgages and other real estate financing vehicles like mortgage-backed securities. Hybrids participate in both property and financing. For the REIT to qualify as one, 75% of its assets must be in real estate or related, and 75% of its income must derive from those endeavors. In addition, the REIT must distribute 90% of its taxable income to the shareholders to maintain its status.
Among the potential advantages to investors are the passivity of the income and the liquidity of the participation. Most REITs are traded on public exchanges (although some are traded privately), so shareholders can typically sell as needed and always know their share values. In addition, with passive participation, participants do not have to be concerned about dealing with tenants, repairs, or vacancies.
On the other hand, REITs have management fees that may reduce the potential profit to the investor, and participants can’t control the decisions that the sponsor and trustees make. REITs may also gain or lose value in response to market forces, and shareholders can’t influence those changes.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. The actual amount and timing of distributions paid by programs is not guaranteed and may vary. There is no guarantee that investors will receive distributions or a return of their capital. These programs can give no assurance that it will be able to pay or maintain distributions, or that distributions will increase over time. Programs that depend on tenants for their revenue may suffer adverse consequences as a result of any financial difficulties, bankruptcy or insolvency of their tenants. All real estate investments have the potential to lose value during the life of the investment. All financed real estate investments have the potential for foreclosure. The income stream and depreciation schedule for any investment property may affect the property owner's income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities. A REIT is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages. REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of investing in real estate. There are risks associated with these types of investments and include but are not limited to the following: Typically no secondary market exists for the security listed above. Potential difficulty discerning between routine interest payments and principal repayment. Redemption price of a REIT may be worth more or less than the original price paid. Value of the shares in the trust will fluctuate with the portfolio of underlying real estate. There is no guarantee you will receive any income. Involves risks such as refinancing in the real estate industry, interest rates, availability of mortgage funds, operating expenses, cost of insurance, lease terminations, potential economic and regulatory changes. This is neither an offer to sell nor a solicitation or an offer to buy the securities described herein. The offering is made only by the Prospectus.
