Investment strategies fall into two main categories: direct and indirect.
A direct investment means you own the asset outright and can take a hands-on approach to asset management. Some investors prefer direct investment because it gives them a greater level of control over their investment capital and potential returns. Indirect investments, on the other hand, mean you don’t actually own the asset, and you have no control over your investment capital or asset management.
Here’s a closer look at direct investments versus indirect investments, as well as some direct and indirect investment examples.
One of the most common direct investments is owning an income-producing rental property. Experienced real estate investors may be able to improve operations and realize increased cash flows by leveraging their expertise. Here’s an example: You purchase a Class-B duplex but transform the property into a Class-A property through significant interior and exterior upgrades and renovations. As a result, you can command an above-market rental rate for the asset. You’ll also have full control over lease terms and conditions and prospective tenants.
Other examples of direct investments in real estate include purchasing an equity stake in a commercial property, or providing funding for real estate development.
Two common examples of indirect investments include real estate investment trusts (REITs) and Delaware Statutory Trusts (DSTs). With a REIT, you buy shares in a company that manages a portfolio of real property assets. With a DST, you buy fractional shares of a trust that’s assembled and acquired a portfolio of commercial investment properties. In both instances, you don’t actually own any real estate – you either own stock or beneficial interests in a statutory trust.
Even though you don't own any real property in either scenario, you still share in the potential risks and returns associated with the assets under management or under trust.
Indirect investments allow you to pursue the potential benefits of real estate appreciation without committing a significant capital amount to one property, and without tying your assets to a smaller number of entities or exposing yourself to operational liabilities. Investment trusts or funds may provide flexibility if you want or need to sell, unlike real property, which may be challenging to liquidate at certain times. Exposure to shared risks can be managed based on your needs. Because there is a much lower entry point, investors can start smaller, spread their capital among funds, and pursue the potential benefits of property investment with a smaller stake. By law, REITs return 90% of taxable income to their participants, so dividends may be very attractive, particularly in a low interest rate environment.
What are Other Indirect Investment Alternatives Besides REITs?
In addition to REITs, if you prefer not to go all-in as a direct investor in real estate or opt for both paths, you can choose exchange-traded funds or ETFs focusing on real estate. Similarly, property-centric mutual funds favor real estate holdings but maintain the security and diversity of mutual fund investments.
Advantages of Direct Real Estate Investments
Direct real estate investments can offer some possible advantages, including tax benefits, strategic diversification, and the potential for capital accrual. Real estate operators and fund managers often charge upfront fees and disposition fees within indirect investments, which may allow direct investments a greater opportunity for realizing gains from appreciation when a property is sold. Direct investments may also provide losses that can offset income gains in other areas to help manage tax obligations. Depending on your investing style, risk appetite, and goals, both approaches may make sense.
As the property owner, you’ll still shoulder the out-of-pocket or operational costs, including property maintenance and any costs associated with renting it out. You may think of things like repairs, painting, landscaping, and so forth as the maintenance items. If the property is commercial rather than residential, the direct costs include utilities, janitorial, and other operating expenses. The costs of renting a residential property, meanwhile, include finding and qualifying tenants, advertising, conducting background and credit checks, and engaging legal assistance for lease agreements. Rental income is designed to provide cash flow, and rental expenses provide tax benefits that don’t come with indirect investments.
Putting it All Together
One clear advantage of direct investment in property is owner control. As the owner, you can determine the timeline for the disposition of the property, make improvements, set rental rate and lease conditions, and other key factors that can impact income generated from the asset. You also maintain sole responsibility for any ongoing and occasional costs associated with the property ownership, and you may find it difficult to liquidate the asset in adverse market conditions.
Indirect investing in real estate may dilute the impact of your experience and decision making on the performance of your investment, but you won’t have to deal with the many concerns that often come with direct investments.
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. It should also not be construed as advice meeting the particular investment needs of any investor.
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.