Adding real estate to your investment portfolio can be a smart way to diversify, boost returns and even hedge against the risk of inflation. When it comes to choosing how you’ll invest in real estate, though, there are a few options to choose from. Two of the most common real estate investment routes include rental property and real estate investment trusts (REITs). But what do each of these investment vehicles offer for you and your portfolio? And between REITs and rental property, which is the better choice?
Investing in real estate can be an especially smart move if you work with a financial advisor to chose the specific type of real estate asset that best fits your risk profile, timeline and goals.
REIT vs. Rental Property
Before you can decide which real estate investment is best for your investment portfolio, you need to first understand how each one works.
Rental property
Most people are already familiar with the premise of rental property. Investors can purchase and then rent out residential property, such as a single- or multi-family home, condominium or apartment building. Ideally, this property will bring in more rent each month than the investor pays in mortgage, taxes, insurance, repairs and other expenses. Any delta provides the investor with a monthly cash flow profit, which they can save or reinvest into the property. The hope is that over time or following a renovation the rental property will appreciate in value. If and when the investor chooses to sell the rental property, it will prove to have been a source of long-term growth.
Real estate investment trust (REIT)
A REIT, or real estate investment trust, works a bit differently. With a REIT, you are purchasing shares of a trust that owns and manages real property. As an investor, you yourself have no say in the property held by a REIT, nor will you have any input or responsibility in its management. As the assets in the REIT appreciate and turn a profit, investors are provided with dividends. If an investor ever needs to liquidate his REIT shares, he can do so at then-current market value. REITs can be publicly traded, privately traded or public non-traded in nature. Each operates a bit differently with its own investment requirements and fund accessibility.
REIT and Rental Property Similarities
In many ways, investing in rental property and investing in REITs is similar, if not the same. Here are some ways that the two options overlap.
Cash flow
If you’re looking for an investment that provides you with a source of cash flow, both REITs and rental property can fit the bill. Per the IRS, REITs must distribute at least 90% of their taxable income to investors in the form of dividends. For this reason, REITs are generally a reliable source of this passive income stream. Under the right circumstances, a rental property can also provide you with a monthly cash flow. However, this hinges on factors such as market rental prices, property taxes, vacancies and even repairs.
Capital appreciation
Rental property and REITs both make strong long-term investments for many investors, as they may each offer strong growth and asset appreciation. If and when these assets appreciate, it can result in an increased cash flow for investors on a regular basis. Once the assets are sold later on, the investor will also recognize any growth in value.
Volatility
Another similarity between REITs and rental property is that both have the potential to be volatile and can fluctuate in value over time. If a REIT recognizes a reduced profit margin – either due to increased expenses or market trends – investors will likely see the effects through lower dividend payouts. This decreased cash flow can impact your budget and financial efforts elsewhere. REIT volatility can also be an issue if you need to liquidate your portfolio. If your REIT has dropped in price since you purchased, you will feel the effects when you go to sell the investment.
Rental property is susceptible to a number of dangers, including volatility, bad tenants and falling property values. Rental prices can fluctuate along with the rest of the real estate market; this can lead to lower rent prices and even extended vacancies. Volatility can also be caused by increased property taxes or unexpected major repairs, which are the responsibility of the owner-investor.
Both offer diversification
Investing in real estate can help diversify your investment portfolio, better securing your savings and helping to soften the blow of factors like market downturns and inflation. Both rental property and REITs work to diversify your portfolio, adding real estate investments to the mix. The more varied these investments are, the better buffered your portfolio may be: this may mean investing in a wide variety of REITs or purchasing multiple types of investment property, or in multiple areas.
REIT and Rental Property Differences
There are quite a few differences between rental property and REITs, which are important to understand if you want to make an informed investment decision.
Tax breaks for direct ownership
Property owners can take advantage of many IRS tax deductions related to their investment property. These include writing off things like mortgage interest, property taxes, repairs, management and other expenses. REITs do not offer these sorts of tax deductions for investors.
Control and flexibility
Whether you want to pick the next set of tenants or just pick paint colors, you don’t have much (or really, any) control over your investment with a REIT. If you want to play a hands-on role in your investment, you’ll need to opt for rental property.
Ability to use as collateral
If you have a rental property, you may be able to borrow against a portion of its equity (or the value that you own) as needed. This can be done through an equity loan or home equity line of credit, also known as a HELOC.
Active vs. passive investments
One very important difference to consider is that rental property is an active investment, while REITs are a passive investment. Rental property requires a hands-on approach and constant attention, even if you hire a management company to make most of the day-to-day decisions. REITs, on the other hand, give investors a sort of “set it and forget it” approach. Once you’ve purchased shares of your REIT, there’s nothing else you’re required to do besides receive dividend payments and watch your asset(s) grow.
Liquidity
If you ever need to liquidate your investments, REITs may prove to be a bit easier than rental property. In order to liquidate a rental property, you will generally need to sell it. This can take time, energy and money, between preparing and listing the house, showing the property and then closing on a sale. Start to finish, it could easily take you months to liquidate a rental property asset. With REITs, however, it may be as simple as clicking a button on your brokerage’s app. If you own publicly traded REITs, they can be sold in minutes (if not seconds), as long as a buyer is available.
Upfront costs and investments
Rental property can be many things for investors, but cheap on the front end isn’t usually one of them. In order to purchase a rental property, investors will need to have at least the down payment, earnest money and closing costs available. If renovations are needed, the investor will either need to provide cash or take out a loan.
With REITs, you can often get started investing with just a few dollars. While there are REITs (especially privately traded or public non-traded ones) with high investment minimum requirements, many other REITs are available on everyday brokerage platforms with no minimum investment.
The Bottom Line
Do you prefer a hands-off approach? Then look into adding REITs to your portfolio. Are you looking for an investment that offers tax benefits and more hands-on control? Then rental property is worth a look. For some investors, purchasing rental property and buying shares of REITs can be the perfect happy medium. After all, the better diversified your investment portfolio is today, the better protected you’ll be for whatever the future markets hold. The right choice depends on an investor’s goals and investment style; in some cases, adding both REITs and rental property could be the answer.
Tips on Investing
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Consider working with a financial advisor as you consider ways to add real estate assets to your portfolio. Finding a financial advisor doesn’t have to be hard. SmartAsset’s matching tool can connect you with several in your area within minutes. If you’re ready, get started now.
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As an investor, finding the right risk tolerance for your portfolio is vital. Bonds can help you find the perfect balance you are looking for in your investments. But navigating how much to put where comes with its challenges. SmartAsset offers an asset allocation calculator that can help you determine the right distribution for your desired risk tolerance.
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