A question that I get often is should I buy REIT or buy Directly my real estate? The answer is never simple as one vs the other. The reality, is that both can be a good and a bad investment, and depending on your situation, one might be better for you than the other. But first let’s explain what a is a REIT.
A Real Estate Investment Trust or REIT is an entity that owns, operates or finance real estate. Basically, a REIT is a company that is heavily invested in real estate, but some companies do only financing of Real Estate such as mortgages and still qualify as a REIT[i]. To qualify as a REIT in the USA, the corporation must:
- Invest at least 75% of its total assets in real estate, cash or U.S. Treasuries
- Receive at minimum 75% of its gross income from rents from real estate property, interest on mortgages financing real estate property or from sales of real estate
- Pay a minimum of 90% of its taxable income in the form of shareholder dividends each year
- Be an entity that is taxable as a corporation
- Be managed by a board of directors or trustees
- Have a minimum of 100 shareholders
- Have no more than 50% of its shares held by five or fewer individuals
So basically, a REIT is a corporation that has exposure to real estate and pays you a dividend. Normally those corporations trade on large stock exchange and therefore are a very liquid investments (meaning that it is easy to convert to cash). They also invest in various type of real estate, some do residential, shopping malls, office spaces and commercial real estate and some do only financing. There is also more “exotic” REITs that invest in towers for telecommunications, self-storage space, and much more. So, if you want exposure to a specific type of real estate you can easily achieve it. There is also REITs ETFs (Exchange traded funds). An ETF allows you to diversify your portfolio by purchasing a single stock and leave the real decisions as to which companies to own to the manager of the ETF. So, who should buy REITs on the stock exchange. People with smaller capital to invest can buy some REIT for as little as 2$ a share you can purchase ETF sometimes commission free (depending on your broker). So, if you do not have enough capital to purchase a single property this is good for you. Also, if you need to have a liquid asset, this is for you. Real estate is normally slow to sell. It can take months or years in some cases to sell. REITs are sold in a minute from the click of a mouse and they could also be a good investment if you do not have the time or the energy to manage properties pass looking at a balance sheet occasionally. It is also very easy to diversify your portfolio or gain access to property types that you will not have been able to purchase otherwise. The major drawback of the REITs is that you cannot leverage yourself to purchase lowering your return and you are fully dependent on someone else to manage your investment. Another drawback is that REITs follow, not exactly but closely, the general stock market such as the S&P500 or the Dow Jones Industrial Average. So, when you purchase them, you should be aware that they will be moving along side the stock market. So, if the stock market gains 20% your REITs will be gaining too, but if the stock market loses 20% your REITs will be losing too. Their value is also dependent on the interest rate. The higher the interest rate the lower the value of the REITs. There is 2 reason for this, the first reason a lot of people own REITs for income purpose so when the interest rate goes up you can find government bonds that have a similar yield. This makes people switch from REIT to bonds lowering the value of the REITs. The second reason is that high interest rate increases the expense of the company which reduce is profits and therefore what it can pay in dividend. In the end choosing a REIT is very similar to choosing any other stock from the stock market.
Now, let’s analyze direct ownership. The first and most important advantage is that you are in control of the investment. If you have time, energy and creativity, you will have great results far beating the general return of a REIT.
Table 1: REITS vs direct ownership vs direct ownership with leverage
The primary advantage of direct ownership is leverage, you can borrow money to purchase the property and leverage can magnify the return on your cash. Cash on Cash return is the best way to compare your REITs return with your direct ownership. Cash on Cash return is calculated by dividing the amount of return in dollar by the total amount of cash that you invested. Here is an example: A property that generated $10,000[ii] of positive cash flow for the year and that you purchase for $250,000 using a loan of $175,000 and $75,000 of your cash. Will give you a cash on cash return of 13.33% ($10,000/$75,000 X100). If you had purchased that same property all cash, you would have had a positive cash flow of $20,000 (10,000 positive cash flow + 10,000 for the mortgage that you do not have). You would have had a return of only 8% ($20,000/$250,000 x100). This is still a good return but not as good as when using the leverage. But using that same $250,000 cash to purchase a larger property or multiple properties you would have went back to the 13.3% return. Larger properties with more units normally produce a better return because of economy of scale. I also did not include paper return for this example. The fact that your property gained value and that the mortgage was paid down in the return is a gain for you. The reason for this is that to collect that money you need to either refinance or sell the property. If you own a REITs you pay all cash and get a return of around 7% so a direct ownership of real estate gives you twice the REITs when using leverage. Of course both your real estate and the REITs will gain in value over time and in both case you will have to sell them to reap the benefit of the gain.
This is where direct ownership
beats again REITs. You can refinance your direct ownership real estate and cash
in the equity or part of the equity without losing the assets. This gives you
flexibility and this is the best way to increase your real estate holdings. You
purchase, wait, refinance, and purchase a new property. By doing this over and
over you will build a great portfolio in a few years.
With direct ownership you are also in control of
the property. This means that you can do things to increase its value. Rentals
are generally appraised by the income they generate and/or by the value per
square foot of the average property in the area. For example, a property
producing $100,000 in free cash flow will be worth a lot more than one that
produces $10,000. So to increase the value of the property the easiest way is
to increase income. To increase income there are many things that can be done.
For example, you can raise rent, you can add washer and dryer in the unit, you
can remodel the apartment to attract wealthier tenants, you can make the
building non-smoking, etc., the point is that you can do something about it. If
you buy a REIT and the dividend payment doesn’t increase over the years you are
stuck with it. You can sell your REITs and buy another one that perform better
but you may now be overpaying for it and ended up with not the greatest
performance again. This is even more true if you purchase a deeply discounted
property that needs lots or major work. Purchasing this way will give you the
capacity to take a property that performs at 50% of capacity and turn it into a
great property performing at 100%. This is a great way to grow rapidly your
portfolio. This is not possible with REITs where you are dependent on the
management team and that you have no say into the decision making.
[ii] Return may vary, this is real return from investment property recommend to a customer