Real estate investing is a common way of building wealth. If you’re a homeowner, then you’re a real estate investor. Investing in real estate has many benefits, but has a high barrier to entry for the novice investor. If you want to invest in real estate, you can do so in several different ways. The two most popular ways to invest in real estate are through buying physical real estate or investing in a Real Estate Investment Trust (REIT). So, which is better? Physical real estate or a REIT?
Real Estate Investment Trusts (REITs) give novice investors access to some of the benefits of investing in real estate without the high upfront capital requirement and learning curve. REITs enjoy many benefits over physical real estate, but established, experienced investors will consider physical real estate over REITs due to the ability to use leverage to compound their capital at higher rates.
Continue reading for a full comparison of REITs vs physical real estate and how you can use both to gain exposure to the real estate market at different phases of your investing career.
We invest in REITs like VNQ now in addition to treating our primary residence as an investment. We live-in-flipped our starter home and walked away with $32k in cash in 24-months. We then geoarbitraged from Washington to Texas to buy a much larger house to participate in one of the fastest-growing regions in the country.
What’s a REIT?
A Real Estate Investment Trust (REIT) is a company that owns and usually operates income-producing real estate. REIT's own real estate in many different sectors ranging from commercial to residential, hospitals, and storage facilities. For the purposes of our comparison, I will specifically be talking about Equity REITs.
Types of REITs:
Equity REITs: Equity REITs deal with physical real estate. They generate most of their income through rent collection. Equity REITs typically focus on a specific property type (apartments, office buildings, etc…)
Mortgage REITs: Mortgage REITs work by investing in property mortgages rather than physical properties. They generate most of their income through loan interest accrued.
Hybrid REITs: Hybrid REITs are a mix of the two other REIT types. They generate most of their income through a mix of rental income and loan interest.
REITs are considered a passthrough investment product meaning they must pass through 90% of the taxable income generated to the investors in the form of a dividend. This is great for generating an income that can be reinvested into the REIT.
How to Purchase a REIT
REITs are very similar to index funds that own company stock. It’s a basket of real estate companies that you’re investing in. Most REITs have a large number of holdings spread out across different sectors (commercial, residential, etc…)
REITs can be purchased through any major investment broker (Charles Schwab, Fidelity, Vanguard, etc…) and can be held in retirement accounts (401k, IRA, etc…)
REIT vs Physical Real Estate
REITs and physical real estate are two of the most common ways to gain exposure to the real estate market within an investment portfolio. They each have their merits and it’s ultimately up to your available investment capital, risk tolerance, and investment timeline on which investment strategy is right for you.
I’ve broken down each of the primary categories one should consider when determining if investing in a REIT or in physical real estate would be right for them.
Physical real estate has a higher minimum investment
Physical real estate ownership is a difficult market to enter compared to simply buying a REIT.
A downpayment of 20% is typically required when purchasing a home. With the median home value exceeding $260,000 in 2020, a 20% downpayment would be $52,000. That $52k would then give you access to earn returns based on the total loan value of $260,000.
A REIT on the other hand may have a small initial investment minimum. The admiral shares index fund equivalent of VNQ requires a $3,000 initial minimum, but ETF has no minimum and can be bought for the price of a single share. Giving investors access to a diversified real estate portfolio without the upfront costs.
When it comes to entering the market, REITs have the upper hand, but physical real estate reigns supreme in its ability to provide leveraged returns.
REITs are more passive
I’ve always heard real estate be called a “passive investment.” Setting up a property management company will improve its passiveness, it’s not nearly as passive as buying shares of stock.
Simply having to worry about the property takes away from its passive nature. Wondering if the tenants are damaging the property if a hail storm is going to damage the roof, etc. may be difficult for some people to deal with. Just as a stock investor needs to have a level of emotional stability with regards to their investments, so too should a real estate investor.
My VNQ shares are about as passive of an investment as I have found. I could go a decade without ever looking at the investment, or thinking about it at all. I simply buy more on a regular basis and plan to hold them forever.
The passive nature of REITs is great but comes at a cost. You’re not going to experience the level of ROI that you can experience with physical real estate.
Physical real estate has a higher ROI
According to Investopedia, “Average 20-year returns in residential real estate has an average ROI of 10.6%, commercial real estate has an average return on investment of 9.5%, and REITs have an average return of 11.8%.” Though this doesn’t tell the whole story.
With physical real estate, you have a triple benefit.
Home appreciation (property value increases)
Mortgage paydown (someone else is paying for you)
Free cash flow (when rent exceeds mortgage and costs)
Investing in physical real estate can build extreme wealth. You can quickly own a portfolio worth millions of dollars by only providing the down payments. The higher barrier to entry is rewarded with outsized investment returns and should be heavily weighed against all other real estate investing options.
Calculating your ROI of rental property requires more skill than simply looking at a 10-year chart like you can for a REIT. It includes cash-on-cash returns, monthly cash flow, cap rates, etc. which can take time and mentorship to understand. I highly recommend understanding these things prior to investing in physical real estate.
REITs are more liquid than physical real estate
Liquidity is defined as the availability of liquid assets (cash). How quickly can you take your investment from being a single-family home to cash? How quickly can you turn your REIT shares into cash?
A home is considered an illiquid investment. You can’t just sell a house and receive cash today. You must go through the selling process that typically takes 30-45 days after an offer on the house has been accepted.
A REIT on the other hand is considered a liquid investment. With a few clicks of your mouse, you can turn your real estate shares into cash. That cash can then be accessed or transferred to a different bank account relatively quickly. Usually within a few business days.
REITs and physical real estate are subject to different risks
Buying a single real estate property comes with a significant amount of risk. Including; market risk, geographical risk, risk of damage, liquidity risk, vacancy risk, and leverage (debt) risk. These risks can be mitigated and planned for, but they still exist and should be considered.
If you own just one rental property, it’s similar to investing in a single company on the stock market. All of your eggs are in just one basket and a large portion of your portfolio is dependent on the success of that one property.
By purchasing a REIT or an index fund, your investment is highly diversified. Not only across multiple companies but multiple sectors and geographies. REITs provide access to residential, commercial, government, land, etc. A simple individual investor like myself would never be able to build a diversified portfolio as you can get with a REIT.
REITs have their own risks to consider. Their performance can be directly affected by the overall market, or sectors within the market, and you're leaving your investment up to whoever is managing the investment fund. We all know that Mr. Market can be manic at times, and your REITs can be subject to the volatility of the market whereas physical real estate largely beats to its own drum.
REITs are more diversified than physical real estate
By investing in a REIT, you will have exposure and access to properties that you wouldn’t be investing in physical real estate. Unless you’re an accredited investor, it’s not likely that you’ll have an opportunity to invest in large-scale apartment complexes or commercial properties. Did you know you can actually be over-diversified?
Take self-storage units for example. In order to build a self-storage facility, you’ll likely need over $1 million just to build or buy the facility. This would typically be in the form of a loan, and the rental income will need to exceed the cost of the property (loan, upkeep, etc…)
The alternative is to purchase shares of a company like Public Storage (PSA). It is the largest brand of self-storage services in the US and operates as a REIT, owning many other self-storage companies across the country. It’s diversified across the self-storage sector, but more concentrated than a broad REIT like VNQ.
Investing in physical real estate is quite a bit different than investing in real estate through a REIT. I believe that in the early stages of your investment career, REITs can be a great way to gain exposure to the real estate market while you learn everything you can about investing in real estate. In the later stages of your investing career, it would be wise to purchase cash-flowing physical real estate to greatly increase your overall wealth.