Direct Real Estate Investment vs REITs
Contents:
- REITs
- What Are REITs & How Do They Work?
- Advantages & Disadvantages
- Direct Real Estate Investments
- What Are They & How Do They Work?
- Advantages & Disadvantages
- Comparative Analysis
- Conclusion
REITs
- What Are REITs & How Do They Work?
Conceptually, REITs are known to be very similar to mutual funds. REITs or Real Estate Investment Trusts are companies that buy and manage large-income producing Commercial Real Estate (CRE) properties- such as office buildings, hospitals, shopping centers, etc. A REIT primarily allows the public to invest in these buildings, without having to actively own them. This simply means that you will be a shareholder and receive the dividend from the property you invest in, without having to buy, manage or operate- all of which will be taken care of by the REIT company. The public shareholders, or you, get the majority ownership in the stock, and the REIT company gets minority ownership. Simply put, upon investing, shareholders get 90% of the taxable income from the REIT as their dividend.
This idea of REITs was conceptualized by Congress in the United States, in the year 1960. Congress was looking to figure out a way that allows the public to invest in large income-producing commercial real estate, without actually buying it. SEBI introduced REITs in India in 2007 and is still the regulating authority for the same. India saw its first REIT- Embassy Office Parks REIT (a joint venture of US private equity firm Blackstone Group and Embassy Group), in March 2019.
The most common REITs are:
- Rental REITs (own and manage large regional malls, outlet centers, grocery-anchored shopping centers, and power centers that feature big-box retailers)
- Residential REITs (own and manage large apartments)
- Office REITs (own and manage different office buildings)
- Healthcare REITs (own and manage hospitals, nursing centers, medical office centers, retirement facilities, etc.)
- Mortgage REITs (invest in mortgages)
There is a lot more to understanding REITs as such, including how they essentially work, knowing its types, qualifications, investment method, tax treatment, etc. You may check out our blog on the same which gives a detailed and comprehensive analysis of everything you possibly need to know about REITs.
- Advantages of REITs
- Public gets a higher dividend:
By law, REITs have to pay 90% of their income back to the shareholders/investors- as an investor, REIT benefits you by getting you a higher dividend compared to the rest of the stock market/ other investment options.
- Income can be secured with the help of long-term leases:
Say you invest in a REIT that in turn invests in an office building that has an anchor tenant. It is most likely that this tenant has a 15-20 years’ long term lease contract, from which you can benefit off of. In other words, it guarantees you a steady and secure income in the long run.
- Liquidity:
Compared to direct investments, which we will be covering in this blog, REITs have lower liquidity risks. Since a considerable amount of the major REITs are publically listed, it allows you to buy and sell at will. This makes REIT a very liquid investment.
- Professional Management:
Imagine having to buy a Commercial Real Estate property, manage and operate it, do the accounting, and a hundred other things that come with holding a CRE property- all by yourself. Leaving it up to a REIT saves you all the trouble, without having to compromise on the benefits.
- Transparency:
The Securities and Exchange Board of India (SEBI) is the regulating body for all REIT activities in the country. Since it is overlooked by this well-renowned and trusted government agency, investing in a REIT promises transparency to the shareholder. This also means chances of occurrence of fraud are decreased to a large amount.
In the US, the Security Exchange Commission (SEC) is the regulatory body for REITs who have to turn in periodic disclosures of their performances.
- Not as capital intensive as direct investments in properties:
This is because REIT eliminates the need for the public to directly buy/own and manage the property. Besides, the dividends are often higher than you can achieve with other investments.
III. Disadvantages of REIT
- Lack of Diversification:
Let’s say you invest in a Healthcare REIT, in a hospital- if the hospital sector doesn’t do well then neither does your stock. Healthcare REITs only deal with hospitals, nursing homes, etc; if you invest in a Retail REIT, they only manage shopping centers, regional malls, etc. If one of those two sectors don’t perform well, then your stock doesn’t either. This lack of diversification proves as a disadvantage while considering investing in a REIT.
- Slow Growth:
What we learned as an advantage previously can also pose as a limitation. Since REITs have to give out 90% of their income to the shareholders, they are left with a mere 10% to re-invest to buy new holdings/ for their core product line.
- Tax Treatment:
Another downside to investing in a REIT is that your dividend is taxed as your regular income. So if you are a high paying person investing in a REIT, you will be paying a lot of taxes.
- Losses don’t pass to investors:
One of the biggest reasons to invest in Commercial Estate is because of all the tax benefits, as an investor you get write-offs. Although in this case, those write-offs are trapped into a REIT, making it another disadvantage while investing.
These are the various pros and cons you must consider while investing in a REIT.
Direct Real Estate Investments
- What Are They & How Do They Work?
When an individual directly buys a property or a stake in one, such as a residential complex or a shopping mall, then this investment is called a Direct Real Estate Investment.
As opposed to REITs, you will have to manage the several duties that come with owning the property yourself.
Sources of Income for Direct Real Estate Investors:
- Rent
- Appreciation
- Profits gained from any business activity regarding your real estate property.
- Advantages of Direct Real Estate Investments
- Substantial Cash Flow
Direct investments derive substantial and regular cash flow via rental income. Since rent is procured periodically, you have a scheduled flow of cash guaranteed as your income.
- Tax Breaks
Direct investments pay the way for tax breaks to offset your income. You can deduct the costs that go towards managing and maintaining your property. You can also reduce your taxable income through depreciation where you deduct the purchasing and the development costs of your property.
- Appreciation
Appreciation is the increase in the value of an asset with time. One of the major perks of direct investment is the income gained from the appreciation of the property purchased. Even though prices in the real estate market are subject to fluctuation, they generally increase over time which means you will be able to sell the property at a higher price as compared to the original buying price.
- More Control Over Your Property
You have more control over your property through direct investments as opposed to investing in REITs, where management is taken care of. You get to choose what kind of property you want to own, how many properties to buy, the tenants, etc.
- Disadvantages of Direct Real Estate Investments
- Time- Consuming
The pro of having more control over your property also becomes a con. With direct real estate investments, you are personally responsible for the management, maintenance, and development of your property. This is an extremely strenuous task that involves juggling several things at the same time, and ends up becoming severely time-consuming as opposed to investments made in REITs.
- Financing
You will mostly have to take on a mortgage or turn to other financing options to fund the purchase/management of your property. If the market does not perform well, you may struggle to pay back the loans or find good tenants.
- Illiquid
This means that you can’t easily sell your property in times of emergencies.
- Comparative Analysis
- Direct Investments ensure that you have better control over your property. REITs do the management for you, this way your time and energy aren’t consumed in the maintenance and the development of your property.
- REITs are liquid investments, direct investments are not.
- Direct Investments pave the way for diversification of purchases whereas REITs don’t.
- You have better tax advantages with direct investments as opposed to investments in REITs, where your dividend gets taxed as your regular income making you spend a lot on taxes as such.
- Overall, direct real estate investment is a wiser choice if you want a good flow of cash and tax advantages, whereas REITs are a good way to build experience or begin your real estate investment journey, without having to look too much into the management.
- Conclusion
In this blog, we analyzed the underlying differences between Direct Real Estate Investments and REITs, by laying out the advantages and disadvantages of both.
We started off by understanding what REITs are, sources of income upon investing in REITS, and then moved on to see the various pros and cons of the same. Following this, we used the same approach to analyze direct investments as well.
Lastly, we laid out a basic comparative analysis between these two types of real estate investments.