Direct Real Estate Investing vs. REITs: The Actual Differences
Diversification has become a widely adopted strategy with many investment strategies and types available, with investors spreading their money across different asset types to minimize risk.
This has led to many investors looking outside the traditional stock and bond investments and into other industries such as real estate, which has led to real estate investments being positioned as the fourth major investment asset behind cash, equities, and bonds.
But what has led to the sudden increase in real estate investments? One of the driving factors has been the reduced upfront capital needed for investors to get involved in the real estate industry.
This article will primarily discuss indirect investment strategies such as ETFs and REITs. Still, first, we will explain the different types of investment options and why indirect investing may be the future in real estate.
Different Types of Real Estate Investments
Before you can begin investing in real estate, you must understand the different ways you can invest in the industry. The primary ways that we will discuss fall into two categories, either direct or indirect investing.
Direct investing
Direct investing in real estate refers to when an investor buys a property with the intent of renting it out or flipping it for a profit. In this type of investment, the investor is directly involved in the management and day-to-day operations of the property.
Pros:
- Potential for higher returns as investors have more control over the property and can decide how to maximize profits.
- Investors can use their knowledge and expertise to manage properties.
Cons:
- Direct investing requires significant upfront capital. Usually $50K+.
- Time commitment required. Investors must be available to deal with tenants/problems, etc.
Indirect investing
Indirect investing in real estate is when an investor puts their money into a real estate investment trust (REIT) or exchange-traded fund (ETF) that owns and manages a portfolio of properties.
Pros:
- Requires significantly less capital to get started. Typically ~$1000.
- No time commitment is needed. Investors can simply buy and hold the investment.
Cons:
- Returns are typically lower than those achieved through direct investing.
- REITs and ETFs can be more volatile than direct investments due to wider market fluctuations.
While direct investing does bring higher returns and yields, the barriers to entry far exceed that for indirect investing. Here, we’ll look at how you can get started with indirect investing by understanding the two primary investment types, REITs and ETFs.
What is a REIT?
REIT stands for Real Estate Investment Trust, and it is a company that owns, operates, or manages income-producing real estate. REITs are created when a group of investors pools their money together to purchase a property or multiple properties. The goal is to have the REIT own and manage these assets to generate consistent profits from rent payments and capital appreciation.
There are two types of REIT structures: publicly traded and non-traded. Publicly traded REITs are listed on stock exchanges such as the NYSE or NASDAQ and can be bought and sold just like any other stock. Non-traded REITs, on the other hand, are not listed on exchanges and are instead sold through private placements to accredited investors.
Pros of REITs:
There are many advantages to investing in REITs compared to traditional real estate investing. These include the following:
- Diversification. REITs expose investors to a wide range of real estate markets and property types.
- Liquidity. REITs are highly liquid, meaning they can be bought and sold quickly and easily.
- Stability. Real estate is a stable asset class that has historically shown low correlation with other asset classes, making it a good hedge against market volatility.
Cons of REITs:
While there are many advantages to investing in REITS, there are also some drawbacks you should be aware of:
- Fees. Many REITs charge high fees, which can eat into your profits.
- Management Quality. Not all management teams are created equal, and some may be better at managing properties than others. We wish it wasn’t a toss-up, but it kind of is.
What is an ETF?
ETF stands for Exchange Traded Fund, and it is a type of investment fund that holds a basket of assets (usually stocks, but can also hold bonds, commodities, or real estate) that can be traded on a stock exchange.
ETFs have become increasingly popular in recent years as they offer investors a way to get exposure to various asset classes without having to purchase individual securities.
There are two types of ETF structures: open-end funds and closed-end funds. Open-end ETFs are the most common type and are structured similarly to mutual funds in that new shares can be created (and redeemed) by the fund at any time. On the other hand, closed-end funds have a fixed number of shares that are not redeemable once issued.
ETFs can be bought and sold just like stocks through a broker or online trading account. However, unlike the stock market, ETFs in the real estate industry tend to remain more stable and consistent.
Pros:
ETFs have numerous advantages over both mutual funds and individual stocks. These include the following:
- Diversification: ETFs expose investors to a basket of assets, which reduces risk.
- Ease of Use: ETFs can be bought and sold like stocks through a broker or online trading account.
- Lower Fees: ETFs typically have lower fees than mutual funds.
- Tax Efficiency: ETFs are more tax-efficient than mutual funds, meaning they generate fewer capital gains taxes.
Cons:
While ETFs do have plenty of benefits, there are some disadvantages to them. These include:
- Limited Selection. There are a limited number of ETFs available compared to the number of mutual funds.
- Trading Costs. When buying or selling ETFs you will incur trading costs, which can add up over time.
- Lower returns. If you are a direct real estate investor, you have the potential for higher returns than if holding ETFs.
Comparing REITs and ETFs
Now that you understand the basics of REITs and ETFs, let’s compare the two.
When it comes to diversification, both REITs and ETFs offer investors exposure to various real estate markets and property types. However, REITs generally have a broader reach than ETFs as they can own properties in foreign countries and domestic ones.
ETFs are more liquid than REITs, meaning you can buy and sell them more easily. However, because of their liquidity, ETF prices can be more volatile than REITs.
As for fees, both REITs and ETFs charge high management fees relative to other investments such as mutual funds and individual stocks.
When it comes to returns, direct real estate investors have the potential for higher returns than if holding ETFs. However, this depends on the individual’s investment strategy and market conditions.
Overall, REITs and ETFs are good options for investing in real estate. Which one you choose will depend on your specific goals and needs.
Summary
Traditional real estate investing has high barriers to entry. Due to this, real estate was primarily for the wealthy, and we all know the rich get richer. So, how does a person get started? Seems like a chicken-and-egg issue.
Now with the advent of REITs and ETFs, real estate investing is now open to basically everyone. These investment vehicles offer investors a way to get exposure to various property types and markets without having to purchase individual securities.
REITs are best suited for broad diversification, while ETFs are more suitable for those who want liquidity and lower fees. Direct real estate investing may provide higher returns but comes with more risk.
Each investor should carefully consider their goals and needs before making any investment decisions.
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