Landlord vs. REITs: Pros and Cons (2024)

FAQs

Landlord vs. REITs: Pros and Cons? ›

Perhaps the biggest advantage of buying REIT shares rather than rental properties is simplicity. REIT investing allows for sharing in value appreciation and rental income without being involved in the hassle of actually buying, managing and selling property. Diversification is another benefit.

Perhaps the biggest advantage of buying REIT shares rather than rental properties is simplicity. REIT investing allows for sharing in value appreciation and rental income without being involved in the hassle of actually buying, managing and selling property. Diversification is another benefit.

Passive. 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 can be a good choice because: Buying and selling REIT shares is easier than it is with a physical property. They obviate the need for market-specific knowledge and property management while making it easier to diversify your real estate portfolio.

REITs enjoy better access to capital because they are publicly listed companies. This allows them to grow faster by raising additional capital to buy additional properties when their cost of capital is below their expected returns, resulting in a positive spread.

2% Rule. The 2% rule is the same as the 1% rule – it just uses a different number. The 2% rule states that the monthly rent for an investment property should be equal to or no less than 2% of the purchase price. Here's an example of the 2% rule for a home with the purchase price of $150,000: $150,000 x 0.02 = $3,000.

REITs are diversified, conservatively financed, liquid, professionally managed, and offer limited liability. Rentals are concentrated, heavily leveraged, illiquid, management intensive, and put you at liability risk. REITs are not only safer, but they are also more rewarding in the long run.

The potential downsides of a REIT investment include taxes, fees, and market volatility due to interest rate movements or trends in the real estate market. REITs tend to specialize in specific property types.

Summary of Why Investors May Not Want to Invest in REITs

But, REITs are not risk free. They may have highly variable returns, are sensitive to changes in interest rates, have income tax implications, may not be liquid, and fees can impact total returns.

Are REITs safer than real estate? ›

Publicly traded REITs offer investors a way to add real estate to an investment portfolio and earn an attractive dividend. Publicly traded REITs are a safer play than their non-exchange counterparts, but there are still risks.

The average REIT outperformance total return spread was 31.3%. REITs outperformed private real estate in nine of 11 instances, or 81.8% of the time. REIT recoveries have tended to be stronger with more extreme divergences.

Can You Lose Money on a REIT? As with any investment, there is always a risk of loss. Publicly traded REITs have the particular risk of losing value as interest rates rise, which typically sends investment capital into bonds.

By law and IRS regulation, REITs must pay out 90% or more of their taxable profits to shareholders in the form of dividends. REIT investors who receive these dividends are taxed as if they are ordinary income. Plus, whether REITs are public or private, they must pay out the standard 90% of their income.

REITs—or real estate investment trusts—are corporations that act like mutual funds for real estate investing. You can invest in a REIT without having to own or manage any property yourself. Alternatively, you can go the direct real estate investing route and buy residential or commercial properties.

Like many rules of real estate investing, the 50 percent rule isn't always accurate, but it can be a helpful way to estimate expenses for rental property. To use it, an investor takes the property's gross rent and multiplies it by 50 percent, providing the estimated monthly operating expenses. That sounds easy, right?

The 80% rule means that an insurer will only fully cover the cost of damage to a house if the owner has purchased insurance coverage equal to at least 80% of the house's total replacement value.

The 70% rule can help flippers when they're scouring real estate listings for potential investment opportunities. Basically, the rule says real estate investors should pay no more than 70% of a property's after-repair value (ARV) minus the cost of the repairs necessary to renovate the home.

Are REITs more risky than stocks? ›

Because of their lower volatility, REIT returns are less correlated to the stock market. That makes REITs an excellent way for investors to build a diversified portfolio and improve their risk and return profile.

In general, no. Although investing in REITs does carry risk, data suggests that REITs are less risky than stocks both in the short term and in the long term.

As interest rates rise, they can depress the price of these REITs. So while dividends may climb with interest rates, the price of publicly-traded REITs may decline. Historically, REITs are one of the better-performing sectors during inflationary periods.

A REIT is not a fixed income investment. A rise in interest rates can reduce the value of the units, as investors can then choose other more profitable investments. A trust's income may also decrease if it needs to renegotiate mortgage debts at higher rates.

Real Estate Investment Trusts, vehicles that pay out most profits as dividends, are better positioned to weather high interest rates and recession fears than private equity real estate or stocks, according to analysts at Bank of America and CenterSquare Investment Management.

Penalties - Imposition of Tax for Failure to Meet the 95–percent or 75–percent Gross Income Tests. If a REIT fails to meet the 95-percent or 75-percent gross income tests but meets the requirements set forth in IRC § 856(c)(6) , the REIT does not lose its REIT status but instead pays the tax imposed by IRC § 857(b)(5) ...

Generally speaking, any distributed operating profit is considered to be an ordinary dividend. This is important for REIT taxation. For the most part, REIT dividends don't meet the definition of a "qualified" dividend, which is taxed as a capital gain.

Two of the primary factors contributing to the recent underperformance of REITs are the rising interest rates and the recent bank failures. However, the fundamentals of many of these REITs remain strong. Their performance is tied more to stock market fears than the actual performance of the real estate market.

The credit ratings agency predicts that recessionary conditions, higher capital costs, and waning demand in some sectors will keep REITs from outperforming in 2023.

The majority of REIT dividends are taxed as ordinary income up to the maximum rate of 37% (returning to 39.6% in 2026), plus a separate 3.8% surtax on investment income. Taxpayers may also generally deduct 20% of the combined qualified business income amount which includes Qualified REIT Dividends through Dec.

What is the 5 or fewer rule for REITs? ›

A REIT will be closely held if more than 50 percent of the value of its outstanding stock is owned directly or indirectly by or for five or fewer individuals at any point during the last half of the taxable year. This is commonly referred to as the 5/50 Test.

When you buy shares of a REIT, you own a perpetual stake in an expanding real estate operation that hopefully pays steadily rising dividends as it grows in value over time. Bonds are a fixed-income asset that is lower risk due to its preferred position in the capital stack.

After looking at correlation patterns and historical data, it appears that returns from REITs vary during different interest rate periods, but for the most part have shown a positive correlation during increasing interest rates.

REITs offer investors several benefits that make them an ideal fit in any investment portfolio. These include competitive long-term performance, attractive income, liquidity, transparency, and diversification.

In order to meet the 95% test, at least 95% of a REIT's gross income must be derived from sources described in the 75% test as well as from earnings from certain types of portfolio income such as interest, dividends and gains from sales of securities.

To qualify as a REIT, a company must have the bulk of its assets and income connected to real estate investment and must distribute at least 90 percent of its taxable income to shareholders annually in the form of dividends.

The 75 percent test is comprised solely of real estate income. At least 75 percent of a REIT's gross income must be derived from rents from real property, interest on obligations secured by mortgages on real property, dividends from other REITs, and gain from the sale or other disposition of real property.

Private REITs may have an investment minimum, and that typically runs from $1,000 to $25,000, according to NAREIT, the National Association of Real Estate Investment Trusts. Risk: Private REITs are often very illiquid, meaning it can be difficult to access your money when you need it.

“I recommend REITs within a managed portfolio,” Devine said, noting that most investors should limit their REIT exposure to between 2 percent and 5 percent of their overall portfolio. Here again, a financial professional can help you determine what percentage of your portfolio you should allocate toward REITs, if any.

The Cheapest Option: REITs—$1,000 to $25,000 or more

These are securities and are traded on major exchanges like stocks. They invest in real estate directly, either through property purchases or through mortgage investments. Many REITs specialize in a particular type of real estate or a specific region.

What is the 30% rule for REIT? ›

Any accumulated expenditures made through the REIT, during the two-year duration, may not exceed 30% percent of the property's net sale price.

A REIT must have at least 100 shareholders (the “100 shareholder test”) for at least 335 days of a 12-month taxable year or during a proportionate part of a taxable year that is less than 12 months. The days need not be consecutive. This requirement does not apply until the REIT's second taxable year.

REITs tend to offer a good yield over and above high-quality bonds and most equities, so they are of particular interest to income seekers, though the combination of income and rental growth can be attractive to all investors.

Since the value of a mortgage bond trades inversely to interest rates (higher rates cause mortgage bond values to decline), higher rates will mean that the NAV of a mortgage REIT will decline and often take the share price with it.

If you look at the chart, on a total return basis, the S&P 500 beat the VNQ index, five out of the seven years. And again, on an overall basis, the S&P 500 dramatically beat REITs, using VNQ as our proxy.

Just like the cap rate, a good cash on cash return will also depend on several factors, including the location of the property, your rental strategy, and how the market performs. Most real estate experts would agree that a cash on cash return of between 8% and 12% is a good range.

The amount will depend on your specific situation, but a good rule of thumb is to aim for at least 10% profit after all expenses and taxes. While 10% is a good target, you may be able to make more depending on the property and the rental market.

Investors probably need no explanation why and convincing that Florida tops the list of the best states for the long term rental investment strategy. Our nationwide rental market analysis shows that, on average, you can expect the highest rate of return in the Sunshine State.

What are the cons of investing in a REIT? Here are some of the main disadvantages of investing in a REIT. Market volatility: Value can fluctuate based on economic and market conditions. Interest rate risk: Changes in interest rates can affect the value of a REIT.

Why don't people invest in REITs? ›

Summary of Why Investors May Not Want to Invest in REITs

But, REITs are not risk free. They may have highly variable returns, are sensitive to changes in interest rates, have income tax implications, may not be liquid, and fees can impact total returns.

Can You Lose Money on a REIT? As with any investment, there is always a risk of loss. Publicly traded REITs have the particular risk of losing value as interest rates rise, which typically sends investment capital into bonds.

Overview. A REIT is taxable as a regular corporation, but is entitled to the dividends paid deduction. Therefore, a REIT does not pay federal income tax on net taxable income distributed as deductible dividends to shareholders. Net income from foreclosure property is taxed at 35 percent.

REITs do not grow too much in value. This is because they are mostly structured as pass-through entities. About 90% of the rental income that the REITs earn from these properties is paid out to the investors as a dividend. A mere 10% is retained and that too, for emergency purposes and administrative expenses.

The FTSE Nareit All Equity index, consisting of REITs that exclude mortgages, generated a 15.9% annualized return during recessions and 22.7% in the year following the end of a downturn, according to the National Association of Real Estate Investment Trusts.

Direct real estate offers more tax breaks than REIT investments, and gives investors more control over decision making. Many REITs are publicly traded on exchanges, so they're easier to buy and sell than traditional real estate.