Many Americans are so enamored with homeownership that they might forget there are other real estate investment options — possibly better ones.
Owning a home provides shelter, appreciation potential, tax deductions and other benefits. Other real estate choices expand on most of that, except that they don't provide a roof over your head.
Rental properties are one possibility, and so are REITs or real estate investment trusts, along with real estate funds. Diversification, profit potential and other benefits are available with these choices, though the specifics vary.
Homeownership can be a sound choice, but with interest rates elevated and many property values up sharply, it's an unaffordable and even worrisome option for some potential buyers, said Jeremy Pagan, a real estate analyst at researcher Morningstar.com. "It can be scary to dip your feet in the water of homeownership," he said.
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NAREIT, the National Association of Real Estate Investment Trusts, describes owner-occupied homes as more of a consumption good than an investment because these dwellings don't produce income yet require owners to meet a slew of ongoing expenses. Not everyone would agree entirely with that description, but rental properties, REITs and real estate funds clearly are investments. Here's how they compare:
Time, effort and control
If you don’t mind getting your hands dirty, owning rental homes directly can be a good way to go. Not that you literally need to unclog toilets or paint scuffed up walls, but you at least should be able to oversee workers doing those tasks. Unless you hire a property manager, you also should expect to deal with tenants, from handling lease applications to collecting rent.
REITs are companies that manage their own property portfolios. REITs trade in the stock market, so anyone buying shares doesn't need to get involved in the property management process. Real estate funds are even further removed from all that and instead buy REIT shares along with the stock of homebuilders, construction companies, and so on.
A new study authored by Pagan at Morningstar suggests rental properties could be good choices for retirees, some self-employed individuals and others with the time, expertise and willingness to oversee properties directly. In contrast, busy professionals might favor REITs or funds, for which much less oversight is needed.
Risk and diversification
Owning a single rental home provides little diversification, as you’d own one type of property in a single geographic location. You can expand on that by owning multiple rentals, preferably spread among different areas. The risk-reducing benefits of diversification ramp up greatly through REITs and real estate funds.
But while a single REIT might own hundreds of properties, they often concentrate in a single industry, whether it’s apartment complexes, office buildings, industrial parks, hospitals or whatever. A REIT thus won't have as much diversification as a real estate fund with stakes in various types of businesses. Some real estate funds even go global with investments in foreign nations.
Many REITs have generated returns over the long haul matching or exceeding those of the broad stock market, but they occasionally get clobbered, too, as happened in 2022 amid rising interest rates. For example, REITs holding industrial, residential and self-storage properties all were down more than 25% on average for the year, according to NAREIT. Office REITs suffered even more, with an average loss of nearly 38%, as the work-from-home trend emptied many buildings.
Tax benefits of real estate investment
Real estate taxation is a complex topic unto itself and rental properties are treated significantly different from REITs and real estate funds.
With rental properties, owners may deduct a range of expenses including repairs, property taxes, mortgage interest, insurance, management fees, depreciation and travel costs to and from the property. If rental income exceeds your costs, you pay taxes on the difference. When you sell a property, you would face taxes on any profit, and depreciation taken over the years must be recaptured, meaning taxes would apply on those amounts. The Internal Revenue Service describes the many tax details of rental properties in IRS Publication 527.
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As an investor in a REIT or real estate fund, you wouldn't deal with all that. Rather, your tax involvement would look similar to that with other stocks or mutual funds or exchange-traded funds, in that you would faces taxes on dividends plus gains if you sell at a profit. One notable feature of REITs is that they're required to pay out nearly all of their net income to shareholders. Dividends thus tend to be hefty, which can be welcome, especially if you're in a low tax bracket.
If you own REITs or real estate funds within an Individual Retirement Account or workplace 401(k) plan, taxes are deferred on any reinvested dividends. But when you eventually withdraw money, taxes apply. As noted, REITs trade in the stock market, and they're treated like most other securities from a tax standpoint.
Cash needs and loans
To purchase even a moderate rental property, you could need tens of thousands of dollars for a down payment, possibly more, and you would face broker commissions and a laundry list of closing costs. Then there are ongoing needs to hire contractors, pay property taxes and insurance, possibly make mortgage payments and so on. All that requires a lot of money, though income would flow in as tenants pay rent.
With REITs and even real estate funds, the cash needs are much different. Stakes in these investments typically cost a few thousand dollars, possibly less, and there’s no requirement to ante up additional money. In fact, you can often purchase shares in REITs or real estate funds through a workplace 401(k) retirement plan, in small increments that might feature company-matching funds.
There’s no mortgage either, which means no application process, no monthly payments and no impact on your credit record. By contrast, those factors would apply on rental properties bought with loans.
Appreciation potential and liquidity
Real estate values historically have risen over time, whether it’s for individual homes, apartment buildings, industrial parks, office buildings, warehouses and hospitals, among others. However, as Pagan noted, returns can vary greatly by property type and geographic location, even by neighborhood or street.
REIT prices reflect the values of the properties held. But because REITs are securities that trade in the stock market, their values also are swayed by what investors there are willing to pay. You can buy or sell REIT shares at virtually any time, providing much greater liquidity compared to the often-lengthy process of rental-property transactions.
Now could be a good time to buy REITs and real estate funds, with prices for many property types having fallen sharply last year under the onslaught of rising interest rates. As interest rates stabilize further or start to fall, "that should be beneficial for REITs," Pagan said.
Reach the writer at russ.wiles@arizonarepublic.com.
