Should You Buy REITs or Actual Real Estate?
Hi, I’m Brooke
And I’m Dan with the high yield real estate investing podcast. So why not just buy REITs with your brokerage account if you want to easily invest in real estate?
This is a common question among many who are looking at expanding their portfolio from the traditional stocks, bonds, and mutual funds. There are plenty of publicly traded REITs out that anyone with a brokerage account or 5 dollars in their robinhood account can buy. While anyone with a brokerage account can get exposure to real estate by buying REITs; You really aren’t getting all the great returns and tax advantages of actually owning real estate. Whether that’s owning property yourself or investing passively.
REIT stands for Real Estate Investment Trust. It’s a company that holds real estate for the sole purpose of generating income for their investors. You can think of them like mutual funds but instead of owning companies, they own real estate instead. They can hold all kinds of commercial properties, mortgages, or a hybrid of both. They pay out their rental income in the form of dividends. They also have a special tax consideration from the IRS as long as they issue out 90% of their taxable income. Investors generally choose these investments for the higher dividend yields (compared to other corporate stocks) and a supposedly lower exposure to overall market trends.
However, here’s one major reason why owning a publicly traded REIT doesn’t compare to owning traditional real estate- The value of your investment changes with the market on a minute-by-minute basis. It’s also subject to overall conditions of the entire stock market. For example, I’m posting on our website a 1 year chart of one of the largest REITS under the ticker VNQ. Take a look at the huge dip during the market selloff during the start of the Coronavirus pandemic in March 2020.
The performance chart of the VNQ REIT from October 2019 or July 2020
I’ll tell you right now that the value of my real estate didn’t instantly drop by 50% in less than a month. Real Estate values move much slower than that! If lots of the people holding this stock start selling, and there are far more sellers than buyers, the price of this stock will drop to find willing buyers. This is what we saw in the overall stock market during the start of the coronavirus pandemic.
That brings us to our next point. How much control do you have over the value of your publicly traded stocks? None, really. If you owned VNQ, how much control do you have over when an asset in that REIT is bought and sold? None. And do you REALLY know what you own? You could, with a few clicks of a mouse on the right website, find out what other REITs this ETF holds. But that’s a lot of funds to look through. You’d have to study each fund. And if you invest in mutual funds or ETFs, have you ever read all the way through a prospectus? I haven’t. 80 pages of SEC mandated computer generated information sounds like a great way to help an insomniac fall asleep. The point being, if you own your own real estate, you have nearly complete control over the success of your investment. If you invest passively in a syndication, it is most common to pick a large, single property to invest in, which allows you to thoroughly vet both the operator as well as that specific property. You’ll probably even talk to the operator running the syndication and establish a personal relationship with them. Not so with a large publicly traded REIT!
One of the characteristics that make REITs attractive is that they must pay out 90% of their income to their shareholders. So, the retail investor gets to benefit from all that sweet rental cashflow, right? But how in the world can a company survive if it only keeps 10% of its income? Remember that the company gets to subtract all of its expenses, then account for the depreciation that the IRS allows on each of its properties, which effectively shelters a lot of income. Some of that depreciation does get passed to you. If you want to know more about depreciation, listen to our podcast episode on it. Just remember, income and revenue are different! So, the company isn’t getting by on scraps. They get to keep the value of their depreciation, account for business expenses, and then split whatever is leftover 90/10 with shareholders. They can also raise money for new properties by issuing more stock. But here’s the real kicker. They get to pass the majority of their tax burden along to you, the investor! Those sweet dividends you get will mostly be taxed at your marginal tax rate. Also, anytime the REIT sells a property you’ll also owe capital gains taxes! If you fall into the highest 37% marginal tax rate, then all your dividends will be taxed at that rate and any long term capital gains generated will be taxed at 20%. That’s a pretty big win for an REIT since they get to pass a majority of the tax burden along to you! Since the tax burdens on these investments can be high, it’s advisable to own these stocks in a retirement account of some sort. Wouldn’t you like to own a business where your shareholders pay most of your taxes?
We’ve already done a podcast on the tax benefits of real estate. But here is a quick recap for the purposes of comparing to REITS. If you own your own real estate or invest passively, you get to fully realize deducting expenses from operating the property from its revenue and also the benefit of sheltering much, if not all, of the remaining income with depreciation. Many times, you won’t owe any tax on your cashflow distributions or it’s a very small amount. Also, when it comes time to sell your property there’s a way to completely defer your capital gains taxes.
Also, Your typical multifamily large apartment complex investment will probably give you a guaranteed 8% return from cashflow but an overall double digit yearly return over the course of your investment. You’ll also benefit from any capital appreciation. If your REIT gives you a 4-6% dividend yield and most of the taxes are passed along to you, then you’re a far cry away from comparing an REIT to an actual real estate investment.
But, If you only have a small chunk of money available and want some exposure to real estate, check out our episode on passive investing for the unaccredited investor. We’ll tell you how you can find actual real estate investments that give you the higher return and tax benefits that publicly traded REITs just can’t without shelling out a minimum of 25,000 dollars.