Real Estate or REIT?

Real Estate or REIT?

REITs are not real estate; REITs are funds that own and manage real estate. REITs and real estate both have advantages and disadvantages. Below is a comparison.

Capital Appreciation

• REIT - REITs must pay 90% of their income to investors annually, significantly reducing their ability to invest back into properties or purchase new holdings.
• Real Estate - Like REITs, real estate provides a stream of income plus capital appreciation. But you keep 100% of the income and capital appreciation.

Liquidity

• REIT - If the REIT is publicly traded, liquidity is excellent. If it is a non-traded REIT, it may be less liquid than real estate. In some cases, non-traded REITs must be held for a minimum of three, five, or even seven years before they can be sold. Sometimes you can sell them early, but with a penalty.
• Real estate - Real estate is not a liquid asset. It can take months to sell a property.

Stability

• REIT - REITs are highly susceptible to economic turbulence because 90% of all profits have to be paid out to investors annually, leaving them no reserve for inevitable market corrections.
• Real Estate - The inability to quickly convert real estate to cash makes real estate markets very stable. Another difference is that no one has to buy or keep REIT shares. Everyone needs a place to live.

Taxes

• REITs - REITs are required to pay out 90% of taxable income to shareholders. Almost all dividend income is taxed as regular income because most REIT dividends don't meet the IRS definition of "qualified dividends".
• Real estate - Depreciation and other tax-deductible expenses may shield some or all income from taxes. A lot depends on the purchase method (financed or cash) and your tax situation. Also, appreciation is not taxable. Plus, you can repurpose equity through either refinancing or 1031 exchange with little or no tax consequences.

Entry Cost

• REITs - You can buy REIT shares for very little money. However, there may be significant upfront fees. Many REITs charge 7-10% and some as much as 15% of all cash invested. So, your initial working capital is reduced by these fees.
• Real estate - Real estate investing requires significant upfront capital.

Leverage

• REIT - None
• Real estate - Up to 30 year fixed rate financing available. Interest is tax-deductible.

Major risks

• REIT - When interest rates rise, demand for REITs decreases. Plus, most REITs target vertical assets groups. For example, retail strip centers, warehouses, office space, etc. Commercial real estate is very cyclical, so you need to be very aware of the current state of the commercial market segment the REIT targets.
• Real estate - Buying in a bad location or targeting the wrong tenant pool. Both are avoidable risks.

Effort

• REIT - None
• Real estate - Significant effort is required if you do not work with a local investment team. If you work with a local investment team, plan on 20 to 30 hours of effort over a one or two month period for your first property. Much less after that.

Cash Flow or Appreciation?

I was asked whether a REIT generating a 10% return or a property appreciating at 10% with zero cash flow (never buy a property that does not provide a positive cash flow from day one) is a better long term investment over a 5 year period. I will answer this question with an over simplified example.

My assumptions:

• Property A appreciates at 10% annually, but has zero cash flow.
• REIT has a 10% cash flow
• Combined state and federal income tax rate is 30%.
• Purchase price: $400,000.
• Down payment on real estate: 25%
• Acquisition cost: $100,000 (25% x $400,000)
• REIT investment: $100,000
• REIT charges zero fees
• No inflation
• No rent increases
• No loan costs
• No closing costs
• No vacancies
• No maintenance cost
• No management expenses
• No principal pay down

Below are the two models.

Property A - No Cash Flow			Property B - No Appreciation
Appreciation	7%		Appreciation (%)	0%
Market Value	400000		ROI (%)	7%
End of year 1	428000		Annual cash flow	7000
End of year 2	457960		Taxes (@ 30%)	-2100
End of year 3	490017		Annual after tax cash flow	4900
End of year 4	524318		Investable Cash after 5 Years	$24,500
End of year 5	561021		Investable Cash after 5 Years even if you ignore taxes	$35,000
75% cash out refi at the end of year 5	420766
Pay off existing loan	-300000
Investable Cash after 5 Years	$120,766

At the end of 5 years, the total net cash you would receive from the REIT would be $35,000. Instead of selling the real estate, I chose to do a 75% cash-out refi for simplicity, and the total net cash received would be $132,563. Appreciation (capital accumulation) is one of many compelling reasons for real estate.

Conclusion

REITs are not real estate. REITs are funds that buy and manage real estate. Unlike real estate, publicly-traded REITs are liquid assets. REITs have no inherent inflation protection, and REITs have little or no capital accumulation. However, with REITs, you can invest with very little money. If you solely seek income and liquidity (and are willing to accept some volatility and risk), REITs are a excellent option.

Real estate is a physical asset that always has value. Real estate has many advantages, including taxes, capital appreciation, income security, inflation protection, and leverage. Real estate is the only asset that offers 30 year, fixed-rate financing. Plus, if you invest in a good location, your rental income will outpace inflation and provide a reliable income stream you and your children will not outlive. However, real estate requires significant upfront capital and knowledge/skills necessary for success. If you are seeking a tax-advantaged, less volatile tangible asset, physical real estate is an excellent choice