Comparing REITs and Rental Properties: A Balanced Approach to Investing

Real estate has long been a cornerstone of wealth-building, with owning rental properties considered one of the most traditional and effective strategies.

However, real estate investment extends far beyond being a landlord. One of the most accessible alternatives is investing in Real Estate Investment Trusts (REITs), which offer a hands-off approach to real estate ownership. Unlike owning and operating rental properties, which involve direct ownership and management of physical assets, REITs allow investors to buy shares in a diversified portfolio of income-generating properties.

With around 170 million Americans—nearly half of U.S. households hold REIT investments through stocks, mutual funds, ETFs, or retirement accounts. This represents a steady growth in participation, reflecting a 1% increase from 2023 and an 8% rise since 2014, according to Nareit.

In this guide, we’ll explain the key differences between REITs and rental properties, helping you determine which investment strategy best suits your financial goals and risk tolerance.

Unlocking the Advantages of REITs

REITs use investor money to finance income-producing real estate across a range of property sectors. These may include commercial real estate, single or multifamily properties, apartment complexes, medical offices, and office buildings.

REITs generate income from rents and may also profit from the capital appreciation of their properties. They are required to distribute at least 90% of their taxable income to their investors in the form of dividends.

You can purchase REIT shares in a similar way you would purchase shares in a stock or mutual fund. This gives you access to a diversified investment portfolio of real estate assets across property types and locations.

Here, we’ll look at some potential benefits of investing in a REIT.

• Dividend income and appreciation: Historically, REITs have provided high dividend returns along with the potential for long-term capital appreciation of the properties.
• Diversification: REITs offer portfolio diversification in several ways. First, when you invest in a REIT, you’re investing in a diversified portfolio of real estate assets rather than a single property, reducing the risk associated with individual assets. Additionally, some REITs are further diversified across sectors, asset types, and geographic locations, providing exposure to various real estate markets and economic conditions. This diversification can help balance an investor’s portfolio and potentially reduce overall risk compared to holding individual real estate properties or other single-asset investments.
• Liquidity: Publicly traded REITs are listed on the stock exchanges and can be easily converted into cash. This gives you flexibility and quick access to your invested capital when needed.
• Affordability: REITs provide a low entry barrier to high-quality commercial properties without the significant initial capital usually required for direct property ownership.
• Professional management: Investors who own REIT shares have little work to do. The REIT portfolio is professionally managed by experienced real estate professionals who handle property acquisitions, management, and operations.
• Tax benefits: REITs typically don’t pay corporate income taxes as long as they pay at least 90% of their taxable income to investors. This maximizes dividends to shareholders who pay taxes on those dividends and any profits made when they sell their shares.

Potential risks of investing in REITs:

• Market volatility: Publicly traded REITs are subject to fluctuations in the stock market, which can lead to significant value changes in the short term. Market conditions, interest rates, and economic shifts all impact REIT prices, potentially increasing risk for investors seeking stability.
• Interest rate sensitivity: REITs are sensitive to interest rate changes, as rising rates can increase borrowing costs for real estate investments, potentially reducing profitability. Higher rates may also make REIT dividends less attractive compared to other fixed-income investments, affecting share prices.
• Liquidity constraints in non-traded REITs: Unlike publicly traded REITs, non-traded REITs offer limited liquidity, making it challenging for investors to access their capital quickly. These REITs often come with longer holding periods and may have restricted share redemption options, limiting flexibility.
• Management and operational risks: The performance of a REIT largely depends on the expertise and strategy of its management team. Poor decision-making in property acquisitions, tenant management, or operational efficiency can negatively impact a REIT’s returns, affecting dividend consistency and long-term performance.
• Tax implications: Although REITs avoid corporate taxes by distributing most of their income, dividends received by investors are generally taxed as ordinary income, which may lead to a higher tax burden than the lower capital gains tax rates. This structure can affect the after-tax returns for some investors, depending on their tax bracket.

REIT Types and Classifications

There are three main types of real estate investment trusts based on the types of business they are involved in:

• Equity REITs primarily invest in income-generating properties, such as commercial buildings, apartment complexes, and retail centers. Their main source of income comes from the rent collected from tenants occupying these properties, which is then distributed to shareholders as dividends.
• Mortgage REITs invest in property mortgages or mortgage-backed securities and generate their income by collecting interest.
• Hybrid REITs combine investment strategies in equity and mortgage REITs.

REITs are also classified into three types based on the methods used to buy and sell their shares. Publicly traded REITs are publicly listed on the stock exchanges and registered with the Securities and Exchange Commission (SEC). Non-traded REITs are not traded on the stock exchanges but are registered with the SEC. Private REITs are not traded on the stock exchanges and are only available to accredited investors via private placement.

The Benefits of Owning Rental Properties

It’s no secret that rental properties can offer valuable investment opportunities, but it won’t be for everyone. There is potential for income and building wealth. But like any real estate investment, there are responsibilities when working with tenants and caring for property, such as addressing hazards, making repairs, tenant communication, and rent collection.

Owning a rental property requires a long-term commitment that demands time and money. Investing in rental properties can bring numerous potential rewards, including:

• Potential rental income: Long-term rentals, typically six months or longer, provide a predictable stream of income monthly. After paying off the mortgage, your rental income becomes pure profit minus the costs of managing the property.
• Property value growth: Income-producing real estate properties have the potential for long-term appreciation, meaning the property’s value can increase over time. Rental income can often increase over time, as rental prices tend to correlate with property appreciation. This means that as the value of a property rises, rental rates may also increase, potentially leading to greater long-term financial benefits for investors.
• Less volatility: While all investments carry some degree of volatility, rental property is considered less volatile than other investment options like stocks.
• Direct control: Rental properties give you complete control over every aspect of management. You can make improvements to improve property value and increase rental income. Additionally, you have the freedom to decide which prospective tenant to pick based on their financial stability and rental history.
• Tax advantages: As a landlord, you are eligible for various tax deductions on certain property expenses, including property taxes, mortgage interest, insurance, and maintenance costs. Moreover, you can depreciate your residential property over 27.5 years to further reduce your overall tax liability. When you decide to sell your investment property, you can defer paying capital gains taxes and depreciation recapture by conducting a 1031 exchange with another property.

Rental properties may offer potential benefits, but starting in the industry can be challenging, particularly for newcomers. Here are some risks associated with direct real estate investment.

• Landlord responsibilities: Managing a property involves time-consuming ongoing tasks, including tenant screening, maintenance and upgrades, and rent collection. Delegating these tasks to professional property management can significantly lighten your workload, especially if you manage multiple properties.
• High capital requirements: Smaller investors often face the cost of initial investments in real estate properties. They must have a large amount of capital for down payments, closing costs, repairs, and renovations.
• Lack of liquidity: Real estate is generally less liquid than assets like publicly traded REITs, equities, and bonds, meaning it can take longer to sell without compromising on value. Unlike publicly traded REITs, which can often be sold quickly on stock exchanges, real estate transactions typically require more time and may involve complex processes. Real estate property values can be affected by factors such as regulatory changes, economic factors, and market conditions. Moreover, because physical properties consolidate substantial investment capital into one asset, an adverse event can pose a serious financial risk.

REITs vs. Rental Properties: A Comparison

Some REITs share characteristics with traditional real estate. For example, private and non-traded REITs are less liquid and typically held with the intention of long-term ownership. In contrast, publicly traded REITs offer high liquidity, allowing investors to buy or sell shares quickly.

Similarly, like real estate, private REITs tend to experience less volatility since their value is derived from the underlying asset, i.e., physical properties, and not subject to market pricing forces.

Consider the following factors to help you gauge whether real estate investment trusts or rental properties are the right investment option for you.

Exploring Both Options: A Comprehensive Approach

REITs and rental properties are financial investments with respective risks and rewards. They both operate differently and cater to distinct types of investors.

Since both asset classes have unique advantages and disadvantages, many financial advisors recommend building a diversified portfolio that includes REITs, direct rental property ownership, stocks, and other investments like equities and bonds. This approach helps mitigate the risk associated with any single asset class.

Your time horizon is a key consideration when choosing between the two investments.

For short-term investment horizons (less than three years), REITs are generally preferred. The yields from REITs can provide stability and ensure that your capital is available when needed. Medium-term horizons (more than five years) might benefit from a balanced approach, combining REITs and rental properties to manage risk and return effectively.

Empower Your Investment Strategy with 1031 Crowdfunding

Rental properties offer ownership, a stable income stream, and tax benefits but may require significant upfront investment and hands-on management. In contrast, REITs can provide dividend income, varying levels of liquidity, and lower capital requirements, though they also come with risks, such as market sensitivity and limited investor control, which apply across different types of REITs.

Determining whether rental properties or REIT investing provides the best investment path for you may come down to your financial goals, risk appetite, and time horizon.

At 1031 Crowdfunding, we offer turnkey solutions for your investments, streamlining the process so you can invest confidently. Through our online marketplace, investors can effortlessly discover a diverse range of REIT investments tailored to their financial objectives, whether seeking income, growth, or diversification.

Join today to streamline your 1031 exchange and invest with confidence.

This material does not constitute an offer to sell or a solicitation of an offer to buy any security. An offer can only be made by a prospectus that contains more complete information on risks, management fees, and other expenses. This literature must be accompanied by and read in conjunction with a prospectus or private placement memorandum to fully understand the implications and risks of the offering of securities to which it relates. As with all investing, investing in private placements is speculative in nature and involves a degree of risk, including loss of your principal. Past performance is not necessarily indicative of future results, forward-looking statements and projections are not guaranteed to achieve the results described, and your actual returns may vary significantly. Investments in private placements are illiquid in nature, and there may be no secondary market or ability to sell the investment should the need for liquidity arise. This material should not be construed as tax advice, and you should consult with your tax advisor, as individual tax situations will vary. Securities offered through Capulent, LLC Member FINRA, SIPC