Real estate is often considered one of the best ways to create wealth and generate passive income. However, not everyone has the time, money or expertise to manage a rental property or flip houses. Fortunately, there is another option for passive real estate investing, without the hassle of active management: real estate investment trusts (REITs). In this article we’ll explore the pros and cons of REIT investing as an alternative to physical real estate.
What Are REITs?
REITs are companies that own and operate income-generating real estate properties, such as apartments, office buildings, shopping centers, and warehouses. They allow investors to invest in real estate without owning physical properties themselves.
REITs must meet certain requirements to qualify as a REIT under U.S. tax law. For example, they must distribute at least 90% of their taxable income to shareholders in the form of dividends, and at least 75% of their total assets must be invested in real estate.
Types Of REITs
There are several types of REITs, including:
Equity REITs: These invest in and operate income-generating real estate properties. They earn rental income and capital appreciation from the properties they own and manage.
Mortgage REITs: These invest in and manage mortgages or mortgage-backed securities, earning income from the interest paid on the loans they hold.
Hybrid REITs: These invest in both real estate properties and mortgages.
Pros And Cons Of REIT Investing
Here are some of the pros and cons of REIT investing:
Passive income: REITs offer investors a way to generate passive rental income from real estate without the need to directly manage properties. This is because REITs own and manage multiple properties, and investors can earn a share of the rental income generated by these properties.
Diversification: By investing in REITs, investors can diversify their portfolios by gaining exposure to a range of different properties and real estate markets. This can help to reduce risk and increase potential returns.
Liquidity: REITs are traded on public exchanges, which means that investors can easily buy and sell shares in them. This makes them a more liquid investment compared to direct real estate investing, where it can be more difficult to sell a property.
Professional management: REITs are run by experienced real estate professionals who have the knowledge and resources to manage properties effectively. This can lead to higher occupancy rates, better tenant relationships, and ultimately, higher returns for investors.
Accessibility: REITs are accessible to a wide range of investors, including those who may not have the capital or expertise to invest directly in real estate.
Market fluctuations: Like any investment, the value of REITs can fluctuate based on market conditions. This means that there is always the risk that an investor could lose money if the market experiences a downturn.
Management fees: REITs are professionally managed, which means that investors will need to pay management fees. These fees can vary depending on the REIT and can eat into potential returns.
Limited control: When investing in a REIT, investors have limited control over the management of the properties held by the trust. This means that investors may not be able to make decisions that are in their best interests, and they may not be able to control the timing of the sale of properties.
Lack of transparency: Some REITs may not be transparent about their investments or their financial performance. This can make it difficult for investors to make informed decisions about whether to invest in the trust.
Market correlation: REITs can be correlated with the stock market, which means that they may not provide the same level of diversification as investing in physical real estate.
Overall, investing in REITs can be a good option for investors who want to generate passive income from real estate without the need to directly manage properties. However, as with any investment, there are risks involved, and investors should carefully consider the pros and cons before making a decision to invest in REITs.
REIT Tax Advantages
In addition to generating passive rental income, REITs, or real estate investment trusts, offer investors numerous tax benefits. Here are some of the key tax advantages of investing in REITs:
The Pass-Through Deduction – The pass-through deduction is a tax benefit that allows REIT investors to deduct up to 20% of the dividends paid from the REIT. This means REIT investors only pay taxes on 80% of the dividends earned.
Depreciation – Depreciation is another tax benefit that allows investors to defer taxes on certain income earned from a REIT. The income is considered a return of capital instead of ordinary income, which is taxed at an investor’s normal tax rate. Return of capital dividends are not taxed because of depreciation.
Qualified Business Income Deduction – Pass-through entity holders can also deduct 20% of their income from REITs. This allows owners to pay federal taxes on just 80% of the dividends paid.
Return of Capital Non-Taxable – Return of capital dividends are not taxed. They lower an investor’s tax basis and help to reduce taxes on dividends paid and future dividends earned.
Avoiding Double Taxation – REITs do not pay corporate taxes, which minimizes the risk of double taxation. Without corporate taxes owed, owners only pay taxes on the ‘pass-through’ income or the income they earn individually. After that, they pay taxes at their ordinary tax rate.
The 90% Rule – REITs must pay out at least 90% of their profits as dividends to shareholders by law. This ensures that investors receive a steady stream of income from their investment.
Learn all the essential financial and investment terminology in our list of A-Z investment and financial terms to know.
How To Buy REITs For Passive Real Estate Investment
Investing in REITs is easy and accessible to many investors. You can buy shares of publicly traded REITs on stock exchanges or invest in non-traded REITs through private offerings. Some REITs have minimum investment requirements, but they are generally considerably lower than investing in physical properties.
Alternative Ways To Create Real Estate Income
If you are interested in passive real estate investing, but REITs aren’t your cup of tea, there are other options available. Here are a few:
Real Estate Crowdfunding: This involves investing in real estate projects alongside other investors through an online financial platform. Investors can choose the specific project they want to invest in, and the platform handles the management of the investment.
Real Estate Notes: This involves investing in debt securities that are backed by real estate, such as mortgages or trust deeds. Investors earn income from the interest paid on the loans.
Real Estate ETFs: These are exchange-traded funds that invest in a portfolio of real estate stocks. They provide exposure to a diversified portfolio of real estate stocks.
Buying and Renting Out Properties: This involves buying real estate properties and renting them out to tenants. While this can be a profitable way to earn passive income, it requires a significant amount of time and effort to manage properties and deal with tenants.
House Flipping: This is an active rather than passive income method. It involves buying real estate properties, renovating them, and then selling them for a profit. This can be a lucrative way to earn money, but it also requires a significant amount of time and effort to find, renovate, and sell properties.
REIT Investing FAQs
Q: What types of properties do REITs typically invest in?
A: REITs can invest in a variety of different properties, including office buildings, shopping centers, apartment complexes, hotels, and more. The specific type of property that a REIT invests in will depend on the investment strategy of the REIT and the goals of the investors.
Q: Are REITs a good investment for passive income?
A: Yes, REITs are a popular choice for passive real estate investing as they offer consistent dividend income without the hassle of property management.
Q: What are the risks associated with investing in REITs?
A: Like any investment, there are risks associated with investing in REITs. One of the main risks is that the value of the REIT can fluctuate based on changes in the real estate market or changes in the performance of the properties owned by the REIT. Additionally, some REITs may be more susceptible to interest rate changes or economic downturns, which can impact their performance. It’s important for investors to do their research and carefully consider the risks before investing in any REIT.
Q: How do I choose the right REIT to invest in?
A: There are many factors to consider when choosing a REIT to invest in, including the investment strategy of the REIT, the type of properties owned by the REIT, the historical performance of the REIT, and the fees associated with investing in the REIT. It’s important to do your research and consider your own investment goals before choosing a REIT to invest in. Consulting with a financial advisor can also be helpful in making informed investment decisions.
Q: Can I lose money investing in REITs?
A: Yes, like any investment, REITs carry risks and there is no guarantee of returns. Factors such as market conditions, interest rates, and company-specific risks can all impact the value of your investment.
Q: What is the difference between a publicly-traded REIT and a private REIT?
A: Publicly-traded REITs are listed on a stock exchange and can be bought and sold like any other publicly traded stock. Private REITs are not publicly traded and are typically only available to accredited investors. Private REITs often carry higher minimum investment requirements and can have less liquidity compared to publicly-traded REITs.
Passive Real Estate Investing Conclusion
Investing in real estate for passive income is a smart way to create long-term wealth. REITs provide an easy way to invest in real estate without owning physical properties. Before investing, make sure to do your research and understand the risks involved. Consider working with a financial advisor to help you make informed investment decisions.