Financial Freedom: REITs vs Traditional Real Estate (2024)

If you're looking for an innovative and potentially lucrative way to diversify your investment portfolio, look no further than the realm of Real Estate Investment Trusts (REITs). These unique entities offer a convenient and fiscally enticing avenue to the world of real estate, allowing for equity ownership in properties that might otherwise be financially out of reach for average individual investors.

A REIT is an organization that possesses, manages, or funds real estate that produces income. REITs, which are structured similarly to mutual funds, aggregate the funds of many investors. This allows individual investors to receive dividends from real estate investments without the need to personally purchase, oversee, or finance any properties.

Understanding REITs

To qualify as a REIT, a company must comply with certain Internal Revenue Service regulations. Here are some of the most notable requirements of a REIT from the IRS:

"(1) at least 95 percent of a REIT’s income must be derived from “passive” financial investments, including rents, dividends, interest, and capital gains, as opposed to “active” income from business activities; and (2) at least 75 percent of a REIT’s income must be derived from real estate sources including rents, mortgages, and capital gains on real estate..."

Learn more about the full regulations regarding real estate investment trusts on the Internal Revenue Service's webpage. For now, though let's dive into the advantages of REITs.

Advantages of Forming a REIT

Just like real estate investing in general, forming a REIT comes with various advantages. REITs can grant investors consistent income through dividends, offer long-term capital appreciation, and allow for easier access to diversified portfolios. Let's explore these benefits:

• Diversification: REITs provide a way for real estate investors to diversify their portfolios beyond traditional assets like stocks and bonds.
• Liquidity: Unlike real estate properties, REIT shares can be bought and sold on major stock exchanges, providing investors with liquidity.
• Stable Income: 90% of a REIT's taxable income is required by law to be distributed annually to shareholders as dividends. This could lead to a steady stream of income, especially attractive to income-focused investors.
• High Returns: Over the long term, REITs have the potential to deliver attractive returns that exceed those of other securities.

Disadvantages of Forming a REIT

Despite their significant benefits, REITs have limitations and risks. They can be more volatile than other forms of real estate investment, with cash flow largely dependent on management expertise. Additionally, REITs are subject to market risk and the 90% payout rule can limit the growth of the trust. Here are some cons to consider:

• Management Fees: Just like mutual funds, REITs come with management and administrative fees which can eat into investors' returns.
• Lack of Control: Investing in a REIT means giving up control over the real estate assets in the trust.
• Potential for Loss: If the real estate market goes down, so does the value of the REIT. It's essential to assess this risk before investing.

Forming a REIT

Starting a REIT is a complex process that requires meeting specific criteria, as defined by the IRS. To begin, you need to form a corporation or business trust, followed by filing with the SEC (U.S. Securities and Exchange Commission). Next, ensure your trust meets REIT requirements regarding investment and income. Finally, you will need to set up management and operations, which may involve hiring staff and securing office space.

REITs vs Traditional Real Estate Investing

While both REITs and traditional real estate investing offer the potential for steady income and capital appreciation, there are key differences. Most notably, REITs offer greater liquidity and accessibility, while traditional real estate investment might provide greater control and potential tax benefits.

In traditional real estate investment, an individual or company purchases property and then generates income from rent, leases, or price appreciation. This method offers direct control over the property but requires significant time, effort, and capital. We here at DealMachine break down the different types of real estate investing from real estate wholesale, house flipping, and rentals so be sure to dive into other blog posts to learn more about traditional real estate investing.

Types of REITs, on the other hand, provide direct exposure to commercial real estate without the obligations of property management. The investor doesn't own the property directly but holds a stake in a trust that owns and manages real estate assets. The income and profits generated from these properties are then distributed as dividends to the REIT's shareholders.

Conclusion

In summary, REITs offer a unique and potentially lucrative way to invest in real estate. They offer the chance to earn consistent income and experience capital appreciation. However, as with all investments, they come with their share of risks. Understanding these pros and cons is crucial as you determine your investment strategy.