Owning land was for royalty in the past. Common folk like you and me will work the lands while the landlords will reap the fruits of our labour – the definition of passive income in feudal times.
Fast forward to the 21st century, and we still hold on to that mindset – passive income comes from renting out land.
We still hold on to the belief that investing in property is the best form of generating secure passive income streams.
If only we had the means to buy more land.
Then came the introduction of REITs.
Real Estate Investment Trust
In 1960, the U.S. Congress established REIT, which gave investors access to income-producing real estate.
A REIT is a particular company, publicly listed, that owns and manage income-generating real estate. It raises capital from investors via shares to finance, purchase and operate real estate. In return for tax benefits, REITs distribute a large percentage of their profits as dividends to its shareholders.
It was a game-changer for smaller investors. Real estate investment is not exclusive for the wealthy anymore.
So, what is the better way of investing in real estate? REIT or buying real estate directly?
#1 Capital
The beauty of REITs is that if you do not have much capital, you could own a small portion, just like shares.
A share of REIT can cost a few cents.
Real estate, on the other hand, requires much larger capital because you are buying the whole place – you cannot own a piece of the building.
- The minimum amount needed to invest in REITs is >$100
- The minimum amount required to invest in real estate is >$100,000
So to invest in real estate, you can either pay with cash or take a loan.
Paying with cash
Even if you could afford to pay with cash, real estate investments might take up the bulk of your portfolio.
In the event of a property market crash, like the recent crash in 2009, you could lose the majority of your investments.
Taking up a loan
Taking a loan is the most common means to purchase real estate nowadays.
However, it does not mean you do not have to fork out any cash. You will still need to pay a minimum sum for the downpayment in cash, and that is still a significant amount. For example, a 25% downpayment for a million-dollar home is 250k.
That is a huge opportunity cost for your cash – you could have invested that amount somewhere else instead of putting it as a downpayment.
There are also some downsides taking on enormous debt to finance your property.
Other than the psychological pressure, you will have to pay interests throughout the loan, which also adds up your cost.
Hence, for those of us who have limited capital, REITs provide us with the means to invest in real estate.
#2 Diversification
Buying one property is hard enough, let alone multiple types of properties across different geographies.
REIT allows you to diversify across:
- Types of properties: Office, retail, hospitality, industrial, residential etc.
- Multiple countries and regions (Asia, Europe, U.S. etc.)
There are two levels of diversification for REITs.
- REIT level
- REIT ETFs or REIT funds
Some individual REITs manage a diversified portfolio of income-generating properties across multiple countries. So buying a single REIT counter can already provide more diversification than direct property investing.
At the fund level, REIT ETFs or REIT funds consists of a collection of REITs. An investor buying a REIT ETF gains access to multiple REITs in a single fund.
There are three REIT ETFs in Singapore, and you may refer to this article for a detailed analysis of each ETF. I have also written an article on Syfe REIT+, which is a managed fund offered by Syfe a roboadvisor in Singapore.
Diversification helps reduce risk. Real estate is very dependent on the economy, political stability and regulation of the country. For example, social unrest in Hong Kong had affected its real estate returns negatively.
Hence, it is important to diversify across multiple countries. Especially since real estate is permanent, i.e. you cannot move the buildings to another location or expand to another region as a business could.
So, for those who have a lower risk appetite, REITs are a better choice as they provide additional diversification benefits over direct investment in real estate.
#3 Convenience
Stating the obvious, REIT makes investing in real estate quite accessible.
To own a REIT, all you need is to sign up for an online brokerage and buy shares of REITs to own a property. Even the REIT management will manage the property for you. All that is left for you to do is to sit back and wait to collect your dividends.
Whereas buying and selling real estate is much harder as there are some regulations with which you will need to abide. You will need more time to broker a deal and engage a lawyer to handle legal documents, etc. It is a complicated and lengthy process.
REITs no doubt is the more convenient option for real estate investments.
#4 Liquidity
REITs trade like stocks on the financial markets. It is much easier to buy and sell REITs.
If you would like to own one now, you could buy one immediately, within fractions of a second, provided you already had a brokerage account set up.
Physical real estate, on the other hand, takes time. There are far fewer buyers and sellers. It is significantly harder to match a buyer with a seller.
Sometimes, even if you had your eyes on a particular property, you may not be able to buy it if there are no sellers.
Hands down, REITs are the more liquid option to invest in real estate.
#5 Management
For REITs, you do not manage the properties directly. There will be a team of professional managers who will do it for you – everything from acquisition, financing, operating and maintenance of the properties in the portfolio.
The pros of having a professional management team are convenience and simplicity.
The cons are higher cost and less control over the properties.
For REITs, you will be paying management fees on top of regular maintenance and operation of the properties. For direct property investment, you can control the costs better (or worse, depending on your management capabilities).
So if you are inexperienced in managing real estate, it is better to invest via REITs. But if you would like more control, directly investing in property is a better choice.
#6 Taxes
A considerable advantage of REITs, if you are a tax resident of tax havens such as Singapore, is that the gains from REITs are tax-free.
Any capital gain is not taxed. Any dividend received from REITs is not taxable.
As for real estate, the rental income counts towards your income tax. Any purchase or sale of real estate is levied with stamp duty. You will also pay property taxes for owning the property.
REITs are more tax advantageous.
#7 Returns
This last point is the most debatable. On paper, there should not be much difference in returns between REITs and physical properties since the underlying investment is the same.
In practice, however, direct property investing might generate higher returns.
It might be easier to scout around the neighbourhood and chance upon an undervalued property and then flip it for a considerable profit. Finding an undervalued REIT is a bit harder as the stock market is more efficient in pricing REITs than a property market pricing a property.
Secondly, property investments are more leveraged than owning REITs. You could take up a much higher loan with much lower interest compared to taking a margin loan. Hence, you have the potential to generate higher returns simply because of REITs.
When you are buying real estate directly, you are less diversified than purchasing a REIT. There is a potential to get higher returns simply because you are more focused and less diversified. Diversification reduces risk but also reduces the chance of hitting the jackpot. So you might get a windfall if you happen to buy the right property. You might also lose big.
Investing in real estate is similar to investing in private companies and startups – it is much harder. Still, there is potential for huge gains or huge losses.
Investing in REITs is similar to investing in stocks of publicly traded companies. It is easier and less risky but with smaller potential gains.
An additional note on leverage
Leverage for purchasing physical property is cheaper and easier to get.
Having a mortgage is not always bad.
If you are the kind of person who finds it challenging to invest regularly, a mortgage helps you do that.
You will need to make monthly payments towards your mortgage. Hence, it forces you to contribute regularly. At the end of the day, once you paid off your mortgage, your property becomes your asset.
So, it could be another way of growing your wealth.
Conclusion
Both investing in property and investing in REITs has its advantages.
It is akin to investing in private equities versus public equities.
REITs remain the better option for real estate investing if you do not have sufficient capital.
Real estate has the potential of more massive returns, but it is harder, riskier and less liquid.
Real estate investing sometimes can be better because by paying the mortgage, you are contributing to your assets in a disciplined manner.
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