When you’re seeking to invest in real estate for the long term, buying rental properties and putting money into real estate investment trusts (REITs) can be great ways to build wealth. Both options have their own share of advantages and disadvantages, and you’ll need to decide which one is best for you. Lets take a closer look at the pros and cons of both investment strategies when comparing REITs vs rental property.
Buying Rental Properties: An Active Approach
Purchasing a single family home or multi-unit building that can be used as a rental property can be a very lucrative way to generate passive income, especially if you find a property in a high demand area at a great price. But as with any real estate investment, there are benefits and risks you should be aware of before you take the plunge.
Pros of Buying Rental Property
- Puts you in complete control of your real estate investment.
- Can be very easy to manage if you have good tenants in place.
- You have the option to increase cash-flow with multi-unit dwellings.
- You can invest in residential or commercial properties.
- You make the decisions on the purchase price, amount of rent and number of tenants.
- You can make upgrades to the property at any time and can charge more rent.
- You can simultaneously build equity and generate positive cash flow.
Cons of Buying Rental Property
- There can be unexpected maintenance problems.
- If demand is low, you can have vacancies for months at a time.
- You may have to evict a tenant or repair damage from unruly tenants.
- It can be time-consuming to manage on your own.
- You have to be on-call (or hire a property manager to be on-call) to hire urgent tenant requests.
- Property management companies typically take a 10% cut of rent.
REITs: A Passive Approach
REITs allow you to make money on a real estate asset without having the responsibilities that come along with owning the property. There are three major types of REITs – equity, mortgage and hybrid. So what’s the difference?
Mortgage REITs – you guessed it – invest in mortgages and earn money by charging interest on cash lent to borrowers to finance a property purchase. These make up less than 10% of all REITs.
REIT with a combination of equity and mortgage assets. There are very few companies that do both.
Let’s take a look at the benefits and risks associated with investing in REITs.
Pros of REITs
- Maintenance is more predictable because it is handled by a property management company.
- Vacancy is more predictable and the property management company typically handles filling empty space.
- Any loss in money is spread out among investors so it doesn’t have as much of an impact on you.
- You don’t have to do any direct tenant management.
- You don’t have any major time commitments, aside from occasional investor meetings.
- If demand drops off in one space (ex: retail), you may be able to re-utilize a property (ex: office space).
- If you invest in mortgage REITs, rising interest rates can increase your funds.
Cons of REITs
- Essentially, you’re investing in real estate stock and as you know, industry economics can turn on a dime.
- Bankruptcies can hurt the overall REIT portfolio and all investors will feel it.
- If property values decrease and you invested in an equity REIT, rents go down and so do your profits.
- With equity REITs, rising interest rates can mean a decrease in your dividends.
Deciding whether to buy rental properties or to invest in REITs basically boils down to how much risk you’re willing to take and how active a role you want to play.
It’s basically like deciding how aggressive you want your stock portfolio to be. For those who don’t want to hassle with finding tenants or maintenance, REITs may be the better choice. For those who want more power over returns, rental properties might be your best bet.