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Are REITs a Good Alternative to Investing in Physical Real Estate?

You’ve been watching the cost of homes and rents steadily rise since the end of 2020 and have witnessed your neighbors sell their homes at exorbitant prices. Your community may have had a hot housing market, especially as investors have been snapping up properties in order to rent them out. “Why can’t I get in on this gravy train,” you ask yourself. You want to make some good money in the real estate and rental market like so many others are doing.

Related: Investors Are Getting Into Real Estate By Purchasing Shares Of Rental Properties For As Little As $100

So you start shopping around for a property to buy. You find a nice three-bedroom house that, at first appearance, doesn’t need much fixing. You work with a realtor that helped you buy your own house a few years ago. You make an appointment at the bank for a loan, but you’re surprised at the down payment that’s required for rental property. You can swing the down payment, but it’s going to hurt your savings account.

The next step is to get the house inspected. The inspector makes a cursory look over everything, and tells the bank the place is solid. You finally meet with your realtor at the title company for the closing, where you’re introduced to the seller and her realtor. All the papers are signed, and now you’re the owner of your first rental property.

The next thing you do is advertise your rental on a website that renters in your community watch for the best deals. You find a tenant in less than a week. But after the new family is moved in and settled, they call you one night during a rainstorm and demand that you fix the roof because water is pouring through the ceiling. You discover that not only do you need new plywood and shingles for the roof, but you also must replace the drywall on the ceiling that got all wet.

As you’re checking out the ceiling on that rainy night at 2:00 AM, you also discover that your renters are smoking in the home, when they agreed in the rental contract that there would be no smoking. It will be impossible to get the tobacco smell out of the new carpeting you had installed. While you’re there, your renters also tell you that the hot heater stopped working a couple of days earlier.

At the end of the month, after you’ve had the roof fixed, the ceiling repaired and the hot water heater replaced, you calculate that you’ve already lost a few thousand dollars on your new rental endeavor. And as the months progress, because of the time you must spend making house repairs, finding new renters, repainting the walls and replacing the carpeting that smelled like smoke, you’ve made less than $100 a month.

There has got to be a better way!

There is a better way. Rather than going to all the expense and hassle of owning your own physical rental property, you can purchase shares in a Real Estate Investment Trust, or REIT (pronounced “REET.”) REITs were started in 1960 by an act of the Congress and signed into law by President Dwight D. Eisenhower. REITs were intended to offer the average person the ability to invest in real property without actually purchasing and managing that property themselves. REITs are also a source of financing for both real estate projects.

There are three different kinds of REITs—

  • Equity REITs that consist of portfolios of real property

  • Mortgage REITs or mREITs that contain real estate mortgages

  • Hybrid REITs that are a combination of Equity REITs and Mortgage REITs

REITs can also be bought and sold in three different ways. There are

  • Publicly traded REITs, traded like stocks

  • Public non-traded REITs

  • Private REITs

Since subchapter M of the Internal Revenue Code applies to REITs, they can avoid being taxed as corporations by:

  • Receiving 75% or more of their income from real estate

  • Distributing 90% or more of their investment income to their shareholders

REITs pay dividends and distribute gains to their investors but don’t pass through losses like limited partnerships do. REIT dividends are counted as ordinary income for tax purposes.

So what are the advantages of investing in REITs compared to regular equities?

The National Association of Real Estate Investment Trusts (Nareit) measures daily the performance of equity REITs. For the 20-year period ending in December 2019, the FTSE NAREIT All Equity REITs Index measured that REITs outperformed the Russell 1000 11.6% vs. 6.29%.

But there are some things to be aware of when investing in REITs:

  • Much of the risk involved with REITs focuses on the quality of the REIT management team

  • Problem mortgages in Mortgage REITS could cause dividends and capital gains to decrease

  • The liquidity for public non-traded and private REITs can be very limited

So, are REITs a good alternative to investing in physical real estate? You can answer that question by answering some different questions for yourself—do you want to:

  • Deal with a bank or a mortgage company?

  • Spend time with a realtor and close at a title office?

  • Buy a money-pit of a rental house with lots of issues?

  • Get calls in the middle of the night for leaky ceilings and broken water heaters?

  • Contend with tenants who don’t keep the terms of your rental contract?

Or would you rather:

  • Simply place an order for a REIT with your online broker like all your other investments

  • Invest in real estate without the headaches of managing the property

  • Receive a portion of the income of that property without suffering the material losses

I know what I would rather do. So, yes, I would say REITs are a good alternative to investing in physical real estate.

Looking for ways to boost your returns? Check out Benzinga's coverage on Alternative Real Estate Investments:

Or browse current investment options based on your criteria with Benzinga’s Offering Screener

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