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5 Reasons REITs Might Not Be the Best Real Estate Investment for You

[Updated: Apr 16, 2021 ] Jan 20, 2020 by Matt Frankel, CFP
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First and foremost, I should say that I love real estate investment trusts, or REITs, as a long-term investment vehicle. In fact, REITs are the single largest type of stock in my own portfolio, with about 10 different REITs making up roughly 30% of my portfolio's value.

Having said that, there are several other ways to invest in real estate. Just to name a few, you could:

  • Buy a rental property, either to rent to long-term tenants or as a vacation rental.
  • Participate in a crowdfunded real estate investment opportunity.
  • Buy a distressed property, renovate it, and sell it for a profit (also known as a fix-and-flip).

Like any other type of investment, REITs have their pros and cons when compared with the alternatives. On the plus side, REITs are entirely passive investments, are highly liquid, and spread your money out over an entire portfolio of properties. On the other hand, if any of the following criteria apply to you, it could be a good idea to look into the alternatives.

1. You have the time to play an active role in your investments

One of the key advantages to REIT investing is that aside from the research involved with choosing which company to invest in, there's not much you have to do on an ongoing basis. However, if you have the time and desire to treat your real estate investing as a part-time job (or even a full-time job), there are some investments that could produce superior returns.

Owning a rental property is a good example, and if you are willing to spend the time, you could potentially boost your returns by managing the property yourself instead of hiring a property manager. A fix-and-flip investment strategy is another form of buying property that has monster return potential, but you'll need to invest the time to plan and execute the project.

2. You don't care much about liquidity

Another big perk of investing in publicly traded REITs is liquidity. If you want to sell your REITs, you can do so quickly. Publicly traded REITs can be bought and sold on major stock markets almost instantaneously with a click of the mouse, and for full market value.

Other real estate investments have varying levels of illiquidity. You're free to list a rental property for sale at any time, but it can take months before you receive an offer close to its full market value. A fix-and-flip is predicated on selling a property at a specified time anywhere from several months to a year in the future, but there's no guarantee it will sell quickly unless you're very flexible on the price. And finally, crowdfunded real estate investments are perhaps the least liquid of all. These investments typically have a target holding period of anywhere from two to 10 years, and you should expect your money to be tied up for the duration of that period.

That said, if illiquidity doesn't bother you much, all of these alternatives have the potential to produce some impressive returns.

3. You have lots of capital to put to work

You can invest in a publicly traded REIT with very little money. In fact, now that most brokerages have eliminated trading commissions, it's practical to invest with a REIT as long as you have enough money to buy a single share.

On the other hand, other types of real estate investments are very capital-intensive. You should expect to put down a minimum of 20% to 25% of the purchase price of an income-producing rental property as a down payment, in addition to money for any repairs and required reserves. Fix-and-flip financing can be easier to find, and you can typically roll renovation costs into the loan, but you'll still probably need at least 20% to 25% of the purchase price upfront. And crowdfunding deals typically have minimum investments of $25,000 or more.

If these capital requirements sound like they're within your means, that could be a good reason to look into one of these other real estate investments.

4. You're an accredited investor

Anyone with a brokerage account and a little bit of money can buy shares of a publicly traded REIT. But there are some real estate investments that not just anyone who has the money can participate in.

Crowdfunded real estate investing is the main example of this. While there are crowdfunded investments available to everyone, most deals restrict involvement to a group known as accredited investors. You can read our thorough description of what this means, but in a nutshell, this term refers to investors who meet one of the following two criteria:

  • They have $1 million in assets, excluding their primary home.
  • They earned $200,000 in each of the previous two years, with an expectation for the same in the current year (or a joint income of $300,000 for a married couple).

5. You have a high risk tolerance

While there is certainly a spectrum of risk levels in the REIT world, for the most part, REITs are designed to be lower-risk investments. They diversify across an entire portfolio of properties instead of just one or two, and they are generally designed to produce steady and growing income over time.

Some of the other real estate investments I've discussed, on the other hand, can be quite risky, especially in comparison with REITs.

Consider rental properties, for example. If a rental property sits vacant for a few months, your cash flow drops to zero -- and you'll still have to pay the mortgage and other bills. And unexpected maintenance issues can easily destroy your profit margins. Plus, don't forget the possibility of having to evict a bad tenant, which can be an absolute nightmare in many parts of the U.S.

Fix-and-flips are another one. Cost overruns are par for the course, and a property taking significantly longer than expected to sell can destroy the profits of an otherwise lucrative flip.

Crowdfunded real estate investing is still in its relatively early stages, and while the early results have certainly been promising, we have absolutely no idea how these investments would perform as a group during a recession. Plus, most crowdfunding deals focus on a single property and have a great deal of execution risk involved.

The point is that all three of these options have the ability to produce fantastic returns when things go well. However, they are certainly riskier than the average REIT, so be sure that you have an appropriate risk tolerance before investing.

Don't abandon REITs entirely

To be perfectly clear, I'm not saying that if these things apply to you, it's wise to avoid REITs altogether and focus your real estate investment efforts elsewhere. Instead, I'm pointing out that if these factors apply to you, there are some exciting and potentially lucrative options available to you that you might want to consider for some of your investment capital.

As a personal example, I own a few long-term rental properties and my wife and I are considering adding a vacation rental to our portfolio, in addition to the REITs I own as a "backbone" to my portfolio.

Explore all your real estate investing options, and find the combination that works best for you.

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