Real estate offers a genuine means of portfolio diversification.
It can act as a hedge against inflation and provide stable cash flow to investors. However, most people usually shy away from investing in this historical asset class due to the high entry barrier and shortage of investment vehicles.
Unlike other assets such as equities, whereby there are a variety of ways through which investors can invest, real estate investment is largely driven by physical ownership of property.
For newcomers that have little cash to spare, the high cost of acquiring physical property is a huge barrier. However, all that has been changing in recent times as the number of investment options in real estate is expanding. Two such options are REITs and Real Estate crowdfunding.
In this article, we carry out a comparative analysis of these two options so that you can know which best suits your investment goals and objectives.
REIT is an acronym that stands for Real Estate Investment Trust.
These are companies that own or finance commercial real estate for the purpose of generating income. Since their inception in the 1960s, REITs have provided investors with a cost-effective way of making investments in real estate without having to buy any property.
REITs purchase or develop real estate properties such as:
...all of which are then rented or leased to tenants.
The revenue generated from rents and leases is distributed to investors in the form of dividends. REITs are modeled like mutual funds, which imply that funds are pooled from multiple investors to finance the purchase and management of the property.
Real estate investment trusts are a viable way of participating in commercial real estate as an investor without owning the properties yourself.
They are a good way for investors to diversify their real estate portfolios with much less risk than if they were landlords. Like stocks, REITs are traded publicly on the stock exchange, which makes them easily accessible to investors.
Want to know more about REITs? Read this next: Investing in Real Estate Investment Trust: Top 5 Benefits & Demerits
Several advantages come with investing in REITs, let's have a look at some of them.
REITs are required to pay 90% of their yearly income as dividends to shareholders.
REITs offer some of the largest dividend pay-outs in the stock market and have an enviable track record of consistent payment. This has made them a viable investment for investors looking for a steady source of income.
REITs potentially have a higher return than most stocks and even the broader index.
This is due to their consistent dividend payments, which can be reinvested to grow the portfolio.
Investing in REITs is less laborious than buying a physical property, managing it, and reselling it.
REITs are traded like shares, which means they can be bought and sold at any time, thereby simplifying the investment process.
REITs tend to have a lower trading volume than individual stocks which makes them less volatile.
With many market players focused on high growth, mega-cap stocks, REITs usually fly below the radar of most investors and traders. This low volatility can help in portfolio balancing by reducing the drag on your portfolio by more volatile stock.
REITs are also a good source of portfolio diversification.
They can perform well during periods of inflation and rising interest rates which can weigh heavily on the broader equity market. This is because investors would be rotating into safer assets such as bonds.
As such, having REITs in your portfolio can hedge against potential losses during such times, while providing dividends that can be reinvested to further reduce losses.
Several disadvantages come with investing in REITs. Let's have a look at some of them.
Apart from publicly-traded REITs, it can be challenging selling shares of REITs. Getting buyers for non-traded and private REITs can be difficult. Some have to be held for years before an investor realizes gains.
Due to the lure of constant expansion to increase revenue and appease shareholders, most REITs are heavily indebted.
REITs are among the most indebted companies in the market, which could be a worrisome sign, especially if the housing market crashes as experienced in 2008. However, long-term contracts such as leases can generate steady cash flow which can be used to finance debt payments.
Since REITs are required to pay as much as 90% of their income as dividends to shareholders, this can affect their growth and capital appreciation.
To raise cash, some REITs may have to issue new shares, which may be interpreted by the investment community as a sign of financial struggles.
Dividends from REITs are taxed, which potentially reduces the profits made on investing in their stocks.
One way investors can side-step this is by investing in REITs through their IRAs.
Investing in non-traded REITs can be expensive and beyond the reach of the retail investor that has little cash to invest in.
The initial investment in some non-traded REITs can go upwards of $25,000. Secondly, buying shares in such REITs is limited to institutional investors or high net-worth individual investors.
Crowdfunding has been in existence due to the soaring popularity of social media, but its foray into real estate is relatively new.
Crowdfunding implies raising capital from a large pool of individuals to finance a project or venture. This method of fundraising shot off the block due to the proliferation of the internet which made it possible for numerous people from around the world to contribute to a specific project or venture.
Real estate crowdfunding entails raising money from a large pool of investors to finance a real estate project.
As the property begins to generate income, this is distributed to investors as dividends. Investors can invest in real estate projects with as low as $10, though some require a minimum investment of $5000.
One major advantage of investing in real estate crowdfunding is that the minimum capital required can be very low.
Some platforms such as Groundfloor and Fundrise require a minimum investment of $10.
When investing in real estate crowdfunding, you do not pay any extra fees.
This is unlike additional costs you would incur if you are buying physical properties or REITs, which usually come with management fees.
With real estate crowdfunding, you can build a portfolio that is geographically diversified with fewer hassles.
The project initiator can have multiple projects in different regions or you can invest in various crowdfunding platforms that are raising funds for projects in different areas. This allows an investor to benefit from the unique business cycles in the different markets.
Real estate crowdfunding offerings offer a greater level of transparency in the management of assets than REITs.
Investors not only have greater control over asset selection and location, but you also know what type of property you are investing in. Crowdfunding also provides investors with regular updates on their properties.
This is unlike REITs, where fund folders do not have control over asset choice and/or location, and would not receive updates regarding the status of the property.
One major disadvantage of crowdfunding is that it is not open to all investors.
To participate in crowdfunding, you need to be an accredited investor. This means you need to have an income of $200,000 and above, with a net worth of $1 million.
The Securities and Exchange Commission also requires a crowdfunding investor to have a Series 7, 65, or 82 license. This high entry barrier prevents most people from participating in real estate crowdfunding.
Crowdfunded real estate investments are illiquid when compared to other types of real estate investments.
Crowdfunded real estate investments usually have a targeted holding period, which prevents the investor from liquidating his holdings. This means that investors would not be able to trade their investments when needed.
This has implications for the value of the investment at the time of sale, which could lead to losses.
When compared to REITs, real estate crowdfunding has a lower income rate.
Firstly, the income is not immediate or predictable. It could also take years before a property begins to generate income and dividends for shareholders. This is a stark contrast to REITs, where an investor begins to receive dividends promptly.
Choosing between REITs and real estate crowdfunding comes down to your investment style.
If you are looking for steady cash flow, and a highly liquid investment with low risk, then REITs are a good bet for you. On the other hand, real estate crowdfunding favors those that have a huge risk appetite and deep pockets.
Some crowdfunding projects are exclusive to high-net-worth individuals due to their high minimum investment levels.
In general, REITs are generally more preferable to crowdfunding. Having been in existence for about 60 years, they have a good track record. This means investors would feel safer investing in REITs than in crowdfunding projects.
Also, the regulation by the Securities and Exchange Commission implies that investors would be assured that their investments are safe.
Real estate is a great investment, and one of the oldest ways through which people have preserved and grown wealth for centuries.
However, most people want to participate in this hot cake without going through the hassles that come with owning physical property.
REITs and crowdfunding are two ways through which people can participate in the real estate market. Though both come with advantages, they also have inherent demerits.
After critical comparative analysis, REITs are a better investment vehicle for people hoping to invest in the real estate space than crowdfunding. They are liquid and pay out dividends which can be a good source of cash flow for investors, plus their activities are directly regulated by the SEC.
Crowdfunding platforms on the other hand are illiquid, and some have high minimum balances, which puts them beyond the reach of many investors. As such, if you can own physical property, your next best alternative should be a REIT.
Photo by Harmen Jelle van Mourik on Unsplash
March 23, 2023