There are many options when it comes to building wealth including direct and indirect property investments. We take a look at basic differences between these investments by exploring their advantages and disadvantages.
Direct Real Estate Investing
When you invest in a direct property, you are investing in real estate investments. Some examples include commercial property, industrial, or residential assets. Investors in direct property investment earn profit through a number of ways: rent, appreciation, and income from business activities in the property.
Pros and Cons of Direct Real Estate Investing
Is direct real estate investing for you? Let’s explore the pros and cons.
Pros
One key advantage to direct real estate investing is its ability to generate stable income. Another benefit to investing in direct real estate is the freedom you have when it comes to making decisions for your property.
In addition, these investments lend itself to tax advantages including deducting specific expenses such as:
Property management costs
Property repairs
Mortgage interest
Property tax
Property conservation and maintenance
Aside from the above tax benefits, depreciation also allows investors to deduct costs related to the maintenance and improvement of your property throughout its expected lifetime. Depreciation takes into account the property’s decrease in value from normal wear and tear. Conversely, appreciation will generally increase property value and could allow you to sell it for more.
It’s important to note that depreciation is not permanent. If or when the property is sold, the depreciated amount will be regained and taxable up to a rate of 25%. One way to defer this tax liability is through a 1031 exchange.
Cons
With the passive income that your property generates comes the responsibility of maintaining and managing it. You have to be prepared to handle emergencies and liability. Fluctuations in the market could also make it difficult to maintain or find new tenants. For instance, the pandemic has put residential and commercial property owners in difficult financial spots with their loans (e.g., defaulting), as some tenants are unable to cover their rental expenses. Finally, if you do need immediate cash, unless you can sell the property in time, you may need to find another source in case of an emergency.
Pros and Cons of Indirect Real Estate Investing
Now we turn to indirect real estate investing. For new investors who wish to diversify their portfolio and reduce risk, a real estate investment trust or REIT can be a good option. REITs are publicly traded companies that own, operate, and finance income-generating real estate. REITs pool money from investors, which is similar to mutual funds.
Pros
As mentioned above, REITs lend themselves well to low risk and high dividend yields. Unlike direct real estate investments, investing in REITs means that you generate income without having to own, manage, or finance your properties. The cost to invest in REIT is also lower compared to direct investing. In addition, direct real estate investments are not liquid. With REITs, you can readily buy and sell shares.
Another benefit is that REITs offer enticing total return potential. By law, REITs have to pay at least 90% of taxable income to shareholders, and it's not uncommon to have a 5% dividend yield—or more. REITs also have to potential for capital appreciation as the value of the underlying assets increases.
Cons of REITs
Of course, there are some drawbacks to REITs. For starters, most REIT dividends aren't considered "qualified dividends," so they're taxed at a higher rate. This is something to pay extra attention to if you own REITs in a taxable brokerage account. Keep in mind that you can hold REITs in a tax-advantaged Roth IRA account.
Another con is that REITs can be very sensitive to interest rate fluctuations, and rising interest rates are bad for REIT prices. In general, REIT prices and Treasury yields have an inverse relationship: when one goes up, the other goes down, and vice versa.
One other drawback is that while REITs can help you diversify your overall investment portfolio, most individual REITs aren't diversified at all. That's because they focus on a specific property type—such as offices or shopping centers. If a REIT invests solely in hotels, for example, and the economy tanks or people stop traveling (think COVID-19), you can be exposed to property-specific risks.
Which Type of Investment is Right for You?
Both direct real estate investments and REITs have their advantages and drawbacks. For its tax advantages, engaging in a 1031 exchange is an excellent option. Our team at Growth 1031 is a proven source of reliable information, a trustworthy ally in areas of uncertainty, and the standard bearer for client relationships. To learn more about 1031 exchanges or to get started with the process, schedule your initial consultation with us today!