Nowadays most financial advisors recommend having at least 10% of your investment portfolio in real estate assets.

While owning physical real estate has its perks, it isn’t necessarily the best choice for everyone.

It can require quite a lot of capital and sometimes doesn’t really fit in one’s portfolio.

Luckily, there are ways to diversify your investment portfolio with income-producing real estate without actually buying physical real estate.

How can this be done, you ask?

Well, with REITs, of course!

What Are Real Estate Investment Trusts

A REIT, or Real Estate Investment Trust, is simply a company that owns different kinds of real estate – usually residential or commercial properties.

There are different kinds of REITs, but here we focus on publicly traded REITs, which own real estate that produces steady income and can be bought from the stock market like any other stock.

So, in other words, a REIT is a company that invests in real estate and operates in a fund-like manner.

REITs vs Real Estate Funds – What’s the Difference?

One thing that puzzled me first was making a distinction between a REIT and a Real Estate Fund. I mean they both pool investor money to buy properties, so aren’t they the same thing?

Well, no.

A REIT is a company or a trust that invests directly in real estate, while funds invest in companies that own real estate. So, in a way, a Real Estate Fund can own a REIT, but not vice versa.

Another big difference is that REITs can be purchased in the same way that stocks are, while Real Estate Funds work more like regular mutual funds that upgrade their value once a day. Thus, REITs can be considered a more liquid asset.

They can also be divided by the fact that REITs produce a steady income stream in the form of dividends, while Real Estate Funds appreciate in value.

Pros of Direct Real Estate Investing – Why Own Real Estate

The top reason why I have a portion of my investment portfolio in physical real estate investments (apartments, in my case), is that they can be used as collateral for loans. This provides a certain peace of mind since I have the possibility of taking on extra debt.

There’s also a diversification benefit since real estate market is usually less volatile than the stock market, provided that you live in a place with a stable housing market.

So even if my stock portfolio would take a massive dive, the value of the apartments would pretty much stay the same, which offers a small measure of peace during market turbulence.

It’s worth remembering that receiving monthly rental income that doesn’t depend on the market also decreases your risk level somewhat.

Last but definitely not least, owning physical real estate for investment purposes usually comes with tax benefits that can be used for tax planning. While rental income is usually taxable income, there are a lot of tax deductions and certain tax breaks you can exploit.

Cons of Direct Real Estate Investing

The biggest downside in real estate purchases is that it tends to require a lot of capital and can thus be hard to finance, especially at the beginning of your investing career. Depending on where you live, the banks usually require a down payment between 5% and 20%.

Even if you manage to negotiate a suitable financial solution, there’s always the profit side to consider. Your investment should always have a positive cash flow, which can sometimes be hard to achieve if you have a lot of debt.

Sometimes the illiquidity of real estate can become a problem. If you have a great apartment at a great location, you can probably manage to sell it in a matter of weeks. Usually, though, it takes months.

Owning real estate and managing tenants can sometimes be a lot of work since you’re the one responsible. In my experience, the crucial thing is choosing the right tenant. The wrong tenant can ruin everything or otherwise lead to massive hassle.

Pros of REITs

Although we’re essentially talking about the same thing, the pros of real estate investment trusts are pretty much the same that the cons of direct real estate investments.

The greatest benefit of REITs in my opinion is that they don’t require a lot of capital. So, even if your investing career is still in its early phases, REITs offer you the chance to diversify your investment portfolio to real estate investments.

Another great benefit is that whereas managing your own real estate requires a certain amount of effort, REITs don’t. You get all the good stuff with minimal effort!

REITs are also required by law to pay 90% of their profits out, so if a REIT makes a profit, you’re obligated to receive your share. So, what this means is that you don’t have to worry about dividend policies.

Last but not least, there’s one major benefit that can sometimes be overlooked. I wrote an article some time ago, in which I concluded that REITs serve as a great inflation hedge.

We sometimes tend to forget that inflation is a thing and a serious one at that. Because we’ve had relatively low inflation for the past years, the real returns of assets have been mainly positive, even with smaller returns.

Nowadays, with inflation being over 7%, it’s much harder to gain real returns. Luckily, REITs have performed extremely well in the long term.

Cons of REITs

If you think that REITs seem too good to be true, you can stop worrying. They do have some drawbacks.

Although REITs are a great inflation hedge, a study from S&P Global shows they tend to become volatile in the short term when the expectations about future interest rates suddenly change.

As they pointed out, though, interest rate changes don’t really affect their performance in the medium and long term.

Interest rates aside, publicly traded REITs tend to go down with the market, which is a big difference from owning real estate directly.  

Also, one thing that will surely diminish your returns is taxes. Since REITs are obligated to pay dividends, there will also be taxes to consider. While a direct real estate investment also generates taxes from rental income, there are fewer possibilities for tax planning in REITs.