Should you Invest in a Residential Rental Property or REITs? (2024)

Many people dream of generating passive income – you do the work once, and the money keeps coming in. For those looking to grow their wealth, real estate – and more specifically buying a residential rental property – is a common source of passive income. But is it actually so passive? Owning residential real estate can be a way to generate rental income and potentially profit from the sale of a property. Many turn to it as a safety net in their retirement. Whether they buy an investment property or perhaps inherit one from a family member, it’s an asset to have – especially in recent years with skyrocketing home values and prices.

But there’s another investment option to consider: real estate investment trusts or REITs. These are companies that own and operate real estate with the purpose of generating revenue. People buy shares of these types of companies on the stock market, and shareholders get dividends on a regular basis (usually quarterly or monthly). These dividends are often higher than other types of stocks because the REIT is required to pay out 90% of its income to shareholders.

If you’re exploring real estate investment options, keep reading as we’ll share the pros and cons of each type of investment option!

Based on current and historical residential real estate market conditions in the United States, real estate is a fairly secure investment overall.

As of 2018, according to the Pew Research Center, 14.1 million individual investors owned between one to four rental properties – representing the largest share of landlords.

Real estate also provides a tangible asset that you can leverage for future financial endeavors. If your home value rises and you build equity, you can have the option to refinance or sell properties to fund other investments or goals.

Additionally, investing in real estate allows you to diversify your investment portfolio beyond traditional options like stocks, bonds, and certificates of deposit. Diversifying with physical property can help minimize risk and protect against the negative effects of swings in the stock market.

You’ve also got a bit more control over any real estate properties you own compared to other types of investments. You can choose how to upkeep them, if and when they need renovation, and to a degree how much to charge for rent, and any policies for tenants.

If you’re forward-thinking about retirement, the rental income from one or multiple properties can serve as a reliable source of passive income during the years when you’re no longer working, and you can sell the property if you need a lump sum of cash. You may also purchase your future retirement home as an investment – maybe you know that eventually, you’ll want to live in a different area than where you live now. Perhaps you could get that beachfront condominium now, rent it out, then move in down the line when you’re done working and don’t want to maintain the single-family house with a yard.

Lastly, if you’re trying to build generational wealth for your children (or maybe nieces and nephews or even grandchildren), owning and passing down real estate properties can help with that goal. Be sure to talk to an estate planning attorney who can set your family up for a smooth ownership transition when that time comes.

While the overwhelming majority of renters are current on their rent, people fall on hard times when things like job loss or illness happen, and some fall behind on rent. The National Equity Atlas reports that as of May 2023, about 5 million rental households were behind on rent. Out of 44 million renter households in the United States, that’s about 11%. The average amount in arrears is just over $2,100.

You may also have tenants that cause damage beyond the normal wear-and-tear of daily life, leading to more money on repairs. How much of a risk this poses to you depends on a lot of factors, including how much you rely on the rental property’s income to recoup your investment or to meet your current expenses.

Real estate investment trusts, or REITs, offer an alternative way to invest in real estate by owning shares of companies that own and operate real estate. In addition to residential properties, they own and operate commercial real estate like shopping centers, but also healthcare facilities, storage facilities, and more. Learn more about REITs from the Securities and Exchange Commission directly.

Data on REITs from the Motley Fool shows that REITs have outperformed the S&P 500 on 20 and 50 year horizons, and dividend paying stocks tend to be less volatile than non-dividend paying stocks in general.

REITs are a nimble way to invest in property. You purchase shares through a stock brokerage so it takes minutes just like any other online transaction. There’s no house shopping, home inspections, or paperwork like when buying a physical property.

If you ever want to sell, it’s as simple as initiating a sell order in your brokerage account. You’ll be able to reinvest the money or transfer it to another account within days. You can also sell a portion of your investment. For example, if the REIT stock price increases and you want to take advantage of the profit, you can sell some shares, while still maintaining some shares for the dividends and more potential future growth.

REIT investing is much more hands-off than maintaining a property. You’re not going to get calls at inconvenient times with news that the oven stopped working or the basem*nt flooded and have to drop what you’re doing to resolve the issue!

You can buy REIT shares and let them sit and provide dividends for years to come. If you’re not the kind of person that obsessively checks your stock portfolio, you can set specific types of sell orders where the stock automatically sells if the price reaches a certain price, like a stop-loss or limit order. You can also enable dividend reinvestment in your brokerage account to automate buying more shares so you can grow your portfolio without having to do it yourself.

Of course, you’ll still want to keep an eye on your investment and the broader stock market – it’s not a total “set and forget” type of investment. But compared to the effort to maintain a property, the time involved to maintain your REIT investment is still substantially less.

So, how long will it take to recoup your investment in a share of a REIT? It depends on the share price when you purchase and the dividend amount. But, the dividends generated from a share of an REIT can potentially cover the initial cost of the share as little as seven years, not including the income taxes on dividends. Let’s see how this works:

If you put $100,000 into shares of a REIT with a share price of $10, you’ll get 10,000 shares. If the REIT pays a quarterly dividend of $0.25 per share, you’ll get a dividend of $2,500 four times a year, adding up to an annual income of $10,000. You’ll pay taxes on that dividend. But with that money you could buy more shares of a REIT, another stock, or take the cash.

If the dividend holds steady, dividends will pay back your initial investment in 10 years (not accounting for taxes – that would a few more years depending on your tax rate).

But like with any stock, there’s always a chance the REIT will do a stock split or reverse split where the number of shares you have will change. Plus, the REIT can change their dividend amount. All of these would impact the timeline to recoup your investment.

In addition, because being a shareholder is less hands-on than investments, you have little direct control. You can vote in shareholder meetings, but you’re really trusting the REIT to deliver a positive return on your behalf.

It also might take a longer time or larger upfront investment for the dividends to feel substantial. You’ll get the same dividend amount per share no matter how many you buy. But if you earn $0.50 in quarterly dividends compared to $500, it may not feel like you’re making substantial progress toward your financial goals.

Lastly, the IRS taxes income from REIT dividends at your normal income tax rate. Depending on your other sources of income and any tax withholding you already have, you may find yourself owing more than you expect at tax time. While rental income has the same tax rate too, there are expenses related to maintaining a physical property that you can deduct to bring the overall tax burden down.

Real estate can be a successful venture for many investors, so it is worth evaluating as an option for your portfolio. You can choose a physical property, shares in REITs, or perhaps both.

It’s important to keep in mind that all investments involve risk, and you should factor in your risk tolerance and personal financial situation whenever you make investment decisions. Ultimately, it’s a smart move to do your research about any potential investment, diversify your portfolio to mitigate risk, and talk to a financial advisor or financial planner who can provide tailored advice for your situation!