Smart investors know that investing in real estate has a lot great benefits, but many don’t want the responsibility of being a landlord. To reap the benefits of real estate and earn passive income, investors will often invest with a Real Estate Investment Trusts (REITs) or real estate syndication.
REITs – pronounced ‘reet’ – is a company that owns or finances income-producing commercial real estate across many property sectors. REITs are publicly-traded companies that invest in a variety of real estate property types and allow individuals to invest in portfolios through the purchase of company stock, a mutual fund or exchange traded fund (ETF). Basically, you’re buying a share in a stock.
On the other hand, real estate syndication – or group investment – is an effective way for investors to pool their capital to buy or build property. It’s a way to leverage buying power for projects much bigger than investors can afford or manage on their own.
In both cases, you earn an income without having to manage property, but the ownership of assets, tax benefits and return on investments varies with each type of investment. Here are four of the biggest differences between REITs and real estate syndications.
When you invest in a REIT, you’re investing in a company that holds a portfolio of properties. Your investment is not directly in a specific real estate property but more on a certain asset classes like senior living facilities, shopping malls, office buildings or apartments. So if you invest in an apartment REIT, chances are that REIT owns and manages several apartment buildings in multiple markets. You don’t own the underlying real estate, you own shares in the company that owns those assets.
With real estate syndication, you can see, touch and feel the property. As an investor, you are investing in a single property that you own. You’ll have details on the layout, financials and business plan of that property. Simply put, it’s a tangible asset you can research, inspect and control.
Investment Capital and Risks
Investing in a REIT only requires purchasing shares with just a few dollars, similar to buying stocks. They have great liquidity because shares are traded on public exchanges. It’s possible to invest in a REIT with a small amount of money. Unlike group investments that have higher minimum investments, REITs are more suitable for new investors with limited experience and limited capital.
However, they are impacted by broader market fluctuations. Any downturn can cause havoc in your portfolio. Additionally, you have to trust what’s on paper. It’s hard to do a risk assessment if you don’t know which properties you’re investing in.
Syndications on the other hand are focused on long-term growth of direct ownership and provides more tax benefits. The higher threshold of real estate investment makes it harder to be defrauded than when investing in stocks. There’s also credit, income and lenders’ requirements for investment. Overall, group investments are typically less risky than REITs because investors know what they’re getting and can evaluate the investment on its own merits.
Depreciation is a tax benefit enjoyed by investors for REITs and syndications because you get to write off the value of an asset over time. For many, the depreciation benefits are reason enough to invest in real estate because it shows a loss on paper while you’re receiving a positive cash flow.
However, the benefits of depreciation with a REIT is not as much as a group investment because the depreciation is factored in before you get your dividends. So there are no additional tax breaks on top of that and investors cannot use depreciation to offset other income.
The income for REITs are treated as dividend income like a stock or mutual bond because REITs are essentially stocks. Dividends are taxed as ordinary income because REITs do not pay taxes at the corporate level. This can lead to a bigger tax bill. Investors are taxed at an individual tax rate for the ordinary income portion of the dividend.
When investing directly in a property through a real estate syndication, investors benefit from a variety of deductions and 1031 Exchanges that allow you to defer the taxes on your profit at sale and reinvest in another property.
From a tax perspective, syndications are the winner here.
To qualify as a REIT, a company must have the majority of its assets and income connected to a real estate investment and distribute at least 90 percent of its taxable income to shareholders annually through dividends. At face value, this sounds like a great deal, but it’s not exactly what you may think.
The payouts are generated from “taxable income” or the company’s cash flow statement, not the company’s earnings. A cash flow statement outlines what a company does with the money it earns. Investors aren’t privy to a company’s tax returns, so we go to their financial results through generally accepted accounting principles (GAAP) to see an asset’s cash flow and earnings. When looking at a REIT’s GAAP earnings it’s possible to see a REIT hasn’t made any money or even has negative GAAP earnings.
This explains why many REITs have lower payout ratios. The payout ratio is the percentage of net income that a company pays out as dividends. For example, a payout ratio of 10% means that for every dollar of net income, 10% is being paid to the shareholder in the form of dividends. Shareholders end up paying the income tax on dividends.
Investors of real estate syndications have higher returns. For example, multi-family real estate has a greater cash flow because there are multiple units with more cash coming into your pocket every month. Investors earn strong passive income returns with a stable stream of income that can even be tax-free after depreciation.
In the end, both REITs and real estate syndications will earn you passive income, but it’s a matter of how much bang you’ll get for your buck. Ask yourself, how much of a risk are you willing to take on the market? Do you direct ownership of an underlying asset or trust what you see on paper? If you’re interested in long-term growth with higher returns, then syndications are the best way to go. Give us a call to discuss investment opportunities.