As a type of alternative investment, real estate can add diversification to a portfolio and act as a hedge against inflation. Real estate investment trusts (REITs) and real estate crowdfunding offer two unique entry points to this alternative asset class.
Both allow you to invest in real estate without being required to own property directly. Comparing the pros and cons of real estate crowdfunding vs. REIT investing can help you decide which one makes the most sense for your portfolio.
Understanding Real Estate Investment Trusts (REITs)
Real estate investment trusts are legal entities that own or finance income-producing properties or invest in mortgage-backed securities. The types of properties a REIT may invest in can include:
• Hotels and resorts
• Office space
• Warehouses
• Storage space
• Multifamily apartment buildings
• Data centers
• Medical facilities
• Retail shopping centers
• Single-family homes
The primary attraction of REITs is the ability to enjoy the benefits of property investment — namely, dividend income — without purchasing real estate directly.
REITs are also considered a type of alternative investment. As with many alternative investments, real estate-based assets don’t tend to move in sync with the stock market. For this reason, investing in REITs may provide portfolio diversification.
REITs may be publicly traded, meaning they trade on an exchange like a stock. REITs must pay out 90% of their taxable income to shareholders as dividends, though some may pay as much as 100%.
If you compare REITs vs. real estate mutual funds, dividends aren’t always required with the latter. Real estate mutual funds can invest in REITs, mortgage-backed securities, or individual properties. While you may have access to a broader range of properties, you may enjoy less liquidity with real estate funds.
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Overview of Real Estate Crowdfunding
What is real estate crowdfunding? It’s a strategy that allows multiple investors to pool funds for property investment. In return, investors share in the profits generated by the investments. Regulation crowdfunding makes real estate crowdfunding possible, as entities can raise capital from investors without registering with the SEC, as long as they offer or sell less than $5 million in securities.
In terms of how it works, real estate crowdfunding platforms seek out investment opportunities and fully vet them before making them available to investors. Individual investors can then choose which properties they’d like to invest in.
Depending on the nature of the investment, you may collect interest payments, rental income, or dividends. Real estate crowdfunding can offer access to a variety of property types, including:
• Multifamily housing
• Industrial space
• Build-for-rent projects
The minimum investment varies by platform — it is commonly upwards of $5,000, but may be $500 or even lower in some cases. Some real estate crowdfunding platforms require investors to be accredited, meaning they must:
• have an income exceeding $200,000 (or $300,000 with a spouse or spousal equivalent) in each of the two prior years, with an expectation of the same income for the current year, OR
• have a net worth exceeding $1 million, alone or with a spouse/spousal equivalent, excluding the value of their primary residence, OR
• hold a Series 7, Series 65, or Series 82 license in good standing
Comparing REITs and Real Estate Crowdfunding
When choosing between a REIT vs. crowdfunding, it’s helpful to understand each option’s potential advantages and disadvantages.
Pros and Cons of REITs
Here are the main benefits of investing in REITs vs. crowdfunding.
• Risk management. Alternative investments like real estate may help you balance risk in your portfolio. REITs and real estate in general have a lower correlation with the stock market.
• Accessibility. Purchasing an actual investment property usually requires getting a loan and raising capital for down payments and closing costs. REITs can offer a much lower barrier to entry for investors.
• Dividends. REITs must pay dividends to investors, which may be attractive if you want to generate passive income with investments.
• Liquidity. Publicly traded REITs offer liquidity since you can buy and sell shares as needed, similar to a stock.
• Returns. REITs can potentially generate significant returns in a portfolio compared to stocks or other investments.
Now, here are some of the drawbacks of REIT investing.
• Fees. You’ll typically pay management fees to invest in REITs, as with any investment, but some may charge more than others. Paying attention to investment costs is key, as the more fees you pay, the less of your investment returns you keep.
• Overweighting. You can choose which REITs to invest in, but you don’t have a say in the underlying properties. Investing in REITs that own similar properties could overweight your portfolio in a single sector (e.g., malls or office buildings) and thus increase your risk profile.
• Interest rate risk. Changing interest rates can affect the value of REITs, which can influence the yield you might get. When rates rise, REIT values can decline, requiring you to adjust your expectations for a profit.
• Taxes. REIT dividends are typically taxed as ordinary income, up to 37% (plus a 3.8% investment surtax). But investors may also see a short- or long-term profit from the REIT, which would be taxed as capital gains. There is also the potential for return on capital, which can be complicated. It may be wise to consult a professional.
Pros and Cons of Real Estate Crowdfunding
Here are the main pros of crowdfunding real estate investments.
• Diversification. As with REITs, real estate crowdfunding allows you to diversify beyond traditional stocks and bonds.
• Low minimums. Some, though not all, real estate crowdfunding platforms allow you to get started with as little as a few hundred dollars. That can make entering this alternative asset class or spreading your investment dollars out over multiple property types easier.
• Geographic diversification. Real estate crowdfunding platforms can offer investors exposure to markets across the country. That can make it easier to target a specific region if you’re looking for the next “hot” market.
• Returns. Crowdfunded real estate may generate above-average returns, or exceed the returns you could get with REITs.
• Passive income. Owning a rental property can be time-intensive if you’re managing the property yourself. Real estate crowdfunding allows you to reap the benefits of rental income, without the typical headaches that go along with being a property owner.
And now, here are the cons.
• Fees. Just like REITs, real estate crowdfunding platforms can charge fees. Fee structures can sometimes be complex, making it difficult to assess what you’ll pay to invest.
• Illiquidity. Liquidity in the stock market is one thing, but when it comes to real estate crowdfunding, it’s an even bigger consideration owing to the length of time your capital may be locked into an investment. Once you invest in a property, you’re essentially committed to owning it for the duration of the holding period. It’s not unusual for real estate crowdfunding platforms to offer investments with holding periods of five years or more, making them highly illiquid.
• Accreditation requirements. Some crowdfunding platforms only accept accredited investors. If you don’t meet the standards, you won’t be able to invest through those platforms.
• Taxes. Income from crowdfunded real estate investments is taxable, though not always in the same way. You may be subject to different tax rates based on how dividends and interest are paid out to you. You may want to consult with a professional.
Which Investment Strategy Is Riskier?
It’s difficult to pinpoint which is riskier when comparing a REIT vs. real estate crowdfunding, as each one has different risk factors.
With REITs, the biggest risks may include:
• Liquidity risk, which could make it difficult to sell your shares if you’re ready to leave an investment.
• Changing market conditions or rising and falling trends, either of which could directly impact real estate values.
• Interest rate sensitivity, which can influence REIT values.
The main real estate crowdfunding risks may include:
• Platform risk, or the risk that the marketplace you’re using to invest could shut down before you’re able to withdraw your capital.
• Poor vetting, which may allow unsuitable investments to make it onto the platform.
• Changing regulations, which may affect the real estate crowdfunding space as a whole.
Whether you choose a REIT vs. crowdfunding, lack of education or understanding is also a risk factor. If you don’t understand the basics of how either type of investment vehicle works, you could be putting yourself in a position to lose money.
Due Diligence Considerations
REITs and real estate crowdfunding platforms should perform due diligence in vetting investments to make sure they’re suitable. However, it’s wise to do your own research to understand what you’re investing in, who you’re investing with, and the potential risks.
As you compare REITs or real estate crowdfunding platforms, keep the following in mind:
• Minimum requirements to start investing, including accredited investor status
• Range of investment options
• Transparency concerning fees and investment selection
• Holding periods
• Performance track record
• Overall reputation
Talking to other investors who have used a particular crowdfunding platform or invested in a certain REIT can offer perspective on the good and bad.
The Takeaway
Real estate can be an addition to your portfolio if you already have some experience in the market, and have an affinity for real estate. As a type of alternative asset class, investing in real estate can add diversification to your portfolio, and potentially act as a hedge against inflation. Both REITs and real estate crowdfunding enable you to invest in real estate without the hassle of actual property ownership and maintenance, but come with different risk factors than you’d find with traditional securities.
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FAQ
What are the main advantages and disadvantages of investing in REITs?
Investing in REITs can offer the benefits of dividend income and portfolio diversification, without requiring you to own property directly. The disadvantages of REITs can include interest rate risk and market risk, both of which can affect the value of your investments.
How does real estate crowdfunding differ from traditional REIT investments?
Real estate crowdfunding allows investors to pool funds together to invest in property and collect interest, dividends, and/or rental income. REITs own and operate investment properties and pay dividends to investors. REITs and real estate crowdfunding can differ concerning the types of properties you can invest in, the minimum investment required, and the fees you’ll pay.
How are taxes treated for REITs and real estate crowdfunding?
REIT dividends are primarily treated as ordinary income for tax purposes (although you may face capital gains on any profits). Real estate crowdfunding returns may be subject to capital gains tax and/or ordinary income tax rates, depending on how they’re structured. Because the tax treatment of these two entities can be complicated, it’s probably wise to consult a professional.
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