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Rental properties, REITs, fractional ownership, and tokenized: is there any one best way to invest in real estate?

Real estate investing

Just as there are many sectors of the real estate market, from houses to apartment buildings, shopping centers to hotels to farmland, there are also many ways to invest. 

These include: 

  • whole ownership of individual rental properties
  • purchasing shares in real estate investment trusts
  • pursuing fractional ownership
  • purchasing tokenized properties.

Various investors choose different ways of investing depending on their own preferences, from how much time they have to spend to what their risk tolerance is.

Some investors might want to buy a home and lease it to a family they can look in the eye, earning monthly rental income; they may want complete control over how the asset is managed. Others prefer to invest from a distance, by purchasing shares in a trust that is run by experienced managers who oversee a portfolio of properties and maximize their profitability. 

Others might want to own part of an individual property that they can live in for part of the year or rent out to tenants, in a fractional ownership arrangement. And with the arrival of the blockchain, some are now investing in tokenized real estate. 

Each of these real estate investing techniques carries advantages and disadvantages. Each can add to an investment portfolio in unique ways. 

Direct real estate investments  

Direct ownership of physical real estate brings both the greatest potential for upside as well as the greatest responsibility for the asset and the greatest risk. This is the most traditional way of investing in the real estate market, in which an owner purchases rental properties, whether commercial or residential properties, and leases or rents them to tenants. 

The pros of direct real estate investment 

The owners of rental properties have the possibility for earning regular cash flow and taking tax deductions, all while employing leverage, and ultimately benefiting from price appreciation. 

In the case of single family homes, these factors have combined to make real estate ownership a powerful engine of intergenerational wealth. 

Owners of rental properties may charge rents as high as the market will bear, creating cash flow. They can, at the same time, take tax deductions for expenses like mortgage interest, property management fees and rental property insurance premiums. They can also take advantage of the depreciation deduction, which allows property owners to recover some costs of an income-producing property.

The owner of a rental property has full control over the asset. If zoning laws allow it and the owner of, for example, a single-family rental property has the money in the budget, they can increase the value of their property by adding an accessory dwelling unit (ADU), finishing a basement, or making an addition, thus increasing the rent they can charge. 

Furthermore, investors can employ leverage: by using other people’s money (typically a bank’s), they can pay only part of the price of a property from which they will earn 100 percent of the rental income. Investors can use various kinds of financing (conventional, interest-only, varying debt service coverage ratios) depending on their financial goals.

As interest rates change, the owner of a property can, if it suits their purposes, refinance the property for any of a number of reasons.

Then there’s appreciation: unless they are flipping the property, most real estate investors plan to hold onto the asset for a significant period of time, during which they assume it will appreciate in value, so they can profit by reselling it at a higher price. 

Though individual markets experience ups and downs, houses in general, over time, have risen in value, according to this chart from the Federal Reserve of St. Louis.

And if they do sell the property, there are strategies by which they can minimize their tax burden, such as a 1031 exchange and a Section 121 exclusion.

The cons of direct real estate investing

Direct real estate investing requires considerable capital. Investors typically have to make a down payment of as much as 25 percent. Even in markets like Indianapolis or Memphis, where median prices for a single family home can be as affordable as $200,000, that’s on the order of $50,000 cash, and then there are closing costs (which can be as much as 6 percent of the loan, so on a $150,000 mortgage, costs could be as high as $9,000). 

It takes a good deal of time and effort to gain expertise. Investors have to get familiar with real estate markets to determine where to buy. They have to know what to expect in terms of vacancy rates, market rents, maintenance costs, and the ins and outs of legal compliance. (Of course, hiring a property management company such as Mynd takes some of the work off the investor’s plate.)

While leverage allows the investor to buy more property than they could afford if they were buying outright, it can also present a liability. If a property that an investor owns outright sits vacant for longer than expected, the owner may be able to eat the expense, but if the owner is depending on monthly rental income to make mortgage payments, they may be at risk of default on the loan in the event of a prolonged vacancy, with serious consequences for their credit rating. 

Real estate is, relative to other kinds of investment, illiquid, meaning that a great deal of the investor’s resources are bound up in a property that, depending on a number of sometimes unpredictable variables, may take weeks or months to sell. 

Real estate investment trust (REITs)

Another popular way to invest in real estate is via a real estate investment trust, commonly known as a REIT (pronounced reet). These are corporations that act like mutual funds for real estate investors, allowing them to invest without owning any physical property themselves. The investor purchases a share of a REIT, much as they would buy shares of stocks or mutual funds, and the trust pays dividends to the shareholders. 

Congress established REITs in 1960 as a way to let individuals invest in large-scale, income-producing real estate. 

REITs can deduct from their taxable corporate income all dividends paid out to shareholders. Most REITs, according to the Securities and Exchange Commission’s Office of Investor Education and Advocacy, pay at least 100 percent of their taxable income to shareholders, and thus pay no corporate tax. 

REITs overall are seen as a good investment. According to the FTSE NAREIT Equity REIT Index, the 40-year compounded annual return on REITs is 9.44 percent.

There are three principal kinds of real estate investment trust:

  • Equity REITs mostly own, operate, and finance income-producing residential or commercial property or real estate-related assets. They work like a mutual fund in that they pool the capital of a number of investors for the benefit of all. Most REITs are of this type. 
  • Mortgage REITs typically lend money to real estate owners and operators, or extend credit indirectly. They manage their interest rate and credit risks by employing derivatives and other forms of hedging. 
  • Hybrid REITs use investing strategies of both equity REITs and mortgage REITs. 

According to the National Association of Real Estate Investment Trusts (Nareit), about 1,100 REITs have filed tax returns, and there are more than 225 in the U.S. that are registered with the Securities and Exchange Commission and trade on one of the major stock exchanges, the majority on the New York Stock Exchange. Those 225 have a combined equity market capitalization of more than $1 trillion. 

Other REITs are registered with the SEC but aren’t traded on public markets. 

According to Nareit, REITs exist in more than 40 countries and regions worldwide.

The pros of REITs 

Compared to buying actual real estate, shares in REITs are very easy to buy, and investors can get started with very low dollar amounts. Some trading platforms even allow investors to buy a fraction of a share. 

REIT shares can be very liquid. Rather than selling a property, which can take weeks or months even in a highly active market, investors can sell shares of a REIT with the click of a mouse, without the involvement of a real estate agent. 

REITs’ dividend distributions create regular cash flow. 

REITs make it easy to diversify among different kinds of real estate investments. The investor can purchase, for example, a few shares of build-to-rent single family homes, a few shares of multifamily homes, a few shares of commercial real estate, and so on. 

REIT investing requires less expertise than buying actual property, because they are managed by experienced professionals. The investor can profit from real estate without knowing lease law, screening tenants, and having a network of trusted contractors to handle renovations and repairs.

The cons of REITs

Most REIT dividends are taxed as ordinary income, without the tax advantages of direct real estate investment. Shareholders have to pay taxes on the dividend income and on any capital gains. Investors should be aware of this drawback if they hold their REITs in a taxable brokerage account. (It is possible to hold REITs in a tax-advantaged Roth IRA account.)

REITs can help investors to diversify their portfolio, especially if they buy shares in various REITs, but individual REITs are generally not diversified. They tend to concentrate on a specific type of property, such as office space or retail space. So investors are exposed to risks that are specific to that industry.

Furthermore, REITs are closely correlated to the stock market. They have an almost 70 percent correlation with stocks, based on a comparison of the NAREIT Equity REIT Index and the S&P 500 over the decade ending in 2020. (They have low correlation with bonds, commodities, and currencies, on the other hand.)

While receiving dividends may be a plus for the investor, it also means that that money can’t be reinvested into the company, the way individual investors could use their earnings to expand their real estate portfolio. 

Fractional ownership

In fractional ownership arrangements, investors own a percentage of actual assets, be they sports cars, private jets, or valuable real estate, along with other investors.

Depending on how the contract is written, the part-owners have rights to use the asset, to a share of any income it earns, or to priority access to the asset. In the case of real estate, the co-owners typically pay a property management company to maintain the property and to handle the calendar. 

For example, six investors might co-own a vacation villa, each having access to the property for two months out of the year, during which they can live in the property, or rent it to one of the co-owners or to another party. They share all the costs associated with the property, including property taxes, homeowner association fees, maintenance, and repairs. 

While some aspects of fractional ownership may recall timeshares, the key distinction is that in fractional ownership, the investor owns part of the title to the asset, while timeshares are typically owned by a large corporation and the timeshare user owns only units of time. Timeshares have grown into a multibillion-dollar industry since they began in the 1970s, though their sales techniques became a punchline, and booking was rigid. Many have moved to more flexible points-based systems. 

According to consulting and market research firm Ragatz Associates’ 2022 report on shared ownership resort real estate, there are currently more than 300 fractional-interest properties and private residence clubs (a similar arrangement), about two-thirds of them in the U.S. Between them, California and Colorado have about a fifth of all such properties. 

But while Ragatz anticipates the trend will increase, Pacaso, the company perhaps most closely associated with fractional ownership, has come up against legal challenges in its home state of California. Golden State opponents argue, among other things, that Pacaso is setting up commercial enterprises in residential areas. 

The pros of fractional ownership

Fractional owners can own a share of a property in a market that would otherwise be beyond their means. 

Unlike properties owned as an investment and rented to others, or the properties in a REIT, the part-owners can actually use the properties partly owned in a fractional ownership.

As the asset rises in value, the value of the fractional owner’s share also rises. And the resale market for shares of property is considerably stronger than that for timeshares, which are notoriously difficult to sell. 

The cons of fractional ownership

Unlike conventional financing, mortgage loans for fractional ownership are hard to come by. The cost to purchase a fraction of a property without leverage may be higher than the down payment on a property the borrower owns individually with a mortgage.

There is typically no option to self-manage the property or use another property management company than the one already in place. 

Reaching consensus on any decisions to be made about the property can be onerous, especially decisions on selling shares of the property. 

A great deal of the co-owner’s assets are locked up in that one property, which may limit their vacation travel options, since they may feel bound to use that one property rather than spend additionally on hotels or short-term rentals in other locations, especially if the arrangement makes it challenging to rent the property when the part-owner isn’t using it themselves.

Tokenized real estate ownership

A new and unconventional manner of real estate investing may be opened up by new technology in the form of tokenized real estate ownership, which has some characteristics of REITs and some characteristics of fractional ownership, but incorporates digital ledger technology and smart contracts. 

A piece of real estate is tokenized when it is broken up into fractions, each of which is represented by a digital token, a record of ownership that is registered on the blockchain, a distributed digital ledger that provides a transparent, immutable online record of ownership and transactions. Trading in these tokens may be transacted with smart contracts, which have the potential to make transactions more efficient and less costly. The owners of the tokens may earn money from rent income, and may sell their share of ownership at a profit. 

Advocates of tokenized real estate investing say that it will lower the barriers of entry to retail investors in a way similar to REITs, which were created to democratize real estate investing. (Tokenized real estate is different from REITs in that the ownership is in individual properties, rather than portfolios of properties.) 

But the entire market is new and largely untested. As KPMG’s Anthony Tuths said in an interview with the Warrington College of Business at the University of Florida, “Tokenized real estate is a bigger topic of conversation than it is an existing market.” In fact, as of September 2022, the Security Token Market estimates the entire market at only $50.8 million. 

The pros of tokenized real estate

Advocates say that tokenized real estate may lower the barriers to real estate investment and inject liquidity into a highly illiquid industry.

The technology has the potential to streamline real estate transactions, reducing the need for paperwork and expensive legal representation.

The cons of tokenized real estate

The tax and regulatory structures governing digital tokens are still in development.

Scams abound. Traders have to conduct extensive due diligence. 

Hackers are working to find ways to intercept money transferred digitally, and once the money is stolen, there’s little chance of recovering it. 

The platforms for tokenized real estate are limited, and there are few actual assets anyone can invest in. 

The bottom line on physical real estate vs. REITs vs. fractional ownership vs. tokenized real estate

Again, there is no one best way to invest in real estate. 

Many owners of actual property take considerable satisfaction in owning physical properties, and, if they find good deals, they can achieve considerable earnings. But good deals are hard to come by, and the owner is responsible for any problems that arise, be they difficult renters or unexpected and expensive renovations and maintenance

REITs may provide a good entry point for those who want to begin to invest in real estate but don’t have the means for a down payment. They don’t provide diversification from securities, but they allow investors with modest means to participate in the benefits of real estate investing. 

Fractional ownership allows investors to own a portion of a real estate asset they might be unable to afford on their own, but the need to arrive at consensus on all decisions can present challenges. 

Tokenized real estate has potential as a streamlined way to invest, but this part of the industry is in its infancy, so there are few tokenized properties to invest in. Scammers are also hard at work finding out how to take advantage of over-eager investors.

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