Article as published in Thestreet.com Feb 22, 2010. Manhattan Property: Direct Ownership vs REITs
Here are some pros and cons to weigh if you're thinking about direct property ownership in Manhattan, such as buying an investment condo or building vs. investing in a real estate investment trust such as Boston Properties(BXP Quote), SL Green Realty(SLG Quote) or Vornado Realty Trust(VNO Quote) that own commercial properties in the area.
No. 1, Liquidity: REIT wins. REITs are liquid and can be bought or sold with the click of a mouse. That's not the case with direct ownership in a condo or building because it takes at least three months to buy or sell.
No. 2, Entry level: REIT wins
The capital requirement for REITs is as low as $100. But to own a Manhattan condo, the entry price point is about $500,000. With a 30% down payment, the capital requirement is at least $150,000 excluding transaction costs.
No. 3, Leverage: Direct wins
Direct property ownership benefits from the power of leverage. If a property appreciates by 10% but the property is purchased with 80% debt and 20% equity, the return on that 10% is magnified to about 50% before transaction costs (10% appreciation/20% equity).
While the 10% is based on the total price of the property, the equity the investor actually puts into the property is just a fraction of the total property value. By comparison, if a REIT appreciates 10%, the return is just 10% as the REIT investor typically does not use leverage.
No. 4, Control: Direct wins
The property owner controls how well the property performs. For example, he can renovate the property to justify higher rents. The flip side is that the landlord has to deal with headaches associated with property ownership. With REITs, the investor is passive and has no control.
No. 5, diversification benefit: Direct wins
REITs do not provide as good a diversification tool because values are correlated with the broader stock market.
No. 6, tax advantages: Direct wins
Direct property ownership benefits from the depreciation allowance. While not a real expense to the investor, it effectively decreases or wipes out taxable income that is reported to the IRS. For example, a 10% property return may still be 10% on an after-tax basis.
However, a 10% return on a REIT, because it's fully taxed, may be 7.5% after tax. Property owners also can defer taxes by exchanging for a larger property in a 1031 exchange. This effectively turns funds, which otherwise would have been used to pay taxes, into productive assets.
No. 7. Return on investment: Direct wins
Returns from direct ownership is higher because of the power of leverage. Further, REITs typically invest in very large buildings to justify large overhead expenses. These properties, because they are being competed for by institutional investors, typically have lower returns.
In summary, if one prefers liquidity or has limited capital, then go for a REIT. If one has the required capital and is willing to tie up that up for at least five years, while maintining most of the portfolio in more liquid investments, then direct property ownership has very good long-term advantages.