It seems like there are always rumblings these days about a looming economic recession. Justified or not, this anxiety has many looking to diversify their portfolios. In this article, we’ll look at REITs vs. crowdfunding – two forms of investment that many people use for just that purpose.
While speculation is usually not the best idea for the passive investor, diversifying your portfolio is not the worst idea – regardless of the economic climate. By definition, a lack of diversity is what can often cause a portfolio to be unnecessarily volatile.
Both REITs and crowdfunding (specifically crowdfunded real estate) can, in theory, add diversity to your portfolio by adding an asset class that is less dependent on how corporations are performing.
What are REITs?
REITs are real estate investment trusts. Unlike index funds, REITs are companies that own and manage real estate properties. In other words, investing in a REIT means you are owning real estate without having the responsibility of managing the property yourself, like you would if you were a landlord.
When you invest in a REIT, you don’t invest in real estate directly, however. That also means the company that manages the REIT makes all of the investing decisions. Thus, you should be sure you are investing in a REIT that invests in the type of properties you want to see them investing in.
To invest in a REIT, you can buy shares in it just like you would with stocks or index funds.
There are two main types of REITs: equity REITs and mortgage REITs. As you might be able to guess, mortgage REITs make money primarily by issuing mortgages on properties. Mortgages charge interest, and that interest makes it back to shareholders of the mortgage REIT.
It’s a little less obvious what an equity REIT is based on its name alone. You have probably heard of someone who has made one or more payments toward their mortgage as having “equity” in their home, but that doesn’t apply to this example.
Instead, equity REITs are real estate companies that buy income-producing commercial real estate properties. They then lease those properties to tenants and the income is paid out to investors in the form of dividends. The dividend payout ratio for REITs must be at least 90%.
What is Real Estate Crowdfunding?
Think of real estate crowdfunding as the “GoFundMe” of real estate purchasing. No, I’m not talking about a GoFundMe that is started to send a woman around the world for her “spiritual healing.” In this case, we’re talking about funding that will actually benefit all parties involved (or should, at least).
But real estate crowdfunding is much the same as funding these causes because you are funding a specific real estate project. So, rather than investing in a company that does what it chooses with your money, you will know the details of the project before you invest.
Perhaps that is one of the reasons crowdfunded real estate has gained popularity in recent years. Another reason is that in 2012, the Jumpstart Our Business Startups Act permitted real estate projects to start marketing directly to potential investors. This can now be done in the same places you see anyone advertising anything these days – Twitter, Facebook, and the like.
All this has also given rise to an increase in accessibility to crowdfunded real estate. At one time, there were significant barriers to entry – such as needing large sums of money to invest. Now, with services such as Fundrise, almost anyone can invest in real estate crowdfunding.
REITs vs Crowdfunding: Which is Better?
When comparing these two forms of investment, one is not necessarily better; they are just different. Both come with their own pros & cons.
For example, as mentioned above, REITs must pay out at least 90% of the income as dividends. This could also be seen as a con, though, since REIT income is usually reinvested back into the business. And because you are investing in a company rather than a single property, you may be diversifying your real estate income since the REIT may have income from many different properties.
However, REITs aren’t perfect. For example, some data suggests that public REITs are actually correlated with stock market performance. Thus, these REITs may not be as well-suited to, say, hedging against a volatile market. On the plus side, REITs can be easily traded; they are much more liquid than investments in crowdfunding.
Those who are experts in a particular type of property may value crowdfunding since they can choose which type of properties their money goes toward. As a result, returns on crowdfunded real estate can be higher, and often are for the savvy investor. In addition, they may be less tied to market performance due to being part of one particular real estate project.
Plus, those who crowdfund a real estate property might feel more “connected” or emotionally invested in the project. They might feel more involved, too. This may or may not be important to you, but for some, it could be a big deal.
In either case, the biggest benefit is that you don’t have to have huge sums of money to invest in real estate. Plus, you’re able to invest in income-producting assets without having to do all the work of managing the property yourself.
At the same time, you are able to take advantage of commercial real estate, which tends to have less turnover than residential real estate.
And, in either case, your losses will be much less if a project turns out to be unsuccessful. If a REIT buys a multi-million dollar office building and the company occupying it goes under, you won’t be feeling the pain nearly as much as a REIT investor as you would if you were the sole owner of the building. Same goes for a crowdfunded office building.
So, indeed, one type of investment is not necessarily better than the other. It mostly depends on what type of investor you are and what you hope to get out of your investment.