Direct vs. Indirect Investing

05.07.2018 |

Episode #2 of the course Real estate investing essentials by Symon He

 

Hey, welcome back!

In Lesson 2, we’re going to go over the difference between direct and indirect ways of investing in real estate.

 

Definitions

When we speak of real estate investing, we’re typically referring to directly investing—that is, when you have direct ownership in a property. If you went and bought a property on your own or if you partnered with friends and purchased a property under your partnership, that’s direct investing.

Indirect investing involves buying shares in a real estate fund, such as buying shares of a publicly-traded real estate investment trust (REIT) or a company that is heavily exposed to real estate (e.g., owning stocks in Lennar, a publicly traded homebuilder). REITs are in the business of owning and managing portfolios of numerous real estate properties. These funds have managers who manage the purchasing, management, and ultimate selling of the properties, while the income generated is distributed to the shareholders as dividends.

Therefore, investing in REITs is investing in the operating profitability of the landlord and not directly in the underlying assets themselves, since owning the stock gives you claim to a share of the dividends of the fund, but not any direct ownership of the actual properties. Similarly, owning stock in a publicly traded real estate company allows you to invest in real estate without directly owning any of underlying assets.

 

So, What’s Better?

Neither. As you’ll see, deciding how you’ll invest in real estate is about understanding and making informed trades. Let’s take a look at what those are.

Indirect investing provides better liquidity

Among the top four major investment asset classes—stocks, bonds, cash, and real estate—real estate is associated with the lowest liquidity. If you own a rental property, you cannot easily convert that investment into its cash equivalent—you’d have to prep it for sale, market the property, get offers, go through a negotiation process, and then finally enter into escrow and closing. The process could take months.

However, that generalization mostly applies to the direct way of investing, where you own the underlying real estate asset. For indirect investments in shares of REITs, they’re just as liquid as stocks and can be easily sold in the open market in minutes.

Liquidity matters more for investors with shorter investment horizons or for those who anticipate they’ll need the cash in the near future.

Indirect investing provides better diversification

Diversification in investing is the idea of not placing all your eggs in one basket to spread out the risk of investing. Just imagine you had $100K to invest. You could put that all in one investment or spread that across ten $10K investments. From this perspective, indirect investing is easier to diversify. Buying shares of REITs allows you to easily invest in multiple REITs that have different investment strategies, covering a wide variety of asset classes in multiple geographical markets.

Investing directly for most investors means having to put more of their investable funds into far fewer investments, thus concentrating investment risk. If one investment goes bad, it hits a larger percentage of your investment portfolio.

Most investors prefer some level of diversification. But for investors with a very long horizon and a high risk tolerance, they may want to concentrate their investments to maximize their potential returns.

Indirect investing is easier to start

Investing in real estate takes capital and time. Even if you’re doing a “simple” investment, such as buying a rental income property, it could take tens or even hundreds of thousands of dollars of starting capital.

But buying shares of a REIT? It’s like buying stocks in a company. You open a investment account and be ready to invest with even just a few hundred dollars.

Direct investing gives greater sense of control

In a direct investment, you’re in the driver’s seat. You will choose the properties according to your investment criteria. You pick the location, asset type, financing structure, investment strategy, exit plan … everything. Direct investing empowers the individual investors with the opportunity to invest in what they know and are passionate about. For investors who prefer having total control, direct investing is the only way to go.

In contrast, buying shares in a fund or a REIT equates to investing in an entity’s broader investment strategy where the fund managers make all the decisions. You’d have little to no control over any investment decisions.

One way isn’t better than the other. Investing in real estate is always going to be about making trade-offs and deciding what works for you. Investing directly or indirectly is deciding on what you want more of in terms of liquidity, diversification, ease of getting started, and sense of control.

Tomorrow, we’ll look at the many kinds of real estate available for investors to consider.

Have a great day!

Symon

 

Recommended book

The Millionaire Real Estate Investor by Gary Keller, Dave Jenks, Jay Papasan