A Self-Directed IRA is a versatile tool to invest in a REIT (Real Estate Investment Trust). With it the account holder will get tax-advantaged growth, the freedom to invest in any kind of REIT, and the ability to self-manage the account. Previously we have discussed different kinds of REITS and choosing the most appropriate Self-Directed IRA account. Today we’re going to switch gears and discuss the pros and cons of actually investing in a REIT as a Self-Directed IRA asset.
A REIT is a natural fit for a Self-Directed IRA. Many Self-Directed IRA account holders already have some real estate experience, often with a small rental property or rehab project. However, as investors quickly learn, property management can eat up a lot of hours of the day. At some point the investor may wish to continue investing in real estate, but in a way that doesn’t consume all of their time. That way may prove to be a REIT. It provides a hands-off venue for being involved in real estate without a lot of the busy work. The question is how should it be structured so that the venture remains profitable for the Self-Directed IRA? To answer this question we’ll discuss some of the pros and cons associated with REITs. The interested Self-Directed IRA account holder will then be able to apply the relevant data to their personal situation.
- Market Diversification
Pro – A REIT provides an alternative to market-based products. By gaining exposure to real estate, the Self-Directed IRA account holder is able to hedge losses from the variability of market returns.
Con – Diversification works when a variety of asset classes are present in the same portfolio. Investing solely in a REIT loses that advantage. Keep in mind that this is not just a REIT issue. Having your Self-Directed IRA go all in on a physical property that you manage yourself would possess the same downside.
Takeaway – REITs have an upside over buying a physical property in that an account holder can invest a smaller amount of funds with a REIT. That means there will still be funds left over to diversify with additional assets. This is a strong selling point for smaller Self-Directed IRA accounts. However, larger Self-Directed IRA accounts should be able to afford to diversify, even if they acquire a physical property.
Pro – A REIT is a more liquid asset than a property bought with a Self-Directed IRA. The investor can get in and out of it fairly quickly (depending on the REIT,) and with a minimum of fuss. A physical property requires a somewhat lengthy sale process in order to cash out on the investment.
Con– One of the advantages of a Self-Directed IRA is that it has a built-in window of investment because the funds may not be accessed until retirement age. This allows the Self-Directed IRA to purchase assets that have longer horizons and profit off of them. Thus, the liquidity of the REIT comes at the expense of potential long-term profitability.
Takeaway – If your investing strategy or personal financial situation requires the possibility of immediate liquidity, then a real estate investment with a REIT is the better choice. However, if you are looking to buy and hold for the sake of potential increased profitability, then your Self-Directed IRA should consider a physical property. This doesn’t necessarily exclude a REIT investment; rather it provides an additional asset option to your investment portfolio.
Pro – REITS are most often contrasted with stocks when discussing profitability. They possess a number of unique factors which allow them to serve up increased return on investment. One of these factors is that they must distribute 90% of their profits in the form of dividends. This dividend is further increased by the fact that a REIT does not have to pay corporate tax.
Con – Even though the dividends themselves can be high, dividend growth is usually slow to non-existent. Also, because they pay out almost all of their profits, they do not possess a cushion to weather financial downturns. At those times, it will usually be the dividend that takes the hit to make up the shortfall. One final element to consider is the fact that when you buy a property, you get the property itself in addition to rental income. With a RIET you will receive your dividends but will not come out with a property on the other end.
Takeaway – REITs are in essence a real estate asset. Their profitability usually follows the real estate market. Currently, they continue to be popular as real estate itself continues to be a solid asset. Understanding the underlying mechanism of REITs will help Self Directed IRA account holders choose the right one for their portfolio.
Pro – When dealing with a non-publicly traded REIT, the value comes solely from the underlying properties. The gives a sense of security to the investment as there are few circumstances where the asset could experience precipitous drops in value. (Unlike the stock market where rumors and financial new can cause severe volatility in stock prices.) REITs also serve as a hedge against inflation as property values should increase over time even though the debt used to finance the property will not.
Con – REITs are sensitive to interest rates and they can experience a decline in value as interest rates go up. REITs can also be sensitive to trends. REITs tend to specialize in various real estate subsets (e.g. restaurants, life sciences, large multifamily units, etc.), and if one of those subsets falter, the fund itself will lose value.
Takeaway – This is a case where a Self-Directed IRA account holder should definitely get educated. Even if a REIT is the right choice for your retirement account, you will want to make sure you pick a REIT that provides the highest level of security. This will mean getting educated about various real estate assets and the consistency of each. Once you decide on the kind of property you feel comfortable with, you can find a REIT that specializes in it.
Choosing a REIT over a physical property can definitely free up your time and remove stress. However, it comes with the cost of potentially lower ROI. Decide what you are looking to achieve with your Self-Directed IRA and then get educated to make it happen.
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