Direct vs. Indirect Real Estate Investment

Adding real estate to your investment portfolio can provide diversification, spreading your risk. 

However, before you jump into the real estate market, you should understand the difference between direct vs. indirect real estate investment. Each exposes you to the real estate market, but the differences between an indirect and direct real estate investment may determine which fits your investment strategy and financial goals. 

Here’s a deep dive into direct and indirect real estate investing to help you decide which might be right for you.

What Is Direct Real Estate Investment?

A direct real estate investment is when you buy a physical property. That can be residential real estate, commercial property or raw land. With direct ownership, you have control over how the property is managed and the decisions made about the property.

Being a direct real estate investor comes with several potential financial benefits, including steady cash flow from rental income, price appreciation by the time you decide to sell and the tax advantages of deducting property taxes and mortgage interest. 

Examples

• Buying a single-family home to rent
• Purchasing an office building to lease to businesses
• Buying raw land to develop
• Acquiring a home, renovating it and quickly selling it
• Investing in a vacation or short-term rental

Pros

• Control your property investment
• Potential rental income
• Tax advantages
• Capital appreciation
• Portfolio diversification

Cons

• Large upfront capital cost
• Lack of liquidity
• Long-term investment

What Is Indirect Real Estate Investment?

When you make an indirect real estate investment, you’re buying shares of a company that owns, operates or finances residential or commercial real estate. You’re buying into a fund or purchasing stock. You don’t own any tangible property.

This type of investing in real estate is done through buying into real estate investment trusts (REITs) or real estate exchange-traded funds (ETFs). Instead of investing in a particular piece of property, you are pooling your money with others to invest in property you don’t select or control.

By not owning any physical property, you don’t have to deal with the responsibilities of managing a property while gaining greater diversification at a lower capital cost than direct real estate investing.

Examples

• Investing in a REIT, a publicly traded company that owns, manages or finances income-generating residential or commercial properties
• Buying a real estate mutual fund, where your money is pooled with that of others to invest in a portfolio of real estate-related assets
• Buying a real estate ETF, which is a basket of securities that tracks a particular real estate index
• Pooling your money with others through a real estate crowdfunding platform to invest in a real estate project

Pros

• Low barrier to entry
• No direct ownership
• Potential dividends
• Liquidity
• Diversification

Cons

• Income and capital gains taxes
• No control
• Lack of transparency

Direct vs. Indirect Real Estate Investment: Which One Is Right for You?

Investing directly or indirectly in real estate gets you into an asset long touted for building wealth and generating income. Those might be reasons enough for you to start investing in real estate. However, you might add diversification and a hedge against inflation.

If you’re ready to begin investing in real estate, do you know which is right for you – direct vs. indirect real estate investment? A closer look at the differences between the two categories of real estate investing might help you decide.

When comparing direct vs. indirect real estate investment, several factors can be considered: control, capital and risk, taxes and liquidity.

Control

If you want to be the one who manages and makes decisions about your property, direct real estate investing might suit you well. 

This may entail handling all the responsibilities of property management – attracting and dealing with tenants, maintaining the property and more – or at least hiring a property manager. You also have power over when the property is sold.

However, if you want exposure to real estate but not the hassle of property management, you might choose indirect real estate investing through REITs, mutual funds, ETFs or crowdfunding.

Capital and Risk

Generally, direct real estate investments require you to pay a large amount of capital up front. That significant capital requirement also means higher risk. However, with your direct real estate investment, you can have the potential for higher returns.

Indirect real estate investments present a lower barrier to entry and a smaller amount of capital needed to get into the game while providing the benefit of diversification. This diversity can reduce the overall risk of your portfolio, so a hit to any one asset won’t wipe out your investments. 

Lowering overall investment risk comes as a trade-off for potentially lower returns than direct real estate investment.

Taxes

If you’re an investor looking for tax advantages, taking a direct approach to investing in real estate could be the right fit for you. 

Owning the physical property can have several tax advantages – deductions for mortgage interest, property taxes and depreciation. These deductions could potentially lower your tax liability and contribute to improving your overall returns.

Indirect real estate investments have the potential for the opposite. For instance, dividends you may receive from your investments in REITs are taxed as ordinary income. Also, if you buy and then sell real estate mutual funds or ETFs, you may have to pay capital gains taxes on any profit.

Liquidity

Directly held real estate is generally illiquid, meaning it may not be easily sold and turned into cash. 

For instance, it can take between 30 and 90 days to sell a home, although local markets, the type of home and other factors can impact the time. The selling process can also be expensive. If you need cash quickly, selling your property may not be a reliable way to get it.

Real estate held indirectly in REITs, mutual funds and ETFs is fairly liquid. You can buy and sell them on public exchanges, making it a lot easier to convert your real estate holdings into cash. Crowdfunding is an exception. Sometimes, you may be bound to stay in a project for several years.

Either way of investing in real estate has benefits. You just have to choose the approach that fits your goals.

Will You Choose Between Direct vs. Indirect Real Estate Investment?

This deep look into a direct or indirect approach to investing in real estate shows the benefits and disadvantages of both real estate investment categories. Now that you know more about real estate investing, you can decide whether one approach suits you best. However, you also can choose both.

Frequently Asked Questions