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If you’re reading this, you’re probably just as curious about the risks of investing in REITs, or real estate investment trusts, as I am. But why invest in REITs at all?

REITs offer benefits that private real estate investments cannot, such as liquidity and a lower barrier to entry. Let’s take a look at the real estate market today to see why this matters.

Real Estate Investing Today

With the national median home price hovering at $420,400 as of the third quarter of 2024 and mortgage rates stubbornly remaining above 6%, barriers to entry in real estate investing have never been higher (and likely will remain this way; this is the new normal for our industry, and we all should get used to it). 

So unless you have at least $100,000 for a 25% down payment into an investment property (assuming the price is the national median) or are willing and able to house hack a primary residence, it can seem like your options to get started in real estate are limited.

Note: There are some affordable markets that have seen relatively strong growth in jobs, price, rents, and population, such as Oklahoma City, Indianapolis, and Columbus, Ohio. According to Redfin, their median home prices remain below $300,000 as of November 2024. These metropolitan areas may be the best places for investors to get started if they’re priced out of their local market.

REITs may be a solution for those looking to benefit from real estate indirectly while they build their savings.

But private real estate investing is still one of the best wealth-creation vehicles out there, so let’s briefly discuss the difference (and why it may be unfair to compare the two).

Active vs. Passive: An Unfair Comparison

Privately owning a rental property can be thought of as owning a low-activity business. You are ultimately in charge of ensuring revenue is being earned (regardless of whether you use a property manager, the responsibility is yours). 

You are also in charge of expense management. If an appliance needs to be replaced, your roof needs repair or a new foundation issue has appeared, money will need to exit your business account to cover these costs, and it’s your responsibility to ensure these expenses are being managed correctly.

However, because asset management is completely under your control, so too is the lever of returns (or losses) you could potentially earn over time. (Private real estate income is also taxed as passive income, while REIT income is taxed as ordinary income.)

Because private real estate ownership is an active business activity, we should end this comparison to REITs on this basis alone. 

One investor may prefer to be more “active” and reap the rewards (and risks) that come with private real estate asset management. Another investor may not want to manage their own physical asset-based business (a rental property). Or they may not have enough capital (savings) to lower their monthly debt obligation (loan payment), but would still like to put their dollars to work and earn a risk-adjusted return higher than U.S. Treasuries (bonds). 

Or an investor might just want exposure to growing sectors, such as industrial or data center properties.

Now, for the investor who is just as willing to invest in private real estate as they are in REITs, let’s move on from this disclaimer.

Risk of Losing Money

So, let’s get down to the real question here: What are your risks as an investor by asset class? 

Private real estate

What is the risk of your private property declining in price? First, let’s look at the U.S. Federal Housing Finance Agency’s (FHFA) House Price Index (HPI) over time:

In 49 years, the HPI declined in value for five straight years (2008-2012) before it started increasing again.

If you bought property before 2008, how much money you would’ve gained (or lost) depends on when you sold. If sold during the dip of the Great Recession, you might’ve lost, but if you held until property values bounced back, you likely gained. And if you are still holding, you likely gained much more.

Unless there’s another pending real estate crash (which is extremely unlikely to happen in the near future), prices will continue to appreciate (albeit likely at a slower price during the next half of the 2020s). 

If we’re just analyzing the HPI, the average annual return is 5.14%, with a volatility (standard deviation) of 4.73% over a 49-year period. This only takes into account HPI growth at the national level and doesn’t include rental income generated from the property.

Now, how likely your property is to decline in real value may also depend on which market you own in. If the market has continued to see a decline in population, there may not be enough demand to sustain price growth. This is why market selection is important.

REITs

One trade-off with REITs is that they have seemingly higher volatility (to be more precise, private real estate apparently had 76% less volatility over a 20-year period, calculated using the NCREIF Property Index and the FTSE Nareit U.S. Real Estate Index).

When I analyze historical REIT index returns by sector, I find that from 1994 to 2023: 

• The residential sector experienced a 12.66% average annual return, with 21.56% volatility.
• The office sector experienced a 10.11% average annual return, with 23.30% volatility. 
• The industrial sector experienced a 14.39% average annual return, with 23.71% volatility.
• For comparison, the S&P 500 only returned an annual average of 10.1% during the same time frame.

As an aside, from 2015-2023, the data center sector experienced a 15.01% average annual return, with 23.48% volatility (the S&P delivered an approximate 11.9% return over the same period).

As you can see, these volatilities are quite higher than the HPI’s 49-year 4.73%. There are plenty of opportunities to sell your REIT holdings and lose money if you’re not careful to temper your emotions during a dip in price. 

Due to the volatility of REITs, there are plenty of opportunities to lose money if you sell at the wrong time.

But over time, REITs appear to perform quite well, with some sectors performing better than the S&P 500, such as self-storage, industrial, and data centers, all of which are assets that many readers of this article won’t likely be owning privately anyway.

Final Thoughts

There are three things to keep in mind here. First, this analysis doesn’t take into account the tax savings you earn by owning your private real estate.

Second, owning private real estate is not truly passive, even if you have a property manager (you still must manage the property manager). Therefore, if you invest in private real estate, your returns should be better than the returns offered by a REIT; otherwise, you are taking on more work for less reward. The FTSE Nareit Equity REITs Index has generated an average annual return of 12.65% from 1972-2023, so that is a good benchmark to beat if you plan on owning and managing your own private real estate.

Third, REITs offer exposure to asset classes you may never own (or want to own) privately, such as industrial properties or data centers, which have seen solid growth over the past 10 years and are likely to continue seeing healthy returns into the future. For this reason, certain REITs may offer the portfolio diversification you’re looking for if you already own residential real estate and are looking to expand the asset classes you invest in.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.