AA - Apr 2022

Author:  Michael Haldane
Global & Local The Investment Experts
22 April 2022

Direct real estate vs property unit trusts
A look at the advantages and disadvantages of each strategy.

You might be one of the few lucky people who have some money, and want to grow their wealth, but are unsure where to put this money.

Two possible and often popular avenues are putting money directly into commercial property or investing in unit trusts that have exposure to the property sector. It is important to know what the advantages and disadvantages of each strategy are.

Direct real estate investing refers to buying a physical property that could be land, a residential building, or commercial property. The idea is to generate an income from this property in the form of rental income and/or appreciation of the property.

Property unit trust funds primarily invest in listed property companies that develop and manage real estate. These are usually more diversified across multiple sectors and geographical locations.

The pros of direct real estate investment

  1. Investing is easy to understand: it’s simply about purchasing a property, maintaining the property, and attempting to sell the property at a higher value and/or earning a rental income whilst you own the property.
  2. Investing using debt: purchasing a property usually involves taking a bond from a bank, so essentially you are using the bank’s money to earn a return.
  3. Real estate can serve as a hedge against inflation: Generally, property is considered a hedge against inflation since it is generally assumed that the value of the property will appreciate, and rents typically increase with inflation.
  4. Property ownership may provide tax benefits in the form of both income tax and capital gains tax advantages. Capital gains tax is taxed at a lower effective rate than income tax or dividend tax. Individuals’ maximum effective capital gains tax rate is 18%. However, if the property is your primary residence, then an individual will not pay any tax.

Some cons of purchasing property:

  1. Real estate can be a lot of work: property ownership to some degree is simple but it does require a lot of sweat equity because of the costs that come with maintaining the properties.
  2. Real estate is expensive and highly illiquid: it’s often easy to put money into purchasing a property but getting money out of that same property through a resale can sometimes be difficult.
  3. It’s difficult to diversify with real estate: location is the key when investing in real estate. One area could improve in value whilst another could slump, thus affecting the value of your property portfolio. Diversification of real estate properties requires deep pockets and knowledge that isn’t available to the average investor.
  4. Return on investment isn’t a sure thing: there’s always a risk of selling property at a loss.

While there are a few pros to investing in real estate, investing in a property unit trust can be advantageous. Here’s why:

  1. Diversification: you can simply choose a property fund as one of the underlying funds of your investment if you would like to have a property component in your portfolio. You could further diversify your portfolio as some investments cover various geolocations and industries.
  2. Fund management: there are experienced fund managers entrusted with managing the performance of the fund chosen and delivering good returns.
  3. Less costs: Although there are management fees to be considered, if you choose a property fund, you won’t have to worry about costs to maintain your properties, transaction costs or capital.
  4. Initial investments do not require large sums of capital, and it is not necessary to apply for a bond. Minimum investments could start as low as R1 000.
  5. Higher liquidity: the buying and selling of unit trusts can be done on any business day.

Some of the cons of investing indirectly are:

  1. Unit prices are more volatile than real estate prices: share prices can be very volatile and fluctuate in price much more quickly than the real estate process. Even though the volatility can be uncomfortable in the short term, it can become beneficial in the long term if you’re willing to hold the units despite the volatility.
  2. Unit sales may result in capital gains tax: if you sell a unit at a higher price than when you bought it, you may be subject to capital gains tax.
  3. Emotional decision making: it is easy to lose confidence in fund managers and make decisions based on emotions. Therefore, knowing how to manage your emotions and paying attention to the empirical evidence about the underlying fund is important.

A few things need to be considered when deciding whether to invest directly in property via a unit trust, real estate, or both. Factors like cash flow, market volatility, tax effects, liquidity, management and transaction costs. Just like any other investment, there are advantages and disadvantages to each of these factors for direct and indirect real estate investing. It all comes down to what you prefer when it comes to your time horizon, investment goals, and how much risk you are willing to take.

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