REITS Vs Rental Properties

2009 June 23
by Kyle Bumpus
from → Real Estate

Despite all the attention paid to the stock market in the financial media, real estate has long been the asset class of choice for many of America’s wealthy individuals.  Indeed, in 2004 approximately 40%** of the top 10% most wealthy households held investment real estate, or about the same as the amount holding stocks and mutual funds combined.  By contrast, only 20% of the bottom 90% of the wealth spectrum held investment real estate.

An Investment Made For The Rich

Traditionally, real estate has been an asset class mostly restricted to the wealthy.  To this day, the costs involved in buying, selling, and leasing real estate can be prohibitively expensive, nevermind the difficulty of acquiring enough properties to be sufficiently diversified across both property types and geographical regions.  A portfolio like that would cost tens of millions of dollars in invested capital, an amount well outside the means of the middle class.

REITs For The Rest of Us

Fortunately, Congress saw fit to foster the proliferation of Real Estate Investment Trusts, or REITs, as a way for the middle class to participate in the benefits of real estate ownership.  REITs are required by law to pay out 90% of their net income as dividends to shareholders, and in return are allowed not to pay any corporate income taxes.  These securities routinely yield between two and three times more than the overall stock market, making them ideal for income investors.

REITs Vs Rental Properties

Income

The income return of REITs is relatively straight-forward to measure:  the Vanguard REIT Index (VGSIX) currently yields 5.81% (and is my REIT fund of choice).  The income potential on investment real estate, on the other hand, depends entirely on the specifics of each individual deal.  It’s difficult to generalize across all property types, but a reasonably-priced, responsibly-leveraged small residential income property (1-4 units) can yield between 8-12% on your invested capital.  However, during the go-go days of the real estate bubble, cash yields were often much lower and in some cases negative in many markets.

Winner: Rental Properties

Appreciation Potential

Since REITs are required by law to pay out 90% of their net income to investors as dividends, they aren’t able to retain much cash to grow their real estate portfolios.  Small individual investors, on the other hand, are free to re-invest 100% of their earnings back into income-generating properties.  On the other hands, large REITs are often able to borrow on much more favorable terms than small investors (once they exhaust owner-occupied financing opportunities) and have teams of professional analysts scouring the market for deals, an effort small investors just can’t match.  Overall, the appreciation potential of individual investment properties versus REIT portfolios is a toss-up.  It totally depends on local market conditions and which real estate sector is currently in favor:  commercial or residential.

Winner: Tie

Leverage

REITs typically carry loan-to-value ratios of between 50-70%, making them moderately leveraged by real estate standards.  By contrast, the norm for small investors is 80% and sometimes even 90% or higher for ultra-aggressive investors.  Sure, you could buy REITs on margin, thus bridging the leverage gap with direct real estate investment, but the interest rate on a margin account is likely to be significantly higher than a mortgage on an investment property.

Winner: Rental Properties

Safety

Rental properties are very expensive, and true diversification is far beyond the means of any middle-class real estate investors.  Additionally, individuals rarely have the opportunity to invest in non-residential real estate sectors such as industrial properties, hotels, shopping malls, and even large apartment complexes.  By contrast, a top-quality REIT mutual fund owning hundreds of REITs spanning tens of thousands of properties in every sector imaginable spanning the entire globe can be bought for as little as a few thousand dollars.  Direct control over small rental properties helps mitigate the risks of direct somewhat, but still fall far short of the safety promised by broad diversification.

Winner: REITs

Cost

Anybody who’s ever owned their own home knows real estate is expensive to buy, sell, and maintain.  By contrast, the Vanguard REIT Index charges a miserly 0.21% of assets, or many times less than the cost of direct real estate investment.  Closing costs alone would amount to more than 0.21% of any real estate deal you’d be likely to find, nevermind the costs of actually maintaining the thing and keeping it leased.

Winner: REITs by a mile

Effort Required

The ultimate goal of most investors is to be able to generate enough income from investments to be able to retire.  Thus, passive income is key.  Direct real estate investment, however, is not even remotely passive.  You have to find tenants, handle repairs, and keep track of accounting details.  If you own more than a few properties, the effort involved can easily turn into a full-time job.  Sure, you could hire a property manager to do the dirty work, but that would take a significant bite out of your profits and you’d probably lose some valuable tax benefits to boot.  REIT mutual funds, on the other hand, couldn’t require less effort.  Buy once and then cash your dividend checks until the day you die.

Overall Profit Potential

Overall, direct real estate investment has far greater profit potential than REITs due to higher amounts of leverage and lower borrowing costs;  however, it is also much riskier in many (if not most) cases.  With high returns comes high risk.  In the long run, REITs are unlikely to return more than they have in the past, which is about 10% per year since inception.  A properly-leveraged direct real estate investment program, on the other hand, could easily return 20-30% per year indefinitely as long as you were willing to put the work in.

Winner: Rental Properties, but with higher risk as well

The Choice Depends On You

It goes without saying that real estate belongs in every investor’s portfolio, but in the end the choice between REITs and direct real estate investment depends entirely on your individual needs and wants.  If you want to earn excess returns and retire a millionaire at a young age, direct real estate investment is probably the best choice for you.  If you just want to set it and forget it, however, REITs offer an ideal balance of return, risk, and required effort.  In the end, the choice will probably boil down to how much work you’re willing to do.  As always, hard work pays off.

Where To Learn More

The bookstore is the best place to learn the ins and outs investing in Real Estate and REITs.  Here are a few books I highly recommend.

Sources:

** Domholf, Willam Who Rules America:  Wealth, Income, and Power.  September 2005

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4 Responses
  1. 2009 June 24

    As a longtime real estate revenue property investor, I now only invest in REITs. The chief reason for this is transaction liquidity. I can enter or exit a position within a brief delay with very little transaction cost. The 2nd biggest benefit is NO property administration headaches, NO tenants, NO employees, NO payables and NO receivables (other than the monthly distribution).
    Since I was doing regular due diligence on most TSX listed REITs, I decided to launch a website so others could benefit from this. You can visit http://www.REITinvestor.ca.

  2. 2009 June 27

    Nice wrap. I favor REITs too, but there’s no doubt people who get rich through property do it buying direct.

    I just wish my bank would give me a mortgage for 80% of the cost of an average rental property to invest in REITs instead. Without such leverag,e slow and steady is the order of the day.

  3. 2009 July 2

    I agree. With REITS, small individual investors are given the chance to get involved with real estate business as this has been known as the business for the wealthy only.

    For tips on personal finance, visit http://www.mikesmillions.com/blog.

  4. 2009 September 6

    very nice, and simple article. I read it with detail. And wow its great.

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