When retirement time comes and the individuals need income, they have several avenues to pick from. One of those avenues is putting all their savings into an interest earning account. Another option is to buy one or more homes and rent them out. Then there are other options too, such as buying REITs. For regular income, I personally favor a portfolio with some REITs and some high yielding dividend stocks.
Here is why I prefer REITs over rental houses:
1) When you are enjoying your retirement, the last thing you should worry about is finding customers and dealing with their drama. Renting a home can be a lot more work than one thinks it is. First, one has to find trustworthy tenants with reliable income. Then, one needs to negotiate rental price and have the contract signed. After that, the work continues, as there may be a lot of issues with the renters over time. REIT owners don't need to worry about all that, and they can just relax and enjoy the income stream.
2) REITs provide far more diversification than buying homes, unless one can afford to buy multiple homes in multiple cities. (Then again, managing multiple homes in multiple cities would become a full-time work, which beats the whole purpose of being retired from work). You never know what city's housing market will be hot or what location will have bad housing trends. You never know where the jobs will be next decade. That's why it's important to have diversification in housing, just like stocks, and REITs are a good way to do that. You can even purchase multiple REITs and focus on multiple industries such as healthcare, retail, hotels and housing.
3) REITs are highly liquid. If you need money for an emergency or if you decide to use your money in other ways, you can always sell your REIT shares with a few mouse clicks and a few key strokes. On the other hand, selling a house can take months of work and often results in fees.
4) Houses age just like you do, and they lose value as they get older, even though the land they sit on might gain value over time. REITs usually keep buying and selling properties, which means the average ages of properties in REITs usually remain stable.
5) When you own a house, you have to spend a lot of money in maintenance and property taxes. While REITs also pay those taxes, it will save you a lot of drama that comes with dealing with maintenance issues.
6) Many REITs increase their dividend payments every year. You may also be able to raise your rental rate every year, however, if your renters decide not to accept the rate increase, you will have to find a new tenant which can be a lot of work. In many cases, rentals end up offering discounts to new renters in order to have them to sign a contract.
Now we will look at some numbers at Zillow:
San Francisco: Median house listing is priced at $669,000 and median rental house is priced at $2,850. Annual rent of a median home covers 5.11% of the house price.
New York: Median house listing is priced at $324,000 and median rental house is priced at $2,450. Annual rent of a median home covers 9.07% of the house price.
Dallas: Median house listing is priced at $194,000 and median rental house is priced at $1,000. Annual rent of a median home covers 6.18% of the house price.
Chicago: Median house listing is priced at $209,500 and median rental house is priced at $1,450. Annual rent of a median home covers 8.31% of the house price.
Miami: Median house listing is priced at $329,900 and median rental house is priced at $2,000. Annual rent of a median home covers 7.27% of the house price.
Denver: Median house listing is priced at $245,000 and median rental house is priced at $1,220. Annual rent of a median home covers 5.98% of the house price.
Seattle: Median house listing is priced at $332,000 and median rental house is priced at $1,330. Annual rent of a median home covers 4.80% of the house price.
If we look at these big cities I picked, our average yield comes down to 6.67%. However, this excludes property tax, and maintenance costs and home owner insurance fees.
In the US, average property tax rate is 1.38%. That is, the individual has to pay 1.38% of his or her property value as tax annually. Property insurance costs in average $25 per month for every $100,000 the house is worth. This brings us to an annual rate of 0.3%. Finally, maintenance costs will be around another 1 to 3% annually depending on how old the home is.
Considering these discounts, the average yield of rental home ownership comes down to 1.99% to 3.99% depending on how much money is spent on maintenance. Also keep in mind that there might be times when your rental property is sitting empty and there will be other times when your renter can't or won't pay the rent, which happens quite often. Furthermore, if you wanted to save drama and hire someone to manage your property, this will cut into more of your profits.
In return, there are many decent REITs that yield 3% to 5% without any drama. For example, Washington Real Estate Investment Trust (NYSE:WRE) is one of my favorites. The trust fund owns many residential, business, and healthcare properties in the DC area, and currently yields 5.87%. Retail Opportunity Investments Corp. (NASDAQ:ROIC) is another good one. The company buys malls and shopping centers and it has a nice dividend yield of 4.10%. Hospitality Properties Trust (NYSE:HPT) owns a lot of nice hotels and yields 7.80%.
I also suggest visiting REITs section of SeekerAlpha for some good recommendations. In conclusion, buying REITs seems like a better income investment than buying rental homes at the moment.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.