REITs Vs. Rentals: What's The Best Way To Invest In Real Estate

Summary

• REITs have historically strongly outperformed private real estate.
• REITs are better diversified, liquid, cost efficient, and therefore, less risky.
• Our REIT portfolio pays an ~8% dividend yield with a safe 65% payout ratio, strong diversification, and growth potential. Does your rental beat that?
• Members of my private investing community, High Yield Landlord, receive real-time trade alerts on this idea and many more. Learn more today >>

Most investors understand that they should invest in real estate whether it is for:

• High current income.
• Long-term appreciation.
• Inflation protection.
• Diversification.

Income-producing real estate has historically generated high rates of return with lesser risk than most stocks and provided valuable diversification benefits. It is often recommended to invest up to 25-30% of one’s portfolio into real estate and this is well-justified in our opinion.

Real estate (VNQ) generated up to 4x higher total returns than the S&P 500 (SPY) from 1997 until 2016:

Source

The trouble comes when trying to decide HOW to invest in real estate, or put differently, what is the best way to earn maximum returns with lesser risk. When looking at all real estate options, most investors consider rental properties and REITs. Each has their own set of advantages and drawbacks. But which one is better?

Coming from a real estate background, I have spent years studying this question and come to the conclusion that the great majority of investors should favor REITs over any other form of real estate investing. Here are 5 reasons why:

#1 - REITs are less risky, better diversified, liquid and cost-efficient

REITs offer the opportunity for non-high-net-worth investors to invest in broad and widely diversified portfolios of properties in a liquid and cost-efficient manner. With REITs, you can easily invest in all property sectors including office, retail, industrial, residential and all geographical locations with even small sums of money.

It reduces investment risk significantly as compared to rental investments, which are likely to be much more concentrated in nature. Unless you have at least $100 million to invest, you won’t be able to build a well-diversified portfolio and will have to accept excess concentration risk. Being concentrated can sometimes lead to higher returns, but it is also clearly a riskier strategy.

REITs also greatly reduce the risk of illiquidity as they can be freely traded on liquid markets at minimal transaction cost. In comparison, buying and selling a rental is very costly and time-consuming. It is common to pay somewhere between 5-10 percent of the purchase price in different fees and transaction costs when buying and/or selling a rental. It dilutes returns considerably for the investors who are essentially losing up to 10% on day one in fees alone when buying a rental. In comparison, REITs have already paid transaction costs and own a portfolio in which you can invest by buying shares, saving the real underlying cost of real estate transactions.

Moreover, REITs are also able to save costs at many other levels, including interest expenses, property management and brokerage. Scale brings cost-efficiency, and the superior relationships of REITs give them a significant competitive advantage. Consider you walking into a bank to ask for a loan, versus a $10 billion REIT walking into the same bank. Who is likely to get the best terms on their financing? The cost savings of REITs can be massive.

Some studies find that REITs have up to 4% head start per year from cost savings compared to other direct property investments. From my experience working in private equity real estate, it is in most cases very difficult for private market investors to ever catch up to this advantage – causing them to underperform in the long run when accounting for all additional expenses and fees.

#2 - REITs have historically outperformed private real estate

The higher cost-efficiency, better diversification, liquidity of REITs have historically led to stronger results with massive outperformance over the average returns of private market real estate investors.

From 1977 until 2010, REITs have returned more than 12% per year according to EPRA. In comparison, private real estate investors returned between 6.4% and 8.7% per year on average depending on their underlying strategy. (Core, Core+, Value-add, Opportunistic)

Source

Interestingly, private equity real estate investors were not able to outperform despite commonly taking substantially higher risks with higher concentration, greater illiquidity, and in most cases, higher leverage.

Now, it is clear that in specific cases, certain Rental investors may manage to beat the average returns of REITs. There is no question about that. But the same can be said about active REIT investors. As an example, GSA has managed to generate 22% annual returns on its BUY picks by following a value approach to REIT investing since 1993.

Source

Many rental property investors commonly point out that they are able to earn higher cash flow by investing in rentals as compared to buying low yielding REITs such as Realty Income (O), Simon Property Group (SPG), Public Storage (PSA), or Prologis (PLD) with 3-5% dividend yields.

But they ignore that they could easily earn higher yields with REITs if they adapted your investment strategy towards that goal.

Our HYPO Portfolio is designed to generate high, sustainable and growing cash flow with an ~8% average dividend yield. We aim to hand-pick only the REITs offering the greatest return potential and have built a diversified portfolio of 16 positions. We are obviously biased here, but we consider this approach to be far superior to owning rental investments.

#3 - REITs provide REAL passive income, rentals don’t.

Owning real estate is more time consuming than many understand. Unless you own a triple net property with a quality tenant and long lease term, you will have to put "sweat equity" into it.

What good is it to generate an 8% cash flow yield if it becomes a part-time job with finding tenants, evicting existing ones, repairing roofs, toilets, finding contractors, monitoring neighborhoods, etc…

REITs, on the other hand, take away all operational responsibility from you. You can literally buy shares and forget about them for the next 10 years and earn great passive income while professionals take care of all the hard work for you.

When investing in private real estate, you could hire a property or asset manager to help you manage the properties, but this would again add significant cost to it. From my experience, this additional work that individual non-professional investors have to put into private real estate investment is rarely worth it. REITs are managed by real estate professionals with significantly better resources and I am therefore happy to delegate this work to them.

If you don't want to end up with a second job, I would favor REITs. Of course, it is a nice feeling of control in your investment, but is this really what you want if it implies more work and more worries?

#4 - REITs are not more volatile

Rental investors commonly argue that REITs are stocks and therefore they are more volatile. We disagree here. It is easy to say that a rental is not volatile if you never receive a quote on your property.

A direct and fair comparison of volatility is not possible as the valuation methodologies between REITs and rentals differ materially. That said, we find evidence that private real estate is even more volatile than REITs when adjusting for the leverage effect and accounting for differences in valuation methodologies.

The below table compares the volatility of private real estate indexes to public REITs and makes a series of adjustments to make the metrics more comparable:

Source: Allaboutalpha

It demonstrates that there are three reasons why investors often make the mistake of thinking that REITs are more volatile than private real estate. First, they compare levered REIT returns to unlevered private returns. Secondly, they do not consider the differences between transaction based returns (REITs) and appraisal based returns (Private). And finally, investors forget that averaged returns (Private) cannot be compared with end to end returns (REITs).

When adjusting for all these differences, the researcher finds out that listed equity REIT returns are actually 17.5% less volatile than private real estate (That is comparing 8.81% with 10.68%). In other words, the conclusion is that using leverage adds volatility, being traded on the stock exchange does not.

Final conclusion: REITs beat rentals

REITs have historically outperformed rental investments while being less risky in my opinion. I do not expect this to change in the future, and this is why I decided to specialize in the REIT sector rather than private real estate.

REITs are far more efficient, better diversified, more liquid, have better access to cheap capital and superior deals than most other investors. It is clear that certain specific investors are exceptions to this conclusion, but I am highly skeptical of any rental investor who claims to outperform REITs in the long run, when accounting for all expenses including transaction costs, property management, repairs, and all the work and time they put into it.

I believe that for most people the best long-term strategy to real estate investing is to invest in a basket to potentially undervalued REITs with above average yields such as W.P. Carey (WPC), EPR Properties (EPR), Iron Mountain (IRM), Brixmor (BRX) or even Washington Prime (WPG) for the more aggressive investors.

Moreover, REITs are today historically cheap trading at high discounts to NAV suggesting that the future returns could be even greater.

Source: Lazard Real Estate

Our real estate portfolio holds today many positions trading at their lowest valuations in years. We consider these to be massively undervalued by the market and expect significant upside to materialize in the next years, in addition to the generous +8% dividend yield. With the majority of the marketplace starting to look expensive, our portfolio appears to be particularly well positioned for 2018 and beyond. To gain access to our full portfolio holdings, along with real-time alerts on real estate opportunities along with regular market updates, join us today at High Yield Landlord with a 2-week FREE trial. Click HERE.

If you enjoyed this article, scroll up and click on the "Follow" button next to my name and choose “email alerts” to not miss my future articles on other REIT opportunities. Like the article and comment your thoughts below!

Analyst’s Disclosure: I am/we are long WPC, EPR, WPG, IRM, BRX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

This article is for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer. Readers are expected to conduct their own due diligence or seek advice from a qualified professional.

Comments

[TagHoyer]

Another point I am concerned about, is that REIT investments in the future may underperform as they have done so well in the past.

[TagHoyer]

I've done both, private more profitable, ....REITS way easier.
If I had to do it over again, would have stuck with REITs, however I shouldn't and am not complaining.
And private more work, so it should be more profitable. Also many years ago, it wasn't clear that REITs would be as profitable as they are, so at the time, private seemed better.

[kwinter$]

I don't know about you guys but I would prefer to invest in private real estate, but as I stated, there is a difference in wanting to and making it happen.
I have considered attempting to start an investment group of some sort (as I have capital to put into a deal). Do you guys know of any investment groups that form to do this sort of thing on a private level? I live and work in the Ft. Worth, Tx area

[Cashflow Curator]

kwinter$ you need to be very careful regarding putting together pools of investment dollars to invest in private real estate. I would consult a lawyer before doing this or even announcing to potential investors your plans if those announcements may be construed as advertising. In many cases, it may fall under securities laws and you would need to have a lawyer who specializes in such things prepare the offering for you, which would cost in the thousands (or tens of thousands) off the bat, and even then it would likely need to be restricted to accredited investors with strict rules around non-solicitations for funds. Unless you are trying to put together a syndication for multi-million dollar commercial proporty(ies) it is not worth all the effort and you will be better off with friends and family, and bank loans to make up the difference.

As for finding such investments for you to invest in, you would likely need to be an accredited investor and find a syndication to invest in ... again, they don't/can't openly advertise so you would need to find them through networking with local investment clubs or online real estate investor forums such as biggerpockets. There are also online offerings through such sites as fundrise, realty mogul, realtyshares, etc. (I have no experience investing with these).

Whether you are the investor or the syndicator, I would not jump right into such things without some hands on investment experience yourself first. As an investor, it will be up to you to do your own in depth due diligence for these more loosely regulated offerings, so caveat emptor. As a syndicator, investors will want to see a track record of hands on investing success.

My take is that unless you want to scale up to be a big syndicator yourself, you are likely better off investing in your own deals if you want control or REITs if you want passive rather than these "in between" options. They may be good for folks already experienced with rentals but no longer want the work, but they usually already know about them through their network and don't have to ask ... that's not a knock on you or your good question, just a warning that they are not the best for newbies IMO. Hope that helps.

[kwinter$]

@Cashflow Curator point taken .. thank you for the thoughts and warnings, just an idea rolling around in my head and I am considering how to execute, if at all ..

[StrattonOakmont]

Yes, there are a lot of security laws when doing these private equity groups. You have to legally meet someone 3 times before you can mention the offering. It is ridiculous.

Now syndication takes work and if you can get a couple 25+% returns, you won't be able to find the properties fast enough or large enough for the number of passive partners that will come knocking. Its a great way for those who don't have money to invest themselves to get ownership.

There are a LOT of these groups already in the dallas area. Its basically the hub of commercial property investors in the US. The higher you go up, the smaller the community. Just do a google search for local area groups. Go to a meeting or two. Most people are very friendly, chances are the wealthiest individuals arrive in used toyotas and honda's wearing tshirts and jeans. There are a lot of great real estate investing podcasts. People give out their names, emails and refer attorneys they use for syndication, etc.

Some people like being partners in thousands of units. Owning 1% of thousands of apartments doesn't appeal to me. I would rather have one 40+ unit paid off and be a 50+% owner netting $500+ per unit. A couple years ago I shifted from leveraging to buy more to accelerating payoffs. Most of my properties will be paid off in the next 3-5 years.

The most difficult part of starting out is covering the due diligence, finding an equity partner and/or mentor. Everyone knows you need 20-25% down, but the cost of a commercial appraisal, environmental and inspections can easily run $30,000+. Which is why using economies of scale is so important. Would you rather have $30,000 in due diligence on a 10 unit or a 40 unit? Its the same amount of work either way.

I have a friend who has a single property with 400 units paid off in houston. He doesn't even own a home. He just stays at vacation rentals all over the world 3-4 months at a time. It helps that he nets over $200k per month.

[kwinter$]

@Jussi Askola I appreciate your work and the way you think about things...
I've spent my career in CRE in Banking and analyzed 100's of deals as both a lender and credit analyst …
The bottom line this:
1) can you make more money sometimes in privately held deals? Yes you can, I have seen it many times
2) it all comes down to risk tolerance and entrepreneurial ability .. some people are natural and/or taught entrepreneurs and some people are not (myself included, I am an analytical type but not entrepreneurial)
3) For those who are such, investing directly in RE can be very lucrative (you can also lose your shirt, I've seen it)
4) For those who are not and have a lower risk tolerance, REIT's provide a great vehicle to invest in RE passively and build wealth over time (I would wager most entrepreneurial people would not like to be passively invested as they like to have more control over decisions and possible outcomes)

No doubt you can make great money privately investing in Real Estate; you can also make good money invested in REIT's (I view REIT's as more of a long term slow growth investment personally).

In my experience, it has always come down to what type of personality are you? Entrepreneurs will argue for private investment (valid argument), more analytical passive investors will argue for REIT investment (valid argument).

[Jussi Askola, CFA]

You make some very good points @kwinter$ I agree with you that personality plays a big role. Since most people are unlikely to be entrepreneurial, REITs seem like the best alternative for most investors. Best, Jussi

[Cashflow Curator]

Yep, and that is why this article is a ridiculous one. An author without much (or any) experience with rentals claiming that it is an inferior way to invest. If it were a guy that had decades of experience in both asset classes it would likely be better a better balance of pros and cons and then I might tend to listen more, rather than just shaking my head and laughing.

[StrattonOakmont]

Well said @kwinter$

Remember, you can't use leverage to buy stocks, then add the tax benefits to that.

These new opportunity zones are going to be very interesting.

[Cashflow Curator]

I can force the value (and net operating income) of a rental property to go up. Try as I might, I can't force the value of a REIT up.

[Sklyazo]

CashFlow: You don't need to force anything with a REIT investment other than perhaps reinvest your dividends to "force the value of a REIT up" because the professional management who manage superior and world class REIT assets already do this very well for you.

Does management of either AVB, BXP, or SPG need any "forcing" to do a good job.

[Cashflow Curator]

DRIP doesn't force the value of a REIT up any more than reinvesting my rental income forces value up. I don't need to force appreciation on any of my rentals either, but when I do I outperform returns of most any REIT, and do so with lower volatility because it is not dependent on the rental or sales market going up or down to achieve those returns. Higher quality REITs offer good performance, some of their management is in fact great, and they are paid accordingly ... Rentals offer anywhere from very poor to great performance, and that depends almost exclusively on the skill of the operator and their knowledge of the real estate market they are operating in. If you do not have the skill, knowledge, or inclination, then by all means invest in REITs ... I agree that this is the better choice for most, just as for most it is best to buy low cost index funds ... most, not all.

[ihookem]

My parents and I built a side by side in a very nice neighborhood and we moved in 28 yrs ago and my parents rented the other side. We moved out 15 yrs ago but my parents kept it a rental for 28 yrs. The family stayed there for 28 yrs. Dad is gone and mom said the rentals are going cause she is 80 now and tired of it. Anyway, each side cost about $70,000 each . We are carpenters with a crew and built it so the price was low, although we lost a summer of wages. We figured they got about $10,000 per yr in rental money on average over 28 yr period. Reinvesting this money @6% ( most likely they put it in the bank) They would have made $726,000 . This does not count deductions of anything including taxes, maintenance , and repairs.. It also does not count vacant months cause there was none, they payed every month for 28 yrs. The cost basis was $70K and she closed on it last week with a check for $160,000. Total profit from the 70K was $ 816,000. Not bad at all . We need to deduct an avr. of $2,500 property taxes, some , but not all that much maintenance and some other things. So say they made $800,000 in 28 yrs before taxes, maint. ETC. That is 9.1% interest on 70K before taxes ETC. In realty it likely came to about 8%. Seems like dad did good. He bought what he knew , and didn't know much else except building houses. Had he put 70 in the S&P and gained 7% he only would have had $465,000, although it would have been darn near tax free and we can't say that about rentals. Now, for the kicker. Had he put it in the Fidelity real-estate fund, FRESX he would have had over $2,000,000 according to Morningstar. The Franklin FREEX has not done well at all but did not start till 1994 and starting then it is down about 40% compared to Fidelity FRESX Now, had they put the 70K it in Realty Income in 1998 when it was founded , they would be sitting on $2,500,000 today, before taxes. CHACHING! , and the real-estate index according to Morningstar they would have had $ 1,344,000 . I will say my parents did good. They were however undervaluing their properties after a long time and that is why the renters stayed for 28 yrs. They could have gotten more rent but feared more turnover and I dont blame them. My parents also bought a house in 2010 and dumped 140K into it and sold it for 190K after the realtor They collected $1,250 monthly for 7 yrs. The renters almost destroyed the place. They did collect $ 100,000 in rent and gained $ 30,000 in capital gains in 7 yrs. So say they gained $130,000 in 7 yrs that doubled their money BEFORE property taxes and their 1099. Again , not bad but had they put it the $140,000 for the house and repaires to get it rentable , they would have came out way ahead putting the $140,000 into the FRESX that I have had for a few years . Had they put $140,000 in FRESX in Nov. 2010 they would have had $ 295,000 gross before taxes and would not have to have lifted a finger but they spent all of 2010 fixing a house. I am convinced they would have been better off with REITS . O would have been worth $343,000,and WPC would have fetched a measly little $ 457,000 from the initial $140,000 investment on Nov. 30 , 2010. This house was not in a dumpy town and rent was a bit undervalued and they payed every month, they did beat the carp out of the house though and left junk everywhere. Mom now is slowly investing in BP, FREL ( reit etf) WBA, T, IEMG, FCOM, FENY that are mostly Fidelity ETF's. She is much happier. If REITS go down we will invest in O, VTR, WPC and FREL, ETC. She will sleep at night and not worry unless the stock market crashes. Many will say if stocks crash she would still have gotten rent money. I say no she wont cause she has a hard time getting it now from some renters. If it does she wont be worse off . We celebrated moms 80th today, she is happy to rid of theses types of people in her life.

[Jussi Askola, CFA]

Thanks a lot ihookem for sharing your experience! Very interesting!

[StrattonOakmont]

Just something I wanted to say, had they reinvested the funds (like O does), even into another duplex, what do you think the returns would have been then (collecting from both units)? Or if you had built an apartment building averaging $25,000 per unit instead of $70,000? Or just continued to buy over the years as each was paid off?

Having said that, I am pretty sure I have owned O since the mid 90's. I don't think 1998 was the ipo year. The power of compounding is amazing.

[markmendlovitz]

As a short-time former landlord, I can tell you owning rental property in California is a nightmare for small investors. If you get a problem tenant, they sue, and insurance companies won't cover everything. That means you have to set up an LLC. It gets complicated fast. I'd much rather spend the time researching REITs managed professionally and avoid the hassle. The absence of hassle, diversification, and liquidity are worth the reduced returns, which are not bad at all if you know what you're doing.

[Bigslix]

Good article explaining the differences. I've owned apartments , commercial real estate and REITS. You did mention private equity but provided little to no explanation of what it is. It's somewhere in between.I am invested in five brand new high end apartment buildings. (One is still under construction) No liquidity at all may be a drawback for many. Some can't afford the minimum investment which is usually 50-100k. The developer provides or hires out all services, and tenants have no idea who the investors even are, so no midnight calls about the overflowing toilet. I'm getting 9-11%, partially tax sheltered. Not for everyone, but a good fit for me.

Big Slix

[Biological]

Bigslix -- thanks; do you mean you are getting 9-11% levered? (meaning, you are mortgaged, correct?) That does not sound so stupendous (for the risk) although not too shabby (nominal).

KBWY, a REIT HY ETF, pays 7% and with no leverage (and if you picked it up in Feb, it was paying close to 10%).

You can get about 8% (now; earlier in 2018, it paid >10%) from RQI which is a CEF that does use leverage (30% use of debt, I think it is). In a good year, it is possible to get a boost in share price in either to get close to your 9-11%. And with total liquidity, little credit risk and no exit costs (broker fee, time, discount in a hard market, etc.). In IRAs, those returns (8%) are equivalent to perhaps 12%.

That is why it would be useful to model alternatives when one is about to look at investing in physical real estate.

Thanks for sharing.

[Biological]

It would be interesting to excel two scenarios and quantify IRRs on an agreed set of assumptions, pre-tax so that everyone can apply results to themselves. The first is 100K in VNQ or some other "basic" REIT cocktail. The other is using 100K, borrowing 400K and buying a 500K home. And making all the necessary cost assumptions (interest, tax, maintenance, insurance, rental broker every 2 years, etc.), and rental yields, that go with this.

And look at this over 5, 10, 20 and 30 years.

My guess is that over the long haul (>15 years, perhaps), buying a house with leverage may make sense. The mortgage is half or more paid down (by someone else), value has increased slowly at inflation and, if you can manage exit costs well (primarily AVOID broker who charges 5% on GROSS sale price), you may come out on top in a rising market. If the market turns, leverage will snag you as your exit will not be a good one. Even so, whilst perhaps you get a higher IRR on actual purchase, the illiquidity, effort, credit risks and damages may persuade you to go with the REIT.

Has anyone done this, side by side? Thanks. (sorry, no time to do it myself)

[Hoosier1978]

Another often overlooked real estate option for a well balanced portfolio is doing “hard money” lending for the home (single family, townhome etc) market. You or a group of investors through an equity company provide the financing to build the home at 7-10%, you get your principal back at sale of the property. Lots of protections built in from 60-70% loan against appraised value, borrower has to have cash in and sign personal guarantees, independent appraisal done, you are a lien holder in case of default and the equity company will have builders who can complete the project etc. Sounds crazy, but for developers and small boutique home builders who need to move fast and can’t work through the torturous process of bank loans it’s a good source of funding. My wife and I have had good success with this. They do generally require $50-100K minimum investment from the fractional investors. Certainly do your own due diligence and there is decent info available via google. Biggest risk to me is getting in right before a big real estate downturn, but again that 60-70% loan to value really helps to mitigate that risk.

[RSloan]

I concur. I made hard-money construction loans in California from 2003 or 2004 until 2006 when I retired and moved out of state. It worked well for me, though I was lucky I quit when I did. Other investors active in my local market got caught in the real estate crash and either lost money outright or were bag holders forced to take possession of partially completed homes and sit on them until the market turned years later.

Regarding owning rental property, I started investing in income property in California in the 1970s. Fortunately, I was in a good place at a good time, and I had a mentor who helped me accelerate my learning curve, so I did well from the start. But it’s certainly not for everyone. On the other hand, if you and/or your spouse have a knack for investing in income property, posses certain skills (i.e., people or handyman skills), and/or have a job in a related industry, the sky is the limit on how much you can make. Finding the proper mentor is like finding gold.

At this stage in life, I prefer investing in REITs. It’s not that I don’t want to talk to tenants; I don’t want to talk — or even think about talking — to a property manager, plumber, or gardener. I’m too busy traveling while I still can. And REIT dividends regularly deposited into my account with no effort on my part are a great way to help pay for that travel.

[vantuckman]

Actually, I like the idea above, only I/we have chosen to leverage our hard-won experience in investment property and lend money on those who are willing to do all the hard work. I require 20% down, inspect and review the property, and carry most notes with a 10 year balloon. I still participate in real estate, but the purchaser does the heavy lifting...

[Kmasse]

Great article Jussi. Renting vs. Rentals, depends from the country. In Finland, if I bought a home to rent I would make around 2,5% after all the costs and taxes, in Georgia (Caucasus), between 7-9%.

[Kmasse]

typo, REITs vs. Rentals

[Plimsoll]

REIT or direct ownership are not the only 2 options. Investing in individual properties thru crowdfunding sites like EquityMultple, RealtyShares, RealCrowd, etc. is another option. I started investing via crowdfunding last year, and I like the ability to select individual properties and not having to worry about the hands on management that direct ownership entails. Lack of liquidity is a reality with crowdfunding, since you are basically stuck in the investment until the sponsor decides to sell, but in some ways that can be an advantage if you want to be buy and hold, but have an itchy trigger finger and end up selling your REITs when prices fluctuate.

[Jussi Askola, CFA]

Personally, I think that crowdfunding is the worse option of all 3. You have the problem of illiquidity without the benefit of control. I will write a separate article on the topic soon.

[Plimsoll]

I look forward to reading your views on RE crowdfunding, Thanks!

[Prodigy Disc Golf]

Great responses here. Thanks all for sharing these excellent strategies and experiences.

[AlieGee]

Yes, very enlightening but those who are property owners will
continue to rent and stock buyers will continue to buy.

I don't think anyone's mind was influenced with the comments !

[ikswo123]

A great illustration of your point would be a property I was looking at in Florida around 2010. I knew the area and the property, and could have bought it at auction for $110-120K. I could turn it around and sell 8 years later for $230K (net of closing and brokerage). If we assume the rental income could cover expenses and a 50% mortgage to breakeven, that would be a $60K investment returning 180K or so, a triple.
That sounds great until you look at an investment in SPG which would have got you 4 or 5 times your money with no additional work on your part, plus a growing dividend all that time.

[StrattonOakmont]

Which is why single-family homes aren't a great investment strategy and the reason why no REITs rent out single-family homes.

[user 7310991]

Interesting comparison but its a little like comparing apples and oranges.

With direct real estate you have control of the financial statement meaning you can control expense items and make judgements on capital vs expense. Thus you also have a degree of control over depreciation. But aside from controlling capital events like refinancing the single most important benefit of direct ownership is the 1031 exchange to allow for tax deferred compounding. Not available with stocks.

With REITs you get liquidity - the ability to hit a button and sell your position any day you want with discount brokerage fees along with daily pricing. Also, you get professional management thinking about maximizing portfolio value with the flexibility of traditional asset financing (single property bank or insurance co) and corporate financing (issuance of their own bonds or preferred shares).

Both have a place in a diversified portfolio but its important to understand the nuances and know what you are most comfortable with.

Thanks for the thought provoking article.

[brainleft]

I'm well versed and experienced with real estate and choose REITs 100% of the time. I don't need the drama of owning rentals. My heavy lifting is in O shares, also have:dlr, nnn, stag,stor,pdi,and ladr.
great article and discussion.

[1504661]

Jussi:
I typically like your articles. But find this article to be extremely misleading.
Your points 3 and 4 are just plain wrong.
Owning a rental property is the easiest thing in the world if you have a management company.
There are way too many people (not talking about you) who have never owned a rental that are convinced beyond a doubt that it is difficult and full of hassles. Thats just simple not true.
It is only difficult if you are an inexperienced person who tries to handle everything themself.
I have rentals in 3 cities and believe rentals to be far less volatile than reits. I check my reits weekly and they can fluctuate greatly. None of my rentals have ever lost or gained 2 or 3% in a single day/week.

[Jussi Askola, CFA]

Hi, and thank you for your comment.

Difficulty is subjective. I know a ton of people who would say the opposite.

"None of my rentals have ever lost or gained 2 or 3% in a single day/week." This is what you like to think - but you really you have no idea because you are not putting your rentals on the market. I guarantee you if you tried to sell it on a daily basis, your price variation would be much higher than REITs.

It is all debatable, but I get your point. Thanks!

Jussi

[Cosmolol]

I have a residential rental, which I have paid entirely with borrowed money from the bank.
I couldn't have done it with REITs.
Now I prefer not to own REITs in my portfolio because I already have a big exposure.
What do you think?

[StrattonOakmont]

We all have our own risk profiles and they change over time. Now if you have 20-30-50 of them, you might be worried you aren't diversified enough.

[Nick Heil]

Thanks for taking the time to produce this article and create a discussion!

As other commenters have pointed out, I think there are advantages to both. I can't argue with any of the points you've made and I dollar cost average into VNQ regularly. I think if you have enough capital to invest into REITS to create a cashflow lifestyle you desire then that's a no-brainer. However, I believe private real estate has the potential to have the largest impact on your life right now with the advantages of creative financing, cash flow, depreciation benefits, and the use of debt. Of course you have to be willing to take on the risks and extra work, but if you are willing I don't think it's rocket science. Cash on cash returns in excess of 15% or 20% is pretty common if you buy right in cities and neighborhoods that aren't like San Francisco or New York. I'm from the Erie, PA area and you can find deals like that all the time. In a market like Erie though, you buy strictly for the cash flow return and don't bank on any appreciation (if you do get some then it's just gravy).

I get that REITS themselves use these same strategies, but the use of traditional debt financing changes things for the individual investor. If I have $20,000 in cash then I can buy $20,000 of a REIT, or I might be able to buy 2-4 rental properties worth a total of $150 - $250k as you will see in my below example.Obviously a lot more work goes into this and all the risks you've already pointed out are inherent, but I think if someone is willing to make a career of rental property investing in combination of investing a portion of their higher cash flow into REITS then that would be a pretty optimal strategy.

As an example, I bought a duplex (that I currently live in one side) and when I move out of my side after all expenses (including budgeting for repairs, vacancy, capex, property management) and the mortgage I will easily clear $300 a month in cash flow and I only put $6,500 of my own money into the deal. To generate the same monthly income from an 8% REIT you would need to invest $45K (assuming you aren't purchasing REITS with any debt). Plus, I believe achieving 8+% cash flow in REITS long term is probably stretching it. More likely to achieve around 4% that VNQ yields in which case you would have to invest $90,000 to achieve the same cash yield (I'm ignoring the obvious benefit of REITS being much more likely to appreciate over time vs. just cash flow) . This same example is repeatable over and over. I plan on doing this to generate a respectable income from 10-20 rental properties and invest the positive cash flow from each into REITS.

Of course a solution to this would be using debt to purchase REITS, but given there is the potential for margin calls and much higher interest rates, that takes from the allure of that idea. I've long said that if you could get 20 and 30 year "mortgages" to invest in REITS like you do in a traditional home or rental investment at comparable rates then that would be a no-brainer. Really, if you think about it the phsycology of it all is pretty messed up. From a banker's perspective, would I rather loan out money over a 20 or 30 year period that will be invested in a portfolio of successful real estate businesses or would I rather see that money invested into 1 single house that someone may or may not be able to pay back? To me, the answer is obvious, but obviously society places a much higher value on owning a home and achieving the American Dream.

[Sklyazo]

Nick: you have a better chance to grow your dividend income via VNQ than your properties in Erie PA because you can’t raise your rents faster than your expenses. You also cannot compound your returns as easily as you can by reinvesting your dividends in VNQ.

Keep in mind that dividends from VNQ are free and clear while your cash flow from a duplex is not because you need to keep a reserve for future capital improvements and vacancies.

I agree with you that the authors 8% yield is excessive in today’s low interest rate environment but the yield on VNQ compounded over 12 or more years would generate really nice cash flow without the hassle.

If one unit remains vacate for two months then your vacancy rate is double digits. This missed profit is lost forever.

By the time your tenants payoff your properties in 30 years you may not be around to enjoy the cash flow.

[Nick Heil]

Thanks Skylazo, I hear what you're saying, but the returns from a private rental I mentioned above are AFTER already budgeting and funding for reserves & vacancies. I think that is what most private investors skip over. They think they can just cover their mortgage and be good, when in reality they need to be setting a significant portion away for reserves. It can be done though, it's all about buying right up front.

I also think a portion of the cash flow generated should most definitely be invested in quality REIT ETF's such as VNQ to still take advantage of the compounding.

But you are certainly right, in order to achieve the success I mention you have to be a good manager, keep high occupancy rates and avoid problem tenants. It can be done, but it requires being a good manager, which may be the whole reason you invest in a REIT to begin with: to avoid being a manager.

[Jussi Askola, CFA]

Love your comment Nick. Lots of great perspective here. Thank you.

[swaldman]

The safest way is to invest in ground leases - low yield but super safe : ground lease capital partners .com

[StrattonOakmont]

LOL