Most investors understand that they should invest in real estate whether it is for:
- High current income.
- Long-term appreciation.
- Inflation protection.
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.
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)
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.
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:
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.
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