Rentals Vs. REITs: What's The Best Way To Invest In Real Estate? A Practical Case Study

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Includes: BPR, CBL, DUNDF, MPW, SPY, SRC, UNIT, VNQ
by: Jussi Askola
Summary

Over the last two centuries, about 90 percent of the world’s millionaires have been created by investing in real estate.

Needless to say, you should invest in real estate, whether it's through rental properties or REITs.

We believe that the risk-to-reward is much stronger for REITs, especially once you take into account the hassle of managing rentals.

We present a practical case study of how our REIT investment strategy aims to produce high returns without all the hassle that comes with rental properties.

What’s your idea of a perfect investment?

That’s a tricky question, but those looking for above average current income, along with reasonably good price appreciation prospects over time – and with only modest risk – will certainly want to consider apartment communities, office and industrial buildings, shopping centers, and other similar real estate investments.

About 90% of millionaires credit real estate as a major contributor to their net worth. Therefore, most investors understand that they should invest in real estate whether it's for:

  • High current income.
  • Long-term appreciation.
  • Inflation protection.
  • or diversification.

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

source

The more difficult question to answer is HOW to invest in real estate? When looking at all the different possibilities, most investors consider two main options:

  • Option 1: Invest in rental properties
  • Option 2: Invest in publicly-traded REITs

We think that this article can help you decide. For us, there's no doubt: REITs are much better vehicles for long-term real estate investing. Below we present why and explain how we seek high income opportunities with REITs, without all the hassle that comes with owning rental properties.

Rentals vs. REITs: The Basics

First off, let me start by saying that I do not take this topic lightly. I have literally spent years studying it to determine which one is the better approach, combining practical experience in the private equity field and academic research at two universities.

This is not an either-or question, and different investors can come to different conclusions based on their personal situation. However, my conclusion is that REITs are superior investments for the great majority of investors for five main reasons:

#1 - Higher total returns on average

This argument is the most difficult one for rental investors to accept. Rental investors will argue that REITs cannot outperform because of higher overhead cost, overpaying for assets, and no leverage benefit.

In reality, these are all common misconceptions from investors who lack basic understanding of REITs. Looking at real factual data, we find that passive REIT indexes have outperformed different private real estate investment strategies by 4% to 6% per year in the long run:

source

(using different data points, the results are the same)

This recurrent and sizable outperformance is the result of two main factors:

  • Efficiencies in Management: REITs may own billions worth of properties, and this results in economies in scale at many levels, including interest expenses, property management and brokerage. Consider a private investor walking into a bank to ask for a loan vs. a $10 billion REIT walking into the same bank. Who is likely to get the best terms on their financing? The superior efficiency of REITs can be massive. Some studies find that REITs have up to 4% head start per year from cost savings alone compared to other direct property investments.
  • Higher Growth: Rental investors are limited to raising rents to grow NOI. REITs have many more opportunities to boost growth beyond rent increases. The most common way for REITs to increase growth rates is by issuing new shares, raising new debt, and investing these proceeds in new acquisitions. As long as the average cost of capital is lower than the expected return of the property, there's a positive spread to be earned for the existing REIT shareholders. Higher growth results in greater income and share price appreciation in the long run.

Can someone earn a higher return than REITs by investing in rentals? Yes, of course. But so can an active REIT investor earn higher than average returns by performing intelligent due diligence and investing in only undervalued REITs. The best REIT investors have reached up to 22% annual returns for decades.

The main takeaway here is that for the "average" investor who works a full-time job and has limited resources; REITs are likely to produce greater total returns over time than rental properties. This is especially true if you take into account the cost of all the extra hours of work you must put into rentals. If rental investors did the calculation, they would find that very often, their investments are subpar at best, and not worthwhile at worst.

#2 - Truly passive income

You want real estate working for you, and not you working for real estate.

REITs clearly fit in the former. They are liquid, professionally managed, and you receive a consistent dividend check from your property investment every quarter. It's totally passive.

Rentals, on the other hand, require a lot of work, effort, and constant worrying. They will often get closer to operating a business than a passive investment, and still then, the long-term results of these additional efforts are very uncertain.

#3 - Liquidity and Transaction Cost

REITs can be freely traded on liquid markets at minimal transaction cost. In comparison, buying and selling rental properties is very costly and time consuming due to the risk of illiquidity. It's common to pay somewhere between 5%-10% of the purchase price in different fees and transaction costs when buying and/or selling a property.

It dilutes returns considerably for the investors who are essentially losing up to 10% on day one in fees alone when making an investment. In comparison, REITs already have paid transaction costs and own a portfolio in which you can invest by buying shares, saving the real underlying cost of real estate transactions.

#4 - Diversification vs. Concentration

REITs offer the opportunity 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 many other specialty sectors in almost all geographical location.

It results in significant risk mitigation as compared to private investments, which are likely to be much more concentrated in nature. Being concentrated can sometimes lead to higher returns, but it's also a much riskier strategy that has not historically paid off.

#5 - Personal Liability

Rental investors will often have to deal with personal liability issues and are at risk of getting sued by tenants, contractors, brokers, and others. Moreover, they may have to sign on loans with their name and be liable for everything. Structuring your investment as an LLC won’t always remove personal liability.

With REITs, you are the shareholder of a publicly-listed company. Therefore, you have no personal liability and you cannot lose more than what you invest.

Just 10 years ago, 1000s of rental investors were filling for bankruptcy due to over-leverage. Yet, most investors ignore the risk of personal liability. I have found that unless you have had to deal with liability issues in the past, you won’t appreciate this argument to its fullest.

Conclusion:

In our book, REITs handily win against Rentals because:

  1. They will generate higher total returns over time for most investors.
  2. They provide truly passive income.
  3. You enjoy liquidity and low transaction cost.
  4. You can easily diversify to mitigate risks and improve risk-adjusted returns.
  5. You have no personal liability.

Higher returns, lower risk, and significantly less work: This should be the conclusion for most investors.

Rentals vs. REITs: A Practical Case Study

To illustrate the above, let us dive into a practical example of how our REIT investment strategy compares to rental investments.

We will here assume that the rental property is located in an average market, not an expensive one like San Francisco, but not cheap like Detroit either.

On the REIT side, we will outline the typical REIT that we target at High Yield Landlord. In this case, we use as an example our late December investment in Brookfield Property REIT (BPR) – a +$17 billion property empire.

  • Example 1 - Rental Investment
  • Example 2 – REIT Investment (Typical REIT targeted at High Yield Landlord)

Rental investment:

Positive

The rental investment produces a high cash on cash return. The cash flow is initially higher than the REIT thanks to greater leverage and saving the cost of management by taking care of everything yourself.

Negative

On the downside, you own a concentrated, illiquid, work-intensive, and riskier investment. You have to take care of all the work, deal with tenants, property damage, etc... etc…

Moreover, in the long run, your cash flow (and appreciation) is unlikely to be as high as for a well-managed REIT.

REIT Investment:

Positive

You generate high passive income that's set to increase over time at a fast and consistent pace. While the rental property may or may not grow its rent at 2% consistently per year, our hand-picked REIT (BPR) has consistently grown in cash flow at 9% per year. We set our expectations lower at 6% for the future years:

source

This higher growth compensates for the slightly lower immediate income and results in greater total returns in the long run. Moreover, your investment is liquid, diversified, invested in Class A assets, and professionally managed.

Negative

Your immediate income is lower because the REIT retains some cash flow for future growth and has to pay for some overhead cost (passive for you).

The Return Kicker for the REIT Investment

This is where our secret sauce of our strategy comes into play: Our REIT investment (BPR) was done at a 50% discount to the private market value of the underlying properties. We managed to get this large discount by investing during the late December sell-off which was way overdone.

REITs have historically traded at a slight premium to NAV to account for the benefits of liquidity, diversification and professional management. Assuming it takes five years on average for this gap between price and value to close, we get an additional ~8% annualized return, pushing our expected annual total return closer to 15%-20% per year.

In reality, our investment has performed even better because the market was quick to recognize that the discount to NAV was excessive. The shares have returned close to 40% since making our investment three months ago.

Chart Data by YCharts

To be perfectly clear, it rarely works out so well, and we occasionally even suffer losses (see disappointing investments in CBL or UNIT). But with a diversified portfolio of deeply undervalued REITs, the results will most often surpass those of rental properties from our experience.

Here are a few other notable examples of how buying at below NAV can result in fantastic results when investing in REITs:

2018 example: Medical Properties Trust (MPW) traded at an estimated ~20% discount to NAV back in May of 2018. Total returns are upward of 50% since then:

2017 example: Spirit Realty Capital (SRC) crashed in May of 2017 after disappointing quarterly earnings. We recognized an opportunity to buy quality net lease assets at an estimated 30% discount to NAV. Total returns are approaching 50% in a less than two year holding period – from low risk assets.

2016 example: Dream Global (OTC:DUNDF) is an international REIT that owned highly desirable German properties back in October of 2016, and yet it was offered at a ~20% discount to NAV. The total return over the two and half year holding period is ~80%:

Active REIT investors who target REITs at discounts to NAV have managed to reach up to +22% annual returns over the past decades.

source

This is what we aim to do at “High Yield Landlord” by specializing in value REIT investing. Right now, our portfolio trades at an estimated 21% discount to NAV on average and pays a close to an 8% dividend yield.

Ending Remarks

We believe that most investors buy rentals (instead of REITs) because they do not know enough about REITs to recognize that they are better investments in most cases. With our "Rental vs. REIT" comparisons on Seeking Alpha, we aim to educate investors on the power of REIT investing. I have myself been a professional real estate investor in the past, but once I learned more about REITs, it became obvious that it's a more efficient way for the average investor to invest in real estate.

Today, I have become a professional REIT investor and I aim to buy REITs at less than what they are worth in order to achieve high income and capital appreciation. It's just common sense that such strategy, when implemented correctly, can lead to fantastic investment results.

Disclosure: I am/we are long BPR; MPW; SRC; UNIT; CBL-E. 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.