Why I Occasionally Buy Rentals Instead Of REITs

Summary

• I strongly believe that REITs are better investments than rental properties in most cases.
• Even then, I occasionally still invest in rentals and other private properties.
• I present 5 reasons why.
• Looking for a portfolio of ideas like this one? Members of High Yield Landlord get exclusive access to our model portfolio. Learn More »

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In a recent article, I explain that in most cases, REITs are better investments than rental properties.

REITs are liquid, diversified, and professionally managed vehicles with limited liability, whereas rentals are illiquid, concentrated, and work-intensive investments with unlimited liability.

And despite being much riskier, rentals generally do not provide better returns. Quite the opposite, REITs have historically outperformed because they enjoy economies of scale and have access to public capital markets to grow faster.

So overall, the risk-and-hassle adjusted returns of REITs are much better in 99% of cases. Even then, there is always that 1% that may justify a private real estate investment.

That's the focus of today's article. Below, I discuss 5 reasons why I still occasionally invest in private real estate, despite favoring REITs most of the time.

Reason #1: Niche Property Type

Today, REITs invest in nearly all property sectors. You can see REITs that invest in apartment communities, billboards, or even prisons.

However, often in the specialty sectors, you will only find 1 or 2 REITs, and if they are poorly managed, overleveraged, or overpriced, then you are left with no viable options.

As an example, today, I would like to invest in farmland to earn income, diversify my portfolio, and protect myself against the risk of surging inflation.

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However, in the case of farmland, there are only two publicly-traded REITs [(Farmland Partners (FPI) and Gladstone Land (LAND)] and they are not particularly attractive.

Farmland Partners has an extremely volatile history and a poor track record of value creation for shareholders. It went public in 2014 at $13 per share and after seven years, it still trades at $13 per share. At one point, it dropped as low as $4.50. That's not the type of volatility that you want to see in a farmland investment, which is supposed to stabilize your portfolio.

Gladstone Land, on the other hand, appears to be a higher-quality REIT and it has managed to generate attractive returns for its shareholders. However, today, it is priced at a large ~50% premium to NAV, which means that you are paying a hefty price. Moreover, the yield has compressed to just 2.5%. Gladstone Land is on our watchlist, and we would like to own it someday, but the current valuation is too rich.

Therefore, I am left with private options. I could buy land directly, invest in a limited partnership, or use a crowdfunding platform. I am currently exploring all these alternatives.

Reason #2: Home Ownership

Often readers ask me: should I buy REITs or buy a home?

My answer is always that it depends on your situation. If you live in a very expensive market such as Silicon Valley, it might be better to rent and buy REITs instead.

However, ideally, you would want to do both: buy REITs and your home.

Your home is not just an investment. It is also where you will live, potentially raise a family, and spend the majority of your time.

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There are many non-financial benefits to owning versus renting. Most importantly, you will never have to deal with a landlord who could potentially ask you to move away for a reason or another. By owning your home, you have greater control over your own residence, which will give you peace of mind.

Not all decisions have to be purely financial, and in the case of homeownership, I think that it makes sense for the non-financial benefits alone.

Reason #3: Exceptional Deal

As noted earlier, REITs are better investments than rental properties in most cases. That does not mean that there aren't exceptions.

I closely follow my local market and if I can buy a property at a steep discount to fair value, I would consider it. Recently, I visited a 6-unit apartment building that was priced below market, and I was close to buying it.

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But as is often the case, what I thought was a great opportunity, it turns out that it wasn't in the end. The property had technical issues that would have been very costly to fix.

Unfortunately, in today's market, you are unlikely to find that "exceptional deal". The housing market is red hot and there is more competition from buyers than ever before.

Reason #4: Foreign Market With No REITs

REITs are very popular investment vehicles in the US and Canada. There are 100s of them and you can almost always find attractive options.

However, that's not the case in every country.

Here in Europe, REITs are still relatively new and many countries don't have any. To give you an example, I am very bullish on the future of Estonia, a small Northern European country:

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I believe that over the coming decades, Estonia will catch up to the living standards enjoyed just 30 miles north in Finland. Even then, property prices remain materially lower in the capital city of Tallinn, and I expect this discount to gradually close down in the coming years.

If there was a good REIT that only focused on Tallinn, I would be very interested, but unfortunately, that does not exist, and therefore, I can only invest by buying properties in the private market.

Reason #5: REITs Get Overpriced

Finally, it always comes down to valuation at the end of the day.

If REITs were dangerously overpriced, but rentals were cheap, I wouldn't hesitate to buy rentals.

But historically, this has rarely been the case. Quite the opposite, today we are seeing rampant speculation in the private rental market with properties being sold at large premiums to asking prices within days:

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The REIT market is the opposite. Investors are still fearful because of the pandemic and many REITs trade at large discounts to the underlying value of their properties.

Below we list a few examples. Note that there are not recommendations:

• SL Green (SLG): New York City skyscrapers at a 30% discount
• Clipper Realty (CLPR): Apartment communities at a 40% discount
• Macerich (MAC): Class A urban malls at a 60% discount

You get the point: REITs are today cheaper than rentals.

If you can get liquidity, diversification, professional management, and limited liability, all at a discounted price, what's the point of investing in illiquid, concentrated, work-intensive rentals at a premium price?

There is no point and that's why most of my capital is today going to REITs.

It is as simple as that.

Bottom Line

It does not have to be one or the other.

Generally speaking, we favor REIT investments, but we also invest in private real estate on rare occasions.

It gives us access to markets that aren't covered by REITs and diversifies our portfolio.

Today, ~90% of my real estate allocation is invested in the REITs presented at High Yield Landlord, and the remaining 10% is invested in real estate in Tallinn, Estonia.

Analyst’s Disclosure: I am/we are long FPI.PB, MAC. 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.