Most real estate investors do not trust stocks. Similarly, most stock investors never invest in real estate. Being a hybrid of both, has made it difficult for investors to invest in REITs (VNQ; IYR).
Still to this day, it is difficult to find good comparisons between REITs and real estate and it has led to many misconceptions.
I have myself worked on both sides of the fence, first as an analyst for a +$150 million private equity real estate investment firm and later as a professional REIT analyst. I have invested a considerable portion of my net worth in both for years and believe to understand the pros and cons of both approaches. It is not an "either/or" type of question and the best approach to pick is mostly a question of:
- Personal preferences
- Expertise and access to resources
- Risk tolerance
- Return objectives
- Current valuations
In this article, we provide an objective comparison between REITs and Rental properties to help you decide which is best for you.
We break down this comparison to the following five topics:
- Risks
- Income
- Total Return
- Taxation
- Other considerations
(1) Buying a Rental Property vs. REITs - Risks
REIT investors will argue that rental properties are concentraded, illiquid, investments that require a lot of work and efforts.
Rental investors, on the other hand, will tell you that REITs are volatile and that you are at the mercy of a moody marketplace.
There's some truth to both and the truth is probably somewhere in the middle. Overall, I believe that REITs are much safer investments. Here is why:
The underlying asset is the same, but the REIT structure mitigates risks on many fronts through diversification, professional management, lower leverage and liquidity.
No investor has ever lost money in the long run by holding a diversified REIT portfolio. However, there are new rental investors that file for bankruptcy each year.
(2) Buying a Rental Property vs. REITs - Income
Investors often compare the dividend yield of REITs with the cap rate of a rental property and quickly conclude that rentals provide significantly more income.
This is very misleading and too simplistic because:
- REITs do not pay out all their cash flow in dividends. The average payout ratio is only ~70%.
- Secondly, REITs spend a considerable amount on capex to maintain and improve their properties. Rental investors rarely account for capex in their comparisons.
- Thirdly, REITs use considerably less leverage to lower risk. Rental investors achieve high yields by leveraging at up to 80% LTV. REITs use only 35% today.
- Finally, when you invest in a REIT, you receive passive income and the management has been paid off. When you own a rental, you put a lot of “sweat equity” to earn that income. It's not passive.
So, if you only compare the average dividend yield of REITs with the average cash flow yield of a rental, the REIT will always look poorer. However, once you make the right adjustments, the difference becomes less meaningful.
Small-cap REITs are arguably the most comparable to Rental properties and they currently trade at an 8% cash flow yield on average. This includes some overvalued, fairly valued, and some undervalued REITs. At High yield Landlord, we have put together a portfolio of 18 undervalued REITs that has a 10.35% cash flow yield with a low 68.75% payout ratio:
Source: High Yield Landlord Real-Money Portfolio
It should be noted that this is after management cost and it is achieved with a low 32% LTV. Most rental investors will need to borrow double of that to achieve a similar yield - unless you live in a cheap market.
So there's no clear winner here. It depends on what type of REITs you target and in which rental market you invest. One thing is however clear: There's much more work required on the rental side to earn that income.
(3) Buying a Rental Property vs. REITs – Total Returns
Historically, REITs have returned more than 12.4% per year. Private equity real estate investments returned just 8.7% on average, resulting in ~4% of annual underperformance:
Many rental investors will be surprised by this outcome. They are quick to brag about their lucrative returns, often in the 20% to 30% range, but how realistic is that really in the long run? Warren Buffett from Berkshire Hathaway (NYSE:BRK.A) (BRK.B) became the richest man on earth by earning 20% per year. I think that if rental investors truly earned 20-30% annual returns, we would have more billionaires on this planet.
The reality is that rental investors underestimate costs, overestimate returns, and do not look at returns over a full cycle. It is very easy to earn 20% returns by leveraging up old properties. What good is it however if you then get crushed in a recession?
REITs provide greater long-term appreciation and total returns because of three key reasons: (1) They grow faster, (2) They enjoy great economies of scale, and (3) they are more prudent with leverage.
(4) Buying a Rental Property vs. REITs - Taxation
Rental properties are private assets that enjoy some unique tax advantages. For instance, they can deduct depreciation, a non-cash expense, from their income to reduce taxes.
Moreover, you can also deduct all the other property-related expenses, including interest from your income. Many rental investors are able to get away with little taxes for many years.
REIT investors do not enjoy the same benefits and will commonly pay higher taxes. REIT dividends enjoy a 20% deduction and you also may hold them in tax-deferred accounts. In the end, it depends from one person to another. In my personal case, I'm better off investing in REITs.
(5) Buying a Rental Property vs. REITs – Other Considerations
Finally, there are some other considerations that make us lean even more in favor of REITs:
Professional management: All the unpleasant work is managed by professionals in a highly cost-efficient way thanks to economies of scale. These are people who do this full time, have great resources, and are likely to do a better job than you.
Liquidity and low transaction cost: Unlike rentals that are highly illiquid and involve up to 10% in transaction costs on day 1, REITs are publicly listed and shares can be traded in one click of a mouse at minimal cost.
Passive Income: REITs must, by law, pay out 90% of their net income in dividends to shareholders. In this sense, without putting in any work, you will be earning very consistent income from a passive investment.
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. 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.
Conclusion: Rental Property vs. REIT Investment
Real estate has historically generated higher total returns and paid greater income than the S&P 500 (SPY). Therefore, it is clear that you should be investing in real estate. The more difficult question is whether you should invest in Rental properties or REITs. Here is how they compare according to our analysis:
We prefer REITs because they have much more pros than cons in our eyes. I put my money where my mouth is. The portfolio that we manage for High Yield Landlord has been funded with about 50% of my net worth and represents the 19 best opportunities out of ~200 REITs right now.
Closing Notes: REITs and Rentals Are Wonderful — If You Know What You Are Doing
I have been investing REITs and real estate for a long time and greatly profited from the sector. Today, I am strongly convinced that most investors should invest in real estate with REITs to avoid the managerial complications of owning rentals.
That said, you need to know what you are doing. A lot of individual investors earn very poor returns investing in liquid assets because they trade too much. To demonstrate this, consider that the average investor generated only 2.6% annual returns over the past 20 years:
Clearly, most investors do not know what they are doing. By simply holding a REIT ETF, investors could have earned up to 12.5% annual returns and outperformed almost all other asset classes:
Then taking it one step further, active REIT investors who invest in undervalued REITs have managed to earn up to +22% annual returns over the same time period:
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