Owning Rental Property or Owning REITs

Feeling brave? Wanna invest in real estate? Do those millions of households underwater on their houses and the ominously empty stores at your local mall just make you want to jump right in?

Residences of Distinction Crop Seriously. Investing in something when it is in what might be called the crater and rubble stage is often a good move. Everybody and their brother has known that real estate is a disaster and has been running away from it as fast as possible for a good long while now. The stuff is really cheap.

So assuming you are feeling brave and clever, how do you carry out your scheme? Do you buy shares in a REIT (Real Estate Investment Trust) or do you buy that condo down the road and rent it out?

This is a good question that was raised by Kyle at Amateur Asset Allocator the other week. I promised to "borrow" it and produce my own version of the answer, so here goes.

The first thing to point out is that this is not an apples-to-apples comparison. Shares in a REIT are a financial asset that will appear on your brokerage statement and (hopefully) make you money without any effort at all. Owning a rental property is not so passive. Although in the ideal case your tenant will mail you a check each month like clockwork, as anybody who has actually owned rental property can tell you, even if things go relatively well it requires a whole lot of bother.

Taxes, insurance, and maintenance need to be paid for. And maintenance is not just a bill, it’s an activity. When the furnace dies at 2 AM guess who gets the first call? And you’ve got to find, select, and negotiate with those tenants.

Of course, there exist businesses that will take care of most of this for you, for a fee. Hire a management company and directly owning a rental property becomes a lot more like owning a REIT. It’s not perfect, but comparing an investment in REITs to one in a professionally managed rental property is almost apples to apples.

So what are the advantages to REITs?

Well, to begin with, there is diversification. Most REITs own many different properties in different locations. And you can buy a fund of REITs, e.g. Vanguard’s VGSIX or the ETF IYR, to diversify even further. A single rental property is just that, a single asset in one place.

Buying and selling a REIT is as simple as clicking on a website, or if you are very old school, talking to your broker very briefly on the phone. Buying and selling real property is expensive and time consuming.

REITs allow you access to almost every property type there is, apartment complexes, office buildings, shopping malls, and so on. There are even REITs that own trailer parks and self-service storage facilities. Directly buying a rental property limits you to what you can afford (or what the bank thinks you can afford) and in all likelihood to property in your immediate area.

And the advantages to owning a property directly?

In principle, considering just the structure of the two investment types, I don’t think there are any. The only reason you might prefer to buy a rental property is the usual reason people prefer one investment over another. Because it’s just such a good deal.

Given the size of the country and the millions of people who read this blog, I have no doubt that there are some readers who have real estate opportunities that just can’t be beat. But if you are considering buying property, it is important to work out the return you expect after you pay for a management company and then compare that to the economics of investing in REITs.

You may find that the REITs look awfully good in that comparison. It’s not that the place you had your eye on was such a bad deal, but that REITs are really cheap just now. That Vanguard fund currently yields 9%. And that’s just the income it throws off. Any recovery in real estate prices we might see is on top of that.

But, you say, if I don’t include that steep fee from the management company, then the rental property looks better.

Looks can be deceiving. What the management company charges to deal with the bother is probably a pretty good estimate of what dealing with it will cost you in time and effort.

Yes, but I’m willing to put in the extra effort for the extra bucks.

Okay, but now you have left the realm of investing and are talking about taking on a part-time job and/or starting a side business. Ask yourself this: if somebody else bought this property, would I be willing to manage it for the fee the management company wants? I’m betting that proposition doesn’t excite you.

Real estate may be a great place to invest now. But it is very likely that the best way for you to act on that thought is via a REIT or REIT fund. As with many things in our advanced society, it is best to let the division of labor do its thing and leave managing real estate to the professionals.

[Photo by yours truly, of a sign in front of a new building in my area. Translated into English, it reads "Silly big condos for sale. No reasonable offer refused."]

37 Comments

  • By Kosmo @ The Casual Observer, July 8, 2009 @ 11:37 am

    How about a farmland REIT? I’ve been told that these sorts of investments exists, although they’re not identical to traditional REITs.

    At least in Iowa, farmland has had relatively few downswings in price over the years.

    And the upside to farmland? It won’t sit “vacant”. If you can’t find a renter, you can actually farm the land (the REIT could hire the work done).

  • By CalLadyQED, July 8, 2009 @ 2:12 pm

    Thanks for sharing this, Frank. I’m trying to get my parents interested in this instead of a rental. Wish me luck. :)

  • By Jim, July 8, 2009 @ 2:47 pm

    I’m a landlord and a fan of real estate investing. But I agree that a REIT is probably a better choice for most folks over direct ownership of real estate.

    Couple benefits of direct real estate investing are:

    1) leverage

    With the right situation you can take a 10-20% downpayment and buy a place with some cash flow and not only get a good return on your downpayment but the rent pays off the mortgage long term. Of course this carries risks too and if you can’t rent the place and don’t make your payments then you can lose the property to foreclosure.

    2) tax breaks

    Tax situation for owning rentals is pretty good. You get to deduct the depreciation on a property over 27.5 years. Thats a pretty sizable tax break. You can also deduct all expenses for the property. Plus the growth of the property is a capital gain so you pay the capital gain rate on it only when you sell.

    There are certainly downsides to REITs too. Most REITs have lost over 50% of their value in the past 12 months and I’ve had REITs suspend their dividends entirely since they simply aren’t making any cash. THe relatively high yields from REIT dividends right now are a reflection of their share prices getting hammered so don’t expect 9% forever. Picking individual REITs can be tricky and a lot of them have had credit problems or been hit by the economy in general. But now IS a good time to buy though with prices down and a REIT index like Vanguards ETF (VNQ) is a good way to diversify.

  • By gpr, July 8, 2009 @ 3:16 pm

    OK, be nice to me and don’t send me over to Suze O’s site:

    I get that a REIT distributes its income. When they sell a property, that’s (hopefully) income. So then as a member of the REIT, I get all that nice leveraged profit, right? Same as if I bought a house myself with 10% down?

  • By Jim, July 8, 2009 @ 7:49 pm

    Yeah you’d get indirectly benefit from the leveraged purchases that the REIT makes.

    With a REIT there won’t be as much leverage. Industry average is ~50%. So the potential for benefit (or loss) from leverage is not as great with a REIT as what you’d see as an individual buyer. Course that leverage has added risk so that counters it as a benefit.

  • By Dave C., July 8, 2009 @ 8:58 pm

    Well, I now need to figure out if we are on the cusp of a major commerical real estate market crash or not. I’d hate to buy in on the verge of another big dip, but I suppose it can’t get too much worse, right? RIGHT?!? heheh :D

  • By bex, July 9, 2009 @ 10:02 am

    Where did you get 9% yield for the Vanguard fund? If I check Google or Yahoo, I see 9%:

    http://www.google.com/search?q=VGSIX
    http://finance.yahoo.com/q?d=t&s=VGSIX

    But if I check Morningstar or Vanguard, they say only 6%:

    https://personal.vanguard.com/us/FundsYieldDisclaimerREITFund?FundId=0123
    http://quicktake.morningstar.com/fundnet/Snapshot.aspx?Country=USA&ss=gf&Symbol=VGSIX

    Why the discrepancy? Is there a good place to get historical yield data to see who is a leader over a long term?

  • By bex, July 9, 2009 @ 10:09 am

    Also…

    I’m a tad weary of REITs because of the whole CDO debacle. How can I make sure there aren’t any sub-prime mortgage timebombs in a REIT? Or is that just a risk you gotta take in order to play the game?

  • By mwarden, July 9, 2009 @ 11:00 am

    Really, Frank? The government has been instituting policies to prop up real estate prices and avoid further deflation. Doesn’t that indicate to you that prices are still above where they ought to be? Or are you in the camp that believes this is purely psychological?

    I agree with your general statement about profiting by being a contrarian, but I have to disagree in the case of real estate. Prices still need to fall. Stay out!

  • By Frank Curmudgeon, July 9, 2009 @ 11:11 am

    Kosmo: There are some topics on which I have complete confidence that I not only know nothing about it, but will never know anything about it. Investing in farmland is one of them.

    Jim & GPR: I think that most of the economic benefits from directly owning are in REITs, including tax advantages and leverage. Although the REITs are “only” levered 50% typically, you can then margin them to get to 4 to 1 if you really want to. (I’m not saying this is a good idea.) And of course the high yield is from the prices being hammered and it won’t last. That’s kinda the whole point….

    Bex: I got the yield from Yahoo, and frankly didn’t think to double check it. If you add up the past four quarterly dividend payments and divide by the current price (this is the standard method) you get 9%. If you just multiply the most recent March payment by four and divide you get 6%. That’s not the right way, because these dividends are seasonal. March is always a lower payment than the other three. (And no, I have no idea why.) Yahoo is pretty good at historical payments.

    And I am not so worried about accidentally owning bad debt when I buy a REIT fund. There used to be a handful of big mortgage REITs (New Century comes to mind) but these are, ahem, no longer with us, so are not in the index.

  • By bex, July 9, 2009 @ 12:27 pm

    @Frank: Thanks! And great post again, as usual ;-)

  • By Jim, July 9, 2009 @ 2:11 pm

    The leverage benefits may be a wash but there are definitely tax benefits built into owning real estate that are not seen by owning REITs.
    Depreciation is a major tax dodge of directly owning real estate. Depreciation does not give REIT owners any tax dodge. In fact the depreciation would reduce the net income of the REIT and cut the amount that they are required to distribute as dividends.

  • By Jim, July 9, 2009 @ 2:44 pm

    I don’t think sub-prime mortgages really directly apply to REITs. Subprime mortgages are for individuals with bad credit. REITS borrow money commercially.

    Credit issues as a result of bank problems did impact REITs a LOT. So some REITs had some major problems getting new credit. I think we’re probably past that stage now though.

    Its always possible a REIT has poor financials and might default on loans and get poor interest rates on their loans. Thats the case with any company really. To find that kind of thing you should examine their balance sheet and dig into their annual report.

  • By GPR, July 9, 2009 @ 10:57 pm

    Although the REITs are “only” levered 50% typically,

    Paraphrased for dummies is this basically just saying that, in effect, while I might buy property with 10% down, a REIT will only do it with 50% down?

    Jim, Frank, others?

  • By Frank Curmudgeon, July 10, 2009 @ 12:22 pm

    Exactly, except that buying property with only 10% down isn’t as easy as it was in the good old days. And you can buy a REIT with only 50% down, so if it in turn buys property with 50% down, you’re net at 25% down.

  • By Paul, July 20, 2009 @ 8:30 am

    I own both REIT’s and rental property. With my actual property, I have more control over what my returns are than with a REIT. My REIT investments are down 50%, my rental property values have growing steadily throughout the banking debacle.

  • By Frank Curmudgeon, July 20, 2009 @ 11:23 am

    You own real estate that has gained in value over the past two years? On what planet?

  • By p. lawrence, November 10, 2010 @ 12:01 pm

    Frank, My rental properties have also increased in value over the last 3 years. Though the ‘assessed value’ has eroded a bit, the cash flow has increased due to rental increases and my equity position continues to grow month after month. Dips in the assessed value do not hurt as much (still suck but aren’t crippling) for buy and hold strategies if the initial purchase was truly a worthwhile investment.

  • By terrysingh, December 8, 2010 @ 4:35 am

    I dont get the comparison between owning REIT and a rental property.

    For instance I compared putting $50k (20%) into a REIT that pays back 6% in 30 years. That gives me $302k after 30 years.

    Now, if I get a rental for $50k, and mortage/taxes etc is paid by someone else, then say the property appreciated by just 1.5% each year over 30 years: I now own soemthing that is worth $337k. At 1.5% appreciation, its $392k.

    So … isn’t generally speaking (and all the headaches aside), owning a real property beat REIT over 30 years hands down?

  • By Rob, February 18, 2011 @ 12:13 pm

    I don’t see how REITS and owning real property is close to an apples to apples comparison. In REITS, you have no control and don’t really know what management is doing, just like in buying company stocks. When you buy a real property to rent out, you have control over improvements, location of where you bought and the screening process of tenants. You control your investment. You also (hopefully) know the market where you are buying.
    Maybe the article should of asked, do you want to be in the business of real estate or just buy some stock in it… owning rentals a couple or 20 is a business/job and should be treated like one if you’d like to make money.

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    Nice share and thank you Frank! actually I have no idea about determine and comparing REITS and rent a property profit. You give me a simple description about it
    Thanks!

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  • By Rek, November 28, 2012 @ 12:29 pm

    Um, I think the reason people buy that condo is because they put down 10 or 20 percent and get the appreciation on an asset worth 5 to 10 times what they paid in cash. If they are lucky or skilled enough to get the rent to cover the mortgage, they get equity and appreciation of a leveraged asset. So comparing these two is not apples to apples unless you bought the condo for cash which I don’t think is the most likely scenario. Also, if a REIT is cooking the books or obscuring how they borrow or how they actually run their business, you would never know it. You get transparency when you buy that condo. Two different investments and not apples to apples. Nice try, but this is utter nonsense.

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