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."]

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