Off and on, I’ve been thinking about buying a rental property but for some strange reason, the idea of Real Estate Investment Trusts (REIT) never crossed my radar. Over the weekend, a conversation with a former coworker sparked my interest in this sector again, and this time, I decided to compare a rental property with REIT. After a bit of research, let me share with you what I learned.
First, The Real Estate Conversation
Over the past year, one of my co-worker bought an income property for $140,000. According to him, he is getting $1,500+ in rent a month and after calculating all the association, property taxes and such, he is getting a 9% return on investment. With a strong cash flow like that, he can afford to wait until prices of housing finally go back to a normal upward trajectory, which is rather impressive. (now you know why I was interested…)
But REITs seem to be a good alternative too. With a bit of digging, I found was that investing in a REIT is similar to investing in an individual stock in that the performance (and risks) are very dependent on the company that owns the actual properties. Therefore, investing in a particular REIT meant that I had to keep up with research and make sure I’m not investing in a dud. That’s too much work, so I turned to ETFs. Luckily, Vanguard has a pretty attractive ETF in this area – Vanguard REIT ETF (VNQ).
At first glance, VNQ’s 4.8% yield is not as attractive as a 9% return, but 9% comes with more hassle and risks. They include:
- Possible Tenant Troubles – They may call you for something that needs to be fixed, which costs you time and money.
- Tenant Payment Issues – If the tenant decides to live there rent free, it takes months to properly evict them.
- Tenant Changeover – Every time the original tenant moves out, you have to pay for cleaning, possible remodeling as well as the down time of having no tenants for a while.
- General Maintenance of the Properties – Houses need fixing as they age, and everything is a cost.
- Soft Costs – Cell phone costs for talking to the tenants, gas to go check out and manage the properties are all costs that add up over time.
On the other hand, REITs offer:
- Liquidity – The ETF can be bought or sold at any time.
- Compound Interests – Dividends are distributed quarterly and if you reinvest it back into the ETF, the returns are higher than the stated 4.8%
- Historically, the yield is higher than 4.8%, but with a sagging economy, vacancies are high. Over the long term, this yield should increase faster than the rent that my coworker is getting.
- Small Barrier of Entry – The reason why my friend is able to buy these condos at such a low price is because he is paying cash. How many of us really have $140,000 lying around? With VNQ, you can start with $50.
Other Factors to Consider
- Taxation – In general, dividends from REITs are taxable as ordinary income. Since this is the same as the income generated from an income property, it becomes a wash. However, REITs sell buildings from time to time, forcing investors to take capital gains, which can erode some gains. With REITs, you can put it in retirement accounts to shelter the income from taxes while it’s not possible (at least from what I’ve read so far) to do so with a real property.
- Appreciation – Rental properties obviously can gain in value, and so will REITs. I consider this a wash because I, or anyone else for that matter, cannot accurately predict which investment is going to appreciate more in the future.
Since I’m striving towards passive income, a REIT ETF seems like the way to go, especially if I’m thinking long term and planning to make investments in my retirement accounts.
What do you think? Do you own either of these and have some suggestions for a novice like me? Anything else you want to add about these?
{ read the comments below or add one }
Your friend didn’t do the right thing why would you ever buy real estate 100 percent down. If your friend bought the house with 20 percent down he would have only had to put in 28,000 dollars so after the loan was paid off not even including cash flow from the raise in rents due to inflation he would make about over 39 percent on his money just from paying off the loan never mind appreciation.
Another advantage of owning rental properties as opposed to co-ownership in a REIT is that in times of volatility, your real property is not subject to buyers and sellers whims as in the sharemarket – you won’t be wiped out in a few minutes. You will still own the investment property as the price may go down (tangible asset). People still need somewhere to live and (providing other economic circumstances are still reasonably stable) your tenants will continue to pay their rent so as you can continue making repayments to your lender.
Real estate volatility is (usually) a lot slower ie: the prices go up an down over weeks, months or years. If keeping a keen eye on the property market trends (as you would the sharemarket) you will have time to act (ie: enact your plan B, C or D) to limit or prevent loss of value in your real estate, or get in early and sell before prices drop in the area where your property is. You have a lengthier time in which to get organised and limit your losses.
That said – I prefer REIT’s – passive income wins the day for me. I am fortunate to own my home in a growing area (after 80% appreciation during the boom). I live in my home. I will realise the capital in this house at some time in the next 5-7years (assuming the current bear cycle eventually becomes a bull again)! 🙂
Good article, I’ve been thinking about investing in both. Unfortunately living in socal, there is an extremely high barrier to entry as you mentioned. REIT’s may not offer the same gains, but they should be in the vicinity with tons of less work.
Thanks for doing the research 🙂
This definitely is a tough decision to make, especially in this economic climate. You need to make sure that you are prepared for the worst and be willing to lose money. However, your friends’ impressive ROI makes this seem like an easy industry to get into.
Purchasing in a great neighborhood is another important tip to remember. Do your research on the neighborhood of the property you are considering. Ensure that rentals will be accepted in the area. Also make sure that the area is safe. Most people won’t want to rent a property in a crime laden neighborhood.
It seems like your friend calculated his return incorrectly. He also has to factor in non-cash expenses such as capital improvements and other one-time or periodic expenses. Since these don’t happen every month and many of them don’t involve cash at all, most investors forget about them, thus dramatically overstating their returns. The REIT’s price and dividend, however, takes all these hidden costs into account, so comparing his stated 9% return to the REIT’s 5% dividend return is apples to oranges. In reality, I’d be very very surprised if his actual cash return on that rental property is higher than 5%.
I’m a little skeptical when I first heard it as well, but after hearing the numbers, I believe him. He told me that the condo cost him $140,000. With rent at $1,500+, it seems that 9% is possible. If it’s 5%, it would mean that he’s getting a net of $7,000 per year, which means something like $600 a month. I’ve got to believe that he’s not spending $900+ a month on repairs and one time expenses.
An FYI – You can purchase a rental property with your IRA. There are conditions – you have to use the funds in your IRA – no mortgage allowed and the property must strictly be an investment – you can’t self manage because then it isn’t an investment but a side job. Check with your financial advisor to find a company set up to administer this type of retirement investment.
Ning, I thought the REIT is a program, which is specially designed for a corporation investing in real estate to reduce the corporate income taxes. After reading your article, I discovered it covered more than I firstly thought…
I’ve been considering jumping back into an investment property as a hedge against (possible) inflation. Locking in a 15 year below 5% would be a sweet deal if we get 3% to 4% inflation over the next few years after printing all those new dollars.
You might also want to checkout carbon based MLPs (master limited partnerships). They trade just like stock, but have a yield around 5% to 15%. Some of the other oil pipeline stocks are decent yielders too.
We really enjoy the tax benefits of rental property ownership as well as the positive monthly cash flow. We only invested 15,000 in the property and our net cash flow after PITI is $300/month. So yeah, I like making $3600/yr on a $15,000 investment.
I have owned both (and still do including LLC). Each provide a form of return.
I prefer REITs for adding a real property component to your portfolio or as an LLC member if possible. Sole owner is my least favorite.
REITs PROs: Liquidity, “Professional” management, immediate market valuation, Cash Flow, low entry $ amount. CONs: Tax treatment, no control on dispostion of underlying asset.
Property Asset: (sole owner): PROs: Cash Flow, favorable tax treatment, disposition control, opaque market fluctuation (until sale). CONs: Up front $, Management nightmare (unless professionally managed and that costs 8% on gross rent), very unliquid, personal liability (must have liability insurance), tax reporting complexity (depreciation, expense v. cap improvement, etc.).
Property Asset: (LLC member): PROs: Cash Flow, favorable tax treatment, opaque market fluctuation (until sale), smart management, NO personal liability. CONs: Gotta find a good one, Up front $ (easily $100K), very unliquid (no control on asset sale), tax reporting complexity (K-1).
I looked at REITs, private real estate partnerships, and direct property ownership and chose to buy properties directly.
Your pros and cons on rental properties are spot on, but the values are unlikely to decline as far as REITs have in a market downturn. Besides, the rental cash flow is tax deferred due to the availability of depreciation deductions.
Just bought my first REIT — MPW. I bought at $6.98; it’s higher now. A few reasons I purchased this particular REIT:
— Medical properties seem to be a more stable area than commercial or residential real estate
— Pays 11% dividend
— Straightforward business model (leaseback of large medical properties)
I would not currently invest in an ETF in this industry due to overexposure of commercial properties/strip malls and other places that may go bust.
I only invest in individual dividend stocks; MPW is part of a larger, balanced portfolio, and is currently my only REIT holding. I would consider buying more in November when I think it may be back in the $6 range.
-Erica
That’s one good trade if you are in it for the short term (of course, it doesn’t hurt long term as well).
Medical buildings definitely sound safer than malls and properties but why is it paying 11%? Have you looked at the dividend history and whether it’s sustainable? When I see double digit dividends like that, I get worried.
I think it is. REITs (along with oil well companies, etc.) typically pay out a large amount of their income as dividends. It is nothing compared to the 31% I got when I invested in MWE.
Feel free to read their annual report, etc. I read their statements and liked what I saw. Good cash flow, low risk. But it’s up to you to draw your own conclusions. 🙂
-Erica
Wow 31% is just crazy high…. I don’t care how safe it looks because if it’s sustainable, the price will go up to a point that it won’t be 31% anymore.
I will look through MPW. Medical buildings do look more stable than almost every other real estate out there right now.
I actually own both. Rental real estate and VNQ. I own VNQ in my retirement accounts since it includes foreign REITS as well as I think 30% domestic REITS. I think this is a good hedge against my index fund equity money.
The rental real estate is a bit of a pain in the beginning, while you are self managing, but necessary long term. you dont want to pile up tons of money and put it all in the stock market do you? that isnt exactly safe or prudent.
The returns on the rental property are massive long term, and you have much more control. You can always wait and buy bigger so that you are forced to get a manager out of the gate, thus no day to day personal management. and only 1 building to worry about, instead of 6 roofs, etc.
Plus, you are always happy when you see your taxes.
I know REITs sound more like a stock than real estate but it’s really the same as a rental property in terms of asset class isn’t it? I guess in a way, the emotions of people will relate it to stocks (so in times of extremes, REITs will correlate with equities). Other than that, I think they are far enough apart to warrant them as separate investments.
And since I will eventually own a house, I will probably have enough real estate exposure in my financial portfolio.
With regards to taxes, why would you be happy? You are NOT suppose to be able to deduct taxes with interest on mortgages for your rental income right? Or are you referring to something else?
You get depreciation on the rental house – plus all your repairs can be written off. ALL your repairs.
With regards to taxation, would an REIT ETF be taxed like a stock rather than ordinary income?
The dividends on the ETF, as I know, are taxed as ordinary income. The capital gains however, are usually long term capital gains since you can pretty much bet that they don’t sell buildings within a year of buying them. With REITs, flipping properties is never the agenda.