The question that I keep receiving the most often is: Why do you buy REITs instead of rental properties? I receive this question almost on a weekly basis.
It seems that a lot of rental property investors are confused about the benefits of investing in REITs, or real estate investment trusts. In their mind, REITs must be less rewarding because the yields are lower, managers take a cut of the profits, you do not enjoy the benefits of leverage, and you have fewer tax benefits. Moreover, they also view REITs as much riskier because they are traded like stocks and can be very volatile.
So, it seems that if REITs offer lower returns with higher risk, what’s the point? Well, this exact reasoning is the result of major misconceptions about REITs.
In reality, I believe that REITs are not only more rewarding, but they are also far safer, and especially today, it makes far more sense to buy REITs rather than rentals. I’ll explain why in three sections:
- Why REITs are more rewarding investments than rental properties.
- Why REITs are safer investments than rental properties.
- Why, especially today, REITs have a lot more to offer than rental properties.
Let me start by correcting some important misconceptions because otherwise, you won’t understand the rest of this section.
I already hear some of you say:
- But REITs cannot even be leveraged!
- REIT investors must pay their managers!
- REITs are not even tax-efficient!
- I can easily earn over 25% per year with rentals!
All four of these are misconceptions. Here’s why.
Yes, you cannot take a mortgage to buy REITs, but that isn’t needed because REITs are already leveraged. When you buy shares of a REIT, you are providing the equity, and REITs then add debt on top of it, so you enjoy the exact same benefits of leverage. What you see traded on the stock market is the value of your equity, not the total asset value.
As such, your $40,000 investment in the equity of a REIT may well represent $100,000 worth of properties. You just don’t see it.
This explains how REITs like Realty Income have managed to generate 15% average annual total returns for the past ~30 years. They use leverage just like private investors. In fact, REITs may get even better terms than you, making it even more rewarding and safer.
REITs do pay millions to their managers. But even despite that, the management cost of REITs is far lower than that of private rental properties because REITs enjoy huge economies of scale.
Again, taking the example of Realty Income, its annual management cost is just 0.3% of total assets. There are huge cost synergies when you own billions of dollars worth of real estate, and REIT investors benefit from this.
Rental property investors can depreciate their property to reduce their immediate tax liability. REITs, on the other hand, are commonly perceived to be tax-inefficient because their income is taxed as ordinary income.
But despite that, I pay fewer taxes investing in REITs than in rentals. Here are the important points that investors are missing:
- REITs retain 30% to 40% of their cash flow for growth. All of that is fully tax-deferred.
- A portion of the dividend income is commonly classified as “return of capital.” That’s tax-deferred as well.
- The portion of the dividend income that’s taxed enjoys a 20% deduction.
- REITs generate a larger portion of their total returns from growth because they focus on lower-yielding class A properties. The appreciation is fully tax-deferred.
- Finally, if all of that still isn’t enough, you can hold REITs in a tax-deferred account and pay zero taxes with great flexibility.
The bottom line is that I pay fewer taxes investing in REITs than rentals.
Moreover, I would also add that the tax benefits of depreciation are very much exaggerated because it reduces your cost basis, which will either hurt you at the exit or force you to remain invested in real estate forever. This loss of flexibility has significant indirect costs, as you may end up having to hold on to real estate even if it becomes a poor investment.
Rental return misconception
How often have you heard people claim that they earn 25%+ annual total returns by investing in rental properties? I see it very often, and in some rare cases, these claims may be true.
But the reality is that Warren Buffett became the richest investor on Earth by compounding the returns at Berkshire Hathaway by 20% annually. So, I can guarantee you that rental investors are not just casually beating Buffett by buying rentals as a side gig. Barriers to entry are low in the rental space, and if returns were truly this high, then a lot more capital would flow into it, increasing prices and reducing future returns.
In reality, what’s happening here is that rental property investors will commonly miscalculate their returns in three ways:
- First, they will not account for the value of their own labor. They will put in countless hours to find the right property, negotiate it, finance it, renovate it, market it, manage it, etc., but assume that all these countless hours of work are worth $0. That’s not right because you could have put all this productive time into a job and earned a salary for it. If you properly accounted for each hour and deducted just $30 for each, your returns would come down considerably. Very often, up to 50% of the returns are actually just the value of your labor, not the return on your investment capital.
- Investors will only look at the returns during a typical good year, which significantly overstates their returns. Once in a while, you will need to heavily reinvest in your property, hurting your average return, and you cannot just ignore that. So no, you are likely not earning 25%+ average annual total returns. If that were the case, we would have many more rental property billionaires.
- The extremely high leverage that rental property investors commonly use inflates the returns in the early, highly leveraged years. Yes, it is possible to earn those high returns in the first years, but only by using extremely high amounts of leverage, and these high returns can only be sustained with consistent refinancing and maintaining high leverage over prolonged periods. This is yet another reason why it is so important to look at “average” annual returns over a long time period.
With these misconceptions out of the way, let me now show you the results of various studies comparing the historic returns of REITs versus those of private real estate and private equity real estate funds.
You will see that the results are consistent: REITs outperform by 2% to 4% annually on average:
This outcome may seem surprising to some of you, but it is very much expected.
1. 10 Reasons Why REITs Are More Rewarding Investments Than Rental Properties
- The management cost of REITs is far lower due to their scale.
- REITs also enjoy other economies of scale. Example: changing the carpets of 100 apartment units in a single market each year versus just one or two.
- REITs can skip brokerage fees because they employ their own.
- REITs will often develop their own properties to earn even higher returns.
- REITs enjoy better access to a wider variety of capital sources.
- REITs have the best talent in the real estate space working for them.
- REITs can make investments grow even faster, thanks to their access to public equity markets.
- REITs can enter real estate-related businesses, such as asset management firms, brokerages, property management companies, etc., to earn extra profits.
- REITs enjoy stronger bargaining power with their tenants because of their superior scale and resources.
- REITs are also in a better position to deal with regulators and tax authorities. An example is fighting against tax increases.
On average, REITs have earned 13% per year over the past 20 years ending in 2022, outperforming even the S&P 500 and growth stocks:
Private-equity real estate funds have also done materially worse on average despite having better resources and skills than most individual investors. This just demonstrates once again that if you correctly calculate your returns, you would probably realize that the actual returns on your invested capital (not your labor!) are quite a bit lower than those of REITs.
I would add that this is just the average of the REIT sector, which includes the good, the bad, and the average REITs.
There are many REITs that have done far better. For example, the entire self-storage REIT sector has earned ~19% average annual total returns over the past 30 years.
If you can sort out the good from the bad, you could earn far better returns by investing in REITs than in rental properties, from my experience.
A final point here that I want to discuss is the indirect costs of owning rental properties because this makes a huge difference, and it is barely ever mentioned.
If you own REITs, you can focus fully on your career, and you will retain geographic freedom. This will allow you to take on opportunities and advance a lot faster in your career, reaching a higher income. This is far more important than whether you actually get an extra 1% or 2% more on your investments.
But if you own rentals, they will be a huge distraction, taking a lot of your time and energy, and you will also give up your geographic freedom. This is likely to slow down the progress of your career, reducing the growth of your primary income, which is really what you should worry about.
So, when taking all this into account, I believe that REITs are far more rewarding investments for the vast majority of investors in most cases.
2. Why REITs Are Safer Investments Than Rental Properties
Rental properties are private, illiquid, concentrated, management-intensive, highly leveraged investments with significant social risk and liability issues. In contrast, REITs are public, liquid, diversified, professionally managed, conservatively financed investments with no social risk and limited liability.
Even then, some will argue that REITs are riskier because they believe that they are more volatile. But even that isn’t true.
The only reason why they think that REITs are more volatile is because they decide to ignore the volatility of rental properties. However, just because you aren’t getting a daily quote does not mean the value is perfectly stable.
Just try to sell your property on a daily basis, and you will commonly get offers 5% to 20% lower than your asking price. And since rental property investors use significant leverage, the value of your equity would be extremely volatile.
If you use an 80% LTV and receive a 10% lower offer, that would mean that your equity value dropped by 50% in a single day. It is not uncommon for real estate to lose 10% in value—especially when interest rates surge at an unprecedented pace.
If the property loses 20% of its value, your equity is fully wiped out. You may even end up with negative equity, and you are still personally liable for the loan since you signed on it.
In comparison, REITs are far less volatile. Remember that what you see traded on the stock market is the equity value. It is leveraged. And yet, the daily prices actually don’t move nearly as much. Again, this is expected since REITs are far safer investments, and they are more transparent public vehicles.
But even ignoring all of that, the biggest risk people tend to underestimate is liability. As the shareholder of a REIT, you enjoy perfect liability protection. You are just the minority shareholder of a public entity.
But as a rental property investor, you will be on the line for a lot of potential risks. You will likely give personal guarantees for the loan of the bank. That’s a big risk, considering that you are making a concentrated, illiquid investment.
Then, you will also deal with a lot of tenants who will seek to take advantage of you. Even if you have an LLC, that won’t fully protect you from a lot of things, and tenants will often sue both the LLC and the owner personally.
And even if you win in court, it is a huge headache, and the stress isn’t worth it. The stress could literally ruin your personal life and career, as well as your health. The cost is huge and rarely ever mentioned.
These liability issues are the No. 1 reason why thousands of real estate investors have to file for bankruptcy each year—yet there have only been a handful of public REIT bankruptcies over the past decade.
3. Why, Especially Today, REITs Have a Lot More to Offer Than Rental Properties
Most times, REITs are priced at a small premium relative to their net asset value, and this makes sense, considering all the advantages that they offer relative to private real estate, as the table shows.
|Private Real Estate||Public REITs|
|Costly, work-intensive management||Cost-efficient, professional management|
|Unlimited liability||Limited liability|
|Limited access to capital||Superior access to capital|
|Discount valuation||Premium valuation|
But there are exceptional times when the performance of REITs becomes detached from that of real estate markets, and as a result, they can become heavily discounted. That’s the case today.
REITs have crashed by 33% on average since the beginning of 2022—even as most REITs continued to grow their cash flow at a rapid pace:
The REIT market appears to have overreacted to the surge in interest rates, thinking that it would lead to significant pain. In reality, cash flows have kept on rising because:
- REITs use little debt—most of it is fixed rate—and have long debt maturities.
- REIT rents keep growing at a rapid pace due to inflation.
To give you a good example: Alexandria Real Estate, a blue chip life science REIT, has dropped by 54% since the beginning of 2022, even as it grew its cash flow by 5% in 2022, and is expected to grow it by another 6% this year.
This unusual disparity in performance between REIT share prices and real estate fundamentals has resulted in exceptionally low valuations across the REIT sector.
According to a late 2022 study by Janus & Henderson, REITs today are priced at a 28% discount to their net asset value on average. Since then, REITs have actually dropped further:
What this essentially means is that you can buy real estate through the REIT market at $0.70 on the dollar.
Again, that’s just the average of the sector. Many high-quality REITs are even cheaper than that. A good example is BSR REIT, which owns apartment communities in the Texan Triangle, has a good balance sheet and management team, and yet is priced at a 42% discount to its net asset value (NAV). Its type of assets are commonly priced in the private market in the 4.5% to 5% cap rate range, but BSR REIT is currently priced at a 6.5% implied cap rate.
If you account for the mark-to-market in its leases, the implied cap rate is closer to 7% based on its forward normalized NOI. That’s a huge spread.
Would I buy an apartment community today at a 4.5% cap rate? Probably not.
But would I buy an interest in a diversified portfolio of apartment communities that are professionally managed and liquid at a ~7% cap rate—representing a huge 40% discount to their fair value? I would gladly do so.
So why would you buy a rental property and pay full price when you could invest in REITs at such a large discount? The decision is pretty easy for me.
Studies show that REITs have historically been exceptionally rewarding in the years following such large valuation disparities. According to Janus Henderson, REITs have, on average, earned a 130% excess return relative to private real estate in the three years following a 24% discount to NAV.
And that’s not all: There is another big advantage of REITs today. They allow you to invest in real estate with a much lower interest rate.
Today, if you bought a rental property, your mortgage rate would likely be around 6% to 7%. But there are many REITs that have locked for their interest rates for many years to come at 3% to 4%. Their interest rates are fixed, and maturities are long.
Therefore, you get to buy real estate at a discount with the added benefit of assuming the REIT’s low fixed-rate debt. This would be worth a lot of money in the private market, but somehow, investors have missed it in the REIT markets.
The Bottom Line
Most of the time, REITs offer better returns with lower risk for most investors. But especially today, REITs offer far better return prospects and much lower risk because their valuations are so heavily discounted. Investing in REITs provides both a margin of safety and future upside potential.
This explains why I am buying REITs instead of rental properties. If, someday, REITs become heavily overpriced, I will need to reconsider this approach, but as of right now, I don’t see the point of buying anything other than REITs.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.