Have you always wanted a slice of the property market but didn’t know where to start? Today I’m partnering up with Ben over at Stock Investment Analysis to talk to you about REITS vs Rental Properties pros and cons. Firstly, we should explain what a REIT and rental property are.
REIT vs Rental Property Definitions
Rental Property – We’re all familiar with this concept, right? A rental property is essentially when you invest in to a specific property (house/flat), and then rent it out for income (when your tenants pay you rent). Although some people pay this with cash, the majority of people do end up taking out a mortgage in order to finance this.
REIT – stands for Real Estate Investment Trust. It’s essentially a corporation which owns many real estate assets which produce income. Think of it like an ETF, just with property. These assets can be anything from office buildings to hotels and residential properties. These funds are mandated to pay out 90% of their income as dividends which means they tend to be a pretty reliable source of dividends.
Time and Effort
REITs take very little time to invest in beyond the research necessary to decide which REIT or REITs you want to buy or sell. Making a purchase on a computer or phone takes only a couple seconds and you are done. When buying a rental property, research is also necessary to ensure you buy the right property. However, the time and effort you invest is just beginning. You cannot purchase the property with the click of a button. You will need credit checks, will likely need to find a real estate agent, get pre-approved by a lender, make an offer, have a home inspection, get insurance, establish utilities, and close and sign a lot of paperwork. The process typically takes at least weeks but often months, especially when searching for the right property to buy. You may need to make necessary repairs immediately and will likely need to continue to do so throughout the time you own the property. You then need to find renters, maintain the property, ensure you receive rent payments, be responsive to renters, and find new renters when old renters move. Finding new renters can take months depending on your location and other factors. Selling the property will again require many steps and often takes months to find a new buyer.
REITs are far more liquid than a rental property, because they are publicly traded on the stock exchange. It is generally accepted that REIT trading is very high volume, so these tend to be very liquid investments.
With a rental property, the process of selling can be extremely daunting and time consuming. Yes, you can get lucky and sell within a couple of months. But more and more people I know are finding that it takes them upwards of 4 months to sell – take into account the fact that in the UK, you have to engage lawyers, carry out property valuations and surveys, arrange to list the property for sale, take viewings and offers, deal with lawyers and contracts back and forth – and more often than not you end up in a chain where you are waiting for someone else to sell their house before they buy yours etc. It took my parents a whole 8 months between listing their house and finally handing over the keys and getting the money for the sale! I think this is a quicker process in the US, but it can still take a while to find a buyer.
A significant benefit to rental property is leverage. If you invest $100,000 into a REIT like Realty Income, you may receive around 5% in dividends every year. However, you could take that $100,000 and buy 5 $100,000 homes, putting $20,000 down on each home. Take a look at a house which happens to be selling for exactly $100,000. If your monthly cost was truly $669 per month and you received $675 per month in rent, you would just break even in terms of profits. However, you would be accruing equity in your house which could be sold in the future. When the house is paid off, the rental payments are pure profit minus repairs, property tax, and maintenance. Let’s do the math. $100,000 in Realty Income with its current 5% yield will give you $5,000 in dividends per year. 5 houses bought for that same $100,000 which make $675 per month in rent will give you $40,500 per month. See the difference? That’s the power of leverage. Leverage also introduces risk, however. If tenants move out, there is a crisis like currently and renters do not pay their rent, or repairs or other costs are high, you may struggle to pay down the mortgages and may risk losing everything.
If you are the kind of investor who likes to have total control of their money, a rental property is definitely more for you. Considering when you purchase a property, it is yours – you can completely control what you do with it; who you rent it out to, which property to buy, how much to rent it for, when to sell.
With a REIT, the only control you really have is when to buy and sell into the REIT – you don’t really have a say on which properties to hold onto, which properties to sell, etc.
Historically, REITs have returned more than 11% per year. In comparison, private equity real estate investments returned just 7% on average, for a ~4% annual underperformance. REITs crushed private peers with much lower average leverage, better diversification, a stronger focus on quality properties, and less risky strategies in general. REITs outperformed for three reasons. First, faster growth: REITs grow cash flow at a much greater rate thanks to better access to low cost capital, professional management and scale. Second, REITs win because of a Full cycle approach: Private investors take on way too much leverage – leading to exceptional returns in good times, and disastrous results in downturns. It’s not uncommon for rental investors to use up to 80% leverage, whereas REITs are more conservative and use only 30% on average today. Third, REITs win because of the Economies of scale: Size brings cost down. REITs are able to save costs on many fronts.
I’m all for not having to think too much about my passive income, and that’s exactly what you get with REITs. Similar to other funds, you can just buy and hold. However, with rental properties, you will have to be involved in things such as maintenance, finding tenants, upkeep, dealing with tenants and disputes. Sure, you can employ people or agencies to deal with this, but that’s just reducing your profit margin.
Both REITs and rental property bring some interesting diversification to your investments. Rental property gives you an investment which is not being traded on the stock market. It’s price won’t rapidly fluctuate based on a myriad of factors impacting the markets. This gives diversification. However, the rental property is only one piece of real estate. This also presents risk as property values in that area can drop. The benefit of REITs is you take ownership of hundreds or thousands of properties which may be spread across many states or countries offering a different form of diversification.
Something I’m very familiar with – downpayments on a property! I got slightly burnt when I was purchasing my own apartment, and my mortgage company suddenly decided that the 5% deposit you usually put down for shared ownership (a scheme we have in the UK), wasn’t enough and I had to fork out 15%! That’s 3x more than I had budgeted for.
If you aren’t using a scheme like this, a typical downpayment for a mortgage will set you back tens of thousands. In the UK, if you assume a property price of £250k (the current average UK house price – although definitely not the average in London (not bitter at all..)) and a standard downpayment of 10%, you will need a downpayment of £25k. That’s a lot of money! If you’re from the US, the downpayment you’ll be expected to make to avoid additional fees such as Private Mortgage Insurance, is 20% of the mortgage value – so double what I said!
With a REIT, you can benefit from investing in real estate without having to fork out these huge initial amounts.
Coming from the UK, we have slightly different rules around taxes. I feel like this deserves a whole other video, and there are so many complications in tax that I would strongly advise consulting with a tax expert in either instance – contact HMRC to get the latest rules and guidance.
However, REIT income here is treated the same as rental property income. I.e. you declare this on your tax returns as if you were receiving this income from renting out a property you own. These are not subject to the dividend tax-free yearly allowance. If you are interested in a further detailed video on this drop a comment below 🙂
An important tax consideration for US investors is REITs pay an unqualified dividend. What that means is that the dividend payments you receive are taxed at the ordinary income rate. If your income is ordinarily taxed at 25%, your dividend will also be taxed at 25%. Qualified dividends are paid by most common stock companies and are capped and typically only taxed at 15%. However, in a sense similar to depreciation and repairs on rental property, taxpayers may also generally deduct 20% of Qualified REIT Dividends.
Finally, we have interest. You will pay interest on your mortgage when you buy a home. Look at this table. If you took out a $100,000 loan and paid $599.55 every month for 30 years, you would ultimately pay $215,838. Not only that, because interest is high at 6%, only $99.55 of your first payment goes to the $100,000 loan. $500 goes straight to intest. After that first payment, you still owed $99,900.45!
Anna – At this point in my journey, I’m sticking with REITs ! Mainly because they are less hassle. Having said that, I would like to invest in at least one rental property in the future.
Ben – Given the amount of time, effort, and inconvenience required for rental property as well the data on total return underperformance, I am only investing in REITs for the time being. Although leverage can result in amazing results, given I already have two jobs, I don’t have the necessary time to invest in rental properties at this time.
What is your opinion on REITS vs rental property pros and cons? Which do you prefer to invest in, REITs or rental property? What do you think are the pros and cons? Leave your thoughts in the comments below. We look forward to hearing from you and learning from you. Don’t forget to subscribe to both our channels because we will be creating new videos for you every week. As always, good luck with your investing.