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Real Estate vs. REITs

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Six years ago, I wrote an article comparing stocks vs. real estate, using a Money Magazine article as a base. Few of my articles stay in memory too long, but this one did. I remembered it being one of my better articles. Unfortunately, in re-reading it, the writing was, well, terrible. There were parts of the article that I can't even follow today.

Today, I'd like to revisit the topic. Perhaps being a few years wiser will translate to a better article. (If it doesn't, then heaven help me.)

Over a month ago, I wrote about expanding our real estate empire. In a comment, Evan from My Journey to Millions, made a great point, "I go back and forth on the real estate investment option. On the one hand it seems to be the clearest way to wealth, while on the other it seems almost crazy to take on that headache for a few hundred bucks of current income. Have you given much thought to REITs instead?"

For those who aren't familiar with REITs, they are Real Estate Investment Trusts. You can buy shares of REITs just like stocks or mutual funds and collect a share of the profits. Typically they pay high dividends making them good for those looking to build an income portfolio. Also, because they are usually diversified amongst a number of properties, risk is minimized. I'm a strong proponent of them and believe that putting 10% of your portfolio into an ETF like Vanguard's REIT index, VNQ is a good diversification strategy.

So if I can invest in real estate without dealing with tenant headaches, I should right? Well, it's all about the numbers.

A Typical Return on REITs

Zack's Research notes that "During the 40-year period from 1972 to 2012, average annual total returns for REITs were 8.09%..." Given that information, I feel comfortable using an 8% estimated return on REITs in general.

For sake of argument we'll presume that you have $23,000 to invest. Yes, it is an odd number, but you'll see why I chose it in a couple of minutes. In 15 years, $23,000 invested at 8% turns into $72,960 (don't we all love compound interest?). Why am I looking at 15 years? Again I ask you to humor me for a few minutes. At that point, $72,960 would give you $2,918 in income using the rule of 4%. That rule of 4% says that you can roughly take out 4% of your invested money safely to live on retirement.

To sum up the last paragraph, a $23,000 investment now in REITs will give me nearly $3,000 per year in income in 15 years.

I realize that there are loads of assumptions here from the expected return on a REIT to the rule of 4% (some say it's closer to 3%). Unfortunately we have to make some assumptions for this exercise and hopefully these are "reasonable" assumptions given the information cited.

The Return on My Investment Property

Last week, we closed on the investment property we were looking for (hold the applause). The agreed price was $95,000. With closing costs, we ended up writing about $23,000 in checks (you should be having an "a-ha" moment). We financed the rest with a 15 year fixed mortgage.

With mortgage, condo fees, property taxes, and insurance it will cost us $1025 a month. We are very confident it will rent at $1250. For sake of argument, let's presume that the $225/month ($2700 a year) "profit" will go towards maintenance and real estate listing fees. That's actually almost scary accurate as estimated maintenance is typically 1% of the purchase price. So that's $950 in maintenance, plus $1250 (one month's rent) a year.

So for sake of argument, the $23,000 is going to be invested for 15 years (another "a-ha" moment?). At that point, we'll collect $15,000 in rent and owe condo fees, taxes, insurance, maintenance and listing fees. The condo fees are a big hit, but that's very much part of the maintenance as I explained in this article. By the time all those costs are added up, we should be clearing $10,000 a year.

So to sum up this section, a $23,000 investment now in this property will give me $10,000 per year in income in 15 years.

(In fact, in the extremely unlikelihood that the property doesn't appreciate at all in 15 years, the $95,000 property will still be worth more than the REIT investment. For what it's worth, 8 years ago the property was estimated to be worth $185,000.)

Real Estate is Even Better

Hopefully at this point, you see the wisdom in dealing with troublesome tenants. We don't need the AT&T guy interviewing a bunch of kids to tell us that $10,000 is better than "nearly $3,000", right? So how could it possibly get any better?

The "nearly $3,000" in income from REITs is money in 2028 dollars, which will probably buy you less than it does today. The $10,000 that I'm using is assuming today's rent of $1250. In reality, in 2028 it would rent for $2250 assuming 4% inflation. The math then comes to 27,000 where I'll pay $8K-$9K in the condo fees, taxes, insurance, etc. and come away with $18-19K in 2028 dollars.

In 2028, do I want to have "nearly $3,000" or $18-19K a year? I think I'll go with the later.

Real Estate is not all Rainbows and Puppies

Real estate comes with its headaches, no doubt about that. A REIT has never called me up in the middle of the night with a plumbing problem. Additionally, if there's a problem and you need access to cash, it's fairly easy to sell a REIT. Good luck selling a piece real estate in an emergency. You'll get pennies on the dollar and take around a 6% hit on commissions from real estate agents. In addition, there are few things less diversified than buying a single property. If the economy in that town takes a nose dive, my property value, and the ability to rent it, takes a nose dive with it.

Finally, the condo complex, having been built in 1985 is just starting to show wear and tear today. What it is going to look like in 2045 when it is 60 years old? It's probably going to look like properties from the 1950's today... no bueno.

What's your take? Let me know in the comments.

Posted on September 23, 2013.

This post deals with:

... and focuses on:

Investing, Real Estate

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16 Responses to “Real Estate vs. REITs”

  1. You are comparing apples to oranges with this example.

    This is because you are comparing unleveraged returns on a REIT versus the leveraged returns on a piece of real estate.

    Honestly, if direct real estate investing works for you, you should stick to it. If you think you are better buying REITs, then go that route.

    I chose the direct REIT way, because I want my income to be derived from hundreds if not thousands of properties, all management to be taken care of by someone else, and I also want to be able to have instant liquidity should I choose to. I can also “reinvest” any distributions back into reits, which makes compounding much more efficient with REITS. Try reinvesting that $200 in excess rent payments back into another rental unit with direct real estate ;-)

    I also like the option of sticking my REIT in one of the many types of IRA’s out there without much extra hassle. Putting a piece of real estate in an IRA is much more hassle.

    Best Regards,

    Dividend Growth Investor

    • Lazy Man says:

      I’m going to have to disagree with you on the apples and oranges front. Realistically we had a number of options of what we could do with $23,000 and I detailed two of them. One of them had the benefit of being able to leverage “for free” (well costs footed by the tenant) and the other couldn’t be leveraged (well, there’s margin brokerage accounts, but that math wasn’t going to be in favor of REITs either).

      At the end of the article I mentioned those benefits of REITs: liquidity, diversification, and worry-free management of the investment.

      As for reinvesting dividends or excess rent payments, I can clearly set up a monthly direct purchase plan to buy a REIT, or any other investment, with the $200. There’s nothing about investing in real estate that says you can only invest excess rent payments in real estate. It’s cash that can be used just like anything else that you’d do with it.

  2. […] Man @ Lazy Man and Money writes Real Estate Vs. REITs – Real estate comes with its headaches, no doubt about that. A REIT has never called me up in […]

  3. TC says:

    I see @Dividend’s point – you say the margin account doesn’t work out in REIT’s favor – can you detail your work on how you came to that conclusion?

    If we assume you took $95,000 (in combination of cash and margin) and invested in a REIT @ 8% return, after 15 years you’d have (95k * (1.08^15)) = $301,356. Using the same 4% rule, you’d be withdrawing $12,054 per year, which is much more in line with your $10,000/yr figure from the house.

    I’m purposefully glossing over the details of the margin loan interest, just as the mortgage loan interest was not stated.

    • Lazy Man says:

      You shouldn’t negate the margin loan interest. Mortgage interest was included in the original article in the statement of “With mortgage, condo fees, property taxes, and insurance it will cost us $1025 a month.” I didn’t break the mortgage payment into principal and interest, because there was no reason to. It’s one check that is sent to the bank.

      I don’t think margin accounts for REITS are going to be helpful because the base interest rate (if TD Ameritrade is indicative of the industry is 7.75%). I’ll leave the math as an exercise for the reader (in other words, I’m going to play my Lazy card here), but that 7.75% interest is a lot more than the mortgage interest. It’s Sunday so my mind is on football, but paying 7.75% margin interest would seem to negate the 8% interest return on the REIT almost entirely.

      Additionally, I don’t think many, or any brokerages will give you $95,000 worth of buying power with a $23,000 investment. I think you can typically margin up to 50% of the investment not 400% of the investment like in real estate.

      It’s been a dozen years since I had a margin account, so I’m going a little off rusty memory and quick research as well.

  4. TC says:

    Fair enough, interest on actually acquiring the capital to go from $23k –> $95k could (and seems to) be a show stopper.

    In the end, though, you’re still comparing the future cash flow on $23k unleveraged vs. $95k levered 4x. If you weren’t able to make significantly more money with leverage, nobody would do it.

    On top of the leverage risk, you’re also exposing yourself to numerous other risks, and with additional risk comes expecting additional reward. How that risk/reward relationship falls along the Markowitz Bullet depends on many factors, most importantly of which is luck! So on that note, I wish you the best of it (luck) with your investment!

    • Lazy Man says:

      I know I’m comparing a leveraged vs. a unleveraged investment. The leverage is core benefit to the real estate itself, just like buying a REIT has a core benefit of not getting calls to fix plumbing at 3AM and being diversified. I approach it as, “I have $23,000 to invest. There are pros and cons to each. Which path do I choose?”

      As for the risks that you state, I don’t believe they are substantially different. The risk of leverage in owning real estate is that you go underwater. It’s possible to be underwater for a long, long time and still derive income from rent. In fact, the longer that the property is held, the less chance of being underwater as the mortgage is being paid off. There’s the potential for the property to go unrented for an extended period of time, but it is unlikely knowing the market and we have a large emergency fund to cover at least two years of vacancy. (We are doing roughly 2-3 showings a week right now, but haven’t found the right tenant yet.) There’s a risk of lower rents in the area, at which point we’ll have to adjust our expectations down, but it wouldn’t be catastrophic, even if they dropped in half.

      You don’t get a margin call like the leverage with buying stocks on margin. That scares me a lot more. I see stocks drop significantly in a very short time where real estate seems more stable.

      Thanks for the well-wishes on the luck front. I think it plays a factor in everything we do. I also believe it is the residue of good design.

  5. Evan says:

    With regards to the other commenters I wonder what the calcs would look like if you leveraged equally (although you probably wouldn’t b/c the margin interest rate is going to be significantly higher than the mortgage).

    In addition (and as we discussed privately), and I am not sure it would matter, I don’t think the calcs are as correct as they could be. It isn’t just 8% growth, it may be 8% growth plus X Dividend which buys more shares which compounds.

    Notwithstanding, your point is still there but to me it has to do with controlled leverage.

  6. I think the core premise of the article is well-reasoned and agree with the bulk of the analysis. All I would do is add more details that would further reinforce the core conclusions and flesh it out a bit.

    For example, one advantage to direct ownership real estate is you will find greater market inefficiency in the pricing of local real estate allowing you to add value through smart purchases. Much tougher to do in the REIT market. This opens the door to much higher potential returns.

    Also, you will see significant tax advantages from your direct ownership against other sources of earned income. In fact, a marginally positive cash flow deal can often result in a net deduction against earned income at the end of year further increasing your ability to grow wealth.

    Also, I might have missed it in your article, but I noticed you treated your income from the REIT under the “4% Rule” which is tantamount to spending principal. I would suggest reshaping the income analysis exclusively around the dividend return form REITs as compared to the cash flow from direct ownership. In other words, really segment your principal and income components of the total return equation on both sides of the comparison.

    Finally, I would add the value of my time to the analysis. The thing about direct ownership of real estate is it’s part business and part investment. Your total return from direct ownership is a combination of business return and investment return. This is not true for a REIT which is pure investment return only.

    Again, I agree with the core analysis and thought these ideas might be helpful to really flesh it out fully. Hope that helps…

    • Lazy Man says:

      That’s a good point Todd. I believe that the property we bought was at a very favorable price. The appraisal came in lower than I expected, so it may not have been “as favorable” as I hoped.

      I couldn’t find good analysis for the dividend return of REITs in general. I’m sure that data is out there, and it’s probably not hard to find, but I had limited time to research. When I found some data that I could grab onto, I went with it. It does make sense to separate the principal and income components.

      I also agree with the value of the time to owning a property. Hopefully, it’s a good return on my time. That analysis gets even more complex.

  7. Nightvid Cole says:

    You have an emergency fund to cover two years of vacancy as stated in comment # 7. Two years of rent at $1200/month is almost $30,000.

    Your initial investment is then $53,000 (i.e. downpayment plus emergency fund), NOT $23,000!

    If you took this $53,000 and put it in the REIT for 15 years, at the end you would have MORE than enough to buy the property OUTRIGHT.

    In which case, how does it make any sense at all to buy the property???

    • Lazy Man says:

      I’m not sure that I’d count that emergency fund as part of the investment. It wasn’t something that we set aside related to this transaction. We’d keep this emergency fund even if we didn’t buy this property. It brings up the question of what is the appropriate amount of an emergency fund. That’s a great question, but probably outside the scope of this article, agree?

      If we took $53,000 and put it in a REIT, we’d have significantly less of an emergency fund. Is there a guarantee that in 15 years of investing in a REIT we’d have MORE than enough to buy the property outright? I don’t think so. Is it likely? The property has previously been assessed at over $160,000 so it could be there again. Does a $53K investment triple in 15 years? I don’t think that’s likely.

      Another way to think of the $30,000 emergency fund is to invest it in a REIT as well, while still buying the property. There’s nothing that’s binding me to having $30,000 or how long we need to prepare for vacancy. Our income can more than carry vacancy indefinitely, the emergency fund is just yet another fail-safe.

      The way we are doing it also gives us the property owned OUTRIGHT (to use your caps) in 15 years.

  8. Nightvid Cole says:

    But you need a larger emergency fund when your expenses are that high, right? So saying you’d just have it anyway doesn’t really seem to do justice.

    You are also neglecting the opportunity cost of the time you spend on the property. If you didn’t have to do all the landlord stuff you could spend the same time working a second job and investing that income in addition to your original capital.

    • Lazy Man says:

      I’d buy the argument that you need a larger emergency fund, but how much larger? We can debate it, but I don’t think anyone would say that you have to $30,000 in an emergency fund. In fact, some could say having a HELOC available could qualify as an emergency fund.

      I don’t think I was neglecting the opportunity cost in the time that I spend on the property. I’ve noted the extra effort that it takes to be a landlord vs. a REIT. I didn’t go into an opportunity cost analysis, because it is almost impossible. Everyone’s second job opportunities are different based on their marketable skills. The amount of time varies based on the property (whether it is great condition or in terrible condition) and the type of tenants you have (some are much easier than others). With all these factors, it isn’t worth trying to quantify it. Having been a long distance landlord for the past 6 years, the amount of time spent was probably less than 20 hours… it’s not a ton of time.

  9. The Real Housewives of New Jersey stars off-loaded the 9,500 sq. ft. home which Joe custom designed for the family after they purchased it in 2007 for $950,000.

  10. A good simple comparison!

    I’m just starting to build a nest egg and am wondering whether to try with a rental property first or build up some stocks and REITs instead to avoid the headaches. I think I might just try all three if possible!

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