It’s been a little while between posts. I’ve been on a short family vacation/road trip. We brought the kids to New York City for a day before moving on to Hershey Park. We’re trying to squeeze every last drop of fun of summer before school starts. It’s been nice to put down the laptop and be blissfully ignorant of whatever is going on in the chicken sandwich wars. However, I’ve been fortunate enough to have a guest post from sureDividend on two of my favorite topics – REITs and passive income. I plan to be back next week with an article (and maybe one before that), before taking another break for the FINCON financial blogger conference.
Real estate is a highly popular method of investing for passive income, and for good reason. It has proven to be one of the most reliable long-term investments capable of delivering consistent, sustainable, and inflation-resistant cash flow.
However, it has the main drawback of potentially requiring extensive hands-on management and the hassles that come with being a landlord, which prevent it from being a truly passive investment. Additionally, real estate often requires considerable capital just to purchase your first investment, making it a cost-prohibitive investment for beginning investors.
However, for those looking for true passivity, a less cost-prohibitive, and/or a potentially even more lucrative and lower risk means of investing in real estate, publicly traded real estate investment trusts (or REITs for short) offer investors a compelling alternative. REITs are also attractive for their high dividend yields.
Why Real Estate?
Investopedia defines REITs as real estate portfolios that receive income from a variety of properties and then distribute at least 90% of that taxable income to investors in the form of dividends. Additionally, the REIT itself qualifies as a pass-through entity which means that it does not have to pay any corporate income taxes and most, if not all, of its dividends qualify for a 20% tax write-off after the latest tax reform bill.
Real estate is a tangible asset that provides clear value to its user. Additionally, the nature of its value is limited, necessary, and flexible – giving it remarkable durability and stability in value and making it extremely unlikely to become worthless over time unless it is grossly mismanaged and overleveraged.
Furthermore, real estate often generates cash flow through a variety of means. This means that it can be repurposed to fit whichever business is in demand at the time.
Finally, its finite supply makes it inflation-resistant. While the fiat currencies of the world continue their inevitable march towards zero, the amount of available land actually declines as the population increases. This has resulted in the value of real estate, on average, growing in a direct positive correlation to the rates of inflation and population growth over time.
This aspect of real estate is extremely valuable for early retirees as it leads to cash flow growing in line with consumer prices over time, making it a great way to ensure stable buying power to fund a retirement lifestyle.
These positive qualities are also supported by the data, as commercial real estate scores as the best possible risk-adjusted investment over long periods of time.
As previously mentioned, while real estate investors enjoy many advantages that often lead to stellar long-term results, real estate still has some drawbacks as a passive income source. In fact, some would argue that it is not really passive income at all. Being a landlord necessitates going through the sometimes arduous and stressful process of finding good tenants, completing the necessary legal work, performing routine maintenance and occasional repairs or hiring contractors, and keeping your tenants accountable to paying their rent on time.
Furthermore, if you ever need to liquidate your investment, preparing, listing, and ultimately selling your property can be a costly, time-consuming, and stressful endeavor. If you have to liquidate it quickly, you will quite possibly have to settle for far less than market value to attract an immediate cash buyer.
Of course, you can always hire a property manager to mitigate many of these stresses, but the costs associated with that will eat heavily into your cash flow and total returns. Additionally, there is the personal liability of getting financing and making mortgage payments if you do not buy your property with all cash as well as the potential for a costly law suit from tenants. In all, these costs could make owning physical real estate a much less appealing long-term investment compared to alternatives.
Finally, there is substantial concentration risk. Unless you are a multimillionaire who can afford to purchase a large empire of rental properties, you will be focusing much of your wealth on a concentrated selection of assets. If that real estate market turns south, or a couple of your properties suffer from prolonged vacancies and/or bad tenants, your investment returns will be significantly harmed.
In contrast, REITs provide investors with all the benefits of traditional real estate investing without the aforementioned downsides. Instead of dealing with the dreaded “triple Ts” (tenants, toilets, and trash) of landlording, shareholders in a publicly traded REIT can kick back and relax, knowing that a professional management team is caring for their real estate portfolio 24/7. This makes REITs a truly passive investment.
Furthermore, publicly traded REITs are very liquid investments. With a simple click of a mouse (and without costly transaction fees), investors can buy and sell shares of a REIT at the current market price. This means that if an emergency strikes or some other reason arises that causes investors to want to liquidate their real estate investments quickly, REIT investors can get out immediately if they need to.
Finally, REITs offer investors much less risk than physical real estate. A single REIT share in some cases can be purchased for a few dollars, providing a stark contrast to the thousands of dollars’ worth of equity typically needed to purchase a piece of physical real estate. This enables even small dollar investors to diversify broadly across a large number of different REITs. Additionally, each individual REIT typically holds dozens, hundreds, or even thousands of different individual properties, often across multiple cities, regions, and even countries. This gives REIT investors an enormous diversification advantage over their real estate landlord peers as their cash flow tends to be much more stable and secure against market, tenant, and vacancy risks.
A final advantage of investing in REITs is that over long periods of time they have proven to offer superior average returns than investing in individual properties by a score of 11% per year to 7% per year (source).
While this outcome may sound surprising at first, it’s very much expected and even normal. There are real economic reasons why REITs outperform and why this outperformance is expected to continue. First is because REITs generally experience faster growth rates than individual property investments. This is due to the fact that REITs have better access to low-cost capital and enjoy professional management and economies of scale. Second, private investors have a tendency to take on far too much leverage and are lulled into a false sense of security during prosperous times. REITs, meanwhile, take a longer-term, full-cycle approach to investing and typically maintain a responsible “happy medium” level of leverage. This enhances long-term returns without putting them at excessive risk of suffering permanent loss or even bankruptcy in an economic downturn.
Real estate has proven to be a great way to build long term wealth and a steady and growing stream of passive income. With access to publicly traded REITs, every investor can begin building wealth and an entirely passive income stream today. In fact, many investors would be better served over the long term by investing solely in REITs instead of physical real estate.
Despite this, many investors lack the proper mentality to invest in publicly traded securities as they will panic at the first sign of extreme market volatility and sell their REIT shares at a loss. Other investors prefer to have as much control as possible over their investments and therefore also prefer to invest in physical real estate. For those that can handle the volatility and prefer total passivity to their income-generating investments, however, REITs are the ideal passive income generating investment.
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