After a departure from some of my normal financial topics I am back to it. I have found that a lot of the financial decisions we make are the symptoms of how we feel inside so I depart from the personal finance and markets discussion sometimes to talk about issues like perseverance and motivation. This helps my mind focus on more than just dollars and cents and hopefully sets this blog apart from others on personal finance you may read. So back to the program…

There are a lot of people, especially in the US, that emphasize that if you want to get wealthy you should invest in real estate. Why this asset class and why do people advise to buy directly rather than go the much easier route of investing in a REIT?

What is a REIT Anyway?

First of all, I think it’s worth explaining exactly what a REIT is for my readers that are not financial experts. REIT stands for Real Estate Investment Trust and is a specially designated class of shares that exclusively invest in anything related to real estate in the US. Many REITs are publicly traded securities so you can buy them just as you would shares of Amazon or Pepsi. There are a few important rules though, that distinguish REITs and they have mostly to do with ownership and how they are taxed. They are:

1. They have to have more than 100 shareholders.
2. They have to pay out at least 90% of their earnings to their shareholders
3. The operations or assets of the REIT have to be related to real estate in some way, either through directly owning and operating real estate or through owning securities related to real estate like mortgage bonds.

If a REIT meets these standards then it gets a special classification from the IRS that says it doesn’t have to pay taxes at the corporate level. It simply pays you the owner the income and you pay the taxes on your own.

It used to be that this income was taxed as ordinary income (i.e. not qualified dividends) but the Trump tax cuts of 2017 gave a special deduction for REIT income which means its taxed somewhere in between ordinary income and qualified dividends.

REITs can be big or small. The largest own property like hospitals or industrial sites, while mortgage REITs hold a portfolio of mortgage bonds. As long as it is real estate related, has 100 shareholders or more, and pays out 90% of its earnings to shareholders, it keeps its REIT classification.

Direct Real Estate

So now that you know what a REIT is, consider the alternative: owning real estate directly. This is the old fashioned landlord route where you buy a property yourself and rent it out to a tenant. Many people really love to do this. They love the deal hunting, working on home improvement and seeing their returns come in when they place a tenant in the home.

Being a landlord can be a pain though, especially if you have a full time job. It also requires you set aside a little extra capital in case things go wrong: heater problems, pipes breaking or upgrades that may be needed from time to time. In addition, you will have to assess the credit of your tenant and hope they pay in a timely manor on a monthly basis, or you may have to take them to court to evict them.

The upside can be great though, especially with mortgage rates as low as they are. The landlord not only gets some current income but also benefits from any home price appreciation. When prices rise, the home can be refinanced or you can sell it for a profit. Again, here the costs will come into play as brokers can charge as much as 5% of the value of the home to sell it and there are fees that need to be paid in order to refinance a mortgage. It is enough to make many people think twice before going through the headache of purchasing a home and renting it.

Using Leverage

The large REIT players can also borrow against their properties just like the rest of us and many of them do. The advantage of borrowing, or leverage, is that when the price increases the gains are increased. The downside is that you give up some of your current income. This is the balance that REITs have to manage, paying out current income to investors while also having upside to increase the value of shares.

Just like those corporations, direct real estate can use leverage as well. This is the one area where a small direct real estate owner may have a bit of an advantage. Investment properties can currently leverage themselves up to 75% of the value of the home and if you bought the home initially as your primary home or a second home you can leverage up to as much as 80% of the value of the home.

This magnifies the returns and also the losses. Your equity in the home is the portion of the value of the home that is not borrowed. To get your return when prices rise when there is leverage, you just divide the growth rate by the percentage of equity you own in the home. For example, let’s say you have an 80% loan to value (LTV) mortgage on a home you bought this year. By next year prices have risen 4%. Your investment though has leverage so you divide the portion you originally owned into the growth to get the return on your investment through price appreciation: 4% / 0.20 = 20%.

This return looks great but it doesn’t take into account a lot of factors.

1. There are initial costs to your mortgage, many fees and other costs like inspections are made when you first purchase your home.
2. The mortgage and insurance payments may be higher than the rent you are receiving so this 20% figure may not take that into account. Of course, if it’s less then you can add income to that return.
3. It’s hard to repeat this every year. This is because most traditional mortgages are amortizing, meaning their balance goes down over time. In addition, the growth also reduces the level of leverage. In our example above, LTV may drop from the 80% initial figure to 75% after a year due to amortization and price rises.

Due to the lowering of leverage, if the price rises another 4% next year, with only 75% LTV we will then see a return of

4% / 0.25 = 16%

So leverage matters. If prices are rising, you will continually need to refinance to keep up your leverage based high returns.

The Idea Behind REITs and Their Performance

Since many REITs are publicly traded it’s very easy for ordinary people to buy them. The idea of REITs in the first place was to be able to put returns that required huge amounts of capital and professional management into the hands of the little guy that could then see these same returns, even if he or she just had a couple of hundred dollars.

They also are professionally managed by people who deal with tenants, building management, contract negotiation and finance. Essentially, they take away all the headaches I described above and just do it for you. They then hand you all the returns.

The reason I think a lot of people shy away from REITs is that they are publicly traded. It’s just not as exciting to own shares. It’s more fun to say you own a home or you own a property and rent it out.

If you don’t care about showing off the fact that you own a property but also don’t mind doing the work of buying and renting one, then the only difference between owning a REIT and owning direct real estate is the return. So which will make more?

Luckily, there have been some academic studies on this which I will summarize here.

Which Offers Better Returns?

The leverage that can be achieved by owning a property outright is pretty attractive. Even with boring growth rates of 3% or 4% in real estate prices, you can achieve returns of at least 15% to 20%. When a lot of entrepreneurs advise to invest in real estate, what is really driving their returns are high risk and leverage. For example the classic case is to buy a property, rent it out for a year or two, then refinance the property once the price rises and use the proceeds to make a down payment on another home and repeat the process. This keeps the leverage up as well as acquiring more assets.

REITs are part of the stock market though and this has the advantage of owning them being that you can get rid of ownership easily if there is a need for the cash. In contrast, direct real estate cannot be easily sold within a day like shares, incurs fees and requires negotiation and a ton of paper work. Studies have shown that REITs tend to have price swings like the stock market in the short run but in the long run behave more like real estate.

In fact when we compare REIT returns to the stock market over time, we can see the total return outperformance.

It’s important to note that the above period includes the real estate crisis so clearly investing in real estate and REITs has huge advantages for diversification and performance.

Within the sector as well, there are various sub categories that offer different levels of risk. For example a REIT that owns a skilled nursing facility is very different from a REIT that owns an apartment building. For this reading the cap rate (the net operating income of a property divided by its value) is higher for certain types of real estate as can be seen below.

In 2015, researchers Long and Naranjo did a study where they looked at the returns over time of direct real estate versus REIT real estate in terms of volatility and return. As can be seen in the summary results below, for some asset classes like apartments, the unlevered returns were a bit higher for direct real estate. For most other asset classes within real estate though, the professional management of REITs paid off. Higher returns were achieved over time for office space and retail space.

The other point to note is that leverage did increase the returns of REITs to start to approach figures like I discussed before, like 12% growth rates for apartment buildings and retail.

The downside being that REITs saw a lot more volatility when they were levered. This isn’t to say that direct real estate is leas volatile, it’s just that REIT volatility is more easily measured. Direct real estate volatility tends to rely on appraisals which may be deceivingly smoother over time because of their backward looking bias and anchoring bias.

What this does show though is that the REIT income is much closer to that of owning direct real estate than you may think over time. Many young people are in a rush to buy into direct real estate but what this shows is that maybe they should at least consider REITs as a starting point. The leverage you can acquire with a direct property does give it some attractive advantages but this has to be taken into account with all the other implicit and hidden costs of managing your own real estate: financing costs, credit risk of tenants, legal fees, not to mention the time you have to dedicate to it which could be spent on an income generating side hustle.

Even doing my own math, I have owned a property in California for about 6 and a half years. At first the returns were great but now that the market has softened, I compared my return to that of the REIT index, VNQ and found that after initial investment and repairs, I have a similar return to that of the index. That being said I did not refinance the home yet which could enhance the return but this would come at the cost of some current income.

I would advise those just starting out to learn from my experience and consider REITs as an alternative. It’s not as alluring as claiming you own real estate but my experience and the studies show that it’s a viable alternative to owning directly that I think some should consider.

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