Over the last few years, I have struggled repeatedly with how best to gain investment exposure to real estate. Should I buy a house and rent it out on airBnB? Should I buy a mall REIT that trades on the NYSE? Maybe I should invest in a real estate-focused hedge fund? Like most things investment-related, the answer is: it depends. Let’s take a look at some of the factors that would go into the decision.
Ownership of a property gives you full control over how you want to manage it. You can decide on what rents to charge, which service providers to use, and when to make improvements. A corollary here is that when a tenant has a problem and you are the manager, you are responsible for fixing it. This can ruin your visions of generating passive income through property ownership as maintenance issues can become a full-time job. I own 3 properties currently but they are all condos and our tenants call the building supers first. On the other hand, if you buy a REIT or fund, you are putting all of these decisions in the hands of its management. This can be a wise decision if the management team is strong and incentivized properly. Or, it can be a disaster if your management team is Nick Schorsch and friends. So, an additional kind of due diligence needs to be done before you hand your money over.
If you are a landlord, you have liability. Your tenants can sue you for any reason or no reason at all. You must carry insurance for your property and for any mishaps that may cause injury (falling tree branches, loose ceiling tiles, etc). But, buy a REIT and your liability is limited to your cost basis even if your REIT is found guilty of shoddy construction that led to the collapse of several buildings. Importantly, you also are not liable for the mortgages that a REIT may incur.
While you are not liable for the debt load on a REIT, you do not really get to lever your investment the way you would if you bought a home with a mortgage. I suppose you could use a margin loan to buy more of your REIT but then you are subject to margin calls if the market price declines far enough. With ownership, you can put as little as 10% down and give yourself huge amounts of leverage to any upside in price appreciation or amortization (of course, this pendulum swings both ways.) Then again, as mentioned above, you are now personally liable for these debts. Some would say you could buy the property in a corporate structure to limit your liability but, frankly, the costs of registering and maintaining an LLC will eat into your returns unless you are talking about very large dollar amounts.
Transaction Costs and Liquidity
You can buy shares in a REIT for as low as $0.005/share at Interactive Brokers nowadays and the trade can be completed in milliseconds if you are purchasing a liquid stock. Compare that to the real estate agent commissions, title and recording fees, and loan closing costs that are part of the typical real estate transaction. Not to mention that the time to close can be as long as two months and in some cases won’t close at all. In the time it takes to close on the average home, I can trade in and out of Vornado thousands of times at a lower cost.
The cost of admission to owned real-estate is in the tens, but more likely, the hundreds of thousands of dollars. And, if you want to increase your investment, there are few options besides buying another property. With a REIT, your entry price can be less than a hundred dollars and if you want to invest more, you can buy more of the same stock.
Or, you can buy another REIT with a different focus. You can own equity interests in residential real estate, malls, skilled nursing facilities, self-storage, cell phone towers, office buildings, and more. The average person will never have the ability to purchase and manage a Class A office building. But, not only can you diversify in terms of the kind of real estate, you also get a diversified portfolio of properties thus avoiding a scenario of putting all your eggs in one basket. Most REITs are composed of many buildings versus a private investment where you are leveraged to only one property. What happens if you own a property that is destroyed in a storm in Houston or a wildfire in Napa Valley?
Here is a real risk to a REIT investment. Mr. Market will give you significantly more volatility in pricing than a private market transaction will. This is a source of opportunity if you are flush with cash but can also be a serious problem if you need to sell to raise money in the midst of a market panic.
Taxes and Dividends
Here, we have another positive of a privately owned piece of real estate. You can deduct operating expenses, real estate taxes, depreciation, and other costs against your rental income. These costs, particularly the depreciation, can significantly shield you from having to pay taxes on your passive real estate income. Moreover, you can complete a 1031 exchange and delay recognition of capital gains indefinitely as long as you are willing to keep rolling over your gains into more real estate. With a REIT, you will receive dividends that will most likely be taxed as regular income but you are able to delay recognition of capital gains until you decide to sell your stock.
Well, re-reading these factors sure makes me think that REITs are the way to go in the near-term. I think a good investor will balance all the positives of REITs with the potential high returns of physical real estate i.e. if you can purchase a condo at a 10% cap rate that may be a better investment than a data center REIT at a 4% cap rate but maybe not an apartment REIT at an 8% cap rate. For me, the current market environment has made it very difficult to find real estate to purchase at a high enough rate of return but, oddly enough, I have been able to invest in a self-storage REIT at a 9%+ cap rate. The current income is more than I would receive if I rented out a home and the potential capital appreciation is significantly more than what would be possible at this point in the cycle. Of course, I can see a point in the future when the situation is entirely flipped and homes are available at far better rates than REITs. That’s why we keep our eyes peeled for the next deal. Happy hunting!