Feverpitched

Earlier this month, I posted an article in which I explained why I think that most rental property investors overstate their returns. They commonly make the following calculation and think that they are earning 20% or even 30% annual returns…

Rents + appreciation – interest expense / down payment = return on equity

… but in reality, their annual returns are closer to 5-10% once you make the right adjustments. Most importantly, people forget that:

  • Net operating income is just around half of the rental income,
  • Major repair expenses may eat up years of rental income,
  • Same for tenant disputes…
  • Rental properties are work-intensive and your time is valuable.
  • Finally, a lot of properties fail to appreciate due to their poor location and eventual physical or technical obsolescence.

Therefore, the right calculation of returns should be:

Net operating income + realistic appreciation – interest expense – reserve for bad surprises – value of your work / down payment = return on equity

Once you have made the right adjustments, the annual returns typically drop to the 5-10% range. That’s not bad, but it is far from the 20-30% annual returns that a lot of investors are claiming to earn.

Then you need to ask yourself:

Is it really worth it to buy a rental property if you are going to earn 5-10% annual returns?

I would argue that it isn’t in most cases because you could just as well buy real estate investment trusts (“REITs”) and likely earn higher returns with lower risk and less effort.

This last point got a decent amount of pushback in part 1 of this article, especially from rental investors.

They claim that REITs cannot earn higher returns than rental properties because you have to pay generous salaries to the managers. Some also argued that rental properties are more rewarding because you can use leverage, implying that you couldn’t when investing in REITs. Finally, they claim that rental properties enjoy huge tax benefits.

I decided to write a follow-up article on this specific topic because there are a lot of misconceptions that need to be corrected.

Below I first give a quick overview of the literature on this topic, I then correct the most important misconceptions, and finally, I also present 10 reasons why I believe that REITs are more rewarding investments than rental properties:

REITs vs. Rental Properties

Today, there are several studies that compare the returns of REITs to private real estate investments as well as private equity real estate funds. They make a series of adjustments to make sure that it is an apple-to-apple comparison and they typically come to the same conclusion.

REITs outperform private real estate investments by 3-6% per year. Here are three of those studies:

REITs outperform private real estate

EPRA

REITs outperform private real estate

Cambridge

REITs outperform private real estate

NAREIT

3-6% per year is a lot and it causes many to wonder how could that be possible, especially since: (1) REITs need to pay managers; (2) you can’t use a mortgage to buy REITs; and (3) you don’t enjoy the same tax benefits.

Let me start by quickly debunking these three misconceptions:

  • REITs need to pay managers: Yes, you are paying managers to do all the work for you, but because REITs enjoy huge scale and the managers are hired as employees, the cost is very small as a percentage of assets. There are huge economies of scale also as we will discuss later and therefore, the management of REITs is much cheaper than the management of private properties.
  • You cannot buy REITs with a mortgage: What rental investors appear to ignore is that REITs are already leveraged and therefore, there is no need to take a mortgage. When you buy shares of a REIT, you are providing the equity and the REIT then adds debt on top of it. What you see traded in the market is the equity value, not the total asset value. Therefore, your $10k investment may represent $20-30k worth of assets depending on how much debt the REIT is using. You enjoy the same benefits of leverage, but you are better protected from risks because you don’t have to sign on any of the loans yourself and enjoy limited liability.
  • Rentals enjoy tax advantages: While it is true that rental properties enjoy some tax benefits, those are vastly exaggerated, and the advantages of REITs are often completely ignored. With rental properties, you can defer taxes by depreciating your property, but you are then stuck with your property and have no exit. Sure you can 1031, but with major limitations and still can’t get out of the property market if needed. With REITs, you can also defer taxation by holding them in a tax-deferred account, and even in a taxable account, they are very tax efficient. I actually pay less taxes by investing in REITs and have a lot more flexibility. Here’s why: 1) REITs pay no corporate tax; 2) They only distribute 50-75% of their cash flow in most cases. The rest is not taxed since it is retained and reinvested in growth; 3) A portion of what’s paid is typically classified as return of capital, which isn’t taxed; 4) The portion that’s taxed enjoys a 20% deduction; and 5) Finally, typically at least 50% of the total return comes from appreciation, and it is tax deferred. Given that REITs are today discounted, the appreciation will likely make up closer to 75% of future total return.

Now that we have corrected these important misconceptions and we are all on the same page, here are 10 reasons why REITs are more rewarding investments than rental properties in most cases:

Reason #1: REITs Enjoy Huge Economies of Scale

Most REITs own $100s of millions or even billions worth of properties.

As a result, they also enjoy significant economies of scale, not just in the cost of the management, but also across all other expenses.

The management cost of REITs is typically just around 0.5% of assets per year, which compares very favorably to the 1-1.5% cost of most private real estate funds. Some REITs like Realty Income (O) are so efficient that their management cost is as little as 0.3% per year!

REITs are very cost efficient

Realty Income

This is only possible because they own 1,000s of properties and enjoy huge economies of scale. If you manage your rental properties yourself and counted the number of hours and multiplied it by your hourly worth, you would note that it is a lot more expensive than the cost ratio of REITs or even private funds. In part 1 of this article, we used an example to demonstrate this point and found that direct management is the costliest option of all.

But beyond the management cost, REITs also save expenses on all other fronts. To give you an example: when a big apartment REIT like Mid-America (MAA) gives a contract to a carpenter to change 2,000 carpets in one region, you can bet that it is getting a much better deal than when you change a single carpet.

The same applies to most other expenses. A leaner cost structure leads to higher returns for shareholders. Rental investors cannot compete on cost.

Reason #2: REITs Have Access To Cheaper Capital

REITs are large-scale vehicles that are well diversified, professionally managed, and highly transparent due to their public listing.

As a result, banks and other capital partners are much more interested in working with REITs. They are safer and have more staying power, reducing the risk of impairments.

Not surprisingly, REITs have access to many more different sources of capital and their average cost of capital is also lower, resulting in greater returns.

REITs can even do things like issuing preferred equity to the public. Agree Realty (ADC) raised some preferred equity at a ~4% cost in 2021 and it is using it to buy properties at a 6-7% cap rate, pocketing the spread for its shareholders.

These are things that private rental investors cannot do because their capital sources are much more limited.

Reason #3: REITs Can Afford to Hire The Best Talent

Because REITs have the scale, they can also afford to pay generous salaries to attract the best real estate investors to work for them.

These are people who go to the top schools, have decades of experience, and dedicate their entire lives to real estate investing.

Not surprisingly, they will do a better job than you at mitigating risks and maximizing returns.

Reason #4: REITs Can Develop Their Own Properties

Because REITs have the top talent working for them, they can also develop their own properties to earn even greater returns.

To give you an example, AvalonBay Communities (AVB) is able to develop new apartment communities at a 6-7% yield, but if it bought similar assets in the private market, it would only get a ~4% cap rate.

Rental investors typically don’t have the skills or resources to buy land, get permits, and actually build something from scratch.

But this is routine stuff for REITs as they aim to maximize returns.

Reason #5: REITs Can Enter Other Real Estate Related Businesses To Boost Profits

Since REITs own 100s or even 1,000s of properties, they can also enter other real estate-related businesses to earn additional profits.

To give you a few examples: Armada Hoffler Properties (AHH) develops a lot of properties for its own portfolio, and because it has its own construction crew, it also provides construction services to other investors in exchange for a fee.

Farmland Partners (FPI), the biggest farmland REIT by acreage, recently began offering asset management services to other investors to also earn additional fee income.

The scale and resources of REITs often put them in a strong position to offer such additional services and ultimately, shareholders share these additional profits, resulting in higher returns.

Reason #6: REITs Can Do Spread Investing to Accelerate Growth on a “Per Share” Basis

At times, REITs may trade at a premium relative to the underlying value of the real estate they own.

In such cases, REITs can earn an “arbitrage profit” by selling equity on the public market and investing that cash into more properties.

If your cost of capital is 4%, but you are buying properties at a 6% cap rate, you earn a 2% that grows your cash flow on a “per share” basis, even despite an expanding share count.

That’s how REITs like Realty Income have managed to earn 15%+ annual returns for decades despite following a simple strategy of buying Class A net lease properties at 5-6% cap rates. Typically, investors who buy such assets are happy to earn a ~10% annual return in the private market. Realty Income has done a lot better in large part thanks to spread investing, which boosted its total returns.

Reason #7: REITs Avoid Disastrous Results During Downcycles

Rental investors commonly make the mistake of only looking at returns during the good years and forgetting about downcycles.

But what really matters is the average annual return over a full cycle.

The bad years matter just as much as the good years, and REITs do a better job at maximizing returns over a full cycle.

Their returns may be somewhat lower during the best years because they commonly use less leverage than private rental investors, but they avoid disastrous results during the tough years, and may even create a lot of value as they buy properties at bargain prices from overleveraged distressed sellers.

There are 1,000s of rental property investors who go bankrupt each year due to overleverage, lack of diversification, and simply bad luck. These disastrous results hurt the average returns of rental investors.

But REIT bankruptcies are extremely rare. There has only been a handful in their history and they were all overleveraged mall REITs.

Reason #8: REITs Do A Better Job at Aligning Interests With Investors

Aligning interests and providing the right incentives is key in the investment field to maximize performance.

REITs do a much better job at that than private real estate investors who may use an external property manager or invest in private equity funds.

The main difference is that REITs are mostly internally managed, but most private properties are externally managed.

This seemingly small difference can have a major impact.

REITs are internally managed, which means that the managers are hired as full-time employees of the REIT. Their sole focus is on this one REIT, they typically have a lot of skin in the game, and their salaries are heavily tied to the performance of the REIT.

Private properties are externally managed, which means that an outside manager is hired to help manage the assets. This leads to much greater conflicts of interest because the external manager has a different profit motive from yours. His/her interest is to spend as little time on your assets and maximize the volume of his assets under management to grow fee income. The incentives are more a function of volume than profitability.

This explains why externally managed REITs have historically generated much lower returns than internally managed REITs. The same applies to rental property investors who use external managers.

Reason #9: REITs Do Sale & Leasebacks Directly With Tenants

A sale & leaseback is when the REIT buys the property and leases it back to the seller. To give an example, 7/11 sold a bunch of its properties to Realty Income years ago and still leases them from it.

The benefit for 7/11 is that it allows it to rapidly access a lot of capital to reinvest in growth.

And the benefit for the REIT is that it allows it to skip all brokerage fees. It can also draft its own lease agreement from day 1. And finally, it skips the competitive bidding process of an open market, which may allow it to get a better deal.

So it is a win-win for everyone involved, and it is only possible because REITs have great relationships with tenants and the ability to rapidly close large transactions.

STORE Capital (STOR) is a specialist in this. It has a whole team that does cold calling to approach real estate-heavy businesses and offer them sale & leaseback solutions. It commonly gets market-leading cap rates of 7-8% thanks to this unique approach to finding its deals.

Reason #10: REITs Have Much Greater Bargaining Power With Tenants

Because REITs are large and well-diversified, they also have much more bargaining power with their tenants.

Individual landlords commonly fear hiking rents on their tenants because it may cause them to leave. This would be a major issue for them since they often own only one or a few properties and cannot afford a vacancy.

REITs, on the other hand, can be a lot more aggressive in making sure that they get fair market rent since they are diversified and have the resources to rapidly lease space if needed.

A lot of REITs are so large that they can afford to spend money on nationwide advertising on TV, billboards, or online. As an example, Public Storage (PSA) commonly has TV ads for its facilities. As the owner of a single self-storage facility, you couldn’t afford that.

Bonus Reason #1: REIT Investors Pay No Transaction Costs

When you buy or sell a rental property, you will commonly pay anywhere between 5-10% in transaction costs.

Therefore, on day 1, you are already down significantly.

Assuming you paid 10% in transaction costs, and you only put 20% equity on the deal, you are essentially down 50% on your equity on the first day and need to catch up back to par before you start earning a return.

REIT investors skip all these expenses by buying shares in an already-existing portfolio. The REIT itself may have paid these costs back in the days or skipped them if it developed the assets itself and/or did sale & leaseback transactions.

But in any case, REIT investors don’t pay them and it gives them a significant head-start. It is simply a more efficient way of allocating capital in real estate investments.

Bonus Reason #2: REIT Investors Can Gradually Buy More Shares Month After Month

If you are buying a rental, you must save for a large down payment, which is quite inefficient and leads to opportunity costs.

But REIT investors can allocate new capital into the market each month as they save money.

It leads to stronger compounding since money is not sitting for months on the sideline doing nothing for you.

Bottom Line

So to recap…

  • #1: REITs Enjoy Huge Economies of Scale
  • #2: REITs Have Access To Cheaper Capital
  • #3: REITs Can Afford to Hire The Best Talent
  • #4: REITs Can Develop Their Own Properties
  • #5: REITs Can Enter Other Real Estate Related Businesses To Boost Profits
  • #6: REITs Can Do Spread Investing to Accelerate Growth
  • #7: REITs Avoid Disastrous Results During Downcycles
  • #8: REITs Do A Better Job at Aligning Interests With Investors
  • #9: REITs Do Sale & Leasebacks Directly With Tenants
  • #10: REITs Have Much Greater Bargaining Power With Tenants
  • #11: REIT Investors Pay No Transaction Costs
  • #12: REIT Investors Can Gradually Buy More Shares Month After Month.

As a result of all of this, REITs have historically been more rewarding than private real estate investments, and there are no good reasons to believe that the future would be any different.

In fact, we would expect REITs to perform even better in the future because their valuations are the lowest in years. There are many high-quality REITs that trade at 20%, 30%, or even 50% discounts relative to the value of the real estate they own.

This essentially means that you have the opportunity to buy real estate that’s diversified, professionally managed, and liquid at a steep discount to fair value.

It should be more rewarding in the long run and it is also safer, liquid, and completely passive. This is ultimately why I stopped buying rental properties to buy REITs instead.

By AKDSEO