Why REITs Trump Rental Properties A Smart Investment Choice 2023
A Smart Investment Choice
The most frequently asked question I receive is: “Why do you choose to invest in REITs instead of rental properties?” This inquiry comes my way almost every week.
Many rental property investors seem to be perplexed about the advantages of investing in REITs, or real estate investment trusts. In their minds, REITs might seem less rewarding due to lower yields, management fees, absence of leverage benefits, and fewer tax advantages. Additionally, some view REITs as riskier investments because they are traded like stocks and can exhibit significant volatility.
However, these perceptions of REITs offering lower returns with higher risk are the result of some common misconceptions about them.
In reality, I believe that REITs are not only more rewarding but also safer investments, especially in today’s market. I will explain this in three sections:
1. Why REITs offer more rewarding investments than rental properties.
2. Why REITs are safer investments than rental properties.
3. Why, especially today, REITs have more to offer than rental properties.
Let’s begin by addressing some of these misconceptions because understanding them is crucial to the rest of the discussion.
While you can’t take a mortgage to buy REITs, they are already leveraged. When you invest in a REIT, you provide the equity, and the REIT adds debt on top of it, providing you with the benefits of leverage. Your investment in a REIT may represent a much larger real estate portfolio than you see.
Although REITs do pay management fees, the cost is considerably lower than managing private rental properties due to economies of scale. REITs can manage billions of dollars’ worth of real estate, resulting in cost efficiencies that benefit investors A Smart Investment Choice.
REITs may not offer the same tax advantages as rental properties, but they have their own tax benefits. For instance, a portion of REIT dividends is often classified as “return of capital,” which is tax-deferred, and there’s a 20% deduction for taxed dividend income. REITs also retain a significant portion of their cash flow for growth, which is tax-deferred.
**Rental Return Misconception:**
Claims of earning over 25% annual total returns from rental properties are often exaggerated. Investors often fail to account for the value of their own labor, underestimate the impact of reinvesting in their properties, and rely heavily on high leverage in the early years.
With these misconceptions clarified, let’s look at the results of various studies comparing the historic returns of REITs with those of private real estate and private equity real estate funds. These studies consistently show that REITs outperform their counterparts by 2% to 4% annually on average.
**Why REITs Are More Rewarding Investments Than Rental Properties:**
1. Lower management costs due to scale.
2. Economies of scale in various aspects, such as property maintenance.
3. Elimination of brokerage fees.
4. Ability to develop properties for higher returns.
5. Access to diverse capital sources.
6. Attraction of top talent in the real estate industry.
7. Ability to grow investments faster through public equity markets.
8. Potential to enter real estate-related businesses for additional profits.
9. Stronger bargaining power with tenants.
10. Better positioning to deal with regulators and tax authorities.
On average, REITs have historically delivered 13% per year over the past 20 years, outperforming the S&P 500 and growth stocks.
Additionally, private-equity real estate funds have underperformed despite their resources and skills, further highlighting the potential advantages of investing in REITs.
It’s worth noting that specific REIT sectors, such as self-storage, have achieved even higher average annual total returns over the past few decades.
**Why REITs Are Safer Investments Than Rental Properties:**
Rental properties are private, illiquid, concentrated, management-intensive, highly leveraged, and carry significant social risk and liability issues. In contrast, REITs are public, liquid, diversified, professionally managed, conservatively financed, and have limited liability.
Liability issues are a significant concern for rental property investors, as personal guarantees and tenant-related legal matters can pose substantial risks.
**Why, Especially Today, REITs Have a Lot More to Offer Than Rental Properties:**
REITs are currently trading at a substantial discount to their net asset value (NAV), making them an attractive investment opportunity. This discount can be as high as 28%, and it allows investors to purchase real estate at a considerable discount through REITs.
This disparity in performance between REIT share prices and real estate fundamentals has led to exceptionally low valuations across the REIT sector. Historically, when such valuation disparities have occurred, REITs have provided exceptional returns in the years that followed.
Furthermore, many REITs have locked in low fixed-rate debt, which can result in lower interest expenses compared to buying rental properties with higher mortgage rates.
In summary, REITs generally offer better returns with lower risk for most investors, and current market conditions make them particularly appealing. Investing in REITs provides a combination of safety and potential upside that makes them an attractive alternative to rental properties.
1. What is a REIT?
- A Real Estate Investment Trust (REIT) is a company that owns, operates, or finances income-producing real estate. It offers investors the opportunity to invest in real estate assets without direct ownership.
2. How do REITs compare to rental properties?
- REITs offer advantages such as diversification, professional management, liquidity, tax benefits, and lower costs compared to the ownership of individual rental properties.
3. Are REITs a tax-efficient investment?
- Yes, REITs offer tax benefits, including tax-deferred income and deductions, making them a tax-efficient investment choice.
4. Are REITs safer than rental properties?
- REIT investors enjoy limited liability protection, reducing their exposure to risks compared to owning rental properties, which often involve personal guarantees and tenant-related liabilities.
5. Why are REITs an attractive investment opportunity today?
- Currently, REITs are trading at a substantial discount to their net asset value (NAV), providing an opportunity for investors to acquire real estate assets at a considerable discount.
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