REITs Vs Rental Property: Why Rentals and Not REITs?
You must be very well aware of investing in real estate. If you don`t know, you can do it in two different ways. Either you can own the real estate through investing in REITs or by buying Rental Property in real. Real Estate is called Real Estate for a reason because you own it for real. If you can understand this, trust me you are way ahead in the game already. If not, you will understand shortly why invest in Rental Property over REITs?
Invest in a Rental Property and not in Reits if you wish to build long term wealth. Though if your goal is just limited to get some monthly payments through dividends, Reits would work fine. However, Reits do have some advantage over physical real estate but it totally depends upon the situation and the goal of an investor.
Comparing REITs Vs Rental Property
Have you ever compared an apple to an orange? Likewise, REITs vs Rental Property is just apple and oranges. The only similarity in an apple and an orange is the nutrition it provides. Likewise, Reits and Rentals have one thing in common that these help you to invest in a real estate business.
What are REITs?
REITs stand for Real Estate Investment Trusts. These Trusts own and operate income-producing real estates like residential or commercial rental properties including apartments, warehouses, storage facilities, shops or malls.
REITs were created by Congress in the 1960s to help individual investors to own an equity stake in the income-producing real estate. By investing in REITs, individuals can benefit from real estate without the need of actually owning and managing their own properties.
Objective of REITs
- To have a minimum of 75% Assets in Real Estate.
- 75% of gross profits should come from Real Estate Activity.
- A minimum of 90% of the taxable income should be returned to investors in the form of dividends.
Types of REITs
There are three types of Reits available for an individual investor. Reits are publicly traded and sometimes private companies that own the real estate.
- Equity Reits
The Equity Reits are the trusts that specifically own and manage Rental Real Estate. They are specialized in renting and managing the properties to generate income. Most of the revenue comes in the form of rents.
- Mortgage Reits
The Mortgage Reits are a different class that doesn’t buy the real estate. Instead, they originate property loans or buy mortgage-backed securities from the banks. Their revenue comes from the interest received on the loans and the securities.
- Hybrid Reits
The Hybrid Reits are a combination of Equity Reits and Mortgage Reits. They generate revenue by both owning properties and interest received on mortgages.
REITs are like the mutual fund in which you invest your money to own shares in a company that deals in making money from Real Estate.
What is the Point of Comparison REITs Vs Rentals?
You may have now understood that REIT`s are no better than investing in mutual funds. Then what is the point of making a comparison? You are absolutely right. It doesn’t make sense for you now to even consider Reits over Rental Property. After all, Reits are not the real Real Estate.
Still, let me tell you why people consider Reits worthy?
First thing first, the idea of owning real estate and being able to generate money from it every month can fascinate any investor. After all the Real Estate has got intrinsic value in it and is considered safe among all other investments. Even after knowing that one can become rich by owning a rental property, most people are not able to own one.
You know why? It is because people think that buying real estate is limited to only the rich class of the society. I certainly hope that you are not among those people. Buying an investment property is possible by putting anywhere between 5%-20% money down.
Tell me what will you do if you wish to invest in real estate and don’t even have the 5% money to put down. It is indeed melancholy but true with today’s generation that hardly bothers to save enough. Most will drop the idea of investing in real estate and others like you will still try to find alternatives.
What makes REITs Worthy Even If It is not?
Compared to owning Rentals, investors recognize REITs as an alternative to get into the real estate business. Though it is not. But still, it makes sense at least for budding investors if you take these into perspective.
- No Entry Barrier
You can start investing in Real estate even with a few dollars by Investing through REITs. Whereas, it will cost you thousands of dollars if you actually go and buy the real estate. REITs have clearly eliminated the entry barrier for the investors to invest in real estate.
- Obtaining a Mortgage
Not everyone feels happy about having a mortgage tied to them. Clearly it is not everyone’s cup of tea even if there is a difference between having a good mortgage and a bad one. With Reits, you can start as small as you want which is not the case with Rentals. 95% of the times, an investor has to obtain a mortgage.
- Becoming a Landlord
Sure, an investor wants to invest in real estate but he may not be ready or willing to take up landlord responsibilities. Not everybody wants to deal with tenants and toilets. With Reits, you don’t need to do any of such tasks and have a team of professionals for such tasks. The only downside is that the property is not yours. But when you own a rental property, you have to take up all those landlord duties unless you have a property manager in place.
- Fear of Failure
Most investors have a fear of failure even before they get started into real estate investing. The fear of failure is so big for them that they want to leave the work to professionals only. And for this reason, they consider investing in Reits over buying Rentals in real.
Still, I will choose Rental Property over Reits Any Day
You may think that I am someone who loves being a landlord and has experience in my hand to invest in Rental Properties. And this is why I am saying Rentals are my thing. But you can have a different case. You may see yourself as a newbie in the field who lacks experience and may have one of the reasons from the above. So now, Reits instantly is making sense to you.
Let me tell you again that it is not REITS but owning rentals that can suffice your goal to become rich with real estate one day. The benefits you can get by owning rentals over Reits will amaze you.
You might be very well aware of the snowball effect in real estate. You can leverage one rental property to buy more cash flowing investment properties. Though it takes a lot of years at first. But once it starts to build momentum, you can increase your portfolio in lesser time. But if you consider Reits, there is no way that you can use leverage to buy more.
- Hedge Against Inflation
Owning Rentals is the best way to put a hedge against inflation. Due to inflation, the prices of your property are most likely to go up. The rent also goes up even though the expenses (Mortgage Payments) stay the same. This means increased cash flow from a rental property even during the time of inflation. But do you think is it possible with Reits?
- Tax Benefits
If you use some leverage to buy Rental Property, you are eligible for a lot of tax deductions by the IRS. Mostly all the expenses that occur on your rental property are eligible under tax deduction. If you account for these tax benefits, the returns you get with REITs will not come anywhere close to the returns you get on a rental property. With Reits, taxes take a big cut from your returns unless you are reinvesting your dividends in an IRA.
When you own a Rental Property, you own a physical asset. You can touch it, feel it and can even live in it if something goes wrong. But with Reits, it’s just an asset on paper. No matter the value of your rental property goes up or down, you can still collect rents. But if the value of your Reits goes down, your dividends can take a toll.
Furthermore, you can increase the cash flow on your rental by forced appreciation. Forced Appreciation refers to making some changes on your property to increase the cash flow from it. With Rental Property, the control is in your hands. But with Reits, you don’t have this kind of control.
Comparing Returns of REITs Vs Rental Property
Rentals surely have an edge over Reits if you have a clear goal of wealth building in mind. Though some may still prefer Reits over Rentals due to its low entry barrier and a 100% passive approach in investing. But do the Reits can stand against Rentals in terms of returns on the money invested?
Vanguard (VGSLX) is one of the top 10 Reits preferred by the investors. It is basically an index REIT and has offered an average of 10.37% returns in the last 10 years. If you had invested $32,000 in Vanguard ten years back, that would be about $85,834 by now.
But what about the returns from a Rental Property?
Let us suppose you bought a Rental Property worth $160,000, 10 years back, and put just 20% down. So you had put $32000 down and obtained a mortgage of about $135,000 at 5% for 20 Years. Your monthly payments would have been $890 then.
Now let’s fast forward the 10 years to the current date and see where, as an investor, you would be standing at? In 10 years, you would have paid off about $55,951 in the principal amount leaving $79,049 still in the balance. The Equity you build by paying off the mortgage is $87,951 ($32,000+$55,951).
Clearly, you can see the Returns from the Rental Property surpasses the returns by REITs by about $5117. Certainly not a big difference, if you include the labor you need to put in managing the rental business. Am I right?
Why not take into account several other factors?
- Counting Appreciation
While counting the difference, we just accounted for Equity Built by paying the mortgage. But what will be the difference if you add the factor of the appreciation? In general, the average appreciation rate is about 2-3% per year.
So, after 10 years, your rental property would cost about $215,000. Now count the equity built up in your investment. It will come to around $127,050 approximately.
- Cash Flow Vs Dividend
For the above cases, if we consider a $160,000 rental property with $890 mortgage payments. It can give a net cash flow of about $4200 annually if it has been rented for $1600 monthly and has about $3500 worth of additional expenses annually.
And a VGSLX portfolio of $32000 can give you annual dividends of $2308 annually. You will earn about $18,920 ($42000-$23080) more in 10 years if you have invested in the Rental Property vs Reits.
- Reinvesting the Equity
What if you pull out the equity from your Rental Property and invest in more cash flowing properties at this time. The $127,050 you got invested in two different properties each worth $215,000.
Put about $43000 on each property as a 20% down and evaluate the equity built again in the next 10 Years. Also, keep the amount in your VGSLX invested for 10 years more. Trust me the return you will get from the rentals compared to REITs will blow your mind away.
If I have to tell you, the value of your Reits will not be able to stand even close to the equity gain from the three rentals combined after the next 10 years.
The combined value of three rentals after the end of 10 years.
The Rental A having $215,000 in value will become $289,000 after 10 Years (Completely Paid off).
Rental B: $114,286 (Equity built in the 10 Years).
Rental C: $114,286 (Equity built in the 10 Years).
Combined Equity=$289,000+ $114,286+ $114,286= $517,572
REIT Value (After more 10 Years)= $230,234
The Bottom Line
Now, compare the returns yourself and see why I suggest owning Rentals over REITs if you have to become wealthy with Real Estate. Though the above strategy I used to compound the returns is not an easy task and involves lots of work. If you are ready to learn and can dedicate lots of efforts, owning rentals will never disappoint you.
But if you are someone who doesn’t want to be involved in such hard work and deal with people, you better stay off with REITs. It is the Reits that offer you 100% passive returns, and provide much better liquidity than owning an actual real estate. Though you must always keep in mind the high volatile nature of REITs.
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