REITs vs. Rental Property (Comparing Apples to Oranges)

by FI Fighter on April 8, 2014

in Real Estate Thoughts

stlouis-2

A common question I get asked from readers is: “Is investing in a real estate investment trust (REIT) a suitable alternative to buying rental property?” On the surface, it would appear that the two types of investments are rather comparable.

A REIT is a company that invests in real estate (incoming producing assets), whether it’s directly through rental property (office buildings, apartments, shopping centers, residential houses, etc.), or through mortgages. REITs are securities that sell on the major exchanges just like stocks. You can even think of buying a REIT like buying a real estate index fund — you get to earn a share of income produced by the index of rental properties without actually having to go out and buy the properties yourself.

There are many benefits to buying REITs. Chief among them are:

  • Liquidity. Like stocks, it is very easy to buy and sell publicly traded REITs. If the price of the REIT you own goes up $2/share tomorrow, you can login to your brokerage account and liquidate your position in an instant.
  • Passivity. You get to own a real estate investment without having to be a landlord. There are no maintenance and vacancy issues for you to have to worry about.
  • High yield. REITs typically produce high returns, yielding around 4% and above.

A popular REIT in the income investing world is Realty Income Corp (O). As of market closing on March 28, 2014, O was trading at the following valuation:

Realty_O

https://www.google.com/finance?q=NYSE:O

REIT Example

Off the top, you can see that the income (dividends) produced by owning shares of O is currently yielding 5.37% annually.

If you had $81,500 to invest:

Realty Income Corp (O)
Share Price: $40.75
Capital to Invest: $81,500
Shares Owned: 2,000

At an annual yield of 5.37%:

Cash Flow (yearly): $4,376.55
Cash Flow (monthly): $364.71

Not bad. $364.71/month in passive income can cover a lot of expenses for most anyone on the journey to early financial independence. The best part would be that the income earned would be more or less 100% passive.

Rental Property Example

Now, let’s suppose you took the same initial capital, and instead used it to purchase a rental property. To keep things simple, let’s use Rental Property #1 as an example. I purchased Rental Property #1 in 2012 for $315,000, and put down a 25% downpayment of $78,750. I forget the exact amount I paid in closing costs, but to keep things equal, let’s just assume I put in $2,750. Total capital invested for Rental Property #1 would then be $81,500, the exact same figure that we used in the REIT example.

Rental Property #1
Capital to Invest: $81,500

2013 Actual Results:

Scheduled Gross Income: $25,240
Less Vacancy and Lease Renewal: $0
Effective Gross Income: $25,240

13-Jan $2,090.00
13-Feb $2,090.00
13-Mar $2,090.00
13-Apr $2,090.00
13-May $2,090.00
13-Jun $2,090.00
13-Jul $2,090.00
13-Aug $2,090.00
13-Sep $2,130.00
13-Oct $2,130.00
13-Nov $2,130.00
13-Dec $2,130.00

 

Total Operating Expenses: $7,191.58
Net Operating Income: $18,048.42
Less Debt Service: $13,129.32

Cash Flow (yearly): $4,919.10
Cash Flow (Monthly): $409.93/month

Rental Property #1 produced a monthly cash flow of $409.93/month in 2013. The annual yield was 6.04%.

On the Surface

For a rental property in the Bay Area, a 6.04% return is pretty good (especially in today’s environment). At this point you might be wondering, is that very minimal return worth all the extra hassle? After all, you could just have easily invested that same $81,500 capital into purchasing 2000 shares of Realty Income (O) instead. A 5.37% yield isn’t that far removed from 6.04%, so is that extra 0.67% associated with the rental property really worth all the extra headaches associated with landlording?

Rental properties also have the following drawbacks as well:

  • Very illiquid. To sell a rental property is not trivial. You’ll probably need to hire a real estate agent. You’ll probably need to list the property on the MLS. You’ll need to show open houses, take in bids, and close escrow. At closing, you’ll pay all sorts of taxes, fees, and commissions. If you’re lucky, you’ll be able to sell the property in 30 days… 45 days or more is usually more typical.
  • Maintenance and vacancy. Rental properties will all have their fair share expenses each year. It’s unavoidable and every landlord knows that’s it’s only a matter of time before something breaks. Further, if you landlord long enough, you’ll come across your fair share of vacancies. People move all the time, and it’s very rare to find a tenant who will stay in place for ten, fifteen, twenty years… Maintenance and vacancy eat into your returns and bottom line. There’s no way to get around this either…
  • Low passivity. Unlike with REITs, rental properties will never generate true passive income. The best that you can ever hope for is semi-passive income. Even if you outsource the management, you’ll still need to keep tabs of operations on a regular basis.
  • Barrier to entry. To get started with REI, you typically need to bring 20% to 25% of downpayment funds to the closing table. Even for a “cheap” single family home priced at $100,000, this still requires at least $20,000, in addition to closing costs (taxes, title policy, appraisal, inspection, etc.).

So, is it all worth it? On the surface, I would absolutely say “no”. Also, it’s worth noting that Rental Property #1 was able to go through an entire year without vacancy. Outside of a few maintenance items, the rental also had a minimal number of issues. Over the years, the property will of course degrade some more, and even more money will need to be allocated towards repairs.

A landlord could argue that they’ll be able to raise rents… But a well run REIT like Realty Income (O) will also regularly increase their dividend payouts. So, that negates that argument…

Hmm… So, what’s the catch? Why not just invest in a REIT and be done with it? Why go through all the hoops and hurdles of owning rental property?

Leverage

Unlike with stocks, buying rental property through the use of leverage is a very common practice (even necessary for many investors to get started). You can buy stocks on margin, of course, but the volatility of the stock market may make this type of endeavor more risky for those who do not have the requisite experience (knowledge) required to trade skillfully. In general, the day-to-day fluctuations in property values are far less volatile than that of stocks. It’s easy to unload thousands of shares of a stock in a trading session (near instantaneous stock market crashes have occurred in the past), but try selling one thousand homes all at once… The latter wouldn’t be so easy to liquidate.

During the subprime mortgage crisis in 2008-2009, property values in the Bay Area plunged by more than 50%. However, the rental market hardly experienced any movement, and in many local areas, rents held steady… or even increased slightly. As such, the savvy investor who purchased with ample cash flow margins built in (even after accounting for sufficient maintenance and vacancy reserves) did not experience great peril when the housing market took a nosedive. Similar to the DGI strategy of investing in solid, stable blue chips that continue to pay dividends in times of turmoil, purchasing in the right rental market is critical to long-term success in REI.

Volatility in both purchases prices and rents will ALWAYS vary from location to location. To mitigate risk, run conservative cash flow numbers when performing your analysis, and purchase in strong housing demand locations. If your buy right, you should have a sufficient margin of safety in place to protect your investment in the case of a market downturn.

Leverage is a double-edged sword; if utilized correctly, it can enhance your returns significantly and help you build massive wealth. The use of “other people’s money” is the bridge that connects the four pillars of real estate investing.

First Pillar: Cash-On-Cash Return (Rental Property)

The first pillar of real estate investing is cash flow, which was already covered and calculated above in the Rental Property #1 example.

Cash flow is the most important pillar (for both REITs and rental property), and the one that will ultimately set you financially free. As shown above, with the help of leverage, the Cash-On-Cash Return for Rental Property #1 was calculated to be 6.04%. In a low interest rate environment, the Return On Investment (ROI) will typically be higher when using leverage as opposed to purchasing all cash (Cap Rate).

The Cap Rate for Rental Property #1:

Cap Rate = Net Operating Income/Purchase Price = $18,048.42/($315,000 + $2,750) = 5.68%

For Rental Property #1, the Cash-On-Cash Return of 6.04% is only slightly higher than the Cap Rate of 5.68%.

For a REIT, the Cash-On-Cash Return, or Cap Rate, would simply be the annual yield, or Yield On Cost (YOC). In the REIT example, this comes out to be 5.37%.

Second Pillar: Principal Paydown (Rental Property)

The Total Cash Return Rate (TCRR) of the rental property investment is not limited to just the Cash-On-Cash Return of 6.04%. If you buy right, the rental property will still be cash flow positive even after accounting for: principal, interest, property taxes, insurance (PITI), maintenance, vacancy, etc.

This means that your tenants will be paying down your mortgage and helping you build equity in your home.

Factoring in the principal paydown for Rental Property #1:

Principal Paydown: $4,450.69
Principal Paydown (Monthly): $370.89/month

The Total Cash Return is now:

Total Return: $9,369.79 (4,919.10 + $4,450.69)
Total Return (Monthly): $780.82/month

Principal Interest
Dec-13 $377.29 $716.82
Nov-13 $376.11 $718.00
Oct-13 $374.94 $719.17
Sep-13 $373.77 $720.34
Aug-13 $372.61 $721.50
Jul-13 $371.45 $722.66
Jun-13 $370.29 $723.82
May-13 $369.14 $724.97
Apr-13 $367.99 $726.12
Mar-13 $366.84 $727.27
Feb-13 $365.70 $728.41
Jan-13 $364.56 $729.55
2013 Total $4,450.69 $8,678.63

 

The Total Cash Return Rate (TCRR) is:
Total Cash Return Rate: $9,369.79/$81,500 = 11.50%

In the above example, the REIT returned 5.37% annual yield. The rental property returned 6.04%, but that did not tell the entire story. With principal paydown factored in (this is also something that increases yearly as more of the loan gets paid down), the total return is 11.50%. That’s a difference worth getting excited over…

In the REIT example, unless you borrowed money to buy shares of Realty Income (O), there would be no principal paydown on your investment. TCRR would be equivalent to the annual yield of 5.37%.

Third Pillar: Tax Benefits

Taxes: (REITs)

When it comes time to pay taxes, REITs are either taxed as ordinary income, or as a qualified dividend, which means an investor is subjected to taxation on long-term capital gains.

In the case of Realty Income (O), the dividends are taxed as ordinary income.

Here is the U.S. tax bracket current as of 2014:

tax_bracket

http://www.wikipedia.org

Long-Term Capital Gains:

capital_gains

http://www.wikipedia.org

Let’s say that you were single and made $90,000 in taxable income. This would put you in the 28% tax bracket. Your yearly cash flow from Realty Income (O) was $4,376.55 for your $81,500 capital investment. After taxes at 28%, you would get to keep $3,151.12. You would owe $1,225.43 in taxes. Your effective cash flow is reduced from $364.71/month to $262.59/month. The effective yield of your REIT investment is now 3.87%.

Unless you were in the 10% or 15% tax bracket, REITs that pay qualified dividends would still be subject to long-term capital gains taxes (15% to 20%).

Taxes: Depreciation and Deductions (Rental Property)

Unlike with REITs, the taxes you pay on a rental property can be highly variable; they will depend greatly on depreciation and deductions. If utilized, these tax benefits will help you offset, or avoid paying taxes altogether.

The government wants you to own rental property and encourages you to buy more with benefits such as depreciation. It’s sort of counter-intuitive, because as we know, historically, housing prices tend to only move in the upward direction. When it comes to taxes, however, the government is actually telling you the opposite — Because buildings wear down over time, you deserve a tax break on your “depreciating” asset.

With residential properties, depreciation is spread out over 27.5 years. For commercial buildings, depreciation is calculated over 39 years. You cannot depreciate the land, but only the building and its contents. The building and land values can be found on your county assessor’s website.

Disclaimer: I am not a certified tax accountant! The following example is solely provided for illustrative purposes and ONLY applies to my own individual property. As always, consult with a certified professional before making ANY financial (e.g. taxes) decisions affecting your own investments.

Depreciation for Rental Property #1:

Building: $169,000
Annual Depreciation: $6,145.45 ($169,000/27.5)

This is $6,145.45 I get to use each year to offset my gross rental income.

Further, property taxes, insurance, interest payments, repairs, improvements, etc. can also be used to lower your taxes. Items that are “ordinary and necessary” may be deducted.

The following is a list of deductible expenses from TurboTax:

  • Advertising
  • Cleaning and maintenance
  • Commissions
  • Depreciation
  • Homeowner association dues and condo fees
  • Insurance premiums
  • Interest expense
  • Local property taxes
  • Management fees
  • Pest control
  • Professional fees
  • Rental of equipment
  • Rents you paid to others
  • Repairs
  • Supplies
  • Trash removal fees
  • Travel expenses
  • Utilities
  • Yard maintenance

Deductions for Rental Property #1:

Property Tax: $4,706.82
HOA: $1,680
Insurance: $286.00
Interest Payments: $8,678.63
Garage Door Repair: $180.00
Utilities: $338.76
Gasoline: (91.2 miles *0.565) = $51.53

Deductions Total: $15,921.74
Total (Depreciation + Deductions) = $6,145.45 + $15,921.74 = $22,067.19
Gross Income: $25,240

Taxable Income: $25,240 – $22,067.19 = $3,172.81

Although the rental property generated $25,240 in gross income, after all deductions and depreciation, only $3,172.81 would be subjected to taxes. At the 28% tax bracket, this comes out to be $888.39 in taxes. In the REIT example, we would have to pay $1,225.43 in taxes. A slight improvement…

For this particular property, the depreciation allowed is not very good (the land value is ~1/2 of the the total value). In many parts of the country, the building value is much higher than 1/2 of the total property value. The depreciation I get from my out of state properties is much better than what I get for my local Bay Area properties… The higher the building value allocation is to the total property value, the more you will be able to claim back in depreciation each year.

Further, if you spent money on capital improvements, you would be able to depreciate these expenses over a few (or many — 27.5) years. This includes improvements such as: flooring, roof, furnace, water heater, refrigerator, stove, etc. Please consult with a certified tax professional to learn more about the depreciation schedule available for the different types of capital improvements.

So, not only would you get to increase the resell value of your property, you would also get a tax break back from Uncle Sam for your “troubles”.

In a best-case scenario, each year, you would be able to completely offset your gross annual rental income and not owe any taxes (not always possible, but try your best on each rental you own), or claim a loss. I wasn’t able to do quite so well with Rental Property #1, but you get the idea… Owning rental property gives an investor many ways to claim tax breaks.

Keep in mind, there are restrictions based on your Modified Adjusted Gross Income (MAGI). From Bankrate:

Taxpayers whose modified adjusted gross income, or MAGI, is less than $100,000 can claim up to $25,000 in rental losses. The $25,000 cap is reduced $1 for every $2 a taxpayer’s MAGI exceeds $100,000. For example, a MAGI of $110,000 exceeds $100,000 by $10,000 so the $25,000 limit is reduced to $20,000. At $150,000, the reduction to the cap is the full $25,000, which is your situation. Any losses you can’t claim are carried over to future years and allowed as a deduction against passive income, including gain on the sale of the property. If your income were to go below the thresholds, then you would also be able to claim the losses, including those carried over.

If you earn high income, this is another good reason to use tax shelters like 401k; you want to reduce your taxable annual income as much as possible.

Fourth Pillar: Appreciation (Rental Property)

The last pillar is appreciation. If no one told you before, it’s true, the bank is really your best friend and partner in any real estate purchase. Not only will your lender fork over the majority of funds needed to purchase (70% or more), they’ll also let you capture all the profits without asking for a cut in return. Upon sale, all you will need to pay them back is the outstanding loan balance.

I purchased Rental Property #1 for $315,000. My downpayment was $78,750, or 25% of the total purchase price. After factoring in closing costs, the total capital I invested was $81,500. The bank loaned me $236,250. As of March 31, 2014, Zillow’s Zestimate for Rental Property #1 is $486,472.

If I were to sell today:

Sales Price: $486,472
Loan Balance: $227,866.92
Delta: $258,605.08
Less Taxes, Fees, and Agent Commissions (10%):$232,744.57

Profit: $232,744.57 – $81,500 = $151,244.57
Return On Investment (ROI): $151,244.57/$81,500 = 186%

This example lies on one extreme end of the spectrum. Although this type of return isn’t always possible in every market location or environment, it shows the tremendous appreciation potential that can be realized through the use of leverage. Also, the enhanced volatility in housing prices created by fear and greed (residential buying and selling is especially emotional for people) can provide much more opportune buying windows for patient investors. Unlike with stocks, the persistent real estate investor can secure deals at below market prices (distressed sales, courthouse auctions, etc.) and win properties that the rest of the public does not even know about. If you want to maximize your appreciation gains, buy as many properties as you can in a volatile housing market (with leverage) when times are bad. You can make money in real estate in any direction, but most of it is made when you buy low and sell high on the way back up; the same holds true for stocks, but with stocks, you can never purchase below market price.

With the REIT example, again, unless you borrowed money to buy more shares, your appreciation gains would be limited to the gains only made possible by your “100% downpayment” of $81,500. In order to achieve the same 186% ROI using just your own money, each of the 2000 shares of Realty Income (O) purchased at $40.75/share would need to appreciate to $116.37/share.

Gravy Pillar: 1031 Exchange (Rental Property)

The appreciation gain calculated above is a hefty sized return for a minimal initial downpayment investment! And if you want to eat your cake and have another one, you can perform a 1031 exchange and tax shelter your profits. With stocks, upon selling, you will always be subjected to paying taxes on capital gains, whether it be short-term, or long-term. There’s no avoiding the tax man with stocks!

With investment property, a 1031 exchange basically allows an investor a way to defer paying back taxes and depreciation until a later (unspecified) date in the future.

From 1031.org:

In a typical transaction, the property owner is taxed on any gain realized from the sale. However, through a Section 1031 Exchange, the tax on the gain is deferred until some future date.
Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment. A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of “like-kind”, while deferring the payment of federal income taxes and some state taxes on the transaction.

The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer’s investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a “paper” gain.

The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax.

  • A Section 1031 exchange is one of the few techniques available to postpone or potentially eliminate taxes due on the sale of qualifying properties.
  • By deferring the tax, you have more money available to invest in another property. In effect, you receive an interest free loan from the federal government, in the amount you would have paid in taxes.
  • Any gain from depreciation recapture is postponed.
  • You can acquire and dispose of properties to reallocate your investment portfolio without paying tax on any gain.

1031 exchanges are a powerful tool that can be used to help a real estate investor grow. Just like in the game of Monopoly, it is a very common practice to trade up houses for something more grand (hotels, apartments, office buildings, etc.). The best part is that you can exercise and use a 1031 exchange over and over again and defer the tax repayments until the end of time… well, almost.

1031 exchanges only work for physical, tangible properties. There is no equivalent to a 1031 exchange for REITs.

*Risk Considerations

Even more important than the potential returns available for each type of investment are the risks that are involved. When deciding between REITs and rental property, you need to carefully assess your own risk tolerance.

REITs Risks:

  • Market Risk: The risk of your share price declining.
  • Interest Rate Risk: The risk of rising interest rates impairing the REIT’s profit margins. REITs tend to be very leveraged so any rise in their borrowing costs tends to hit their valuations hard. This risk slammed the entire REIT sector badly a few months ago during all the Fed taper talk.

Rental Property Risks:

  • Legal Risk: As the owner of physical property you are exposed to liability if a tenant or third party gets hurt on your property. This will require you to buy additional insurance for protection (increase coverage on primary insurance, or add on an Umbrella policy), thereby increasing your costs.
  • Property Manager Risk: If you own turnkey properties you are relying on the property manager to perform their job to your standards. Your PM might quit, sell the business to a less capable PM, or just decide that finding tenants and maintaining your property isn’t high on their list of priorities because they’re more focused on pursuing new clients over servicing old ones.
  • Major Repair Risks: You might find yourself paying far more in maintenance and repairs than you reserved for. One bad winter and your could find yourself spending thousands to replace ruptured water pipes. One bad storm and you could find your property flooded with thousands in water damage and a vacancy that lasts for months. A broken furnace, a leaky roof, anything like this could eat up an entire year’s worth of earnings in a short time period.

Summary

There are many reasons to invest in REITs; they are a convenient, and most passive way of letting an investor gain access to the real estate sector. However, comparing REITs to rental properties is like comparing apples to oranges. The two investments are vastly different, and just simply comparing a REIT’s yield to the Cash-On-Cash Return of a rental property is not sufficient.

Real estate investing through rental properties appeals to investors primarily because of the four pillars: cash flow, principal paydown, tax benefits, and appreciation; all of which are enhanced through the use of other people’s money (leverage).

If you really want to take advantage of all the benefits that rental property has to offer, you should always look for properties that help maximize each of the four pillars. Only then will you be able to realize the true potential of your ROI. The icing on the gravy is the 1031 exchange, which will let you upgrade properties without having to face any upfront tax consequences. If you can keep scaling up, it will really feel like you’re playing real life Monopoly. 😉

 

*Thanks to reader Joe Carnation for writing and contributing to the Risk Considerations section.

{ 38 comments… read them below or add one }

1 Income Surfer April 8, 2014 at 4:15 am

I think a lot of readers can benefit from your comparison Fighter. Clearly you give up some return investing, when investing in REITs, in exchange for more liquidity and lower hassles. I don’t think there is a clear answer which is better, because it varies by the investor (and that investor’s parameters). Thanks for your post
-Bryan

Reply

2 FI Fighter April 9, 2014 at 7:52 pm

Bryan,

No, there’s no clear answer, and I don’t think you can directly compare REITs to rental properties either. They are too different and you just have to go with the one that is most suitable for your own investment style.

Both are proven methods of helping investors build passive income. There are much worse alternatives!

Cheers!

Reply

3 Retire Before Dad April 8, 2014 at 4:51 am

FIF,
Very detailed comparison here. By far, the REITs are less hassle. The 4 pillars you mention lead to wealth building which buying a REIT won’t do nearly as much. I’ve been looking into my own market for another property and there is nothing to give me a decent return. Starting to look in other markets I am familiar with. I bought the VNQ recently too, a pool of REITs for my retirement account.
-RBD

Reply

4 FI Fighter April 9, 2014 at 7:53 pm

RBD,

Yes, REITs are definitely less hassle, just like stocks.

Same here, the local market just doesn’t work for cash flow. I started looking elsewhere in 2013, and won’t invest back in the Bay unless another major market correction happens.

Happy hunting!

Reply

5 Joe S. April 8, 2014 at 6:36 am

Love your comparison, just to add to the debate…for the last decade the performance of O with dividends reinvested was 225%, now I wonder how many real estate properties appreciated that much during this period….food for thought, indeed.

Regards,

Joe

Reply

6 FI Fighter April 9, 2014 at 7:58 pm

Joe,

Thanks! O has definitely been a top performer over the years, so you can’t go wrong there.

In regards to real estate appreciation, it varies quite a bit from location to location. I can only speak for the Bay Area, but I know anyone who bought up houses in SF or Cupertino, Los Gatos, Palo Alto areas in the 80’s, 90’s, early 2000’s is sitting on massive capital gains right now… The appreciation from 1-2 homes over that time period could retire you easily.

All the best!

Reply

7 No Nonsense Landlord April 8, 2014 at 7:17 am

An additional thing to think about is this.

When you die, the inheritor gets the RE asset, at the new basis. So, if you pay $250K and you may have depreciated the property down to $0 by the time of your death. Even after several 1031 exchanges.

If the property was worth $1M, your heirs could inherit the property on your death, and sell it the next day for $1M, and no tax is due. Their basis is now $1M.

If you sold the property the day before you die, or gave it away and it was sold right away, a major capital gains tax is due on the $1M recapture.

It is a great estate tax avoidance plan.

You cannot depreciate a REIT. It’s just a partnership or ETF thing.

Reply

8 FI Fighter April 8, 2014 at 9:39 am

Eric,

A most excellent point! I missed this, and this is definitely something anyone investing in rental property needs to consider.

This is an amazing “loophole” that most don’t know about.

Also, on the point of $0 remaining on depreciation, a lot of people will wait until this very moment before capitalizing on the 1031 exchange. When you move into a new property, you reset the depreciation clock. It’s great!

Take care!

Reply

9 Roadmap2Retire April 8, 2014 at 7:54 am

This is by far one of the best posts Ive read comparing REITs and rental property. A well balanced comparison showing both the good and bad in each. Ive often debated about buying rental property (thought about buying something in the US during the housing crash) but considering that I dont own a home here, I ended up saving it for my own house downpayment.

regards

Reply

10 FI Fighter April 9, 2014 at 8:00 pm

Roadmap2Retire,

Thanks! Glad you enjoyed the article.

There are many good markets in the US for real estate property. Cash flow is harder to locate these days, but it can still be found in abundance in many areas.

All the best!

Reply

11 Tom April 11, 2014 at 10:13 pm

I have to agree, for a long time I could not understand why some people would say “want to in vest in real estate but not the headaches? Buy REITs!”

But to me here always seemed to be a disconnect and FI explains that disconnect very well here.

Reply

12 FlyerM April 8, 2014 at 8:00 am

+1
Great post FIF

Reply

13 FI Fighter April 9, 2014 at 8:00 pm

FlyerM,

Thanks!

Reply

14 Dividend Gamer April 8, 2014 at 8:23 am

This is why my goal and many others, should be to work towards having both. Receive income from a number of sources to build up the walls and moat of your financial fortress.

I also like BDCs and MLPs and CEFs, some are exceedingly risky, but can provide 15%+ yield, that even if it won’t last more than a few years, each interval is still 5%+ more than a lot of other options.

When you look at assets as replacement income for current expenses it is a great way to motivate people to save and invest.

I love showing other young people the benefits of this thinking. Take Prospect Capital (PSEC) it is currently around $10.8 a share and pays a monthly dividend of $0.11.
As long as you hold even 75 shares, which would cost you a little more than $810, it will pay you $8.25 a month.

That is covering the cost of all of their Netflix subscriptions, and will continue to do so. Many of them will routinely buy clothes and shoes, accessories and things that can quickly add up to more than $810 a month.

This is how you turn the light on inside their head. This is how to light the fire towards investing, and seeking financial independence.

Reply

15 FI Fighter April 9, 2014 at 8:02 pm

Dividend Gamer,

Yes, it’s a great strategy to mix up your assets into different classes. I’m focusing on rental properties now, but eventually will get back into buying stocks, and probably other investments as well.

That’s a great way of looking at things, and I love how you focus on winning the little battles. I tell anyone who’s trying to get started to first take care of your little items: cellphone bill, gasoline, utilities, etc. before trying to replace their entire earned income.

One step at a time, and you will be successful in the long run.

Take care!

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16 Done by Forty April 8, 2014 at 8:58 am

A really comprehensive analysis, and I’m totally pumped about the prospect of a 1031 in our future, should we decide to exchange rental properties down the line. I wonder if you can avoid taxation altogether, if you later move into a property you purchased via a 1031 exchange, making it your primary residence…

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17 FI Fighter April 8, 2014 at 9:28 am

Done by Forty,

1031 exchanges are great… If you plan on selling your owner primary residence and upgrading, there’s an even easier way to do so.

Per the IRS: Topic 701 – Sale of Your Home
“If you have a gain from the sale of your main home, you may qualify to exclude up to $250,000 of that gain from your income. You may quality to exclude up to $500,000 of that gain if you file a joint return with your spouse.”

“You are eligible for the exclusion if you have owned and used your home as your main home for a period aggregating at least two years out of the five years prior to its date of sale. You can meet the ownership and use tests during different 2-year periods. However, you must meet both tests during the 5-year period ending on the date of the sale. Generally, you are not eligible for the exclusion if you excluded the gain from the sale of another home during the two-year period prior to the sale of your home. Refer to Publication 523 for the complete eligibility requirements, limitations on the exclusion amount, and exceptions to the two-year rule.”

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18 Chad April 8, 2014 at 4:06 pm

When selling your primary residence you will have to recapture the depreciation taken. So you can’t really have a zero basis rental, turn it into your primary residence for 2 years then sell it without having to claim the $250k capital gain. Also on 1031 exchanges you don’t get to reset the depreciation clock. You only get to depreciate any extra money that you pay for the new rental in the 1031 exchange. One last thing about the 1031 exchange, it can be very expensive to do. Not a cheap process. Sometimes it’s cheaper to just pay the tax on the gain. Something to think about before doing a 1031 exchange.

1031 exchanges can be a great benefit for rental real estate investors, just know that they do have some downsides.

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19 No Nonsense Landlord April 8, 2014 at 3:48 pm

If you move into a property you originally depreciated, you have to capture the depreciation on the sale. I think you can still take the $250K gain, but the depreciation must be recaptured.

If you do a bunch or repairs just before moving in, they are deductible though. New appliances, carpet, garage door opener, etc. Assuming you do a Sec. 179 expense on them.

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20 FI Fighter April 9, 2014 at 8:05 pm

Eric, Chad,

Thanks for the clarification on the depreciation! That’s something that of course needs to be considered when selling.

Good point on the 1031 not being a complete free lunch. There are fees, and when selling you’ll also have to pay agent commissions, more fees, taxes, etc.

Still, if you are sitting on a ton of capital gains, it’s still very, very much worth doing.

All the best!

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21 Dave @ The New York Budget April 8, 2014 at 2:02 pm

Amazing comparison. I am always hearing people talk about getting into REITs as their real estate play, but I think you hit the nail on the head in saying that REITs and rental properties are totally different animals.

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22 FI Fighter April 9, 2014 at 8:08 pm

Dave,

Thanks! REITs and rental properties are very different. You can invest in both, or pick the one that works best for you.

Rental property generally involves more headaches, but the 4 pillars makes it very attractive.

REITs are like stocks and much more passive. However, you lose out on being able to leverage your money… It’s easier to grow/scale through real estate b/c of leverage.

All the best!

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23 Joe Carnation April 8, 2014 at 6:28 pm

FI Fighter, Great comparison of REITs to rental properties. I would also include a comparison of the relative risks involved with both types of real estate:

REIT Risks:

1) Market Risk: The risk of your share price declining.

2) Interest Rate Risk: The risk of rising interest rates impairing the REIT’s profit margins. REITs tend to be very leveraged so any rise in their borrowing costs tends to hit their valuations hard. This risk slammed the entire REIT sector badly a few months ago during all the Fed taper talk.

Rental Property Risks:

1) Legal Risk: As the owner of physical property you are exposed to liability if a tenant or third party gets hurt on your property. This will require you to buy additional insurance for protection, thereby increasing your costs.

2) Property Manager Risk: If you own turnkey properties you are relying on the property manager to perform his job to your standards. Your PM might quit, sell his business to a less capable PM, or just decide that finding tenants and maintaining your property isn’t high on his list of priorities because he’s more focused on pursing new clients over servicing old ones.

3) Major Repair Risks: You might find yourself paying far more in maintenance and repairs than you reserved for. One bad winter and your could find yourself spending thousands to replace ruptured water pipes. One bad storm and you could find your property flooded with thousands in water damage and a vacancy that lasts for months. A broken furnace, a leaky roof, anything like this could eat up an entire year’s worth of earnings in a short time period.

I’m in the process now of deciding between an investment in turnkey property and an investment in a basket of REITs. I haven’t made up my mind yet but the risk comparison for me is even more important than the yield comparison. The extra yield that rental properties offer is the price that is put on taking on these extra risks and I need to make sure the price I’m being paid is appropriate for the risks I might assume.

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24 FI Fighter April 8, 2014 at 6:39 pm

Joe,

That’s an awesome list! Thanks for taking the time to write that out. I didn’t factor risk consideration in the article, but you’re right, that’s absolutely one of the most important factors in the decision making process.

REITs are definitely more passive and with a well diversified portfolio, you’ll experienced a lot less headaches.

All the best!

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25 CI April 8, 2014 at 10:01 pm

Good read today.

The closest apples to apples comparison would be a REIT (no margin) vs. a rental property (no mortgage). Assume 100% cash payment for both, that’s fair. I suspect a rental property would have a higher return even without leveraging through mortgage debt. But yeah it depends on the property and also depends on the REIT.

REITs might be better for risk averse income investors who are afraid of debt and might only have a small amount to invest each month.

Rental Properties might be a better fit for those who either: a) are more tolerant towards leverage (more aggressive) or b) have a large sum to invest.

The main advantage of rental properties is the easy access to secured debt (mortgage) for higher returns. Usually secured debt (mortgage) have lower interest rates and that’s a good thing! Extremely high returns are possible with real estate and you, FIF, are living proof of that! Well done btw.

The REIT investor won’t have as many headaches (calls from the property manager when on out of country, vacancies, bad tenants/repairs, etc.) and generally will spend less time on the investment. However he/she needs to be able to stomach the day to day volatility of the stock market. Both vehicles have market risk, it’s just that it’s much more visible with publicly traded REITs.

Maybe large price swings will cause loss of sleep for REIT investor? Maybe servicing a looming debt payment each month will cause the rental property investor to toss and turn at night? It’s different for everyone.

Nobody ever talks about non-publicly traded REITs… that don’t have volatility… or liquidity… An even better apples to apples comparison?

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26 Joe Carnation April 9, 2014 at 4:32 am

I’ve looked into privately held REITs and they tend to offer similar yields to publicly traded ones, plus you usually have to pay a management fee to get into those deals. All that plus the lack of liquidity made me stay away from the non-public REITs but I only looked into a few of them. It’s possible there are some gems out there.

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27 Scott April 12, 2014 at 10:54 am

FI Fighter,

Thanks for the great comparison article! I look forward to the day when I’m settled down enough that I’d be able to own some local rental properties. As it is now, my only exposure to real estate is in the REITs, O and VTR. I know there’s been a lot of negative talk regarding how interest rates will affect these companies. However, since they are in my Roth, which I won’t be able to touch for another 30 years anyway, I’m not too concerned about the month-to-month fluctuations.

Thanks for all the good resources on your site!

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28 Free To Pursue April 28, 2014 at 6:13 am

Wow! What a great, detailed article.

I would add lack of diversification to the property rental risk. REITs certainly spread the risk over multiple properties. Sometimes a property’s rentability changes with changes in the economic conditions of a particular area. We’ve seen homes in our area go unrented for extended periods of time over the last few years when, only a few years prior, you could hardly find one available.

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29 David May 23, 2014 at 5:22 am

Hi – I just came across your blog as I was searching for a comparison of these very same options. I don’t have any money in either at the moment but have been considering both.

The big question I have is are they REALLY that separate? Your pillars came across as if only an individual investor can take advantage of leverage, tax deductions and equity appreciation, but don’t REITs also get to take advantage of these very same tools? I’m not an expert but I do believe REITS are able to take out the very same bank loans, deduct the same expenses, depreciate their properties, and can buy and sell properties for the same gains (or losses) that we could as individual investors. If a REIT believes they can get a good return on that capital gain money they should be reinvesting it into new properties, growing the rental income, and thus growing the dividend over time.

Taking this a step further, your initial equity investment can also appreciate with a REIT through its stock price. The stock can increase in value based on an expectation of future returns to shareholders (i.e, dividend increases). Those could be as simple the REIT announcing an increase in next quarter’s dividend to larger macro-economic plays (e.g., your REIT only invests in Texas, and their population of “renters” is expected to grow above the national average for the next decade, etc.). Of course it can also go down for those same inverse arguments as well, but to me that is not much different then the market value of any individual property fluctuating throughout the years on paper (i.e., your “Zillow” price). At the end of the day this is a dividend stock, so if you hold all other factors equal any expected increase in future dividends should directly correlate into an increase in the price per share of the stock price. Although you may not have personally benefited from these future dividend increases yet, the next individual in line to buy your REIT share has the expectation that they will receive it at some point the future and is thus willing to pay a higher price for it. As an example, you mentioned the Realty Income Corp (O) in your post, it has seen its stock appreciate 25% over the past three years (but down -15% the last year), which happens to be about the same as the Dow Jones REIT index. Those aren’t jaw dropping returns for 3 years of course, but its not too bad for a dividend stock that is already giving you 90% of its income.

Again, I’m not an expert and have just started researching both options for my own portfolio, but I thought some of those points were worth debating. Thanks!

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30 FI Fighter May 23, 2014 at 11:29 pm

David,

Thanks for stopping by and commenting.

When it comes to REITs, that’s tough to answer b/c as an individual investor, how much insight can you really have into the operations and management of the REIT? Does the REIT pass through all the benefits of leverage to the investor? How much does management take for themselves?

The fundamental difference with rental property is that there are no other parties or middlemen outside of the tenant and landlord relationship. As the landlord, you reap all the benefits of appreciation, tax benefits, cash flow, principal paydown, etc.

On your point with dividend increases… As an investor, you don’t really have any control over this… The REIT will set the dividend and the growth rate. They can even keep the dividend static… As a landlord, you have full control on how often and how much you raise rents (unless you landlord in a crazy rent control market like San Francisco).

These are just my thoughts, but I’m sure others will have a much different opinion.

Cheers!

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31 David May 24, 2014 at 12:01 am

To qualify as a REIT the IRS /SEC require they distribute 90% of all taxable income as dividends, so management can’t really hold back on increasing dividends or on not sharing the benefits of leverage. Their biggest option would be whether to reinvest their capital gains from selling a property into new properties or pay it out as a dividend. Most funds do the former to grow their portfolio.

The management fee (I.e., their cut) is a true cost though and is something any investor in a fund has to carefully consider similar to a property manager, listing agent, etc. of personal properties. As you are expanding out of state or if you start to invest in large multi-unit properties you will have to start paying these these of costs as well (could be more or less expensive depending on how passive you want to be).

In the end I’ll probably end up doing both types of investments to see first hand which one I prefer.

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32 Terry December 19, 2015 at 8:34 pm

One way of getting a tax break for REITS is to use them in your IRA.
I get a tax break upfront and growth tax free also. This makes it closer to rentals in total return

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33 jt January 2, 2016 at 11:16 am

Isn’t counting principal paydown in addition to cash-on-cash return double counting? You are paying down the principal from the positive cash flow on the rental which is also accounted for in the cash-on-cash return. What am I missing?

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34 FI Fighter January 2, 2016 at 11:36 am

jt,

No, cash-on-cash return is cash flow AFTER PITI (principal, interest, taxes, insurance) and any other expenses…

If you add back in the principal paydown, the cash flow increases, which is usually categorized as total return, or some other term.

Hope that helps.

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35 Ernesto February 24, 2016 at 9:05 am

I really enjoyed your article, it really helped me understand how to evaluate both investment vehicles, on here it looked as if the loan rate was 3.5%, am I right about that? I was able to get a variable rate of 3.1% a while back on an amount that if interest rates increased to much I could pay the loan off, but I’m not sure that one can actually get a 3.5% rate on a $244,500 loan for an investment property. What am I not considering? are my calculations wrong?

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36 Benji September 20, 2016 at 8:34 am

I don’t know if I’m missing something here but let me know if what I am saying is correct, and it’s just in detail, just a brief outline and calculations:-

Mortgage:-
25% down on a 200k house = 50k liquid
Mortgage of 150k over 10yrs = $1500 per month
Rent from the condo per month =$1600 per month ($100 extra for maintenance if needed)

Therefore, there will be no income generated for 10 yrs to myself, but in 10 yrs time I will have a property that is worth 200k+ with a rental income every month of around $1600+, so close to a 10% yield and I would also have a 200k+ property that only cost me 50k, so therefore that is also a 400% increase in my initial investment.

Overall – $50k and in 10 yrs it is now $200k with 10% dividend of $20k per year

REIT:-
50k liquid to invest
Yield is 5.5%-6% = $3k per year income
Over the 10 yr period, I put the $3k back in and after the 10 yr period this has totaled to around $85-90k.
So overall a $35k – $40k profit.

Overall – $50k and in 10 yrs it is now $90k with a 6% dividend of $5k per year.

Please tell me how there is a comparison as to which one to take, or am I missing something.

Thanks All

Ben

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37 Paul September 27, 2016 at 10:03 pm

I agree with David. The benefits such as step up in basis and 1031 are also available for REIT’s. Also, REITs should have economies of scale and expertise and those expenses as a % of assets are lower than individuals. A large % of a REIT’s dividend is not taxable because it is often treated as return of capital, because the REIT’s take depreciation. This is why it doesn’t make sense to me to have REITs in an IRA. It’s a waste of the tax benefit.

Also, you can borrow against your publicly traded REIT in your brokerage account at low rates. This is on top of the leverage the REIT takes to buy properties. Adding principal pay down doesn’t make sense to me. Does that mean you’re getting an 11.5% cap rate in San Fran?

I have both REIT’s and rental property. I own DEI and the cap rate is 4.5%. That looks expensive until I look at my property in Santa Monica with high rent at 3.8% with hassles. DEI properties are also mostly in Santa Monica.

Thanks for the article.

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38 BobbyJ October 9, 2016 at 8:09 am

i do like the article very informative. i’d say one size does not fit fall as each may like one or the other or both.

i would say that in the case with realty income. they’ve boasted claims of 17% annualised return since inception or since 2013, 2014, 2015 (1.8%, 33.7, 13% or 16% annualised since 2013). so your earning potential is still vast even comparing with rental property as you still get the appreciation potential + dividends with the right pick.

So it is similar too but not equal in some instances to property.

However, in my opinion the passive route is less hassle and you still get the upside to property plus there are tax wrapper structures (im a Brit btw) to shield against Big daddy G.

Happy Hunting and Happy Prosperity

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