I recently read an article titled, What I Wish I Knew Before Investing In Rental Properties by Jussi Askola. Mr. Askola is the President of Leonberg Capital who has authored several academic papers on REIT investing.
A Distorted View of Real Estate Investing
The premise of his article is that real estate investing:
- Is a lot of work
- It’s a lot of worrying
- It’s not passive
- You will have sleepless nights
- You won’t have freedom of movement
He concludes, “Sooner or later toilets get clogged, tenants will cause problems, rents will get unpaid, you need a lawyer and roofs will leak… If your goal is financial freedom, investing in rental properties will most often be a mistake.”
Wow. What a distorted view of real estate investing. And I suppose if you invest in single family homes or small plexes and self-manage your properties there is some truth to his opinion.
Mr. Askola then devotes the rest of his article espousing the benefits of Real Estate Investment Trusts better known as REITs. Essentially, REITs are corporations that own and manage a portfolio of real estate properties and mortgages. Anyone can buy shares in a publicly traded REIT.
Let me make my position perfectly clear, I’m not trashing REITs as an investment vehicle. I do believe that there is a legitimate place for REITs in an investor’s investment portfolio along with mutual funds, stocks, bonds and precious metals. But I am annoyed with Mr. Askola’s skewed view of real estate investing.
A More Objective Analysis of REITs vs CRE
So let’s begin with the basics. A real estate sponsor, also called a syndicator, finds a property to invest in and then searches for equity partners, also called passive investors. It’s a symbiotic relationship between the real estate sponsor and the equity partners. The real estate sponsor puts the deal together but without the passive investor’s equity the deal does not close. They need each other. One can’t succeed without the other.
My guess is that most real estate assets today are owned by passive investors, such as myself. I don’t know about you, but as a passive investor I’ve never unclogged a toilet or dealt with a difficult tenant late on his rent as Mr. Askola tells us is inevitable if we invest in real estate. Nor has my real estate sponsor. That’s why we hire property management companies. Nor do I have sleepless nights worrying about my rental properties.
So let’s go through Mr. Askola’s reasons for owning a REIT.
1. Professional management.
This is not an advantage over owning real estate. I wouldn’t own real estate if I had to manage my own properties.
2. Liquidity and low transaction costs.
Half true. Yes, owning real estate is an illiquid asset. You shouldn’t buy a rental property unless you plan to hold it for a minimum of five years, preferably longer. Low transaction costs? That depends on how you look at it. The cost of purchasing real estate whether directly by purchasing your own rental property or indirectly by owning real estate in the form of a REIT are more or less the same.
I would argue that the transaction costs are substantially more when a REIT buys a property than when a smaller investor buys a property. Why? REITs typically buy very large properties in the $50 to $100 million range. Lenders who finance these properties require substantially more due diligence in the way of third-party reports. And these reports are expensive. And the legal bills associated with these transactions are ginormous! These higher closing costs in the form of additional third-party reports and legal bills are baked into the cost of the REIT stock. Or if the stock price is unaffected then you’re paying for these closing costs through a lower return on your investment. So make no mistake, you the owner of a REIT stock are paying for these closing costs one way or the other.
Agreed. REITs generally have a diversified portfolio of 20 or more real estate assets. But diversification has its drawbacks. True it does reduce your risk, but it also reduces your return. It brings your return on your investment down to the median return for that asset class. Warren Buffett didn’t become one of the wealthiest men on the planet by diversifying his stock portfolio. He did it by focusing on buying companies that he deemed were bargains. And that is what real estate investors do. They search the real estate market for properties that are underperforming the market and buy them.
4. Passive income.
Investing in real estate is all about passive income. And owning rental properties has a significant leg up on REITs and here’s why: Not only do real estate investors receive monthly distributions we also from time to time get to refinance our properties and take cash out. Once needed improvements have been made to a value-add property, rents increase significantly, and the property’s value skyrockets. I’ve had instances where the cash back from the refinance has paid back all of my original equity and then some. And the property with the new debt still continues generating healthy monthly ownership distributions. REIT stocks do not have the ability to generate large cash distributions when refinancing a property.
5. Better long-term returns.
Mr. Askola pivots at this point and compares the return on REITs with the return on the S&P 500. He boasts that REITs have a 12.4% average annual return compared to 10.9% with the S&P 500. But notice he does not compare a REITs return with investing in commercial real estate. Why not? Because a side-by-side comparison between these two asset classes would show the superiority of investing in real estate. I regularly receive offering memorandums from real estate sponsors seeking equity partners to invest in their latest acquisition. Typically, their pro formas show a 17% or greater Internal Rate of Return (IRR). From personal experience I believe a 17% IRR is very realistic. Sure, some investments turn out to fall well below this return but on average a 17% IRR is quite likely.
Now let me explain my reasons why I believe owning real estate is far superior to owning REIT stock:
6. REITs are notorious for overpaying for their property acquisitions.
Today, the only way to make a decent return from investing in CRE (commercial real estate) is to purchase value-add type properties, i.e., properties that are in poor condition and/or are poorly managed. With the right improvements and a change in management these properties can dramatically increase rents. With increased rents comes a corresponding increase in the property’s value. That’s how smart investors are investing today in CRE.
REITs not only don’t buy value-add type properties, they buy turnkey properties, i.e., properties that are well maintained and well managed. To make matters worse they gravitate towards the Class A properties with the exceptionally low cap rates. They buy properties that look great on the front cover of their investment brochures. And because they have considerable funds they pay overpay for these assets. There is no way they can get better returns than an investor who buys value-add properties. It’s not going to happen!
7. REIT stocks are at the mercy of the whims of the stock market.
When the stock market plunges all stocks are affected, including REIT stocks. In 2008 when the U.S. stock market lost a third of its value overnight it made no difference what stock you owned. They all plummeted together like lemmings stampeding over a cliff to their deaths. Not so real estate. Real estate that maintained a good vacancy rate weathered the economic turbulence of the Great Recession quite well. Those investors who over leveraged their properties on the other hand, paid the ultimate price and lost their properties.
8. Rental properties have the tax advantage of depreciation. REITs do not.
A rental property can generate both positive cash and a tax loss at the very same time because of depreciation. A tax loss on rental properties shelters other income on the taxpayer’s tax return resulting in less taxes owed. It’s a beautiful thing to behold! Again, REITs do not share this tax advantage.
9. Rental properties can defer capital gains taxes. REITs cannot.
When you eventually sell your REIT stock you pay taxes on any capital gains made. However, when you sell a rental property you can defer capital gains taxes by doing a 1031 exchange. A 1031 exchange is a deferral of the capital gains tax on the sale of an investment property when it is exchanged for a like-kind replacement property. In reality a real estate investor can permanently defer the capital gains tax over his lifetime by continuing to buy a like-kind replacement property each time he sells a rental property. When he dies, his heirs receive a stepped-up basis in the property based on the value of the property at the time of his death. So no capital gains taxes are paid even by his heirs.
I believe I’ve made a convincing argument why owning rental properties is far superior to owning REIT stocks. Those are my thoughts. I welcome yours. Where is my argument flawed? What have I overlooked?
Sources: What I Wish I Knew Before Investing In Rental Properties, by Jussi Askola, Seeking Alpha, March 30, 2019; How REITs Work, by Lee Ann Obringer, https://home.howstuffworks.com/real-estate/buying-home/reit.htm