Why I Stopped Buying Rental Property to Buy a REIT Instead
Most rental property investors miscalculate their returns. The returns are not as attractive as it may first seem. Once you properly account for most expenses, REITs are typically more rewarding than rental properties.
I come from a family of real estate entrepreneurs and investors.
As a result, I’ve been in real estate literally my entire life and so when it came time to invest, it felt natural to buy a rental property.
I bought my first one when I was 18 and I still remember the numbers.
It was a condo in Germany. It was for sale at around €38k, I managed to negotiate it down to around €33k, and its expected rent was around €400 a month. I had access to cheap debt to increase the return on equity.
On the surface, it was a no-brainer.
The return on equity was 20%+ p.a. and this was even before accounting for any future appreciation.
I thought that even with conservative projections, I would have had more attractive returns than what I could have earned in the stock market.
But I was wrong!
Later, I started working in private equity real estate and I quickly realized that my calculations were too far.
And I am not the only one to make these mistakes.
In fact, I would argue that most investors in rental property overestimate their returns by misinterpreting them. Returns can still be attractive once you properly account for all expenses, but often, they are less than REITs (VNQs), and that’s on top of taking on a lot of risk.
I show you this:
Computation of Return of Rental Properties: 101
The simple math that everyone is doing is the following.
Rent + Appreciation – Interest Expense / Down Payment = Return on Equity
With this calculation, you can often get 30%+ annualized returns.
But even fairly new investors will understand that this is widely misleading.
Taking it a step further, investors will typically replace rental income with net operating income, which removes property expenses such as utilities, taxes, insurance, etc.
Net Operating Income + Appreciation – Interest Expense / Downpayment = Return on Equity
Here already the returns start falling drastically. Net operating income is typically just half of rental income if you properly account for all property expenses.
So let’s say the return is now reduced to 20%+ p.a.
Still great, isn’t it?
Well, we still haven’t accounted for the most important expenses… which are often forgotten by investors.
Computation of Return of Rental Properties: Issued
Some investors may include a renovation reserve expense in calculating their net operating income, but most likely, it will not include large repair expenses that rarely occur, or at least, it properly accounts for them. Will not done.
Sometimes you’ll have a nasty surprise. This is virtually unavoidable and must be taken into account while computing returns.
If you come back to my first rental property, a single repair bill can wipe out years of rental income. To take an example, imagine that the apartment was flooded and there was significant water damage. If you’re lucky your insurance may cover some things, but most likely not everything. The repair bill could easily be a few years or rental income.
But you’ll have other negative surprises as well. It is not only the repair of the property but also other things like a tenant who refuses to pay rent…
To take another example: Let’s say some mold was growing in your rental property due to poor ventilation, and your tenant decides to sue you when he finds out he’s got asthma.
You’ll have to hire a lawyer to defend yourself and this can be dragged into the courts for months or even years, costing you a lot of money (and time… more on that later).
The point here is that bad surprises are inevitable, they are very expensive, and they need to be included in your return calculation.
So let’s revisit the previous calculation:
Net Operating Income + Appreciation – Interest Expense – Reserve for Bad Surprise/Downpayment = Return on Equity
So now, your returns come down to 15-20% per annum.
But this is where things get really messy because we still haven’t accounted for the value of your time and work.
Buying and managing a rental property is closer to running a business than making passive investments. It’s a lot of work and your time is not free. You can also work at another job and earn salary so we have to account for this expense.
First, we need to estimate how many hours per month you will be working on your property. It depends on a number of factors, but assuming you have some assets that you manage on your own, it could be something like 15 hours per month. In this estimate, I also include all the time spent in acquiring the property. Some months, you’ll be working 30 hours. In other months, you’ll only do 5 things. We are using an average of 15 hours.
Then, we need to find out what your time is worth. This will also depend from person to person. If you work a regular job, let’s say your price is $25 an hour.
So the cost of working at your rental property (instead of your regular job) is $25 x 15 = $375 each month.
Net Operating Income + Appreciation – Interest Expense – Reserved for Bad Surprises – Value of Your Work / Downpayment = Return on Equity
Now your returns can drop by about 10% per annum.
Still, it’s not bad, but we’re far from 30%+ in the initial discussion, and our estimate is still pretty conservative.
Now let’s say you are a lawyer and your time is worth $300 an hour.
Then the monthly cost of putting hours into your rental property is $4,500.
Is your return sufficient to justify this expense?
No. It’s not like that. Your time is better spent working on your main job and investing that money in passive investments like REITs than working on a rental property, which at the end of the day is usually much less rewarding.
The higher your income potential, the worse your return after properly accounting for the value of your time.
Why REITs earn higher returns than rental properties in most cases
Several studies have shown that once you account for all expenses, publicly listed REITs tend to generate higher returns than private real estate investments.
Here are three of those studies:
REITs outperform private real estate
REITs outperform private real estate (Cambridge)
REITs outperform private real estate (NAREITs)
How is this possible?
We listed 10 reasons in the previous article which you can read click here,
In short:
- 1) REITs spread investment to make investing faster
- 2) REITs can enter into real estate related businesses to increase returns
- 3) REITs can develop their own assets
- 4) REITs Can Sell and Leaseback
- 5) REITs enjoy significant economies of scale
- 6) REITs enjoy strong bargaining power with tenants
- 7) REITs Employ the Best Talent in Real Estate
- 8) REIT’s Total Return Approach
- 9) Most REIT managers are well-connected with shareholders
- 10) REIT investors pay no transaction costs
It explains how REITs like Realty Income (O) have managed to deliver 15%+ average annual returns since their IPO in 1994:
Realty Income Generates 15%+ Annual Return (Realty Income)
And Realty Income is no exception. Many other REITs such as American Tower (AMT), Prologis (PLD), Public Storage (PSA), etc. have achieved similar results over time…
And if you are an active REIT investor who can pick the best opportunities and improve your returns even more.
That is our goal at High Yield Landlord. We invest in only the best REIT opportunities to maximize returns:
High Yield Landlord Selection (High Yield Landlord)
This has historically brought us even stronger results. We have managed to compound returns at 15%+ per annum and we also earn high dividends with an average yield of 6%.
Ultimately, it made me stop investing in rental properties to invest in REITs instead.
They allow me to earn returns comparable or better than rental properties, but the important thing is that I earn these returns with far less risk and less effort.
I put in a lot of work to make the right selection, but other than that, I simply monitor my investments, collect the income, and wait patiently for long-term appreciation.