BROXF - Passive Income: Why High Yield Stocks Beat Rental Properties

2023-09-05 08:00:00 ET

Summary

• Rental properties are a popular passive income investing method and have created immense wealth for many.
• However, buying high yield stocks over rental properties is a no-brainer in our view.
• We discuss three reasons why and also share some attractive high yield picks.

In his 2010 shareholder letter, Billionaire Warren Buffett of Berkshire Hathaway (BRK.A)(BRK.B) discussed the investment merits of his home purchase, stating:

I would have made far more money had I instead rented and used the purchase money to buy stocks.

While not a definitive remark on the merits and demerits of investing directly in rental properties versus stocks, we believe that Mr. Buffett is on to something. In this article, we will discuss three reasons why we believe that high yield stocks are a better passive income investment than rental properties, especially right now.

#1. Lower Risk

One of the biggest reasons why high yield stocks are better investments than rental properties is because they are almost always lower risk, especially when invested in correctly. There are several reasons for this:

1. Publicly traded stocks are backed by companies worth millions or even billions of dollars and therefore generally have significant scale and diversification that would be virtually impossible to replicate as an individual investor buying rental properties. For example, you can buy REITs ( VNQ ) like Realty Income ( O ) or W. P. Carey ( WPC ) that own thousands of individual properties leased out to hundreds of individual tenants across dozens of industries. You can also invest in high yielding business development companies ( BIZD ) like Ares Capital Corporation ( ARCC ) or Main Street Capital ( MAIN ) that invest in hundreds of individual senior secured loans and other investments spread out across nearly as many individual counterparties. The diversification benefits are further compounded by the fact that you can buy a basket of stocks diversified by geography and other factors and buy many different stocks, whereas replicating this with individual real estate properties is much more difficult for an individual real estate investor to replicate.
2. High yield stocks have professional management teams and an army of employees working around the clock to deliver attractive returns on investment while also guarding against downside risk. For example, the aforementioned businesses like O, WPC, ARCC, and MAIN have each world-class teams that have developed stellar track records over the course of decades and know their industries inside and out. This investing skill is very hard to match as an individual investor trying to take a DIY approach to rental property investing, especially if it is not your full time job.
3. In the age of big data where machine learning algorithms and data science are increasingly driving decision-making - including when it comes to capital allocation - bigger, better established companies with lengthy track records and large scale have an inherent advantage. This comes not only from their treasure trove of data, but also from their ability to hire data analysts and machine learning engineers, whose sole job is to build models that will enable them to generate alpha. Several high yield companies like Blackstone ( BX ) and OneMain Holdings ( OMF ) have come out and explicitly stated that this is something that they are focused on. As a do-it-yourself part-time rental property investor, this is an impossible feat to pull off.
4. Publicly traded businesses are often - though not always - backed by high quality assets. For example, Simon Property Group ( SPG ), Federal Realty Investment Trust ( FRT ) and Macerich ( MAC ) own some of the highest quality retail real estate assets in the world. An individual investor - or even small group of real estate investing partners - cannot possibly hope to compete with them in terms of quality and instead would likely have to settle for redeveloping failed Class B or C properties or investing in a lower tier shopping center or strip mall. The world's leading alternative asset managers such as Brookfield ( BN )( BAM ) and BX are able to take this to an even further level by using their hundreds of billions of dollars in assets under management to invest in some of the world's highest quality office, retail, industrial, energy generation, and infrastructure assets that few can even afford to bid on. As a result, they enjoy the durability that comes from owning the highest quality assets in the world while also often getting to purchase these assets on a value basis.
5. Last, but not least, many high yielding stocks are backed by investment grade balance sheets and enjoy access to public capital markets, which is once again something that individual do-it-yourself rental property investors cannot possibly hope to have access to. In addition to the lower cost of capital that this affords, leading to higher investment returns, it also makes these investments lower risk given that these firms are generally better positioned to weather economic storms than a small, privately run rental property business.

#2. Less Effort

Another reason why high yielding stocks are better investments than rental properties is because they take much less effort. As was already discussed, publicly traded companies have experienced and skilled management teams and an army of employees working for you. As a do-it-yourself investor in rental properties, you are on your own.

As a result, rental property investors will have to choose between either putting in hours of their own labor and take on the stress and mental exhaustion that comes with it to run what amounts to a business or hire a property manager. The first option makes rental properties anything but a passive income generating endeavor and the second option significantly eats into the cash flow potential of the assets.

#3. Better Total Return Potential

Last but not least and hearkening back to Buffett's comments at the beginning of this article, high yield stocks also offer significantly superior total return potential over the long-term. The reasons for this are many:

1. They enjoy a lower cost of capital due to having access to public capital markets and often enjoying an investment grade credit rating. This leads to higher leverage-neutral returns on equity than what an individual investor can typically earn on a rental property investment.
2. They are generally led by more knowledgeable, skilled, and focused managers than an individual part-time investor can hope to be.
3. They often have access to higher quality assets and deals than what is made available to an individual part-time investor.
4. They enjoy economies of scale.
5. They often enjoy competitive advantages that can lead to a superior return on invested capital relative to what a commoditized rental property can generate.
6. High yield stocks often trade at valuations that fluctuate wildly with market sentiment. Given that public markets are often much more volatile than private real estate market valuations, the opportunity to buy high yield stocks at compelling bargains is much more common than it is in the rental property world.
7. It is much easier and cheaper to buy and sell high yield stocks - with their instant liquidity and minimal frictional costs - than it is to transact physical real estate.
8. The current record-high home prices and very high mortgage rates have made housing extremely unaffordable. Moreover, cap rates on quality rental properties are in many cases below the interest rate that you would have to pay for an investment mortgage on the property. As a result, leverage actually has a cash flow negative impact on a rental property investment, confining the total return equation to the cap rate plus appreciation. Given that home prices are so elevated from an affordability standpoint, the outlook for appreciation in many markets is quite weak. As a result, rental property investors are unlikely to generate double-digit annualized total returns at current pricing in most cases. In contrast, there are several high yielding stocks - such as Energy Transfer ( ET ) - that offer current tax-advantaged distribution yields of nearly 10% along with expected 3-5% annualized growth for years to come. As a result, the passive income stream and total return potential are often superior for high yielding stocks relative to rental properties.

Investor Takeaway

Rental properties are a popular passive income investing method and have created immense wealth for many who purchased them during the era of free money and relatively attractive home prices in the early 2010s. However, over the past few years mortgage rates have soared, combining with already record high home prices to compress cap rates and eliminate the previous benefits of leverage on rental property investing.

Meanwhile, high yield stocks are generally quite attractively priced today as they have largely priced in the effects of higher interest rates (whereas rental properties have not). When combining the more attractive valuation and cash flow yields with the many other qualitative advantages discussed in this article, buying high yield stocks over rental properties is a no brainer in our view.

For further details see: