AMT - Why I Ceased Buying Rental Properties To Buy REITs Instead

2023-06-25 09:00:00 ET

Summary

• I come from a private equity background and used to buy rental properties.
• But today, I mostly buy REITs.
• I explain why in three reasons.

Real estate has historically been one of the most rewarding investments of all time. The rental income combined with the steady long-term appreciation, the leverage, and tax benefits have compounded into exceptional returns relative to stocks ( SPY ) and bonds ( BND ):

Therefore, most investors understand that they should include a real estate allocation in their portfolio, even if it is just for the sake of diversification and inflation protection.

But a more complicated question is how should you invest in real estate?

There are many options but two of the most popular ones for individual investors are:

• Buying a rental property
• Investing in public REITs ( VNQ )

I myself started my real estate investing journey by buying rental properties, but later, as I learned more about REITs, I sold what I had and shifted my real estate allocation to REITs.

Here are three reasons why I favor REITs over rentals:

Reason #1: Higher Returns When Adjusted for the Value of Your Time

Most rental property investors are convinced that they are able to earn higher total returns than REITs over long stretches of time.

But research studies on this topic claim the opposite: REITs earn 2-4% higher total returns annually on average:

There are many REITs that have managed to generate ~15% average annual total returns. Examples include Realty Income ( O ), American Tower ( AMT ), and Public Storage ( PSA ).

This is because:

• They enjoy significant economies of scale
• Have better access to capital
• Hold more bargaining power with their tenants
• Are able to skip brokers
• Can develop their own properties to earn higher returns
• May earn additional profits from other businesses
• Enjoy the best talent
• Can close off-market transactions
• Etc.

These are all important factors to consider.

But I think that it misses an even more important element: rental property investors are simply miscalculating returns by ignoring the value of their own time/work.

How many times have you seen a real estate investor claim that he or she can earn 25%+ annual returns by buying rental properties?

In reality, returns are nowhere close to that in most cases. Warren Buffett became the richest investor on earth by compounding returns at Berkshire Hathaway ( BRK.B ) at 20% per year, so I can guarantee you that rental property investors are not just casually earning 25%+ per year.

The important cost that rental investors are missing in their calculation is the value of their own time/work.

Take a step back here and try to calculate how many hours you would need to:

• Research the market
• Meet with brokers
• Find the right deal
• Negotiate it
• Close on it
• Finance it
• Renovate it
• Market it
• Manage it
• Do more repairs
• Fill up vacancies
• Etc.

Just looking for the right deal could easily take you 50 hours for each property and that's not even the most time-consuming part of the job.

All of this work has value because you could just as well work another job or side hustle to earn a return on your time.

If you assumed that your time is worth $40 per hour and that you spend 5 hours per week on your property (average over a full year including the purchase phase), then you would need to deduct $200 per week or $800 per month from your returns.

If your monthly net operating income is $1,000, you have essentially bought yourself a second job. Even if you used a lot more aggressive assumptions, a big chunk of your returns would still be lost in management costs, and when adjusted for that, your returns drop lower than those of REITs.

The higher the value of your time, the less sense it makes for you to buy rental properties. Example: if you are a doctor or lawyer and the value of your time is $200 per hour, please don't waste your time on rental properties!

You could of course hire a property manager to help you, but even then, you would still need to spend a lot of time finding the property and then managing your manager - in addition to giving him/her a big cut of the revenue.

Reason #2: Lower Risk For Long-Term Oriented Investors Who Can Ignore The Market Noise

Rental property investors also commonly think that private properties are safer than REITs.

They believe so because they are not seeing a daily quote and it gives them a sense of safety and stability.

But here's the truth:

Rental properties are illiquid, private, highly concentrated, heavily leveraged, work-intensive, liability-heavy, tenant-facing investments with a social component.

REITs, on the other hand, are liquid, public, diversified, conservatively leveraged, management-free investments that also enjoy limited liability.

The risk profile is day and night.

Rentals are far riskier than REITs.

Just because you get to ignore market volatility does not mean that your property is safer. In fact, if you put your property for sale and collected offers on a daily basis, you would understand that the equity value of a rental property is extremely volatile.

What's traded on the stock market is the equity value and rental property investors will commonly finance properties with an 80% LTV. This means that a 5% drop in the property value would wipe out 25% of your equity.

If you collected offers on a daily basis, you would get offers that are 5-10% lower/higher all the time, resulting in huge 25-50% volatility. Also, a small hiccup like a tenant moving out or a leaking roof would massively influence the value of your equity as well.

Comparatively, REITs are very stable.

Again, just ignoring information does not make rentals any safer.

The ultimate proof is that there are countless rental property investors who file for bankruptcy protection each year, but very few REITs have ever filed for bankruptcy.

Reason #3: Passive Returns and Total Freedom

Many investors talk about "risk-adjusted returns", but I took this concept a step further and coined the term "risk-and-hassle-adjusted returns"

Rentals will hurt your lifestyle, your career, your personal life, and potentially even your health. You won't enjoy the same geographic flexibility. You will have personal plans interrupted by random issues with your tenant or property. And all the stress could lead to sleepless nights and hurt your health.

This last point may seem like a stretch to some of you, but let me put you in a situation that a friend of mine experienced. His tenant had stopped paying the rent, was aggressive towards him, making regular threads, and he wasn't able to repossess the property for many months. In the meantime, the tenant was also abusing the property and causing problems with neighbors. My friend had put a large chunk of his net worth into this property and had to work extra hours to afford his mortgage payments and the lawyer fees because the tenant had also sued him to take full advantage of the pro-tenant regulations.

Would such a situation stress you out?

It literally ruined his life for a year. He was stressed out at all times and I am sure it affected his health, personal life, and overall sense of freedom and happiness.

No investment is worth such a big risk.

REITs shield you from all operational issues so you can enjoy total freedom. This freedom will ultimately result in a better lifestyle and more happiness. But it could also lead to greater wealth if it allows you to more rapidly progress through your career because you aren't stressed out, have more time, and have greater geographic flexibility as opportunities come along. People tend to forget that their careers will have the biggest impact on their wealth generation journey and REITs help you optimize your career. Rental property investors will hurt it.

Bottom Line: REITs Offer Much Better Risk-And-Hassle-Adjusted Returns

REITs are more rewarding when adjusted for the value of your time.

They are also a lot safer investments in most cases.

And finally, they give you total freedom, allowing you to optimize your lifestyle, career, and happiness.

Sure there are exceptions when buying a rental property may make sense, but in 99% of cases, I find that REITs offer better risk-and-hassle-adjusted returns, and this is especially true today because REIT valuations are the lowest they have been in years.

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