REITs vs. Private Real Estate Investing

Many Money Vikings know I have years of experience in real estate investing. From a young age I developed a fondness for design and real estate. Perhaps it was playing with Legos or designing castles as part of a Dungeon’s and Dragons session as a kid. Building castles and designing dungeons was just so much fun. Later in life I chose real estate as a career field and have highly enjoyed the various projects and teams I’m honored to be a part of. From Nuclear Power Plants to housing construction and everything in between, I have worked on many different kinds of real estate projects. You start to realize that many aspects of human existence come down to real estate and our built environments. Everything from food production to water rights can be addressed through real estate. Some say that McDonald’s corporation is more involved in the real estate business vs. the hamburger business. I have even read that most millionaires are created through some form of real estate investing.

Pandemic & Real Estate

The pandemic clearly and fundamentally changed our relationship with real estate. For many of us the where we work, where we live, where and how we shop has perhaps been altered forever. Not in a bad way, I do not think the office or mall is “dead”, but our relationship to these places has changed.

Real Estate Investing, How and What?

So if someone is interested in real estate, the question for the individual investor is what and how? By what, I mean what kind of real estate investing is most suited to an individual? And then the question is how to execute the investment? This is one of the dozens of things I like about real estate investing, there are so many ways. And a major thing about real estate is that humans always need it in some form and it is hard to increase the supply. When something is needed (demanded) and the supply is hard to come by, then we have classic economics of supply and demand at play. Additionally, real estate is configurable and changeable. The location cannot change, but the use can change to almost anything humans can imagine.

REIT’s vs. Private Real Estate Investing

The main areas of real estate investing that I have expertise in are acquisition of shares in publicly traded Real Estate Investment Trusts (REITs), investments in single family homes and investing in crowdfunding ventures such as Fundrise. I enjoy them all very much, but there are advantages and disadvantages. For this analysis, I am focusing on REIT’s vs. private “hands on” real estate investing in single family homes. SEE RELATED: Real Estate, Your Home

REIT, What is it?

A REIT is a company that owns and in many cases operates income producing real estate. An investor can buy shares of these companies. In other words, a REIT is a pool of properties and mortgages bundled together. The company offers shares of these combined assets in the form of a security or stock that an individual can buy into. There are all kinds of REITs that specialize in different types of real estate including office/commercial, apartment buildings/housing, hospitals, shopping centers, hotels, etc. REITs were invented as a real estate vehicle under a Public Law signed by President Eisenhower. REITs give all investors access to large scale real estate development investing.

IRS Rule on Income

One really neat feature of REITs is that IRS rules require the company to pay out 90% of their income back to share unit holders. This is typically in the form of a dividend. Dividend income is one of several strategies Money Vikings are harnessing to reach FI, so this makes REITs an ideal investment vehicle.

Advantages

a. diversification within real estate. With hands on private real estate you may get stuck on one kind of property. residential, duplex, apartments, retail, etc. It is very hard and capital intensive to diversify this way. With REIT investing you can easily gain exposure to Amazon warehouses, Walmarts, Commercial, speciality properties such as medical, entertainment properties, cell site towers, etc. Some REIT funds will do it all on one investment vehicle, for example Vanguard Real Estate ETF (VNQ). Check out the top ten holdings that give an investor great diversification and exposure to real estate: American Tower Corp., Prologis Inc., Crown Castle International Corp., Equinix Inc., Public Storage, Digital Realty Trust Inc., Simon Property Group Inc., SBA Communications Corp. You will only achieve this kind of exposure through REIT vehicles, making it a far superior way to invest in real estate. b. Hands off.  REIT’s are quite simply hands off compared to private real estate investing. When you are investing directly in real estate you are managing contractors, choosing finishes and colors, managing budgets and schedules, negotiating and executing lease agreements, collecting income and doing general property management. None of this is required with REIT’s. Simply purchase shares through your brokerage, sit back and collect dividends. Pretty easy! c. Instant income. REIT’s can provide almost instant income to the owner of the shares. With a REIT such as Realty Income “O”, the owner of the shares receives a dividend every single month, much like owning a physical piece of RE and collecting the rental income. I am huge REIT fan for many reasons. First of all, real estate will always be a demand of humans, we will always utilize real estate in some way to survive and make life better. Second, it has built in scarcity. Third, it can be configured and modified for different uses and requirements. And REIT investing is very straightforward, the IRS rules are clear, income must be sent back to shareholders in the form of dividends. REIT’s can appreciate in value and return health dividends for very long periods.

Disadvantages of REIT’s

a. less equity stake and inability to use equity as a tool. A REIT does not offer the owner a direct connection to the equity built in the property. Equity is basically the fair market value of the property vs. what is left on the mortgage. So if you own a $500,000 property, and owe $200,000 on the mortgage, then you have $300,000 in equity. An owner can do things with this equity. It becomes part of your net worth, where if you wanted to sell the property you could take that money out in cash and use it in other ways. You could open a line of credit and borrow against your equity and use funds that way as well. With a REIT, the owner of the shares does not have access to the equity in the property. c. less tax advantaged, there are tax advantages of owning private real estate which we will go into further detail below. An owner if a REIT cannot deduct property management expenses or improvements to the property such as a private holder can. SEE RELATED: REITS, O, STOR, MPW, etc.

Private Real Estate Investing

There are many great reasons to consider real estate investing as a way to build wealth.  So having worked in the field for many years, I have learned a lot about the advantages of real estate.  And keep in mind that Warren Buffet said his home was the best investment he ever made, that is saying a lot!  he also said if he could find a way to efficiently acquire thousands of single family homes and rent them out, he would. For Warren’s personal home, he was thinking beyond he financial considerations and meant more for the wonderful family memories, but also because there is something awesome about real estate investing.  He also paid about $30k for a house probably worth $2 million now.

Advantages Of Private “Hands On” Real Estate Investing:

a. You Can Make A Profit Without Selling The Investment

The underlying investment retains it’s value while you collect monthly cashflow. Net operating income is the name of the game. In other words, how much you make above and beyond all monthly expenses. And make no mistake, there are many monthly expenses such as mortgage and interest, taxes, maintenance, landscaping, etc. The rule of thumb for real estate is that 50% of profits are eaten up by maintenance over the years.

b. It’s A Tangible Asset That One Can Add Value To Through “Sweat Equity” And Improvements

You have way more control over the destiny of the property vs. the inner workings of a company you own stock in. An investor has no control over a stock or bond investment. With a piece of property never underestimate the power of a paint job and cleaned up landscaping.

c. Tax Advantages Of Depreciation Over Time

The tax laws understand that a piece of property basically falls apart over time and needs consistent up keep. You get to take a depreciation expense each year against the rental income. Remember you can only depreciate the cost of the building or structure and this must be separated from the value of the land. Rental property tax laws can be complicated, so it is always recommended to see a tax professional. Simplified example of how to take the depreciation tax break:
  1. Purchase price – Land Value = Building Value.
  2. Building Value / 27.5 years = Annual allowable depreciation deduction.
For our example a single family home, we’ll assume that the value of the half-acre on which it sits is $60,000. Now let’s look at our calculation:
  1. $400,000 – $60,000 = $340,000 Building Value.
  2. $340,000 / 27.5 years = $12,363 per year in depreciation.
This already reduces our taxable income.

d. Rents Rise

The amount one can charge each month tends to rise in desirable markets. This increases the cash flow over time. That is why they say location is so important. An investor will want to find markets where there is strong employment, safety, proper governance, desirable amenities, etc.

e. Expenses Are Tax Deductible

You can deduct the costs of repairs, maintenance and materials. So if you make a profit in cash flow, but need to make repairs or put on a new roof, then all those costs can reduce your tax liability. You will want to find a good tax professional to guide you through all the advantages and ensure you obtain the best reductions in your tax burden. The government rewards this kind of activity because providing structures/housing and managing property is social good that adds value to a society and economy. Remember that rental property expenses – including mortgage insurance, property taxes, repair and maintenance expenses, home office costs, insurance, professional services etc. can be deducted in the year you spend the money.

f. Rising Value

As the loan is being paid down, generally speaking the value of the property goes up. This increases your net worth.

g. Inflation Hedge

Real Estate investments are generally considered a hedge against inflation.  As the price of everything goes up over time, an investors fixed rate mortgage payment stays exactly the same as day one 10, 15, 30 years prior. In other words, your monthly mortgage stays fixed even as rents rise all around us.

Conclusion

In my opinion, I really can’t go wrong with both the high quality REIT investments and private real estate. Private real estate investing has many many more real world complications. A person will regularly need to manage property, people, contracts and address problems. Some people enjoy this. But you should know yourself and what you can handle prior to.It takes time to make money. I do not believe real estate is a get rich quick thing, I think it is a good long term investment if you focus on improving the subject property and cash flow.  It is also important to be in tune with your local market and the sub-market within.  I have always chosen to invest near my home in a neighborhood I am familiar with. One should have a sense of the economy, the demographics, the schools, the development, the access to jobs and infrastructure, the culture etc.  I believe all these things factor into the property quality.  There is also the ability of the investor to keep an eye on the property for increased property management advantages.  It is a physical thing that needs care and feeding to thrive. Keep in mind you are providing a very important “product” and service to people, a place to live.  I take pride in providing a clean, well maintained and high quality product to my tenants.  A place where people can rest, eat, learn and spend quality time with loved ones. There are more ways to gain exposure to this sector now than ever.  You do not necessarily need to become a landlord and handyman.  There are hundreds of Real Estate Investment Trusts and other vehicles to gain a share in the real estate world, although these may not have all the advantages described above. I will talk a lot about real estate in future posts and crunch some sample numbers.  In the meantime, what have been your experiences with real estate, the good, the bad and the ugly?

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