Skip Real Estate, Buy REITs Instead

Co-produced with PendragonY.

As you work hard to build up your assets, there is no shortage of people offering you “opportunities” to invest. Owning real estate and renting it out is one asset class that has lots of proponents touting it. Weekly radio shows, magazine articles, and books all talk about how easy it is to generate an impressive income stream by investing in various rental properties. You’ve heard the ads for “workshops” on how you can become independently wealthy through real estate. While “get rich quick” is too on the nose to be an effective advertising line, there is no shortage of people who will essentially tell you that you will get rich with real estate.

We often romanticize careers where we only see the results. People dream of being a Hollywood star, an astronaut, a sports star, a doctor, President, or a landlord. Yet those dreams tend to focus on the perceived benefits – wealth, fame, and the cool factor. We rarely think about the hard work that goes into reaching lofty dreams.

My own experience (and in particular that of my wife) says that direct ownership of real estate is not only not as easy as many claim, nor is it a “safe” investment. Being a landlord of any meaningful scale is not a passive activity. It’s a full-time job, or two… or three. Yes, you can make a lot of money being a landlord, but it is a career. It takes a lot of time and work.

REITs (Real Estate Investment Trusts) offer a way to invest in real estate and rental properties while offloading many of the problems that can arise from directly owning real estate. The returns on REITs are often not as impressive as those from directly owning real estate. I think the reduction in risks, the increase in safety, and just the more passive activity of REIT investing is more appropriate for investors who aren’t looking for a second career.

When compared to the numerous groups that will promise to do the work for you and are fundraising with their “exclusive” opportunities, publicly traded REITs have strong competitive advantages, are more easily accessible, and have greater liquidity.

The Risks of Direct Real Estate Ownership

Scale is one area where REITs will beat most other real estate investment options. Few investors will have millions of dollars to buy properties, while even small REITs easily have $100 million or more. Larger REITs typically have billions in properties.

This scale allows REITs to grab the best properties in the best locations. With access to cheaper debt and easy access to equity, REITs are able to profit from smaller spreads and gain more profit than smaller competitors.

This scale also means that the REIT can hire dedicated managers for its properties. An individual investor will manage them on their own, hire a management company (where they will be one of many clients), or even hire a part-time manager. My wife supplements her income as a Realtor by managing a few strip malls for clients.

Trash is something that a REIT investor never has to worry about. But if you are the owner of real estate that is being used, then it will generate trash which has to be collected and removed from the property. Even when the tenants are responsible for this, as the owner, the ultimate responsibility is yours. So your time and sometimes quite a bit of hassle will be required to make sure that trash is being handled. For instance, in the strip malls my wife manages, she has to monitor that tenants are using the dumpsters provided and that the dumpsters have enough space (and are being emptied often enough). On several occasions, she has had to get dumpsters replaced when they got damaged or just worn out.

Tenants are another factor that REIT investors never have to deal with. But individual investors will have to deal with tenants even if they just hire someone to do all that work. It is a fact that not all tenants are good tenants. Some will be late on rent. Some might even stop paying rent at all. And all tenants will eventually need to have something fixed. This will require your money and often your time. Scale steps in as a major benefit again. In a portfolio of 5 properties, a vacancy in one is a huge deal capable of completely destroying any hope of positive returns. That’s something that could easily happen just through bad luck, even in a great economy. In a portfolio of 100+ properties, you can expect 3-8% to be vacant at any given time, depending on the property type and conditions. Vacancies will reflect averages, not just luck.

Rent collection is also less of a concern for REIT investors. While they will need to monitor the rent collected, they have no involvement in actually collecting the rent. An individual investor will need to make arrangements to collect the rent. This is actually one of the more time-consuming tasks my wife has. She often has to go to the property several times a month to collect the rent. Beyond that, she has had to go to court (at least once a year) to collect rent from tenants that are way behind on their rent or to get them evicted.

And we shouldn’t forget issues like snow removal, plumbing issues, electrical problems, and storm damage. Owning and managing rental properties is not really passive investing.

So, now that we have looked at some of the issues that make direct real estate holding less desirable than what its proponents claim, how can we get the benefits of real estate while avoiding these pitfalls? Let’s take a look at a couple of examples.

Cohen & Steers Quality Income Realty Fund (RQI) – Yield 7.1%

In passive investing, the idea is to do the least amount of work possible. When choosing a REIT, one has many options that focus on various sectors. That requires the investor to monitor which sectors are doing well and can be expected to do well in the future.

Diversification is an important tactic to add to the safety of the income flow. Or the investor can buy a closed-end fund, or CEF, and have professionals figure out the mix of REITs to own. On top of that, CEFs get leverage at a lower cost than most retail investors can get, along with professional management of that leverage.

Cohen & Steers is one of our favorite managers of CEFs (Closed-End Funds), and it has a very good offering in the REIT space with RQI. RQI provides leveraged exposure to the highest quality REITs: Source.

Most of these REITs use “triple net” leases. This means the tenants of the REIT are liable for most property-level expenses. Given the recent run of high inflation, that means the tenants had to cover most of the increases in costs due to inflation while the REIT got larger rents. Inflation will continue to drive rents higher as leases renew.

Distributions have been fully covered between income and gains. And not only has the distribution been fully covered in 2022, but RQI had to issue a special distribution because it hadn’t met the minimum required distribution with its 8 cents monthly payout. That works out to be a generous 7% yield.

Ares Commercial Real Estate Corporation (ACRE) – Yield 12.2%

One way to invest in real estate is to own it directly and rent it out. Another option is to be a lender and own mortgages. ACRE is a REIT that provides mortgages for commercial properties. Instead of collecting rent, ACRE profits from interest payments on the loan, with the option to foreclose on the property if the borrower defaults.

The best part is 98% of their loans are floating-rate loans. Common sense would say that in a time when interest rates are increasing, the income from floating-rate loans would increase. And so should the share price of companies that made their money from holding floating-rate loans.

Yet the share price of ACRE over the last year has been down about 16%, even though their income is up. Combined with hedges on their debt costs that don’t expire till late 2023, the interest rates for the last year have increased income and should continue to do so until rates stabilize later this year. Source.

At 33 cents a share each quarter + 2 cents supplemental for the last 8 quarters, this works out to be a yield of 11.8%. That is a very generous income stream for a passive income. With earnings rising, there is a strong possibility of a dividend hike this year.

ACRE reports earnings Wednesday morning, Feb. 15th.

Conclusion

There are a thousand ways to make money on real estate and a million ways to lose money on real estate. If you are looking for a career, I wish you the best. Be particularly cautious of groups that are trying to raise capital from investors. There are investments like those that can work out, but they are frequently higher risk than you might expect.

Publicly traded REITs provide an avenue for retail investors to benefit from real estate. They have scale, expertise, and access to capital. All provide a competitive advantage over most non-public investment options.

For the investor, the liquidity of publicly traded companies makes for a more flexible investment option. In contrast, direct ownership of real estate can take many months or even years to exit. And non-public investment groups typically limit your ability to withdraw your capital. Even large non-traded REITs like Blackstone’s BREIT can and will suspend withdrawal requests.

RQI is a great option to gain broad exposure to publicly traded equity REITs. ACRE is an option for investing in commercial mortgages and we expect will see earnings rising quickly in this interest rate environment.

The Income Method aims to provide a growing stream of income so that you can enjoy your retirement doing what you love to do. Maybe you want to sip iced tea while watching the sunset from your porch, take some dancing lessons so that you can dance better in the rain, enjoy a cruise, or travel the country in an RV. This means you need investments that you don’t need to maintain daily.