A common question I get asked from readers is: “Is investing in a real estate investment trust (REIT) a suitable alternative to buying rental property?” On the surface, it would appear that the two types of investments are rather comparable.

A REIT is a company that invests in real estate (incoming producing assets), whether it’s directly through rental property (office buildings, apartments, shopping centers, residential houses, etc.), or through mortgages. REITs are securities that sell on the major exchanges just like stocks. You can even think of buying a REIT like buying a real estate index fund — you get to earn a share of income produced by the index of rental properties without actually having to go out and buy the properties yourself.

There are many benefits to buying REITs. Chief among them are:

Liquidity. Like stocks, it is very easy to buy and sell publicly traded REITs. If the price of the REIT you own goes up $2/share tomorrow, you can login to your brokerage account and liquidate your position in an instant.

Passivity. You get to own a real estate investment without having to be a landlord. There are no maintenance and vacancy issues for you to have to worry about.

High yield. REITs typically produce high returns, yielding around 4% and above.

A popular REIT in the income investing world is Realty Income Corp (O). As of market closing on March 28, 2014, O was trading at the following valuation:

REIT Example

Off the top, you can see that the income (dividends) produced by owning shares of O is currently yielding 5.37% annually.

If you had $81,500 to invest:

Realty Income Corp (O)

Share Price: $40.75

Capital to Invest: $81,500

Shares Owned: 2,000

At an annual yield of 5.37%:

Cash Flow (yearly): $4,376.55

Cash Flow (monthly): $364.71

Not bad. $364.71/month in passive income can cover a lot of expenses for most anyone on the journey to early financial independence. The best part would be that the income earned would be more or less 100% passive.

Rental Property Example

Now, let’s suppose you took the same initial capital, and instead used it to purchase a rental property. To keep things simple, let’s use Rental Property #1 as an example. I purchased Rental Property #1 in 2012 for $315,000, and put down a 25% downpayment of $78,750. I forget the exact amount I paid in closing costs, but to keep things equal, let’s just assume I put in $2,750. Total capital invested for Rental Property #1 would then be $81,500, the exact same figure that we used in the REIT example.

Rental Property #1

Capital to Invest: $81,500

2013 Actual Results:

Scheduled Gross Income: $25,240

Less Vacancy and Lease Renewal: $0

Effective Gross Income: $25,240

13-Jan $2,090.00 13-Feb $2,090.00 13-Mar $2,090.00 13-Apr $2,090.00 13-May $2,090.00 13-Jun $2,090.00 13-Jul $2,090.00 13-Aug $2,090.00 13-Sep $2,130.00 13-Oct $2,130.00 13-Nov $2,130.00 13-Dec $2,130.00

Total Operating Expenses: $7,191.58

Net Operating Income: $18,048.42

Less Debt Service: $13,129.32

Cash Flow (yearly): $4,919.10

Cash Flow (Monthly): $409.93/month

Rental Property #1 produced a monthly cash flow of $409.93/month in 2013. The annual yield was 6.04%.

On the Surface

For a rental property in the Bay Area, a 6.04% return is pretty good (especially in today’s environment). At this point you might be wondering, is that very minimal return worth all the extra hassle? After all, you could just have easily invested that same $81,500 capital into purchasing 2000 shares of Realty Income (O) instead. A 5.37% yield isn’t that far removed from 6.04%, so is that extra 0.67% associated with the rental property really worth all the extra headaches associated with landlording?

Rental properties also have the following drawbacks as well:

Very illiquid. To sell a rental property is not trivial. You’ll probably need to hire a real estate agent. You’ll probably need to list the property on the MLS. You’ll need to show open houses, take in bids, and close escrow. At closing, you’ll pay all sorts of taxes, fees, and commissions. If you’re lucky, you’ll be able to sell the property in 30 days… 45 days or more is usually more typical.

Maintenance and vacancy. Rental properties will all have their fair share expenses each year. It’s unavoidable and every landlord knows that’s it’s only a matter of time before something breaks. Further, if you landlord long enough, you’ll come across your fair share of vacancies. People move all the time, and it’s very rare to find a tenant who will stay in place for ten, fifteen, twenty years… Maintenance and vacancy eat into your returns and bottom line. There’s no way to get around this either…

Low passivity. Unlike with REITs, rental properties will never generate true passive income. The best that you can ever hope for is semi-passive income. Even if you outsource the management, you’ll still need to keep tabs of operations on a regular basis.

Barrier to entry. To get started with REI, you typically need to bring 20% to 25% of downpayment funds to the closing table. Even for a “cheap” single family home priced at $100,000, this still requires at least $20,000, in addition to closing costs (taxes, title policy, appraisal, inspection, etc.).

So, is it all worth it? On the surface, I would absolutely say “no”. Also, it’s worth noting that Rental Property #1 was able to go through an entire year without vacancy. Outside of a few maintenance items, the rental also had a minimal number of issues. Over the years, the property will of course degrade some more, and even more money will need to be allocated towards repairs.

A landlord could argue that they’ll be able to raise rents… But a well run REIT like Realty Income (O) will also regularly increase their dividend payouts. So, that negates that argument…

Hmm… So, what’s the catch? Why not just invest in a REIT and be done with it? Why go through all the hoops and hurdles of owning rental property?

Leverage

Unlike with stocks, buying rental property through the use of leverage is a very common practice (even necessary for many investors to get started). You can buy stocks on margin, of course, but the volatility of the stock market may make this type of endeavor more risky for those who do not have the requisite experience (knowledge) required to trade skillfully. In general, the day-to-day fluctuations in property values are far less volatile than that of stocks. It’s easy to unload thousands of shares of a stock in a trading session (near instantaneous stock market crashes have occurred in the past), but try selling one thousand homes all at once… The latter wouldn’t be so easy to liquidate.

During the subprime mortgage crisis in 2008-2009, property values in the Bay Area plunged by more than 50%. However, the rental market hardly experienced any movement, and in many local areas, rents held steady… or even increased slightly. As such, the savvy investor who purchased with ample cash flow margins built in (even after accounting for sufficient maintenance and vacancy reserves) did not experience great peril when the housing market took a nosedive. Similar to the DGI strategy of investing in solid, stable blue chips that continue to pay dividends in times of turmoil, purchasing in the right rental market is critical to long-term success in REI.

Volatility in both purchases prices and rents will ALWAYS vary from location to location. To mitigate risk, run conservative cash flow numbers when performing your analysis, and purchase in strong housing demand locations. If your buy right, you should have a sufficient margin of safety in place to protect your investment in the case of a market downturn.

Leverage is a double-edged sword; if utilized correctly, it can enhance your returns significantly and help you build massive wealth. The use of “other people’s money” is the bridge that connects the four pillars of real estate investing.

First Pillar: Cash-On-Cash Return (Rental Property)

The first pillar of real estate investing is cash flow, which was already covered and calculated above in the Rental Property #1 example.

Cash flow is the most important pillar (for both REITs and rental property), and the one that will ultimately set you financially free. As shown above, with the help of leverage, the Cash-On-Cash Return for Rental Property #1 was calculated to be 6.04%. In a low interest rate environment, the Return On Investment (ROI) will typically be higher when using leverage as opposed to purchasing all cash (Cap Rate).

The Cap Rate for Rental Property #1:

Cap Rate = Net Operating Income/Purchase Price = $18,048.42/($315,000 + $2,750) = 5.68%

For Rental Property #1, the Cash-On-Cash Return of 6.04% is only slightly higher than the Cap Rate of 5.68%.

For a REIT, the Cash-On-Cash Return, or Cap Rate, would simply be the annual yield, or Yield On Cost (YOC). In the REIT example, this comes out to be 5.37%.

Second Pillar: Principal Paydown (Rental Property)

The Total Cash Return Rate (TCRR) of the rental property investment is not limited to just the Cash-On-Cash Return of 6.04%. If you buy right, the rental property will still be cash flow positive even after accounting for: principal, interest, property taxes, insurance (PITI), maintenance, vacancy, etc.

This means that your tenants will be paying down your mortgage and helping you build equity in your home.

Factoring in the principal paydown for Rental Property #1:

Principal Paydown: $4,450.69

Principal Paydown (Monthly): $370.89/month

The Total Cash Return is now:

Total Return: $9,369.79 (4,919.10 + $4,450.69)

Total Return (Monthly): $780.82/month

Principal Interest Dec-13 $377.29 $716.82 Nov-13 $376.11 $718.00 Oct-13 $374.94 $719.17 Sep-13 $373.77 $720.34 Aug-13 $372.61 $721.50 Jul-13 $371.45 $722.66 Jun-13 $370.29 $723.82 May-13 $369.14 $724.97 Apr-13 $367.99 $726.12 Mar-13 $366.84 $727.27 Feb-13 $365.70 $728.41 Jan-13 $364.56 $729.55 2013 Total $4,450.69 $8,678.63

The Total Cash Return Rate (TCRR) is:

Total Cash Return Rate: $9,369.79/$81,500 = 11.50%

In the above example, the REIT returned 5.37% annual yield. The rental property returned 6.04%, but that did not tell the entire story. With principal paydown factored in (this is also something that increases yearly as more of the loan gets paid down), the total return is 11.50%. That’s a difference worth getting excited over…

In the REIT example, unless you borrowed money to buy shares of Realty Income (O), there would be no principal paydown on your investment. TCRR would be equivalent to the annual yield of 5.37%.

Third Pillar: Tax Benefits

Taxes: (REITs)

When it comes time to pay taxes, REITs are either taxed as ordinary income, or as a qualified dividend, which means an investor is subjected to taxation on long-term capital gains.

In the case of Realty Income (O), the dividends are taxed as ordinary income.

Here is the U.S. tax bracket current as of 2014:

Long-Term Capital Gains:

Let’s say that you were single and made $90,000 in taxable income. This would put you in the 28% tax bracket. Your yearly cash flow from Realty Income (O) was $4,376.55 for your $81,500 capital investment. After taxes at 28%, you would get to keep $3,151.12. You would owe $1,225.43 in taxes. Your effective cash flow is reduced from $364.71/month to $262.59/month. The effective yield of your REIT investment is now 3.87%.

Unless you were in the 10% or 15% tax bracket, REITs that pay qualified dividends would still be subject to long-term capital gains taxes (15% to 20%).

Taxes: Depreciation and Deductions (Rental Property)

Unlike with REITs, the taxes you pay on a rental property can be highly variable; they will depend greatly on depreciation and deductions. If utilized, these tax benefits will help you offset, or avoid paying taxes altogether.

The government wants you to own rental property and encourages you to buy more with benefits such as depreciation. It’s sort of counter-intuitive, because as we know, historically, housing prices tend to only move in the upward direction. When it comes to taxes, however, the government is actually telling you the opposite — Because buildings wear down over time, you deserve a tax break on your “depreciating” asset.

With residential properties, depreciation is spread out over 27.5 years. For commercial buildings, depreciation is calculated over 39 years. You cannot depreciate the land, but only the building and its contents. The building and land values can be found on your county assessor’s website.

Disclaimer: I am not a certified tax accountant! The following example is solely provided for illustrative purposes and ONLY applies to my own individual property. As always, consult with a certified professional before making ANY financial (e.g. taxes) decisions affecting your own investments.

Depreciation for Rental Property #1:

Building: $169,000

Annual Depreciation: $6,145.45 ($169,000/27.5)

This is $6,145.45 I get to use each year to offset my gross rental income.

Further, property taxes, insurance, interest payments, repairs, improvements, etc. can also be used to lower your taxes. Items that are “ordinary and necessary” may be deducted.

The following is a list of deductible expenses from TurboTax:

Advertising

Cleaning and maintenance

Commissions

Depreciation

Homeowner association dues and condo fees

Insurance premiums

Interest expense

Local property taxes

Management fees

Pest control

Professional fees

Rental of equipment

Rents you paid to others

Repairs

Supplies

Trash removal fees

Travel expenses

Utilities

Yard maintenance

Deductions for Rental Property #1:

Property Tax: $4,706.82

HOA: $1,680

Insurance: $286.00

Interest Payments: $8,678.63

Garage Door Repair: $180.00

Utilities: $338.76

Gasoline: (91.2 miles *0.565) = $51.53

Deductions Total: $15,921.74

Total (Depreciation + Deductions) = $6,145.45 + $15,921.74 = $22,067.19

Gross Income: $25,240

Taxable Income: $25,240 – $22,067.19 = $3,172.81

Although the rental property generated $25,240 in gross income, after all deductions and depreciation, only $3,172.81 would be subjected to taxes. At the 28% tax bracket, this comes out to be $888.39 in taxes. In the REIT example, we would have to pay $1,225.43 in taxes. A slight improvement…

For this particular property, the depreciation allowed is not very good (the land value is ~1/2 of the the total value). In many parts of the country, the building value is much higher than 1/2 of the total property value. The depreciation I get from my out of state properties is much better than what I get for my local Bay Area properties… The higher the building value allocation is to the total property value, the more you will be able to claim back in depreciation each year.

Further, if you spent money on capital improvements, you would be able to depreciate these expenses over a few (or many — 27.5) years. This includes improvements such as: flooring, roof, furnace, water heater, refrigerator, stove, etc. Please consult with a certified tax professional to learn more about the depreciation schedule available for the different types of capital improvements.

So, not only would you get to increase the resell value of your property, you would also get a tax break back from Uncle Sam for your “troubles”.

In a best-case scenario, each year, you would be able to completely offset your gross annual rental income and not owe any taxes (not always possible, but try your best on each rental you own), or claim a loss. I wasn’t able to do quite so well with Rental Property #1, but you get the idea… Owning rental property gives an investor many ways to claim tax breaks.

Keep in mind, there are restrictions based on your Modified Adjusted Gross Income (MAGI). From Bankrate:

Taxpayers whose modified adjusted gross income, or MAGI, is less than $100,000 can claim up to $25,000 in rental losses. The $25,000 cap is reduced $1 for every $2 a taxpayer’s MAGI exceeds $100,000. For example, a MAGI of $110,000 exceeds $100,000 by $10,000 so the $25,000 limit is reduced to $20,000. At $150,000, the reduction to the cap is the full $25,000, which is your situation. Any losses you can’t claim are carried over to future years and allowed as a deduction against passive income, including gain on the sale of the property. If your income were to go below the thresholds, then you would also be able to claim the losses, including those carried over.

If you earn high income, this is another good reason to use tax shelters like 401k; you want to reduce your taxable annual income as much as possible.

Fourth Pillar: Appreciation (Rental Property)

The last pillar is appreciation. If no one told you before, it’s true, the bank is really your best friend and partner in any real estate purchase. Not only will your lender fork over the majority of funds needed to purchase (70% or more), they’ll also let you capture all the profits without asking for a cut in return. Upon sale, all you will need to pay them back is the outstanding loan balance.

I purchased Rental Property #1 for $315,000. My downpayment was $78,750, or 25% of the total purchase price. After factoring in closing costs, the total capital I invested was $81,500. The bank loaned me $236,250. As of March 31, 2014, Zillow’s Zestimate for Rental Property #1 is $486,472.

If I were to sell today:

Sales Price: $486,472

Loan Balance: $227,866.92

Delta: $258,605.08

Less Taxes, Fees, and Agent Commissions (10%):$232,744.57

Profit: $232,744.57 – $81,500 = $151,244.57

Return On Investment (ROI): $151,244.57/$81,500 = 186%

This example lies on one extreme end of the spectrum. Although this type of return isn’t always possible in every market location or environment, it shows the tremendous appreciation potential that can be realized through the use of leverage. Also, the enhanced volatility in housing prices created by fear and greed (residential buying and selling is especially emotional for people) can provide much more opportune buying windows for patient investors. Unlike with stocks, the persistent real estate investor can secure deals at below market prices (distressed sales, courthouse auctions, etc.) and win properties that the rest of the public does not even know about. If you want to maximize your appreciation gains, buy as many properties as you can in a volatile housing market (with leverage) when times are bad. You can make money in real estate in any direction, but most of it is made when you buy low and sell high on the way back up; the same holds true for stocks, but with stocks, you can never purchase below market price.

With the REIT example, again, unless you borrowed money to buy more shares, your appreciation gains would be limited to the gains only made possible by your “100% downpayment” of $81,500. In order to achieve the same 186% ROI using just your own money, each of the 2000 shares of Realty Income (O) purchased at $40.75/share would need to appreciate to $116.37/share.

Gravy Pillar: 1031 Exchange (Rental Property)

The appreciation gain calculated above is a hefty sized return for a minimal initial downpayment investment! And if you want to eat your cake and have another one, you can perform a 1031 exchange and tax shelter your profits. With stocks, upon selling, you will always be subjected to paying taxes on capital gains, whether it be short-term, or long-term. There’s no avoiding the tax man with stocks!

With investment property, a 1031 exchange basically allows an investor a way to defer paying back taxes and depreciation until a later (unspecified) date in the future.

From 1031.org:

In a typical transaction, the property owner is taxed on any gain realized from the sale. However, through a Section 1031 Exchange, the tax on the gain is deferred until some future date.

Section 1031 of the Internal Revenue Code provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment. A tax-deferred exchange is a method by which a property owner trades one or more relinquished properties for one or more replacement properties of “like-kind”, while deferring the payment of federal income taxes and some state taxes on the transaction. The theory behind Section 1031 is that when a property owner has reinvested the sale proceeds into another property, the economic gain has not been realized in a way that generates funds to pay any tax. In other words, the taxpayer’s investment is still the same, only the form has changed (e.g. vacant land exchanged for apartment building). Therefore, it would be unfair to force the taxpayer to pay tax on a “paper” gain. The like-kind exchange under Section 1031 is tax-deferred, not tax-free. When the replacement property is ultimately sold (not as part of another exchange), the original deferred gain, plus any additional gain realized since the purchase of the replacement property, is subject to tax. A Section 1031 exchange is one of the few techniques available to postpone or potentially eliminate taxes due on the sale of qualifying properties. By deferring the tax, you have more money available to invest in another property. In effect, you receive an interest free loan from the federal government, in the amount you would have paid in taxes. Any gain from depreciation recapture is postponed. You can acquire and dispose of properties to reallocate your investment portfolio without paying tax on any gain.

1031 exchanges are a powerful tool that can be used to help a real estate investor grow. Just like in the game of Monopoly, it is a very common practice to trade up houses for something more grand (hotels, apartments, office buildings, etc.). The best part is that you can exercise and use a 1031 exchange over and over again and defer the tax repayments until the end of time… well, almost.

1031 exchanges only work for physical, tangible properties. There is no equivalent to a 1031 exchange for REITs.

*Risk Considerations

Even more important than the potential returns available for each type of investment are the risks that are involved. When deciding between REITs and rental property, you need to carefully assess your own risk tolerance.

REITs Risks:

Market Risk: The risk of your share price declining.

Interest Rate Risk: The risk of rising interest rates impairing the REIT’s profit margins. REITs tend to be very leveraged so any rise in their borrowing costs tends to hit their valuations hard. This risk slammed the entire REIT sector badly a few months ago during all the Fed taper talk.

Rental Property Risks:

Legal Risk: As the owner of physical property you are exposed to liability if a tenant or third party gets hurt on your property. This will require you to buy additional insurance for protection (increase coverage on primary insurance, or add on an Umbrella policy), thereby increasing your costs.

Property Manager Risk: If you own turnkey properties you are relying on the property manager to perform their job to your standards. Your PM might quit, sell the business to a less capable PM, or just decide that finding tenants and maintaining your property isn’t high on their list of priorities because they’re more focused on pursuing new clients over servicing old ones.

Major Repair Risks: You might find yourself paying far more in maintenance and repairs than you reserved for. One bad winter and your could find yourself spending thousands to replace ruptured water pipes. One bad storm and you could find your property flooded with thousands in water damage and a vacancy that lasts for months. A broken furnace, a leaky roof, anything like this could eat up an entire year’s worth of earnings in a short time period.

Summary

There are many reasons to invest in REITs; they are a convenient, and most passive way of letting an investor gain access to the real estate sector. However, comparing REITs to rental properties is like comparing apples to oranges. The two investments are vastly different, and just simply comparing a REIT’s yield to the Cash-On-Cash Return of a rental property is not sufficient.

Real estate investing through rental properties appeals to investors primarily because of the four pillars: cash flow, principal paydown, tax benefits, and appreciation; all of which are enhanced through the use of other people’s money (leverage).

If you really want to take advantage of all the benefits that rental property has to offer, you should always look for properties that help maximize each of the four pillars. Only then will you be able to realize the true potential of your ROI. The icing on the gravy is the 1031 exchange, which will let you upgrade properties without having to face any upfront tax consequences. If you can keep scaling up, it will really feel like you’re playing real life Monopoly. 😉

*Thanks to reader Joe Carnation for writing and contributing to the Risk Considerations section.