Owning a Rental Property vs Purchasing REIT
In order to purchase a rental home, we will assume that our hypothetical saver needs to finance at least a portion of that property through a mortgage, but will make aggressive payments on that mortgage to ensure that it is paid off on a reasonable timeline. We can start by assuming that our borrower purchases a $400,000 home which they will rent out for the cost of their mortgage, taxes, and a small buffer for repairs as needed. The end result is that the saver takes in $2,100/month in rent, and has $100/month set aside for emergency repairs. From there, approximately $900 of this amount goes towards building equity in the home, while $1,000 will be interest paid on the mortgage (at least for the first half of the term).
Over the course of the mortgage, the saver will then wind up earning a rough average of 4.6% returns per year on the rental income of the property, after the debt is taken into consideration. However, if we look at the returns as being self-fulfilling on a cash flow basis, we can use a base investment amount of the down-payment on the property ($100,000) as being the only real cash flow, and recalculate the returns to be 10-25%/year. This is certainly a remarkable return for a saver to consider, which is why people are happy to take on the hassle of managing a rental property (with repairs and so forth). However, let’s take a look to see how it is that a similar situation would work out for a saver that is buying into a REIT investment.
If a saver were to borrow funds secured against shares in a REIT investment, the bank would likely only allow them to use the stocks at 50% collateral value, meaning that right away our hypothetical investor is only able to have $200,000 in assets as a part of this portfolio, whereas the home owner is building up a property worth $500,000. This means that our investor will invest $100,000 into REIT shares, and then borrow another $100,000 to purchase the remaining amount.
From there, they will not need to worry about repair or maintenance costs associated with keeping their property intact, and they won’t have any headache to deal with in terms of handling a tenant. The end result in evaluating these two opportunities is then that the rental property will earn a slightly larger total return than the REIT position, but will earn a smaller return on asset than the REIT because of the way in which the owned property is much more highly levered.
So what’s the final outcome of owning a rental property versus buying shares in a REIT using leverage? It essentially comes down to an investor’s willingness to take on leverage, and the intangible benefits associated with owning a rental property. On the one hand, having a rental property allows an investor to have access to the physical asset itself. However, a REIT will provide an investor with access to diversification, in both the properties owned, as well as by allowing them to have multiple tenants at once, whereas the single physical residence will be exposed to the single renter. Lastly, the REIT asset is liquid, in that it can be sold on the stock market without any expensive real-estate agent fees, while the rental property must be sold through the arduous process of listing a residential unit.
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