July 12, 2009

Is owning a Rental or buying a REIT more profitable?

A little bit ago Frank at Bad Money Advice discussed Owning Rental Property or Owning REITs. It was an interesting article. I agree with Frank that for most people buying a REIT is a better choice. Few people are really cut out to be landlords and owning a rental is essentially like starting up a side business or taking on a part time job. But when evaluating the two you really need to compare the investment returns. So I figured I would do that.

Lets look at an example of how both invests would have performed over the past 10 years.

Buying a REIT:

Vanguard REIT Index Fund (VGSIX) would be a good choice to invest in REITs since its a diversified index with low expenses. From June 1999 to June 2009 the fund has paid out $9.15 in dividends per share. Thats a pretty good return. The value of the shares hasn't fared as well in the pas t10 years though. In June-July of 1999 the fund sold for over $11 a share and today its trading at $9.50. Overall if you bought the REIT in July 1999 accumulated all the dividends and then sold today you'd be up $7.65. That equates to about 5.4% annualized return in 10 years.

Buying a rental:
Case Shiller home price index has data on the history of home prices. The composite-10 index went from 92 in April 1999 to 150 in April 2009. Thats a 5% appreciation rate in the property values across the composite index. And thats after the drop in real estate, the index peaked in summer of 2006 around 226. Plus you would get rent from the property. Current capitalization rates for rentals is around 5-6%. Lets say you bought a property in 1999 for $100,000. You'd get rental income profits of say $5,000 a year which would add up to $50,000 over the 10 years. Then in 2009 you could sell the property for $150,000. Thats a total of $50,000 in equity appreciation and $50,000 rental profit for $100,000 increase in the investment. Your money doubled in 10 years which equates to a 7.2% annualized return.

So comparing broad average performance between real estate and REIT industry the direct ownership of a rental comes out a bit ahead in average annualized gains in the past 10 years.

Of course as with any kind of investment the historical returns are no guarantee of future returns. Nobody has a crystal ball to see what real estate will do in the future and how REIT yields will compare to rental profits. But the previous returns are about the best indicator we've got to look at to compare the returns of the two. I'd also like to look at a longer period than 10 years but its hard to find solid data for longer time frames. The Case-Shiller index doesn't go back too far and most REITS haven't been around a long time.

I'm purposefully not looking at tax implications for owning rentals versus REITs since thats an entire topic in itself. Briefly though: REIT dividends are taxed as income and equity growth is taxed at capital gains rate. Rental profits are taxed as income and equity growth is taxed at capital gains rate. Owning rentals does get a big fat deduction due to depreciation. So the tax situation for rental ownership should be better overall than buying a REIT.

Location, location, location.

These examples are basically national averages. A REIT index is the reflection of a wide variety of REITs and the composite price index is a national composite of house prices across the country. But the real estate in your local market is probably not going to act the same as a national average. Location is very important for real estate. Certain areas are going to have better real estate markets and other areas will have worse markets. IN the same 10 year period from 1999 to 2009 real estate values in Detroit dropped 3% annually. Likewise if you bought the wrong REIT it could have lost money. ProFunds Real Estate UltraSector (REPSX) was trading around $21 when it started in 2000 and is now only at $8.47. Their dividends in the past 9 years were about $7.25. So thats about a 3.1% annual loss. A good REIT will beat a bad rental and a good rental will beat a bad REIT.

So, whats the bottom line?

REIT returns appear to be a bit less than owning rentals historically. Of course owning the rental requires more work.

[edit 7/13: fixed grammar error in title]

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