I often get asked the question, “Mr. Tako why don’t you invest in physical real estate?” Today I’m going to try to answer that question. Real estate has long been a popular investment among those seeking financial independence, but (other than my home) I don’t own any physical real estate. However, I have made TONS of money from real estate…
What’s The Attraction?
Small investors really love real estate. Maybe too much! A lot of the attraction to real estate comes from the fact that it’s a physical thing. It’s solid, it’s real, and you can touch it. By contrast, stock ownership is merely some numbers and letters on your monthly brokerage account statement. The average Joe has no control over that kind of investment beyond a little voting power (which some might argue is no power at all). With physical real estate, the average Joe can use his own sweat equity to make improvements, and perhaps realize some additional return. I can definitely see the attraction.
Residential real estate remains extremely popular with the ‘common man’, but it isn’t without its own pitfalls. Everyone and their Grandma wants to own a rental property for the income and tax advantages. Consequently, everyone seems to think they’re some kind of real estate investment guru these days!
There’s also about five million of these hucksters trying to sell you their real estate investment course, seminar, or book on how to get rich quickly (with real estate). You won’t find any of that garbage here.
Problem #0: Time
For small investors, physical real estate investment forces you to wear many hats. Typically the owner will play the part of property owner, marketer, accountant, and repair man. It’s a heck of a lot of work for a busy individual to take on…but many people are fine with this arrangement. They feel sweat equity is their road to wealth. I only wish I had that kind of time…
As a father of very young boys (ages 1 and 3), my time comes at a very large premium. Kids take a lot of time, and I happen to have two of them. Most of my waking hours are dedicated to their care and feeding. This won’t last forever of course, and every day they get more and more independent. But for now, I essentially have no leisure time to spare.
For me, a physical real estate investment that could potentially suck up all my nights and weekends with maintenance (and tenant issues) seems like a very bad idea. Something in my life would have to give; either my relationship with my children, or my relationship with Mrs. Tako. Neither of those is something I’m willing to compromise.
Problem #1: Leverage
One of the biggest problems with real estate is leverage. Physical property is expensive! To buy income producing properties, most investors need to have significant leverage. In order to realize returns from real estate that match other asset classes (like stocks), huge amounts of leverage are usually required. Ten to twenty percent equity (or less) is not uncommon. This isn’t necessarily safe plan. Leverage can work against you when business makes a turn for the worse.
Real estate is essentially a big levered bet on your local economy. Any experienced landlord will tell you that your success as a real estate investor is entirely dependant upon what happens with your local economy. If the local economy goes to hell, you could stand to lose a lot. If you’re in the next Silicon Valley…well, congratulations!!
For Mr. Tako and family, we’ve got enough debt with our mortgage. Right now, I could write a check to the bank and pay off my mortgage. Adding more debt and diminishing this advantaged position seems like a bad idea.
Problem #2: Local Prices
In my case, I happen to live in a high cost of living (HCOL) area. Physical property is extremely expensive here. Property prices are often 20 to 30 times yearly rents, which I think is kind of insane. Cap rates from such a property are tiny. Any significant maintenance can kill your positive cash flow for the year.
If I was to invest in a physical property here, it would definitely be a “pray and hope” situation; Pray for capital appreciation and hope nothing breaks. That’s just not how I invest….
Another Option: REITs
What if there was a way to invest in real estate without all those problems? There is, and I’ve been investing in it for many years….Given a situation like mine, there’s no better real estate investment than a Real Estate Investment Trust (REIT). It happens to be one of my favorite investment vehicles.
The first thing we need to talk about is how cashflow is paid out. REITs are required by law to pay out at least 90% of taxable income. Typically this is in the form of dividends. In many cases, they frequently pay out more than their taxable income (more about tax advantages later).
One other major advantage to owning a REIT is the ability to invest in classes of real estate that would normally not be an option for individuals: Want to buy a skyscraper in the middle of a city? Good luck as a individual investor. How about a large multi-family property with thousands of units? Yeah, again, good luck with that one!
REITs open up large swaths of real estate investments normally impossible for you to invest in: commercial, large multi-family residential, large retail properties, industrial properties, mortgage investments, or even forest land.
[Note: I should also mention REITs and leverage here. It really depends upon the individual REIT, but *usually* REITs are considerably less levered than any individual investor might be. This is a good thing.]
If you do your homework right, some real estate investments are going to generate better returns than you would realize on your own, and sometimes even better than index funds!
REIT Dividends And Tax Advantages
Small investors often tout the tax advantages of investing in real estate: The good news is that these same tax advantages exist for REIT’s. Things like depreciation, and 1031 exchanges, REITs have those same advantages.
How about cash-flows from the investment? How are they taxed? Well, unlike a C-Corp, REIT’s don’t pay taxes on the funds they distribute to shareholders. The shareholders themselves pay the taxes. This makes REITs a more efficient cash machine than a C-Corp because there is no double taxation of dividends. Win!
Typically REITs are traded on a stock exchange (much like any public C-Corp), but pay far larger dividends. At the end of the year, the REIT will issue a press release detailing the taxable composition of these dividends. For our MAA example, here’s the 2015 press release.
REIT Dividends can fall into several categories (and the composition varies from year-to-year):
- Ordinary Taxable Dividends – This falls into ordinary income tax brackets.
- Long Term Capital Gains – Subject to the same taxation rules and rates as other long term capital gains (usually 15%)
- Unrecaptured Sec. 1250 Gains – This happens on the sale of a depreciated property that is not rolled into a 1031 exchange. Currently depreciation recapture is taxed at 25%.
- Return of Capital – Return of capital is my favorite form of REIT dividend…because it isn’t taxable in a given year. Let me quote the IRS to help you understand how this works: “Distributions that qualify as a return of capital are not dividends. A return of capital is a return of some or all of your investment in the stock of the company. A return of capital reduces the adjusted cost basis of your stock”. Essentially the IRS will not impose taxes until you sell your shares. Collect now, pay later. What’s the best thing to do with Return of Capital? Reinvest it of course!!!
Comparing To An Index Fund
Can REIT’s really provide decent returns compared to something like a S&P500 Index fund? In my experience, they definitely can! Here’s the performance of my MAA shares from the initial date of purchase (2/13/2002), up to today:
How about them apples? As you can see, this investment has clearly trounced the S&P 500 (as represented by the SPY ETF) when looking at price appreciation alone. Capital appreciation of 281% compared to the humble 85% of the S&P 500. What’s missing from the chart? Dividends of course!!
In 2002, when I invested, MAA was paying $2.34 per share in dividends. That’s a yield of 9.2% on my purchase price of $25.32. Today, dividends have grown to $3.28 per share, a 40% increase and yield of 12.9% on my initial purchase price.
I think this is a pretty decent return. It also cost me $0 in fees for the 14 years that I’ve owned the investment (other than the initial $7 trade). Anybody have an index fund that charges $0 in fees for 14 years?
REITs vs. Physical Real Estate
Like any other investment, picking and choosing your real estate is key. Some are treasures and some are trash.
Like me, you could avoid physical real estate, and buy REITs instead. You could also buy a REIT mutual fund if you’re into funds. Either way, REITs are far more diversified (frequently with less leverage) than buying into a physical property. They also take far less of your precious time.
Like physical real estate, education is key. Any investor looking to invest in REITs needs to study how they work – and they work definitely work different from a C-Corp. Understanding terms like FFO, NAV, and AFFO are going to be key to learning about REITs. Do your homework here folks!
Traditional measures like ROE often look terrible on REITs. Couple that with dividend payouts that exceed taxable income, and at first glance REITs might look like complete trash.
Don’t get me wrong, despite my success, I don’t believe REIT’s are a perfect investment; I let REITs consume only about 10% of my portfolio. There’s lots of things about even MAA that I don’t like! But no investment is ever going to be perfect.
Remember: The road to wealth isn’t paved. It’s a big potholed mess, and learning to navigate that road is half the fun…
[Image Credit: Flickr]