It's Decided. REITs are Better Than Physical Houses

Dear investor,

Today’s edition of the newsletter is about investing in real estate, which I think is a particularly powerful investment.

Not because it has the potential to be the next Nvidia, or Bitcoin, or anything sexy like that.

The real reason I like real estate so much is pretty much the opposite. It delivers steady cash flow and it encourages a buy-and-hold forever mentality. After a couple of decades of ownership the benefits really start to happen.

But I firmly believe a lot of real estate investors are doing it wrong. They should embrace the world of REITs, rather than physical real estate.

Here’s why.

The power of real estate

There’s one simple reason why I like real estate.

It’s a proven wealth generator. 

I’m thinking of five random multi-millionaires I know. Three of them became wealthy by slowly buying up real estate. One of them ran a successful business. And the other slowly built a portfolio of boring dividend-paying stocks.

(That last one is Jim the Plumber, btw. I think about him a lot. It’s a little weird, I know.)

The beauty of real estate is virtually anyone can understand it. You don’t need a 140 IQ or years of studying finance. You need a decent understanding of your province’s landlord/tenant act, a knowledge of the city you’re going to invest in, and the ability to do basic financial math.

I know several landlords who don’t even have all of those things, either. I once asked a landlord what the cap rate on his properties was.

He looked at me dumbfounded. “What’s a cap rate?”

Hoo boy. I explained that the cap rate was the rate of return on his investment.

His eyes lit up. He understood that. “As long as my return is higher than my mortgage, I’m a happy camper!”

I’m presenting this guy as unsophisticated, but he was clearly successful. I’d guess his net worth was closer to eight figures than seven. He had been buying up properties for decades, and many had been paid off for years. He also had the ability to improve fixer-uppers, creating equity that way.

The point is you hardly need to be a genius to amass wealth in real estate.

The problems with physical real estate

While I do believe that real estate is one of the more idiot-proof investments, it doesn’t mean that it’s all sunshine and lollipops.

In fact, there are a few different disadvantages that make it a tougher way to make a buck.

The big disadvantage is owning your own real estate is work, dammit. It’s only a passive investment if you compare it to a full-time job.

Here are just some of the responsibilities of a good landlord:

• Show the place to prospective tenants

• Screen any tenants that appear decent

• Collect and deposit the rent

• Coordinate repairs (or fix things yourself)

• Do periodic property inspections

• Update financial statements

It might only add up to a few hours a month, but it’s still time spent away from your family.

No diversification

Another problem with owning physical real estate is most landlords end up making a big ol’ levered bet on the city they live in.

Sometimes, like with Toronto real estate over the last 25 years, that bet works out ridiculously well. And other times, like with countless other cities, that bet works out terribly.

I know a landlord who was getting 15% cap rates on real estate in a mining town in the 1990s. The mine closed down in the 2010s, and now he’s stuck with houses that nobody wants to live in, never mind buy.

Buying a REIT, meanwhile, offers instant diversification. A REIT like Morguard Apartment REIT (TSX:MRG.un) — which is a favourite of mine — offers an investor instant diversification throughout North America, with its 12,000+ suite portfolio located in places like Toronto, Chicago, and Pensacola.

REITs also offer a different type of diversification. Most landlords just don’t have the capital (or the expertise) needed to get into commercial property. A REIT offers instant exposure to areas like retail, office, or industrial real estate.

Comparable returns

One argument I hear against REITs is how much money people have made on their rental portfolio.

Usually these are Toronto-based investors, who happened hold a property that went up 500% in two decades. They hit gin, and are now comparing every other investment to that magical outcome.

But for the rest of us, REITs offer pretty much a comparable return to rentals. A REIT’s distribution tends to track its underlying cap rate relatively closely, meaning both investors get about an equivalent amount of cash flow.

Many investors also compare a single property investment with 10% equity and 90% debt with a REIT that has 60% equity and 40% debt. These are completely different investments with vastly differing amounts of risk. A REIT is designed to weather a real estate crash. A rental with 10% down is taking way more risk.

Physical rental landlords don’t factor in their cost of ownership, either. They find a property, pay $250,000 for it, and laugh all the way to the bank 25 years later when it’s worth $750,000. Look at my 200% return! Plus I got the rent!

Sure, but assuming a $225,000 loan over 25 years at a 5% interest rate, this investor will pay $167,583 in interest alone. Meaning they actually paid a little over $392,000 for this property. They also have to pay for property taxes, insurance, perhaps condo fees, and any upkeep. By the time you factor in all those costs, this investor will have spent nearly $500,000 for that asset worth $750,000.

Not such a great return now, is it?

Liquidity

Anyone who has ever sold a house knows what a pain it is.

First you have to do all those little maintenance things you’ve been putting off. Then the place needs a deep clean, some hardcore organizing, and likely a coat of paint.

Then you need to find a Realtor, sign contract that agrees to pay them $10,000+, and coordinate showings.

Compare that to a REIT, which can be bought or sold for about $5. Pretty much instantly, too. And if you want the money from the sale, it can be in your bank account in just a few days.

A REIT investor also has the ability to partially sell their holdings to raise cash. To extract equity from a physical property is a long process that involves applying for a loan. That gets a hard pass from me.

Periodic great deals

Your author grew up in a small town (a little less than 10,000 people) and eventually about six people ended up owning much of the rental property in town.

This created a nice little flywheel effect for these investors. Whenever someone wanted to unload property quickly, one of those six would get the call. They’d show up, offer about 20% under the market value, and the deal was over in about an hour.

This was a fantastic thing for those lucky six, but it sure did suck for someone just trying to get into the market.

Buying REITs is far more democratic. A dirt-cheap REIT is available for anyone with a brokerage account and extra capital to put to work. There’s no gatekeeping, no old boys’ club conspiring to keep the new guy out.

The problem with this is most investors can’t bring themselves to buy a REIT when its value is down 20-40%. They view the price action as a bad thing, rather than an opportunity.

The bottom line

I used to own physical real estate. And despite earning much better returns than most landlords, I wish I would’ve embraced REITs years before I actually did.

REITs have numerous advantages over physical rentals. They’re completely hands off, which is the best. There’s no better feeling than knowing you’ll never get one of them emergency plumbing phone calls.

I believe no investor with physical real estate has true independence. You’re always going to have to worry about that asset, even if there’s a property manager in place.

They also offer instant diversification, similar returns versus physical rentals, instant (and dirt-cheap) liquidity, built-in leverage, and occasional terrific deals in public markets.

A diverse set of REITs is the perfect way to get real estate exposure with the kind of hands-off management that guarantee true independence.

One more thing

Thank you to everyone who took advantage of our Pre-Black Friday sale.

That deal has since expired, so hopefully those people who were interested acted quickly.

Keep an eye out for our next sale, which will likely be in May or June.