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I recently discussed why I invest in rental property REITs instead of rental properties. The biggest reason for this is that REITs (VNQ)(RQI) give you much greater diversification than investing in physical rental properties. For example, Avalon Bay Communities (AVB) offers a broadly diversified portfolio of multifamily properties that you can get instant access to just by simply purchasing a share or even a fractional share in some brokerages. It would take a massive fortune for an individual rental property investor to be able to even come close to that level of diversification when investing in physical multifamily rental properties. REITs also come with professional management that knows the industry and how to run the property portfolio much better than I would be able to as a part-time real estate investor. This also makes the investment much more passive than it would be if I ran it myself.
REITs also offer much greater liquidity. You can buy and sell them with a single click of the mouse and with minimal transaction costs, whereas buying and selling physical rental properties is a lengthy ordeal that also comes with significant inefficiencies. You also have limited liability since you are automatically putting your capital into a different entity. If you were managing physical rental properties, you would either have to take on personal liability or go through the hassle and trouble of setting up a separate entity and maintaining it with all the necessary filings each year.
I also prefer REITs over rental properties because current market conditions price many of them at a discount to net asset value, whereas physical rental properties, especially in the United States right now, are quite expensive, especially if you’re going to use leverage to buy them with mortgage rates being so high. For example, many blue-chip multifamily property REITs like Mid-American Apartment Communities (MAA) and Camden Properties Trust (CPT) trade at discounts to their private market values. In the single-family space, Tricon Residential (TCN) traded at a deep discount to its private market value before Blackstone (BX) bought it out, unlocking significant value for TCN shareholders in the process.
That being said, there are some important considerations to keep in mind, as the comparison is not entirely apples to apples between rental properties and REITs. Unfortunately, many REIT investors, including myself, are not fully aware of these important differences that can significantly impact the outcome of your investment. So, in today’s article, I’m going to discuss how these investments differ from each other.
#1. REITs Are Much More Interest Rate Sensitive Than Traditional Rental Properties
One of the most important differences especially emphasized in recent years with interest rates rising so rapidly, is that REITs are often much more interest rate-sensitive than rental properties are. The reason for this boils down to how they are financed. Most publicly-traded REITs take out considerable amounts of corporate-level debt and service it by making interest payments over the term of the loan. Upon its maturity, they repay the principal as a lump sum, often through refinancing by taking out another loan to pay off the existing one.
Additionally, even when they use asset-level mortgage debt, they often pursue a similar model where there is little to no amortization of the principal until the maturity date, and they service it by paying out the interest. The advantage of this is that it increases the cash flow of the REIT, since it does not have to allocate a portion of its rental income each month or quarter to paying down the principal on the loan. Thus, they are able to generate more cash flow to either reinvest in growing the REIT or pay it out to shareholders as dividends.
In contrast, traditional single-family rental property investments are typically financed with amortizing mortgages of the 15 to 30-year variety, which means that each month the landlord has to make a payment to the mortgage lender that includes both interest and principal, gradually paying down the debt over time. Once the mortgage loan matures or expires after 15 or 30 years, the property is owned free and clear. What this means is that rental properties are much less interest rate sensitive since the debt is self-amortizing and there is no refinance risk involved, although the borrower can refinance opportunistically if interest rates drop.
The REIT model is much more interest rate sensitive since there is significant refinance risk. As we saw in the past few years, with interest rates rising rapidly, this can put significant strain on a company’s balance sheet. An example of this is Medical Properties Trust (MPW), which has a large amount of debt maturing in the next two years and as a result, they have had to aggressively move to sell properties to pay down these debts. W. P. Carey (WPC) is another REIT that had significant debt coming due during this period of elevated interest rates, likely playing a meaningful role in motivating them to exit their office properties and also cutting their dividend to generate liquidity to deal with upcoming debt maturities.
#2. REITs Offer More Paths To Attractive Returns Than Rental Properties Do
Another major difference is that REITs offer more paths to attractive returns than rental properties do. While traditional rental properties are often viewed as a buy-and-hold investment due to the hassles and transaction costs involved, investing in publicly traded REITs offers far more options. Yes, it can be treated as a buy-and-hold investment where you simply buy your shares and hold them for the long term, hoping that the REIT will compound through the appreciation of the underlying real estate, prudent capital allocation by management, and ideally an ever-growing stream of attractive dividend cash flow. For example, investors who bought Realty Income (O) back when it first went public and held it until today have done exceptionally well:
However, there are many other opportunities to generate very attractive total returns. For one, the REIT itself can take advantage of regular disconnects between the public market valuation of the shares and the private market valuation of the underlying real estate. For example, they can potentially sell real estate opportunistically, recycle the proceeds into buying back shares, or simply use excess cash flow to buy back shares. Farmland Partners (FPI) has done this extensively.
Meanwhile, if the shares are priced at a premium to the underlying real estate, they can issue additional shares to create value for existing shareholders and reinvest the proceeds accretively to buy new properties and further increase the REIT’s earnings per share as well as its economies of scale, ultimately growing the dividends. This practice is very common in the triple net lease space, with REITs like WPC, O, NNN REIT (NNN), and Essential Properties Realty Trust (EPRT) doing this regularly.
Another way that investing in REITs can increase your returns in a way that physical rental properties do not is that market volatility can cause shares of REITs to appreciate or decline rapidly in a manner that is disconnected from the value of their underlying real estate. Investors can take advantage of this by buying when prices are low and selling when prices are high, thereby providing incredible optionality because an investor can buy with the intent to hold for the long term but sell in the short term if the market presents an attractive opportunity, then recycle the capital into another attractively priced REIT or other investment opportunity.
While some argue that rental properties offer the option of actively managing your portfolio to extract additional value, REITs have the same potential because management teams do this all the time with their underlying properties. This is evident through the numerous value-add and redevelopment investments they make.
#3. REIT Risks Are Much Different Than Rental Property Risks
Lastly, it is important to keep in mind that while both rentals and REITs are investments in the real estate sector, the risks between REITs and rental properties are quite different. Beyond the aforementioned differing interest rate sensitivities, another major difference in risk is management risk. While many REIT management teams are professionals with greater knowledge, skill, and access to resources than an individual part-time real estate investor, there is still the risk that management will not prudently manage your investment. This is particularly a concern with externally managed REITs (such as Global Net Lease (GNL) prior to its recent internalization) or those where management teams are not well aligned with shareholders. This is because no one cares about your money as much as you do, and as a result, individual investors typically manage their investments more diligently, even if they have less industry-specific skill or access to as much data as REIT management teams do.
Another risk to keep in mind is that, while it is possible to buy single-family or multifamily rental property REITs, there are also many REITs with exposure to many other types of real estate sectors, each with unique risks. This is very important to keep in mind, as it can have an outsized impact on the performance of the underlying REIT (i.e., office REITs like Boston Properties (BXP) or mall REITs like Simon Property Group (SPG) have performed very differently from the average single-family home rental property in recent years).
Additionally, REITs are often diversified significantly by geography, whereas individual properties are inherently concentrated by location. Finally, publicly-traded REITs often face dividend cut risks as, when they cut their dividend, it can have a catastrophic impact on the stock price, even if the underlying cash flow and private market intrinsic value do not change at all. With a rental property, you do not face this same risk as the property is priced for the perceived value of the asset itself rather than the market’s perception of it as an income vehicle.
Investor Takeaway
As you can see, investing in REITs and rental properties, while sharing many qualities, also have many important differences that can impact the outcome of your investment. Therefore, investors should keep these differences in mind when deciding whether to invest in one or the other. Personally, I think that as long as you are aware of the differences and set up your investments accordingly with the right mindset, publicly traded REITs are the most attractive way to invest in real estate, especially right now. As a result, I am not investing in rental properties but instead I am buying REITs and have been recently increasing my allocation to them, as I think they are one of the most opportunistically priced sectors at the moment.