Real estate has always been one of my favorite investment vehicles. In addition to direct purchases of residential, multifamily, commercial, and industrial real estate, I also have invested in crowdfunded debt instruments through Peerstreet, Patch of Land, Realtyshares, and Alphaflow as well as real estate investment trusts (REITs). I actually started investing in REITs and building residual income with real estate investment trusts and publicly traded real estate investments in the 1980s with Cohen and Steers. Over the years, REITs have become a larger part of my real estate investment portfolio due to the diversity, liquidity and total overall return REITs deliver versus direct real estate investing.
Investing In REITs Diversifies Your Real Estate Investment Portfolio
Diversification in real estate investing is the key to success. If you have enough funds to purchase one investment property, you have your entire real estate investment portfolio tied up in one property. All of your residual real estate income is from one source, the exact thing we are seeking to avoid with the concept of Levered Income. If you own one $500,000 investment property paying you $35,000 per year in residual income, that one income stream is at risk due to natural disasters (we deal with hurricanes all of the time in Florida), emergency repairs to the property, location risk, political risk (ie tax increases) and vacancy.
Investing in REITs spreads out your risk among all of the properties that the REIT owns. For example, Realty Income (stock symbol O), owns over 5600 commercial properties subject to long-term net leases. As of this article, the properties in the portfolio are leased to 260 commercial tenants that operate in 48 different industries. These 5600 are located in 49 of the US states and Puerto Rico. When you purchase a share of Realty Income, you are buying a piece of those 5600 individual properties.
When building residual income with real estate investment trusts, it is important to spread out your income streams across properties as well as across individual REITs. This diversifies management risk of the REIT portfolio in case the REIT manager makes a mistake and the dividend paid needs to be reduced. Of course, when researching a real estate investment trust prior to investing, researching management is critical to investment success.
Investing In REITs Increases Your Liquidity
Being able to get your money out of an investment is important.
With publicly-traded REITs, you can sell your investment immediately if needed. You may not get the price you want, but you have the ability to push a button and sell your real estate investment. Direct investment in real estate is different. Selling a piece of property takes time and is considered an illiquid investment. The property needs to be prepared for sale, listed with a broker, and has to complete the entire closing process before you can pull your money out of the property. Sometimes this process can take a year or longer, depending on the type of real estate.
The additional liquidity of real estate investment trusts versus direct real estate investment also protects your residual income cash flow. For example, if you are building residual income with real estate directly, you are at the mercy of each tenant for your residual income cash flow.
Empty Commercial Spaces Hurt Returns Through Lost Income and Expensive Carry Costs
If that tenant breaks the lease, your cash flow disappears. If you cannot re-lease the property and need to sell, you have to both carry the property (pay all of the running costs like taxes, insurance, maintenance, etc.) as well as you are not receiving any return on your capital in the building. This type of “double-whammy” from an illiquid investment can be very painful.
If you are building residual income with real estate investment trusts, on the other hand, you can immediately jump out of a poor investment. If a REIT you are invested in cuts its dividend, reducing your cash flow, you can press a button and get out of that investment. The ability to move to a different investment quickly can protect your cash flow streams. Unfortunately, when a REIT or dividend stock cuts its dividend, you typically take a hit on your capital investment.
Investing In REITs Can Increase Your Total Return
Investing in a real estate investment trust is investing in real estate, just in a different format. However, the format does not take into account operator or management skills. There are REITs with both good and poor management that affect returns, as well as direct real estate investors that are good and bad managers that also affect returns.
The idea behind Levered Income is to seek out some form of leverage to reduce the amount of time needed to create cash flows. Investing in REITs leverages the management experience of the company (in addition to a whole host of other things) on your behalf. I read an interesting article on Seeking Alpha with a detailed analysis of direct returns versus REITs returns. The author uses Cambridge Associates Data which shows that from 1992 until 2017, REITs returned more than 11% per year versus 7% for private real estate investments. (Note that this does not take into account operator or management prowess as discussed above.)
Source: Cambridge Associates
How does that 4% average difference work out in dollar terms? Over a 25 year period, investing in REITs would return 2.5 times as much as direct investing. All of that with no management or maintenance headaches!
Investing In REITs Is A Great Form Of Levered Income
Building residual income with real estate investment trusts can deliver higher returns, with less risk, more liquidity, and fewer responsibilities versus direct real estate investing. All of the positives of REIT investing combine to give REITs a high Lever Rank and is a solid way to build long-lasting, low-effort residual income.
