Investment Face-Off: Rental Property With 6% Cap Rate vs. REIT With 8% Return
There are several options for how you can invest in real estate, as you well know, and a lot of them are so different from each other that you may not have a hard time choosing which to go with. But what about some of the less obvious differences between some of them? Or rather, what if two different options seem obvious as to which is better — are you sure you know which one is actually better?
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To give you a better idea of weighing different options, I’m going to choose a battle between:
Rental Properties and Real Estate Investment Trusts (REITs)
More often discussions of different investment methods are comparing things like rental properties and flipping properties, which have a much more distinct difference between their work levels and return styles. Rental properties and REITs, though, often get grouped together because they are both methods of passive income and the return styles are similar (cash flow).
The Basics of Rental Properties and REITs
To make sure everyone is on board with what we’re really talking about here, let me just clarify how both of these work.
- Rental Property. This is when you own an actual piece of property that you rent out as a means of collecting income. The property itself is in your name, you own it, you can do whatever you want with it — live in it, rent it out, make improvements, sell it, refinance it, spray paint it. Whatever you want.
- REITs. Think “mutual fund for real estate investments,” and you are thinking along the right track. It’s just like buying stocks, but instead of buying stock in a company that does whatever business, you are buying into a company that owns or finances real estate. If you buy into a REIT, you don’t personally own any of the properties; you own shares just as you would if you were buying stocks.
Which to Choose: Rental Property or REIT?
Well, as with any decision in life, there are pros and cons to going with either. Here is a list of the most basic pros and cons for both rental properties and investing in REITs:
- Sole control over any decisions, improvements, or changes to the asset
- Major tax benefits, usually resulting in tax-free income or better
- Ability to leverage capital invested (ability to buy a $100,000 property with only $20,000)
- Hedge against inflation
- Appreciation potential
- Passive income
- Income is directly tied to performance of the individual property
- Requires more capital to purchase property
- Less liquid
- Ability to be part of a very large asset holding — better security typically (especially with publicly-traded REITs) due to strict oversight, professional large-scale management, and diversification of assets
- Long-term growth potential and typically provides high dividends (from non-taxable pool of money)
- Options for liquidity of money invested
- Stable income generation — not tied to individual property performance
- Low-entry costs to invest
- Passive income
- Income is fully taxable
- No equity build
- Value of shares often trend with the general stock market
- Less flexible management of assets, if any flexibility
A Hidden Advantage to Rental Properties
It’s not hidden in the sense that it’s not in the above list (because it is), but the big picture idea of it isn’t blatantly stated up there. I also don’t emphasize this pro for rental properties to suggest rental properties are better; I just point it out as a major clarification point.
In looking at the list above, look at the pros and cons that specifically relate to the income received from each type of investment. What a lot of people don’t realize is that cash flow isn’t the only financial gain you receive if you own rental properties. In defense of that thought, though, cash flow is typically the only income that is really evaluated and measured when shopping for properties. This is because it is the easiest, if not the only, income stream that is really known — how much you pay for a property versus how much you collect in income.
Obviously, some unexpected expenses can come up on a rental property so that would affect your cash flow, but at least the general numbers are known. So when you see cap rates and cash-on-cash returns, those are only speaking to cash flow because those are known variables. You may also see people calculate in estimates for appreciation, but the fact is, appreciation isn’t guaranteed so those numbers are only guesses and can’t be relied on in calculating true returns. Because of this, cash flow is usually all that is conveyed as the return on a rental property, so people think cash flow is all the income you’re getting.
But here’s the thing: cash flow isn’t the only income you’re getting on a rental property. As you see in the list above, you are also getting major tax benefits, which put a surprising chunk of cash in your pocket, and you also have the potential for appreciation and equity build. These three things can put a substantial amount of cash in your pocket! Nevermind that you can also leverage, which is tied in with the equity building, so that’s yet another income benefit on rental properties that you wouldn’t experience by investing in something like a REIT.
Those additional income streams are arguably the biggest benefit of owning real property over things like notes or REIT shares. Anything on paper will not give you the same level of additional income streams.
Again, I don't tell you this about rental properties to try to sway you one way or the other while you are deciding what to invest in, but I tell it to you so you can more accurately determine the returns on an investment. People quickly mistake an 8% return on a REIT investment as being a higher return than a rental property with a 6% cap rate. It's fine if you decide to stick with the security of an 8% return REIT investment, but don't just choose that because it sounds higher than a 6% return on a rental property.
So how about you—would you buy the 6% cap rate rental property or the 8% REIT return? Did I miss any important pros and cons?
Let me know in the comments section below!