This is the third article in a 4-part series about getting started as a real estate investor.
Now we’re ready for the fun part — talking about your real estate investment options. In this article, we’ll cover direct investment and publicly traded REITs.
Direct Investment in Real Estate
Investing in Your Own Home
Real estate is one of the most tax-advantaged asset classes available. The best way to maximize those tax breaks is to own real estate directly. For most individual investors that means buying a residential property such as a condo, townhouse, single family home, or duplex. That’s why the first and largest real estate investment many people make is buying their own home.
A couple benefits of owning your own home are pretty obvious from the start. You get a place to live! And instead of paying rent to a landlord, you pay rent to yourself. Many homes are purchased with a mortgage, so your monthly payment acts like a built-in savings plan that pays down your debt and increases your equity over time.
There are (at least) two other benefits you should be aware of. If you have a mortgage, you can deduct the interest portion of your mortgage payment from your federal taxable income (up to $750,000 of mortgage debt). When you sell your home, up to $500,000 of your home value appreciation (capital gains) are tax exempt. That’s why some folks “trade up” houses in the same city or neighborhood every few years. They are rolling their capital gains into a new investment tax free.
Of course, homes come with expenses and responsibilities also, like regular maintenance, property taxes, and homeowner’s insurance, so take a careful look at your budget before jumping in.
Investing in a Rental Property
The next real estate investment many individual investors consider is buying a rental property. Again, this often means buying another residential property.
Given today’s low interest rates, it’s possible (not guaranteed) that your rental income could cover your mortgage payment and still provide a little extra income each month. Just like your own home, you’ll need to budget for maintenance, insurance, and property taxes. To rent it out, you’re likely to encounter expenses to find a renter. And it would be wise to keep a cash cushion on-hand in case your renter fails to pay on-time or breaks the lease early.
The good news is that most of these expenses are tax deductible for a rental property, including depreciation. This is another way that real estate is tax-advantaged and why direct ownership delivers such great long-term returns. When it comes time to sell your rental property, a qualified 1031 Like-kind Exchange allows you to defer taxes on capital gains if you reinvest the proceeds in a similar property of the same or greater value. This is similar to the “trading up” benefit for a primary residence. A variation of a 1031 Exchange is a 721 Exchange. This allows an investor to defer capital gains by contributing their property to a REIT (sometimes called in UPREIT) in exchange for shares in the REIT.
Costs and Risks of Direct Ownership
I don’t want to make this all seem easy though. Rental properties and direct ownership involve a lot of time, money, and risk. For one thing, you are the management team for your rental property. So think of it more like starting a small business, rather than investing in one. If you don’t have the time or interest to do the work, consider another investment option.
In addition to time, direct property ownership is expensive. According to Zillow, the median home price in the US is more than $259,000. That’s a pretty high investment minimum. Unlike passive investments that allow you to limit your exposure to a specific dollar amount, there all kinds of extra costs that can come from direct ownership.
Direct Ownership + Property Management
If you’re wondering, “but can’t I pay someone to do the work for me?” the answer is yes. That’s where property managers come in.
The cost of a property manager depends on the services you contract them to perform, but for long-term rentals you can expect the cost to be in the ballpark of 10% of monthly rent plus any expenses. With a high quality property and conscientious long-term renters, the numbers could still work out to be cashflow positive.
For a vacation rental or short-term rental (like an AirBnb or VRBO), that involves frequent renter turnover, cleaning, and maintenance, property management fees increase significantly to 28% (with some as high as 50%). This will make it more challenging to keep the property cash flow positive. It can also be challenging to sell a vacation home, since it is a luxury that a relatively small set of buyers can afford.
Rental property investment platforms
If you like the idea of direct ownership, but don’t know where to get started and doubt you have the time to figure it out on your own, the internet has a solution for you.
One of the more recent innovations in real estate investing are online rental property marketplaces like Roofstock and HomeUnion. Both platforms aim to provide a simple, turnkey solution for identifying, acquiring, and managing rental properties for investors. They provide home and neighborhood information similar to Redfin or Zillow, but also include cash flow and long-term value estimates for listed properties. A key difference between the two platforms is what you get at the time of closing.
- Roofstock properties come with a tenant in place. This is one of their screening criteria. Roofstock will also recommend property managers but selecting the property manager is up to the investor.
- HomeUnion comes with built-in property manager service, who will help you find a tenant after close.
Many of the promoted properties are “starter homes” or “workforce housing” located in secondary or tertiary markets where property values are lower than the national average ($100k – $250k price range). The location and lower prices is what makes the investment math work while paying third-parties to handle the heavy lifting.
Before bidding, think through how you will oversee the property if you don’t live close enough to check on it yourself. We’re still talking about a $25-100k investment plus a mortgage, so these turnkey solutions don’t eliminate the high minimums and concentration risk. If you’d rather dip your toe in the water for a smaller amount and less risk, read on to check out publicly-traded REITs.
Publicly-Traded Real Estate Investment Trusts (REITs)
The stock market is the original equity crowdfunding platform as it offers a lower-cost, more diversified, hands-off, and liquid alternative to direct real estate ownership. With publicly-traded REITs you get the benefit of a professional management team, quarterly and annual reports — and the ability to invest as little or as much as you want, whenever you want.
Of course, anything publicly-traded inherits the volatile nature of the stock market, even if the underlying assets are durable. Publicly-traded REITs do not pay taxes on their net income, avoiding double taxation on dividends paid to investors. However, investors do not get the tax benefit of using expenses and depreciation to offset the dividend income. That is one of the trade-offs with indirect or passive real estate investments.
Wondering how to get started? Start simple with a broad-based Real Estate ETF. For $85 you can buy 1 share of the Vanguard Real Estate ETF (VNQ), the largest US REIT ETF. This gets you exposure to 181 of the 225 publicly-traded US REIT stocks. It has averaged ~9% annual returns for the last 10 years and comes with a 3.86% dividend yield, offset by a minimal expense ratio of 0.12% (consider it a 3.74% net yield). iShares (IYR), Schwab (SCHH), and State Street SPDR (XLRE) all offer a US REIT ETF, though each is different. Compare total assets, holdings, expense ratio, and performance before making your selection.
Want something more adventurous? Select individual REITs from different real estate sectors to create a portfolio that reflects your investment thesis. You can pair your individual REIT picks with a broad-based REIT ETF to make sure your portfolio doesn’t go too far off the beaten path.
REITs are businesses just like other publicly-traded corporations, so there is no single metric that will tell you if a REIT is a good investment or not. That said, here is a short-list of suggestions to help you get started. These high-level metrics generally apply to any REIT.
Just as you would consider the sector that a company operates in, you should consider the real estate sector of a REIT. As you might guess, office building and mall REITs have’t performed as well as data centers and industrial REITs in 2020. But investing is about the future, so make sure you understand short- and long-term sector trends.
Net Asset Value (NAV)
NAV is the value of all assets (predominantly properties) minus all liabilities (predominantly debt). NAV is used as a comparison benchmark for a REIT’s total market value and stock price. REITs can trade at a “premium” or “discount” to NAV. REITs trade at a premium when the financials and future prospects look bright — such as high cash flow, high-growth, and high-quality assets. But NAV only tells part of the story.
Fund Flows from Operations (FFO)
Cash flow is the life blood of any business and an REIT in particular. The standard cash flow metrics for REITs is FFO, which is calculated by starting with net income then adding back non-cash expenses and eliminating one-time gains or losses.
- Total FFO = Net income + depreciation and amortization – gain/loss on the sale of a property or asset
Price-to-earnings ratio — or P/E ratio — is a common metric for comparing valuations across stocks. You can do the same thing with REITs using Price-to-FFO ratio. You can calculate this on a per share basis, or using total values from the REITs financial statements. Either of the two methods will get you the same answer.
- Method 1 = Price per share / FFO per share
- Method 2 = Market value / Total FFO
Since one of the reasons to invest in real estate is the dividend income stream, it’s a good idea to understand if a REITs dividend is sustainable. We can do that using the payout ratio. A payout ratio of 50% is relatively low for REITs and could indicate the dividend is not only stable, but could increase over time. However, a payout ratio of 100% is high and means the REIT is using every dollar of cash generated to cover the dividend — that may not be sustainable.
Similar to Price-to-FFO ratio, we can calculate the payout ratio in two ways.
- Method 1 = Dividend per share / FFO per share
- Method 2 = Total dividends / Total FFO
Debt and Interest Coverage
REITs typically use a significant amount of debt to build their portfolio of properties. Understanding a REIT’s debt and interest coverage metrics is important to make sure there isn’t a risk of defaulting on its obligations.
For evaluating debt and interest coverage, investors often use Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). The big difference between EBITDA and FFO is that EBITDA is calculated before interest expense — FFO is after interest expense. Since our goal is to understand the REIT’s ability to cover debt and interest payments, we use EBITDA.
- Debt-to-EBITDA = Total Debt / annual EBITDA.
The resulting number tells investors how many years it would take to pay back all debt, if the company chose to do that (and only that). The right debt-to-EBITDA depends on the REIT’s overall financial picture. All else being equal, look for a ratio of 5-6x or lower.
- Interest coverage = annual EBITDA / annual interest expense.
The resulting number tells investors how many times over the REIT could pay its interest expense. In other words, how much cushion it has in case there is a dip in revenue or cash flow. Look for interest coverage ratios of 2-3x or more.
As you can see, ownership of a residential property and publicly-traded REITs are pretty different animals, but these are often the two ways that real estate investors get started. If it fits your lifestyle and you can cover the payments, owning your home makes good investment sense. Publicly-traded REITs and ETFs offer a low-cost and flexible way to increase your exposure to real estate without the work of managing properties yourself. Together they can make for a solid start to a long-term real estate portfolio.
In the next and final article, we’ll talk about advanced and innovative real estate investment options.
Wall Street has Morningstar, S&P, and Bloomberg
The equity crowdfunding market has KingsCrowd.
About: Mike Cozart
Mike is a senior product leader and angel investor. Mike started his career as an investment banking analyst and venture capital associate before taking on general management and product management roles with Amazon and Axon Enterprise. He earned an MBA from Columbia Business School in New York City, a BA in Economics from The University of Texas at Austin, and a BS in Geographic Information Science from Texas A&M University at Corpus Christi.