Real estate and REITs
A property of your own is a single, very large investment, usually bought on credit and with a lot of work attached. REITs give you rental income spread widely and tradable at any time, but they swing like shares.
Learning objective: After this lesson you can weigh up owning a property against a REIT as an investment.
Your own flat feels safer than a portfolio because you can touch it. Looked at soberly, it's the opposite of spreading: one single, very large investment in one single place, usually paid for with a loan.
Costs of Renting Out
Then there are costs that tend to get lost in the excitement. Take Markus. He buys a flat for €300,000 and rents it out for €1,000 a month before utilities. That sounds like a 4 percent return. But property transfer tax, notary and estate agent cost him a good €36,000 extra. If he allows about €2,500 a year for repairs, management and the occasional empty month, just under 3 percent is left, before tax and loan interest.
The Owner-Occupied Home
That doesn't make property bad. A home you live in yourself has a value that can't be expressed as return. You live in it, and in old age you pay no rent.
REITs as an Alternative
If you want to earn from rent without dealing with tradespeople and tenants, you can buy REITs. These are listed companies that own lots of properties and pay out most of the rent. The price: they swing like shares, because they are shares.
The gross rental yield is the annual rent divided by the purchase price. It only becomes meaningful after all costs: purchase costs, reserves for repairs, management, vacancies and costs you can't pass on to tenants. In Germany purchase costs are usually ten to fifteen percent of the price. You have to earn those back before you make anything at all.
A Mortgage as Leverage
The loan works as leverage. As long as the flat earns more than the loan costs, your return on your own money rises. If that reverses, for example because refinancing after ten years is much more expensive, the same leverage works against you. Unlike a portfolio on credit, nobody checks the value of your flat daily and demands more money. That feels calmer, but it doesn't change the risk.
REIT Taxation
In many countries REITs are a special case for tax. They have to pay out most of their profits and in return pay hardly any tax at company level. Their correlation with the stock market is much higher than that of directly owned flats. That's partly because your own flat is only rarely valued, for example when you sell or for the bank. Because nobody quotes a price every day, it seems more stable than it economically is.
Summary
- A property you buy is a large single investment, usually on credit.
- You have to earn purchase costs back first.
- Directly owned property seems more stable because it's rarely valued, not because it swings less.
- Common mistake: measuring the return only by the rent and forgetting repairs and vacancies.
Did you get it?
Why is the gross rental yield misleading?
Because purchase costs, repairs, management and vacancies are missing. Only the net rental yield tells you something.
When does the loan work against the owner?
When the loan costs more than the property earns, for example with more expensive refinancing.
Why does directly owned property seem more stable than REITs?
Because it's rarely valued. That's a measurement effect. It doesn't actually swing less.
Check your understanding
Your task
A condo costs $250,000 and the rent, excluding utilities, is $800 a month. Calculate the gross rental yield. Then redo the calculation with 12 percent closing costs and $2,000 a year for repairs, management, and vacancies, and note what is left as yield. Write one sentence on what the second number tells you about the first.
Sources and further reading
- An analysis supported by Nareit (CEM Benchmarking) shows that the returns of REITs and direct real estate only converge strongly (correlation of about 0.90) once the lag caused by infrequent valuations is removed from the data, a sign of how smoothed the valuation of direct real estate is. View source ↗
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