6 min read
I think one of the most enjoyable ways to build wealth is to do work you love while managing to generate a high enough income that you can invest excess cash into assets that produce passive income.
Using this approach, you can increase the active income you earn from working (whether that’s in the form of a day job or self-employment) over time while also increasing the passive income you earn from simply owning assets. Over the long run, wealth creation becomes inevitable.
For example, I love actively building and working on websites. But I don’t want to generate just “enough” money to live on. I want to generate excess income that I can invest in passive assets like stocks and REITs that will slowly pay me more and more money over time without any active work on my part.
This approach supports my master life & money plan that I carry around in my head:
1. Get out of debt – done
2. Earn enough money online to quit day job – done
3. Earn enough money to provide for a whole family – in progress
4. Earn enough money to help my parents & siblings – to be done
5. Earn enough money to help friends – to be done
6. Earn enough money to help my community – to be done
If I want to be in a position where I can help out people financially who are outside of my immediate family, I need to build up a little army of income-producing assets.
One asset class that I’m particularly fond of is real estate because it tends to provide reliable income, long-term appreciation, diversification, and even inflation protection.
However, there are two completely different ways that one can invest in real estate:
2. Rental properties
In this post I take a look at the pros and cons of investing in REITs vs. rental properties as ways to generate income, along with why I tend to prefer one approach over the other.
The term REIT is an acronym for real estate investment trust, which is a company that owns and operates income-producing real estate. A REIT can own many types of real estate, including office buildings, apartment complexes, warehouses, shopping centers, hotels, hospitals, and nursing homes.
REITs were created in 1960 by the U.S. Congress to give individual investors the ability to invest in real estate without actually purchasing an entire physical property themselves. You can think of REITs as being similar to mutual funds for stocks. You’re not physically doing any work to generate income; you’re merely investing in a company that does the hard work of earning investment returns for you.
There are many pros to investing in REITs, including:
Passive income. Here’s the process behind investing in REITs: Click a button on your laptop to purchase shares, then go on with your daily life. You’ll receive dividend payments either every month or every three months, depending on the REIT you invested in. This is the most obvious pro of investing in REITs: they produce completely passive income for you.
Strong historical performance. Since 2000, REITs have delivered the highest annual returns of any major asset class with 11.0% annual returns, handily beating the next best performing asset class, small cap stocks, which delivered 9.8% annual returns. (Data source: A Wealth of Common Sense)
Liquidity: Publicly traded REITs can be bought and sold just like stocks. This means they’re much more liquid than rental properties. You can literally buy and sell shares with the click of a button, unlike physical properties which take much longer to buy and sell.
Diversification. Most REITs invest in hundreds or even thousands of different properties across the country, which means that poor performance among one or two properties won’t affect the portfolio much. Conversely, the performance of a single rental property in a single market can fluctuate much more, resulting in more volatility and higher risk.
Low barrier to entry. To buy a physical rental property, you will likely need tens of thousands of dollars to put down. With a REIT, though, you can often get started with buying just one single share, which can be $100 or less, depending on the REIT. Thus, it’s much easier and more feasible for the average investor to gain real estate exposure through REITs compared to rental properties.
No expertise needed. When you invest in a REIT, you don’t need to be an expert and have extensive knowledge about several different real estate markets across the country. Instead, you can rely on the expertise of the individuals in the company you invest in who are real estate professionals and spend their days analyzing markets and deals.
Predictable cash flow. By law, a REIT must distribute at least 90% of its taxable income each year to shareholders in the form of dividends. Most REITs pay either quarterly or monthly dividends, which means you count on fairly predictable cash flow on a regular basis when you own REITs.
Despite the long list of pros, there are some potential cons to investing in REITs.
No control. As mentioned earlier, one of the biggest pros of investing in REITs is that it requires no active work on your part to generate income. But on the flip side of the coin, this means you have no control over the investment returns or how the company chooses to operate. The opposite tends to be true when you invest in a rental property – you’re in charge and you make the decisions regarding the property.
Less tax benefits. The majority of REIT dividends are taxed as ordinary income up to the maximum rate of 37%, which means you may have to pay a decent chunk in taxes if your REITs are held in a non tax-advantaged account. Conversely, most owners of rental properties are able to deduct the majority of expenses they incur in managing the property.
The more hands-on approach to earning income through real estate is to buy a physical property yourself and rent it out to tenants. If the rent that you’re able to charge is higher than the mortgage payment you must make each month along with expenses incurred for repairs and upkeep, then you can make a decent monthly profit.
The pros of investing in rental properties include:
Complete control. When you buy a rental property, you’re in control. You call the shots. This means you determine what upgrades to make to the property, what monthly rent to charge, how to market it to potential tenants, etc. While this requires active work on your part, you can rest assured that you’re in complete control of your investment.
Potential for higher returns in certain markets. If you’re deeply familiar with a particular real estate market, you may have the ability to find great deals and earn excellent returns. This is in direct contrast to investing in REITs, where the performance of a single property rarely affects the entire portfolio much.
Tax deductions. When you own a rental property, you are able to deduct the majority of expenses you incur in managing and renovating the property. So, even if you have to make significant investments to upgrade, renovate, or manage the property, most of these expenses will be tax deductible.
The cons of investing in rental properties include:
Active management. When you choose to invest in a rental property, you take on the responsibility of managing, renovating, and marketing the property yourself. This can be more work than most investors are willing to take on. Of course you can outsource this work to a property manager, but that requires additional expenses and a lack of control over the property.
High barrier to entry. When you invest in a rental property, you either need to have enough money to put down on the property yourself or acquire a mortgage loan that does not require a down payment. Because of this, many investors don’t have enough capital that is needed upfront to actually invest in a rental property. This is in direct contrast to investing in REITs, where you can gain real estate exposure with just a few hundred bucks.
Higher potential risk. If you find great tenants to occupy your rental property, you may have a hassle-free form of passive income in the form of monthly rent payments. However, if you land difficult tenants then you might be in for a headache. Or if you have trouble finding tenants in the first place, you might be stuck in a situation where you have to pay the monthly mortgage without having rent payments coming in the door. This is the risk that comes with investing in a single rental property.
Why I Prefer REITs
I personally prefer to invest in REITs over rental properties because I love the passive income associated with it. Through clicking a button on my laptop I’m able to buy shares in REITs and receive reliable dividend payments like clockwork every three months. And in the event that I would need access to cash quickly, I could click another button to sell my shares.
Conversely, I don’t like the idea of doing the work needed to find, invest in, and manage a physical rental property. I have no expertise in this field and, although it’s something I could learn if I really wanted to, it’s not a priority for me. I prefer to simply invest in REITs managed by professionals who spend all day finding and investing in real estate deals across the country.
Note: I prefer to invest in REIT index funds, which are composed of hundreds of individual REITs. So, not only do I get to avoid picking individual properties, but I get to avoid picking individual REITs as well.
With that said, I know plenty of people in the personal finance community who have had great success with rental properties, the most obvious being Chad Carson. It’s certainly possible to do well with rental properties and if it’s something that piques your interest, feel free to dive deeper into the field yourself.
I also don’t like to declare that I would never invest in something and if the opportunity came along in the future and I had the knowledge required, it’s certainly possible that I would jump at the right deal.
But at this time I’m not interested in doing the hands-on work required to succeed with rental properties, so I’ll continue to use REITs as my preferred asset class for generating passive income.
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