Why I Stopped Buying Rental Properties To Buy REITs Instead Part 2

Last week, I explained in an article why I think that real estate investment trusts, or REITs, are better investments than rental properties in most cases.

In short:

Studies show that REITs (VNQ) generate higher returns over long periods because they enjoy significant economies of scale, better access to capital, and can develop their own assets, among many other reasons.

Moreover, REITs are a lot safer investments as well given that they are large, diversified, professionally managed, liquid vehicles that also protect your personal liability.

Finally, REITs give you complete freedom over your time and geography, which will allow you to focus on your career and optimize your lifestyle.

All in all, I like to say that the risk-and-hassle-adjusted returns of REITs are a lot stronger in most cases, and I am not saying this without proper consideration, as I come from a private equity real estate background.

But there are exceptions, and I want to cover those in today’s follow-up article.

It is not a black or white topic, and I also own some private real estate in addition to my REIT portfolio.

Here are 5 exceptions when I would favor private real estate over REITs:

Exception #1: If you cannot deal with volatility

This is the most important one.

If you know that you cannot deal with market volatility, then REITs probably aren’t for you. REITs are publicly listed, and they will go through periods of intense volatility. Just to give you an example, REITs have dropped by nearly 30% over the past two years simply because they have been out of favor:

If such volatility would cause you to do something stupid like sell at the bottom, then don’t even try investing in REITs.

They require a lot of patience and a multi-year investment horizon. You need to be prepared to hold on to them for at least 5 years to let the investment thesis play out. Anything less than that is highly unpredictable.

Rental properties are also very volatile, but since they are not marked-to-market on a daily quote, it is much easier for a lot of investors to stay focused on the long run.

Know your psychological limitations.

Exception #2: If REITs become pricey

This is not the case today.

In fact, REITs are today priced at their lowest valuations in many years, with lots of REITs trading at 30-50% discounts relative to the fair value of their real estate. This is one of the main reasons why buying private real estate makes no sense today. Even the private equity giants like Blackstone (BX) prefer to buy REITs these days.

But there are other times when REITs may become expensive and private real estate could offer better value.

There have been times in history when REITs were priced at large premiums relative to the fair value of their real estate, which essentially means that you are getting less than what you are paying for.

That could negate some of the benefits of REITs vs. private real estate.

Exception #3: If you are buying your home

Your home is not just a financial investment.

It also has many non-financial benefits. Most importantly, it will give you full control over your destiny. No landlord will be able to kick you out of your residence. You will also be able to customize your home as you wish. For instance, it was important for me to have a sauna because I come from Finland, and I am used to going to the sauna daily.

Therefore, buying your own home may make a lot of sense, even if financially it may not always be the smartest choice. REITs will likely produce higher returns, but so what? Life is not just about money.

Exception #4: If you can secure long-term fixed-rate debt

This point is tied to #3. Certain countries including the USA incentivize home ownership by granting home buyers exceptional loan terms.

If you can get something like a 30-year fixed-rate mortgage with a low interest rate, then buying private real estate could be very rewarding.

Today, this is not really an advantage, given that interest rates are historically high and are expected to be cut in the near term.

Moreover, it should be remembered that REITs also benefit from leverage in the same way. When you buy shares of a REIT, you are providing the equity, which is the equivalent of the down payment. REITs then add debt on top of it, and you benefit from this leverage. It also isn’t unusual for REITs to issue 30-year fixed-rate debt, but in most cases, they won’t use as much of it as private investors because they are finite-life vehicles that keep growing over time. As a result, they will have a lot of tranches of debt with different maturities, some shorter and some longer.

In some cases, being able to load up on cheap fixed-rate long-term debt to buy private assets could be an advantage. This is not the case today.

Exception #5: If REITs do not exist in your targeted market

Finally, REITs do not exist for everything.

Yes, the REIT market is vast and versatile, and they exist now in 30+ countries and invest in 20+ property sectors.

But that still leaves some market niches with no REIT coverage.

Here are three examples:

• 1) I am very bullish on the long-term prospects of Estonia and want to invest in their capital city, Tallinn. But there are no REITs there, so I end up buying a private property.

• 2) I want to own some farmland as part of my portfolio strategy, but there are today only 2 farmland REITs in the U.S., and both of them suffer some issues. Therefore, I am also investing in farmland via crowdfunding.

• 3) I am interested in investing in Argentina following Milei’s victory, but again, the options are limited in that country. I am still exploring various options.

So, in some cases, REITs aren’t an option, and you are then left with the private markets.

Closing Note

Keep in mind that these are all exceptions.

I have about 90% of my real estate allocation in REITs, and the other 10% is in private real estate.

I favor REITs in most cases because they simply offer better risk-and-hassle-adjusted returns, especially today given how heavily discounted they have become.