The concept of owning rental property looks great on the surface. Borrow money to buy a home (or condo, or townhouse), rent out that property to someone else, and have them effectively pay your mortgage while you build up equity in the property and it (hopefully) appreciates in price.
Unfortunately as many rental property owners will tell you, there can be a fair amount of headaches in the process. Do you do all the work and maintenance, answer the 2 a.m. phone calls and market the property yourself? Or do you give up 10-15% of your rental income to have a property management company do the hard work?
Then there is the potential risks. There is a huge potential hidden liability in owning a rental house. When the roof needs work, do you have $5,000 ready to fix it? When the HVAC goes out, can you fork over another $5,000? The number of big ticket items that can break in a house is a bit scary.
And with the median home price at about $204,000, investing in rental property without taking out a mortgage is out of reach for most individual investors.
But Wall Street has made a much easier, and much less scary way of investing in rental properties. Today we look at one such exchange traded fund: iShares Residential Real Estate ETF – Ticker: REZ. – Then we show you a new, even better way to investing in rental property with Motif Investing.
Real Estate Investing – REITS and more
When many think of investing in real estate via the stock market, they think of REITs, or Real Estate Investment Trusts.
REIT (Real Estate Investment Trusts) is really just a different kind of corporation structure, think LLC, S-Corp, C-Corp, Sole Proprietor, etc. And like those structures, REITS have some great benefits, including tax free status if they pay out 90% of their earnings to owners (shareholders).
This is one huge reason REITs have gained in popularity over the last decade. As interest rates have fallen, REITS have provided a higher dividend yield than stocks (on average), because they have to pay out 90% of their profits. So in order to invest in real estate all we have to do is find a REIT mutual fund or REIT ETF and jump in, right?
Not so fast, because really just calling yourself a REIT can mean almost anything.
REITs do have to have a majority of their assets in Real Estate, and get a majority of their income from payments associated from those properties.
But the concept of what “real estate” is may vary from what you had in mind, to what lawyers have decided. Here are just some examples of the wide range of companies that are considered REITs:
- American Tower Corp (Ticker: AMT) – Owns/operates communications towers (cell phone towers, radio towers and other broadcast towers)
- Plum Creek Timber Company (Ticker: PCL) Owns and operates logging forests and produces products like plywood, lumber, etc.
- Public Storage (Ticker: PSA) – Owns public storage facilities
- Annaly Capital Management (Ticker: NLY) – Owns the mortgages to many residential and real estate properties.
- Simon Property Group (Ticker: SPG) – Owns commercial malls and outlet stores.
- Boston Properties (Ticker: BXP) – Owns and develops office properties.
- Gaming and Leisure Properties (Ticker GLPI) – Owns/operates casinos.
- Ventas Inc. (Ticker: VTR) – Owns/Operates/Finances and Leases Health Care Properties.
So when you buy a simple REIT index fund, like Vanguard’s REIT ETF (Ticker: VNQ), you may be getting much more than what you originally thought of as “real estate”:
Not that it is a “Bad” ETF by any means. VNQ is actually one of the cheapest all around REIT index funds out there.
But, chances are if you are looking to invest in rental property, it’s not what you are looking for (as you can see, VNQ has only 17% allocation to residential property).
So, Wall Street has tried to narrow down some ETFs to include just residential real estate. Here is one of the major players:
iShares Residential Real Estate Capped ETF (Ticker: REZ)
- 37 holdings
- Expense Ratio of 0.48%
- Dividend Yield of 3.35%
More information on REZ can be found on iShare’s site here: http://www.ishares.com/us/products/239545/ishares-residential-real-estate-capped-etf
The fund’s prospectus can be found here: http://www.ishares.com/us/literature/prospectus/p-ishares-residential-real-estate-capped-etf-4-30.pdf
So would an investor who wanted to use this ETF as a replacement for an investment in rental property be happy with this ETF? After all, it is called the “Residential Real Estate ETF”?
Personally, I don’t think so. Looking at the fund’s top holdings will tell you why:
Over 10% of the fund’s assets are in a single public storage company, hardly residential real estate at all. Overall the fund does not even have half of its assets invested in traditional residential real estate:
How to Invest in Rental Property the Right Way
So what is an investor left to do? Is REZ the best a small investor can hope for?
Thanks to a new company called Motif Investing, we can create something similar to an ETF (called a Motif), with just the stocks we want. We can take REZ, cut out the public storage companies, cut out the health care office rental companies and add companies that invest solely in single and multi-home rental properties.
You can see my full review of Motif Investing, and a much more in depth description of its features here – Updated to include special offers (like $150 for creating an account!)
With a little bit of research and time, I have created an ETF-like fund that invests in PURELY residential real estate property.
Take a look at it here:
(click image below to enlarge)
The motif consists of 20 stocks, each company gets at least 75% of their income from renting residential property. Each company is evenly weighted at 5% in the portfolio.
Why do I believe this is a superior investment compared to REZ for investors looking to invest in residential real estate or rental property?
- The only PURE play on residential rental property. No storage companies, no office rental companies, just property owners and leasers.
- No expense ratio:
Compare the hypothetical performance of an investment of $10,000 in REZ’s residential real estate ETF, with an expense ratio of 0.48%, to Begin To Invest’s Rental Property Motif, which has no expense ratio or upkeep fees of any kind:
(The results below come from our expense ratio calculator)
Over 30 years, the expense ratio on REZ would add up to more than $7,300 in lost capital! (Assuming the above growth rate, equal performance and assuming no increase or decrease in REZ’s expense ratio – see our expense ratio calculator page to see how all this is calculated)
By investing in our Begin To Invest in Rental Property Motif, you pay no expense ratio.
(Do you see why I am rapidly becoming a huge fan of Motif Investing?!)
- No Market Cap Weighting
I am beginning to hate the idea of market cap weighting, especially in a fund with a smaller number of holdings like REZ. With REZ, its top holding (which as you can recall – is not even a company that invests in residential rental property!) makes up more than 10% of the fund’s assets. With this Motif no company makes up more than 5% – reducing your exposure to single company failure.
Investing in Rental Property – What’s The Best Way?
Let’s say an investor has $200,000 they want to invest in rental property. They are trying to decide between buying a $200,000 house in their area, or buying our Rental Property Motif, how would these 2 scenarios compare- which has more risk? Which provides the best return?
Obviously this is going to vary widely based on where you live. $200,000 buys a much different house in Kansas than California. Using data from Zillow found here: http://www.zillow.com/research/data/ , we can determine that the median price to rent ratio national is almost exactly 10, which means that a $200,000 house rents for about $1650 per month.
But of course that is not $1650 directly into your pocket. After a property manager takes 10%, you pay taxes (assume 1% tax rate), insurance (for my area, $100 per month) and assuming a 98% occupancy rate (which is high), you would end up with about $1200 per month, or about $14,400 per year in rental income.
Didn’t buy the house with cash? A mortgage of $200,000 would cost about $950 a month with a 4% interest rate. Add in insurance and taxes to your payment about you are looking at about $1200 per month – so unless you can rent for a price above the national average, your rental property will not generate any free cash flow until the mortgage is paid off. This makes the whole discussion of “wildcards” below even more interesting, as the property doesn’t provide additional money to save in time of crisis – like a new AC unit, or roof. It all has to come out of your pocket.
But let’s give rental property investors the benefit of the doubt, and say you had the cash to buy the house – so no mortgage payment.
Then we consider a ton of wildcards. How long with the A/C last? How long will the refrigerator last? How long until you need to replace the roof? I don’t think it is unreasonable at all to think that would will cost at least $2,000 per year in maintenance (I think that is very low, but I’m giving the homeowner the benefit of the doubt here).
Now our hypothetical homeowner is left with about $12,400 per year in rental income from his $200,000 investment. This equates to a return of 6.2% – not bad.
Our Property Rental Motif we built earlier sports a nice 3.45% dividend, or about $6,900 per year. Not nearly as much as owning a property outright.
So is buying a house a better option?
I don’t think so.
There is a ton of “What-ifs” for this homeowner. What if it is unoccupied for 3 months? What if a renter trashes the house? What if the roof needs to be fixed?
All of this hypothetical rental property investor’s assets are in this one house. Everything depends on that one house. Compare this to the Investing in Rental Property Motif we created earlier, where your $200,000 would effectively buy into tens of thousands of properties (and you don’t have to worry about maintenance and answering phone calls!) You can just sit back and collect your 3.45%, plus any capital appreciation in the share prices.
To me, it’s a no brainer. An investment in a single $200,000 house has too much risk compared to an investment in a diversified fund of companies that own rental property.
Plus, there are benefits to having your money invested in the stocks that a single home simply does not have.
Companies have the ability to compound their gains over time, unlike a house (or gold, or silver, or oil, or any other commodity). Money that the rental property companies spend is reinvested into the businesses, where it may generate higher future returns.
This is the concept of compounding interest, and is what makes investments into stocks such a great long term investment, and is a big reason real estate company stocks have seen such incredible gains over the last 5 years compared to home prices. Since 2009 this rental property motif has kept pace with the general market, and produced returns in excess of 100% over the last 5 years, IN ADDITION TO THE DIVIDEND.
Even though we have seen a bounce back in housing prices since the recession (about 15% on average nationally), very few property owners can say they have seen the value on their property double without any kind of work.
This idea is nothing new. Stocks have historically outperformed an investment in residential real estate SIGNIFICANTLY:
Of course, there is no guarantee on what happens in the future, and this motif may not continue to perform similarly to the general stock market. But it’s hard to argue with 125 years’ work of data.
Looking to allocate some of your investment dollars into real estate without the risks associated with buying and managing the property yourself? There is no easier way then using our Rental Property Motif at Motif Investing. This fund gives exposure to companies in the business of residential rental property and their dividends, but diversifies risk much better than an investment into a single house or property.