Recently, we discussed the topic of “8 Reasons Why REITs Offer Greater Rewards Compared to Rentals.” In summary, research indicates that Real Estate Investment Trusts (REITs) generate annual returns that are 2% to 4% higher than those of private real estate. The reasons for this advantage are as follows:

1. REITs benefit from substantial economies of scale.
2. They have the ability to pursue external growth opportunities.
3. They are capable of developing their own properties.
4. They can enhance profits by leveraging their operational platform.
5. They possess superior bargaining power with tenants.
6. They gain access to off-market transactions on a larger scale.
7. They attract top talent in the industry.
8. They effectively mitigate the risk of catastrophic failures.

However, it is essential to recognize that higher returns often come with increased risk. This perception leads many rental property investors to shy away from REITs, viewing them as significantly riskier due to their stock-like trading nature, which is accompanied by notable volatility. Nevertheless, I maintain that REITs represent a safer investment alternative compared to rental properties. Here are six reasons to support this assertion.

Concentration vs. Diversification
Investing in rental properties often involves significant capital, resulting in many investors owning only one or a few properties. This concentrated investment leaves them vulnerable to the performance of a limited number of assets, tenants, and markets. In the event of adverse circumstances—such as property damage, legal disputes, or unfavorable market conditions—investors may incur considerable losses due to a lack of diversification.

In contrast, REITs possess portfolios comprising hundreds or even thousands of properties, which provides extensive diversification across different properties, tenants, and markets. Moreover, with approximately 1,000 REITs globally operating in over 20 property sectors across more than 20 countries, investors can assemble highly diversified portfolios capable of withstanding economic fluctuations.

Private vs. Public
Rental properties are considered private investments, making them relatively illiquid, less transparent, and more susceptible to inconsistent regulations, which increases the risk of fraudulent activities. Obtaining reliable information about private properties can be challenging, and investor protections are often limited, leaving many vulnerable to exploitation.

Conversely, REITs are public entities that are liquid, transparent, and regulated by the Securities and Exchange Commission (SEC). They undergo scrutiny from numerous analysts, including short-sellers and legal professionals, who search for any discrepancies or issues within the company. The risks associated with purchasing private properties—such as overpaying due to incomplete information—are significantly higher, and the complexities involved in selling such properties in the future can be both costly and burdensome.

High Leverage vs. Low Leverage
Rental property investors typically utilize around 80% leverage when acquiring properties. This level of indebtedness means that even a modest 10% decline in property value could result in a 50% loss in equity. This dynamic explains the prevalence of bankruptcies among property investors during the financial crisis, where many found themselves with negative equity and ultimately forfeited their properties to lenders.

In contrast, REITs adopt a more conservative approach, leveraging only 30% to 50% of their investments based on property type, which lowers their risk exposure during economic downturns.

Personal Liability vs. Limited Liability
Many rental property investors tend to underestimate the risks associated with personal liability. While establishing a Limited Liability Company (LLC) or obtaining insurance may offer some protection, it does not eliminate risk entirely. Lenders often require personal guarantees when securing a mortgage, and tenants or contractors may still pursue personal lawsuits if they believe the property owner is liable for certain issues.

For instance, if mold were to develop in a rental property, resulting in health complications for a tenant, that tenant could potentially pursue legal action against the landlord, regardless of fault, leading to significant stress and financial implications.

With REITs, however, investors are protected from personal liability as they merely hold minority shares in a publicly traded company. They are not personally accountable for loans, and in the worst-case scenario, their losses are limited to their equity investment. Tenants cannot directly sue REIT shareholders, further safeguarding personal assets.

Social Risk vs. Operational Protection
Real estate investment inherently involves interpersonal interactions, exposing investors to social risks. There are instances where property owners have been exploited by tenants, leading to emotional distress or physical harm. Although such incidents may be rare, they do occur, with some landlords facing threats, harassment, or vandalism from tenants.

While one might believe that selective tenant screening could mitigate these risks, human behavior can be unpredictable, and eventually, most landlords will encounter challenges of this nature. The potential returns from rental investments seldom justify the associated risks.

I would prefer to earn a slightly lower return while being entirely insulated from operational responsibilities, with professionals managing the property on my behalf. Although hiring a property manager is an option, it can be cost-prohibitive due to the scale limitations compared to REITs. REITs, on the other hand, can efficiently manage their properties at a lower cost due to their size, effectively shielding investors from operational risks.

No Quotation vs. Daily Quotation
If you believe that REITs exhibit greater volatility than rental properties, reconsider. The misconception often arises from comparing the total asset value of a rental property to the equity value of REITs, which is an inappropriate comparison. Instead, one should evaluate the volatility of their equity in rental properties against the fluctuations in REIT share prices. Upon doing so, it becomes evident that REITs generally demonstrate more stability.

For instance, when utilizing an 80% loan-to-value ratio, an investor only retains 20% equity in a property. Therefore, a 10% decrease in property value could lead to a 50% drop in equity value, and a 20% decline could result in total equity loss. Consider the likelihood of facing setbacks with a private, illiquid, concentrated asset featuring a single tenant and significant capital expenditures—this risk is considerably high.

Damage from a leaky roof or tenant disputes can easily decrease property value by 5% to 10%, translating into a 25% to 50% drop in equity. Even without issues, the illiquidity and opacity of private property values introduce substantial uncertainty. If properties were evaluated on a daily basis, offers would likely fall 10% to 20% below perceived value, resulting in extreme equity volatility.

The absence of daily pricing quotes does not equate to stability in equity value. In contrast, REITs offer transparency regarding equity value, which may fluctuate but typically not to the same degree. The nature of REITs as large, diversified, publicly traded entities that are SEC-regulated facilitates a more accurate market price determination, leading to reduced volatility.

Research by Brad Case, CFA, PhD, has shown that when appropriately adjusted for an accurate comparison, REITs are 17% less volatile than private real estate.

Final Thoughts
In summary, rental properties are characterized by concentration, privacy, illiquidity, high leverage, liability concerns, and social risk. Conversely, REITs provide diversification, public access, liquidity, moderate leverage, limited liability, and professional management.

The disparity in risk profiles between these two investment options is striking. In my view, rental properties are significantly riskier than REIT investments, and any arguments suggesting otherwise reflect a misunderstanding of the dynamics at play. This disparity is further illustrated by bankruptcy rates; numerous real estate investors file for bankruptcy annually, while REIT bankruptcies are exceedingly rare.

In the previous post: “Is Now a Better Time to Invest in Real Estate Debt or Equity?“