Investing in Real Estate

While I have some years of experience investing, primarily in index funds and mutual funds, I can’t help but watch the financial community on Twitter blow up about REITs and how real estate should be a key piece of my investing strategy. While many people rave about real estate, I’ve always been a fan of keeping my investments diversified and wanted to learn more before considering investing.

In this post, I will cover (1) what options we have to invest in real estate, (2) the pros and cons to investing in real estate, and (3) our plans in the future. Full disclosure, I enjoy learning and writing about finance, and am not a certified professional – so please consult a professional before implementing any strategies discussed in this post.

How to Invest in Real Estate?

We have multiple ways to invest in real estate, whether that is by (1) becoming a landlord, (2) investing in a company that specializes in real estate, or (3) investing in a fund diversified in multiple real estate companies.

When you are a landlord, you are responsible for purchasing the property, maintaining the upkeep, and finding residents to live in your property to minimize vacancies. You will need to research the market to set how much to charge for rent, and take on the risk of bad tenants damaging your property, expensive repairs like replacing the roof, or risking long periods of vacancy if the population is declining in that community. You may feel like you need to invest in your hometown, but many people will purchase homes in a different location and hire someone to perform the maintenance and cleaning required, so you can invest in specific regions or cities.

Alternatively, you could invest in a company that handles all of that responsibility for you. You may have a specific company you are interested in such as a REIT (Real Estate Investment Trust). A REIT is a company that invests in many different properties and typically will focus on a segment such as commercial, retail, residential, etc. Many REITs trade on the stock exchange and you can trade them just like you would shares of a company like Amazon or Apple. You may also see an mREIT, which doesn’t invest in the property itself, however, is focused on the financing side such as mortgages. Note that you can invest in both public and private REITs, the main difference being whether it is publicly traded on the stock exchange.

A real estate investment trust (REIT) is a company that owns, operates, or finances income-generating real estate. Modeled after mutual funds, REITs pool the capital of numerous investors. This makes it possible for individual investors to earn dividends from real estate investments—without having to buy, manage, or finance any properties themselves.

Investopedia.com

While investing in a REIT provides more diversity since the company may manage multiple properties, you can also invest in a mutual fund or exchange-traded fund (ETF) that gives you the benefit of investing in multiple real estate companies. Theoretically, this still provides the gains you would expect from REITs, however the diversification and reduced risk of allocating your investments with multiple companies. The process is similar to a fund that invests in multiple stocks (index fund, mutual fund, etc) versus investing all of your dollars in one specific company like GameStop, which hopefully you didn’t do on January 29th, 2021.

The Pros and Cons of Real Estate Investing

Let’s start with the good stuff. Many people will rave about real estate investing and consider it a must-have in their portfolio, or you are leaving money on the table. So how have REITs performed compared to the industry standards? Keep in mind, that past performance is not a guarantee of future performance, and we will need to review both performance in long term gains and dividends.

If we were to compare VTSAX (Vanguard Total Stock) vs. VNQ (Vanguard Real Estate), historically over the last 5 years, VTSAX has delivered significant gains compared to VNQ.

Reference: Google Finance

Pulling the annual data since 2008, VNQ appears to have underperformed the total stock market index, VTSAX, six of the thirteen years with an average of -3%. However, the return on the Index Fund price doesn’t tell the full story, since Real Estate, VNQ in this example, pays out a much higher dividend every quarter.

YearVTSAXVNQDelta
202020.99%-4.72%-25.71%
201930.80%28.91%-1.89%
2018-5.17%-5.95%-0.78%
201721.17%4.95%-16.22%
201612.66%8.53%-4.13%
20150.39%2.37%1.98%
201412.56%30.29%17.73%
201333.52%2.42%-31.10%
201216.38%17.67%1.29%
20111.08%8.62%7.54%
201017.26%28.44%11.18%
200928.83%29.76%0.93%
2008-36.99%-36.98%0.01%

As we look at the annual dividends last year, VNQ paid out over 2% higher dividends over the year in 2020. While this doesn’t make up for the 3% average gap in price gains, 3.65% is a nice annual dividend payout while still ideally recognizing gains in the fund price. Many people prefer the dividend payouts because you receive that money today versus waiting in the future to sell the funds and recognize capital gains at that time.

VTSAXVNQ
Expense Ratio0.04%0.12%
Yield1.42%3.65%
Dividends [2020]$1.34$3.34

Even with the high dividend payout benefit, there are tax reasons to be critical of whether this path is the best for you. While receiving a dividend payout may bring you comfort today, it is quite possible that you are paying a higher tax on that income and may be forced to pay taxes on a year when you are earning at a higher tax bracket. If you’re unfamiliar with how taxes are calculated on dividends versus capital gains, I recommend you learn more about how to increase your future income by understanding capital gains and dividends from my previous post.

Income LevelFederal Income RateFavorable Rate
$9,526 to $39,37512%0%
$39,476 to $84,20022%15%
$84,201 to $160,72524%15%
Individual Tax Rates; Reference Investopedia

Being forced to receive your earnings through dividends is the reason why many people will allocate their REIT investments in a tax-deferred account so that they don’t pay taxes on these gains until a later date. If you choose not to invest with a tax-deferred account, you must remember that the dividends you earn from real estate typically are not qualified dividends, meaning that you are paying the higher tax rate aligned with your federal income tax level versus the favorable rate used for capital gains or qualified dividends.

Our Plans for the Future

My husband and I have tossed around the idea of investing in a home that we could rent out, but find ourselves hesitant of the extra work that comes with finding tenants and maintaining another property. We also live in a state with a declining population for the last 10 years and have little desire to hire someone else to maintain properties elsewhere. Therefore, investing in REITs are a more realistic option for our lifestyle choices.

Given my analysis so far, it appears that the biggest benefit of investing in a REIT is to earn higher dividend payouts while still having the option to see capital gains long term on the fund prices. After learning about the tax impacts, I don’t feel that keeping real estate investments outside of a tax deferred account is the best solution because I will be forced to pay taxes on the earnings today and also not benefit from the favorable tax rate since these will be considered non-qualified dividends. Since we still have many years until we retire, unless we anticipate missing out on significant gains, the benefit of dividends is irrelevant until we retire and can cash in on capital gains.

Personally, I anticipate that REITs are going to be challenged as we continue from 2020 into 2021. Already in 2020, many of these companies struggled as people were unable to pay rent, or closed their doors due to the pandemic. More people are shopping online, and many people are working at home, reducing the demand for retail and office space. While I’m certainly no expert, at this time we have decided to focus on investing in stock heavy index funds so that we can still recognize the long-term benefits without the added risk of depending on the real estate market.

Just because we’ve decided not to invest here, doesn’t mean that it isn’t a good opportunity for everyone. What have you considered regarding real estate, whether you are considering being a landlord, or investing in REITs?

Questions to Consider

  • Do you have an opportunity to house hack and rent a room in your house to help with your mortgage?
  • Are you interested in becoming a landlord and willing to put in the work to maintain the property and find reliable residents?
  • Are you willing to take on the risk of significant damages or long periods of vacancies?
  • Do you expect the home/property value to increase while you own it?
  • Do you have a preference for dividends over capital gains?
  • Are you investing in a tax-deferred account or a brokerage account?
  • Do you anticipate your income changing in the future (potentially lowering your taxable income?)
  • Have you evaluated how much more you will pay in taxes if you earn non-qualified dividends vs. qualified?

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