REIT versus real estate: total yearly returns (when accounting for leverage)

Question

Recently, I saw an article arguing that REITs performed better than traditional real estate (RE) in terms of total returns:

• Jussi Askola, Don't buy real estate, buy REITs instead, Seeking Alpha, December 15, 2018.
• https://seekingalpha.com/article/4250369-earn-high-passive-income-rental-properties?ifp=0&app=1
• https://www.reit.com/news/blog/market-commentary/comparing-listed-reits-private-equity-real-estate-what-cambridge

However, I'm confused how this could be the case when considering the lower cost of capital investment home-buyers have access to to boost their ROE over someone buying REIT shares. Investment home-buyers can take out a mortgage loan at ~6% interest (which appears to be conservative relative to what I could find), whereas someone buying REIT shares would be borrowing on margin at around 8% (Schwab's baserate+margin, though there are some cheaper alternatives), ~30% greater than the investment property buyer.

To me it seems like RE would have the superior ROE when considering the leverage most people use to buy properties and a 2%/month rental charge (anecdotal example here). Though this study seems to quantify an added (il)liquidity-risk penalty for holding physical real estate, 20% down on a $100,000 rental with a 1%/month rent (and assuming a 6% loan APR and 50% maintenance cost on the monthly rent), you'd have

(($100000 x 0.02 x 12) x (1 - 0.5) x (1 - 0.06) ) / $20000 = 28% ROE

which seems to beat REITs (from this brief analysis you may be able to tell I don't actually know all the costs involved with investment property ownership). Could anyone explain how REITs would still beat physical RE in this case?

I know there are already several post here about REITs versus RE, but was curious specifically about the total return comparison between the two. Basically, I was hoping that someone could explain how the math actually averages out justifying (or refuting) REITs over real estate with a rough ROE analysis for each case.

Answer 1

Summary first: you probably can achieve higher returns with physical real estate investment (RE) than by investing in REITs thanks to higher leverage and not sharing your returns with the management of the REIT. You "pay" for those higher returns with personal liability; higher idiosyncratic risk; your time; far lower liquidity.

A comparison in more detail:

• Leverage and personal liability: REITs themselves leverage their real estate investments, but the typical amount of leverage (50% LtV) is far lower, than for the typical retail direct real estate investment. Reason for the low leverage within REITs is that they are only liable within the assets of the vehicle itself, whereas in the typical private person investment case, those are liable with all their possessions on top of the mortgaged property and all their future income. The interest rates REITs pay on their financing are typically floating and typically quite competitive, since those are negotiated by professional investors in the wholesale market. This makes REITs prices sensitive to changes in interest rates. As you point out, additional leverage in the case of REITs can be achieved if the REIT itself is bought on margin, but the costs to this in your example seem so high, as to forfeit any benefit in expectation (8% is ca. current FED rate + 600bps). Even typical retail investors should pay less for financing when trading on margin.

• liquidity: while in extreme cases REITs can be closed for redemptions or trade at steep discount to NAV, typically it is far more easier to liquidate the investment compared to physical real estate (finding a buyer, notary fees, realtor fees, bank fees for cancelling the mortgage, etc.). On the reverse side of this, you pay someone to manage the REIT and share the returns with them.

• Idiosyncratic risks: REITs are more diversified than a single RE investment by an individual. The risks that a tenant stops paying, litigates, damages by natural hazards occur, price/income be negatively affected by unfavorable developments in the neighborhood are more manageable within a diversified REIT. Typically you do not get additional compensation for bearing those risks (apart from it being easier to manage if you have a smaller number of properties).

• control over the asset, other optionalities: As a private investor if you share the property with others (unit in a condo complex), you forfeit a lot to facility managers and plain stupidity and mismanagement due to dispersed ownership and unprofessional attitude. Professional management by REIT, which has complete control over the whole asset can harvest more. On the other side, as a private investor, you enjoy some one-off benefits on your first property like government subsidies for home ownership, you being your best tenant, since otherwise you need to pay rent anyway, good financing conditions when you are not leveraged yet, etc.

• you work for free: for your personal RE investment you need to write contracts, deal with providers, facility management, taxes, tenants. If you attribute costs to this time, the calculation might look less favorable.

Answer 2

This isn't going to be much of an answer but you are performing a an apples to oranges comparison against the position of the article you quote.

The article is roughly comparing the relative returns of investment properties versus REIT units, not single-family-home-that-you-live-in versus REIT units which tosses out the 4% mortgage rate you're citing as well as most of the underwriting criteria you'll read about related to buying property.

The best thing that REIT units offer over physical real estate is zero administration. You aren't a landlord. The worst thing about a REIT is you don't really know what's in the REIT.