Rental property vs investments

[FlorenceMcGillicutty]

This is probably a dumb question but I'm hoping someone can enlighten me. What are the advantages to having a rental property vs just investing cas into REITs or index funds? It seems like investing in the market is a more passive way of getting a similar return. Am I missing something obvious?

[honobob]

Yes, the similar return.

[2527]

Rental properties can be very successful for people who can select properties well, handle tenants well, and can much of their own maintenance.  If a person can't do those things, or isn't inclined, a REIT is probably better.

[Another Reader]

If you pick and manage properties correctly, your returns should be much higher than an REIT.  More risk and more work means more return, if you do it right.

[Nords]

This is probably a dumb question but I'm hoping someone can enlighten me. What are the advantages to having a rental property vs just investing cas into REITs or index funds? It seems like investing in the market is a more passive way of getting a similar return. Am I missing something obvious?

No, you're correct, and you're not missing anything.

Picking individual stocks offers an opportunity to find value investments with outsize returns and rapidly-growing dividends, assuming you can put the learning, time, & effort into it.  Or you could just buy index funds to get most of the market's return with minimal effort.

Picking individual bonds offers the chance to buy dollar bills for 75 cents and possibly earn capital gains in addition to high interest rates, assuming that you can put the learning, time, & effort into it.  Or you could just invest in a bond index fund to get most of the return with minimal effort.

A rental property gives you the chance to buy undervalued properties, rehab them, and rent them out for a highly reliable cash flow with the prospect of capital gains.  Assuming that you can put the learning, time, & effort into it.  Or, as you've pointed out, you could just buy a REIT.

If you have to ask whether you have what it takes to be a landlord, the answer is that you could probably read and learn and figure out to do it.  But if you have to ask then you're probably not hard-wired to be a landlord, and it's better to buy a REIT.

[arebelspy]

Those were some great answers. 

The other thing I'd add to the above is the stability of your return is more likely with individual property holdings, IMO.

Even if rents decrease a bit, how many people who owned property without being massively over leveraged kept seeing the rents rolling in month after month versus saw their REITs (and related payouts) drop quite a bit?

Would you be comfortable with an SWR of 10% with REITs?  I very well may be with individual property holdings (and other real estate related holdings, such as notes).

[Another Reader]

+1 on the stability.  In a way, real estate has a lot in common with dividend paying stocks with consistent payout records.  As long as the rent or dividend checks keep rolling in, the price of the stock or the property on any given day is not really important (unless you are trying to sell that day).

Another feature of real estate is the favorable tax treatment.  Depreciation offers tax shelter and if your income is too high to expense it for tax purposes, it can be used to offset the tax consequences of a sale.  REITs don't give you that advantage.

[Nords]

Another feature of real estate is the favorable tax treatment.  Depreciation offers tax shelter and if your income is too high to expense it for tax purposes, it can be used to offset the tax consequences of a sale.  REITs don't give you that advantage.

I'm confused.  The IRS assumes the structure is depreciated whether you depreciate it or not, and when you sell the place then you pay depreciation recapture.  That's tax deferral, not tax shelter, and it doesn't seem to offset the tax consequences of a sale.  If anything it's a tax in addition to cap gains.

The only other way to avoid depreciation recapture would seem to be a 1031 exchange-- which also appears to be tax-deferred, not tax-free.

As far as I can tell, the only tax-free way to transfer the title of rental real estate is... probate.

[Jwilliamson22]

I may have missed where someone else mentioned it, but you also have to consider the leverage of rental properties (assuming a mortgage) versus straight investing into REITs.

[arebelspy]

I may have missed where someone else mentioned it, but you also have to consider the leverage of rental properties (assuming a mortgage) versus straight investing into REITs.

That would automatically factor in when you calculate ROI (as the I component would be smaller with leverage).

People in real estate tout this as this great advantage, but if you get a 8% total ROI on your investment (counting principal reduction, cash flow, appreciation, etc. etc. on your real estate investment) or 8% in the stock market, it boils down to the same thing.

Now it's likely that leverage will boost your overall ROI to much higher than another investment, however that is borne out when you look at ROI.  The leverage itself washes out, and isn't a separate benefit, just another factor in the calculation.

But yes, it is one reason why you will likely see higher returns with rental property than REITs, it just is reinforces the answer "the returns are different" with a reason, rather than providing a separate reason itself for rentals over REITs.

[Jwilliamson22]

I may have missed where someone else mentioned it, but you also have to consider the leverage of rental properties (assuming a mortgage) versus straight investing into REITs.

That would automatically factor in when you calculate ROI (as the I component would be smaller with leverage).

People in real estate tout this as this great advantage, but if you get a 8% total ROI on your investment (counting principal reduction, cash flow, appreciation, etc. etc. on your real estate investment) or 8% in the stock market, it boils down to the same thing.

Now it's likely that leverage will boost your overall ROI to much higher than another investment, however that is borne out when you look at ROI.  The leverage itself washes out, and isn't a separate benefit, just another factor in the calculation.

But yes, it is one reason why you will likely see higher returns with rental property than REITs, it just is reinforces the answer "the returns are different" with a reason, rather than providing a separate reason itself for rentals over REITs.

Well Said. I didn't mean to imply any "additional" benefit, but just as you said the ability to often have greater returns because of the associated leverage.

[FlorenceMcGillicutty]

Thanks much for all the thoughtful responses! I hadn't checked in for a while or I would have responded sooner. It's great to be able to hear from people with landlording experience. I can definitely see that there are advantages but it's certainly not "passive" income either. We're not going to buy a rental anytime soon--maybe within 5 years or so--but I want to read up on it now so I can see if it's the right move for us. I'm thinking that if we found an opportunity nearby our house, we might pounce.

Thanks again, mustachians. The folks who responded are a real estate brain trust. 

[Another Reader]

My understanding is that unused depreciation is "stored" and can be used to offset depreciation recapture and capital gain.  My taxes are done by a CPA, so I can't tell you how to handle stored depreciation in Turbo Tax or with a paper form.  I have a fair amount sitting in the back pages of my tax return now, waiting to be used on the next sale of a rental. 

Jeff Brown used to have a couple of good articles on his website on the subject of stored depreciation.  Most of what's there now is in video form.  This one mentions the subject:  http://bawldguy.com/socratic-questioning-part-2-video/

[honobob]

Another feature of real estate is the favorable tax treatment.  Depreciation offers tax shelter and if your income is too high to expense it for tax purposes, it can be used to offset the tax co nsequences of a sale.  REITs don't give you that advantage.

I'm confused.   

As far as I can tell, the only tax-free way to transfer the title of rental real estate is... probate.

Probate is probably the WORST way to transfer title to real estate.  There are so many cheap and easy ways to avoid probate.  Probate generally will cost a LOT of TIME and money.  A smart investor will NOT transfer title of real property through probate.

[arebelspy]

I think Nords was being facetious, and using probate as a proxy for "dying" - however you want to transfer title just before or after that (using a trust or what have you), his point stands regarding the tax deferred nature of most real estate tax benefits such as depreciation.

That being said, 1031s and depreciation are still better than what's available to REITs (which are all also available to real property).

[Another Reader]

Any CPA's out there that want to explain stored depreciation and the uses?

[Undecided]

Any CPA's out there that want to explain stored depreciation and the uses?

I am not a CPA.

I think you mean suspended passive activity loss. Passive activity loss (or gain) is the tax loss (or gain), in each case including depreciation, of a passive investment. Ordinarily, you may not deduct a net passive activity loss that arises from a continuing investment against other income. Absent exceptions (one of which is broadly available with respect to rentals, so read on), the losses from rental real estate are passive activity losses that may not be deducted from other income (they are instead suspended until available). However, real estate professionals (engaged primarily and at least 500 hours/year in the real estate business) may deduct losses from rental properties (it's not passive) and there is a so-called "special allowance" that permits a taxpayer to deduct up to $25k/year in passive activity losses against other income if the taxpayer's income is otherwise below the applicable limit. If you have passive activity losses that you may not deduct against other income, they are suspended until you qualify or the asset is disposed of (in the case of a rental, ordinarily when you sell the house), at which time they become available to offset against other income---so note that this offset may be better (at that point) than just offsetting against the capital gain, which is (at least presently) taxed at 15% (assuming you held the rental at least a year), because it could offset against income taxed at a higher rate (e.g., your earned income in your marginal tax bracket).

[Mr Mark]

Aren't REITs also highly leveraged, but not with 3.9% fixed for 30 years?!  They may be a lot more volatile than your own quality rental or 3.

I'd probably prefer 10% in reits plus 25% in physical real estate equity, own home included along with it's imputed rental income.

[LinCO]

I'm a little late to this conversation, but have experience with both and am reading the forum with this very thought in mind!

Here's how it has worked out for me: I've managed to buy stocks that barely budge - like Disney for my son's education account and it went nowhere. My mom bought AT&T for my second son, and they stole $900 of the $1000 she put there for him! Then after the criminal trial and civil lawsuit, a whole $27 was returned to him! I also managed to invest an inheritance the DAY BEFORE the market went down - was it 1998? This was all late 90s. You could say I don't know enough to work the market. Or you could say my strong dislike of Wall Street criminals trips me up. I do have index funds in my retirement accounts.

Later we put $$ in fixer uppers. Once we had 3, we bought a lot to put a modular on. This was branching out and it hasn't worked out-the HOA changed the rules on modulars! We can't convince ourselves to hire a builder, but that's going to happen and we won't have leaky pipes or other difficulties in the near future. We were in the midst of a fixer upper when the crash of 2008 hit and haven't been able to sell a house we planned to sell. This is the huge downside for us - we have been cash poor. But our rents didn't take a hit, our mortgage balances are down and if we are planning to keep the properties it doesn't matter what they are worth, just what their rent is. All my bonds and equities definitely sagged.

However, we have had the huge rehab expenses on 2 of our 4 rentals in the last 5 years. Our financial planning was undercut by not being able to sell that one house which is our 4th rental, but we need to include budgeting for replacing carpets etc. We also need to get some kind of insurance for when your insurance screws you over!!

We've also gone back and forth on paying for management-I think I prefer paying 10% to have someone else take the phone calls and check the condition of the property.

My current question is whether I'm better off paying off the 6% mortgage I have on one of my properties.