Passive Income In 2023: Why High Yield Stocks Will Pummel Rentals

Investing in rental properties has been established as a successful strategy for building a passive income stream. Many financial experts and websites dedicated to early retirement and wealth creation emphasize the benefits of investing in real estate rental properties as a means of rapidly growing wealth and generating a steady passive income stream.

One of the reasons why rental properties have proven to be such an effective means of building up passive income is because buying them is made simpler through the availability of long-term, low-interest mortgage loans, which eliminates the need to save large amounts of money to buy them. Additionally, the historically low interest rates enjoyed over much of the past decade – largely influenced by the Federal Reserve’s purchase of trillions of dollars in mortgages – made mortgage debt highly affordable and resulted in large investment spreads on rental property cap rates.

However, in the coming years we believe that investing in high-yield stocks will prove to be a more effective means of building passive income than investing in rental properties. In this article, we will outline our reasoning and also provide a list of some of our current top high yield stock picks.

#1. High-Yield Stocks Are More Efficient Investments Than Rental Properties

High-yield stocks offer several advantages over rental properties, making them a better option for building passive income. First of all, high yield stocks are truly passive investments that require minimal effort, whereas owning rental properties can be comparable to running a business with the responsibilities of managing tenants, maintenance, and legal liabilities. Furthermore, hiring a property manager to ease the burden can incur additional expenses, reducing your passive income.

In contrast, high yield stocks come with no such responsibilities, and transactions can be easily executed at the click of a button. Publicly-traded stocks are generally more liquid than rental properties, and therefore easier and quicker to convert into cash. This can be beneficial for investors who need to access their money quickly and also makes it easier to partially exit an investment, whereas rental properties are generally either fully owned or not owned at all.

High yield stocks also provide the opportunity to invest in a wide variety of industries and companies at the same time, which can help to diversify your portfolio and reduce risk. This is not as easily achievable with rental properties, which are usually limited to a specific geographic area and require a very large net worth to achieve any sort of meaningful diversification.

Furthermore, buying and selling stocks are typically done with commission-free trading and at very narrow bid/ask spreads. In contrast, real estate is generally very inefficient to transact given the hefty preparation, marketing, and closing costs that are often involved.

High yield stocks also benefit from the expertise of highly skilled professionals who manage the underlying business on the behalf of shareholders. This can be more convenient and often more effective than managing rental properties by oneself, which often requires significant time and effort. As already mentioned, if you elect to hire a property manager to run your rental business for you, it can wind up eating significantly into profits. In contrast, the money paid to corporate management teams is often a much smaller percentage of revenues when compared to property management fees given the economies of scale involved.

#2. Residential Real Estate Has Poor Near-Term Return Potential

Another major reason why we believe high-yield stocks will pummel rental properties as a source of passive income in the future is due to the decline of the residential real estate boom. The profitability of rental property has diminished in recent times due to elevated costs, weakening macroeconomic conditions, and rising interest rates.

The cost of buying homes, whether through cash or via a mortgage, has become increasingly unaffordable due to high prices and rising mortgage interest rates. This development is particularly significant for investment properties, as rental rates have not kept pace with interest rates or prices in many markets. Additionally, interest rates for rental properties tend to be higher than those for owner-occupied homes. This makes it challenging for investors to achieve positive cash flow from rental properties when using a significant amount of debt financing. As a result, investors have to invest more equity up-front to generate positive cash flow on rentals, which in turn weakens their long-term return on equity potential.

Furthermore, the elevated prices at the moment – that have outstripped the cash flowing potential of the properties – as well as the declining appeal of mortgages means that demand is drying up. As a result, the appreciation potential for single family properties has declined substantially. Lower cash flow and weaker appreciation potential simply means that rental properties are no longer nearly as attractive an investment as they were just a few years ago.

Our Top Picks

While rental properties have been on a great run over the past decade and have made many casual investors wealthy with impressive income streams, we currently favor high-yield stocks.

In addition to the weak total return and effort-intensive cons facing rental properties, there are also a number of high yield stocks on sale right now thanks to the downturn in the S&P 500 (SPY, VOO), Nasdaq (QQQ), and REITs (VNQ) over the past year. As a result, we think an intelligently constructed portfolio of high yield stocks will deliver significant outperformance relative to rental properties in the coming years.

Some of our top picks of the moment include:

• Triple net lease REITs (NETL) like Realty Income (O), Essential Properties Realty (EPRT), Spirit Realty Capital (SRC), and W. P. Carey (WPC). These REITs should be able to weather any upcoming recession due to their long-term leases with annual rent escalators, strong investment grade credit ratings, and substantial growth pipelines. Furthermore, they have proven to perform quite well during previous periods of macro distress, including during the Great Recession (2008-2010) and the COVID-19 lockdowns of 2020. Triple net lease REITs are also proven passive income machines given that many of them boast lengthy dividend growth streaks in combination with attractive mid-single digit current dividend yields.
• Alternative asset managers like Blackstone (BX), Brookfield Asset Management (BAM), and Blue Owl (OWL) all combine very strong growth momentum due to a strong fundraising environment with attractive current dividend yields. Moving forward, we expect each of these companies to continue growing their dividends at CAGRs ranging from 7-15% over the next half decade. As a result, they number among the very best dividend growth stocks in the market today and offer the potential to significantly outperform rentals in the coming years.
• Finally, we think that energy midstream businesses – particularly the likes of Energy Transfer (ET) and Enterprise Products Partners (EPD) – offer a compelling story as passive income investments. They both offer high single digit current yields along with significant tax benefits (if held in a taxable account) and very strong balance sheets. They also generate fairly stable cash flows regardless of macro conditions thanks to their long-term fixed-fee, take-or-pay contracts that help insulate them over the short-term against dramatic swings in energy commodity prices. Note that these investments often issue K-1 tax forms, so be sure to do your own due diligence and speak with a tax advisor before purchasing them.

Investor Takeaway

While it had its day in the sun, we think that investors should steer clear of rental properties when looking to build a passive income stream in the coming years. Instead, we think that high yield stocks – especially those like we shared in this article – provide much greater promise as passive income and total return instruments.

At High Yield Investor, we are filling our portfolio with about three dozen similar investments as those discussed in this article, providing us with a well-diversified, truly passive, highly liquid, and professionally managed portfolio that throws off a ~7% annualized yield while delivering significant market outperformance. Why buy rental properties when you can build a portfolio like that?