Real Estate Passive Income: Forget Rentals And VNQ, Buy REITs (NYSEARCA:VNQ)

As the great Warren Buffett of Berkshire Hathaway (BRK.A)(BRK.B) once said:

If you don’t find a way to make money while you sleep, you will work until you die.

Generating passive income is truly the key to unlocking your freedom from wage slavery and opening doors to spending your precious time in the best way possible. The equation is simple: more passive = more freedom.

One of the most popular methods for building a massive passive income stream is investing in real estate. The reasons for this are simple:

• Real estate is always in demand
• It is relatively disruption-proof
• Its limited supply and dependence on significant labor and raw material to produce makes it quite inflation-resistant
• It is often easily leveraged, making it easier to increase returns on equity
• Real returns are increased even further given the unique tax advantages of real estate

There are three popular paths for building a passive income stream through real estate:

Option 1: Own Rental Properties

Owning rentals is obviously a popular approach given that it can be easily leveraged, leading to some eye-popping cash on cash returns and IRRs, especially when interest rates are low. Furthermore, it is a tangible asset that gives investors full control of what they own and has very low correlation to public markets. For entrepreneurial investors who like to roll up their sleeves and have a passion for building sweat equity through real estate projects, this can be a great way to go.

However, there are also significant cons to owning rental properties. The biggest is simply that they come with the infamous triple Ts:

1. Tenants
2. Toilets
3. Trash

This means that owning rental properties is more akin to having an actively managed business rather than a passive investment that throws off cash flow while you give your attention elsewhere.

Another major con is that mortgage rates and residential real estate prices are sky high at the moment. Therefore, the value proposition of rental property investing is at arguably an all-time low right now.

A lack of liquidity can also be a big con. If you ever want to sell your property, it will take a lot of work, time, and expense to repair and stage the property, determine a proper selling price, market it, negotiate a deal with a buyer, and finally to pay significant closing costs upon sale. If you happen to be in a down real estate market like we find ourselves at the present, this can be a particularly acute problem.

Finally, given the high cost of buying rental properties, it is very difficult to get sufficient diversification using this method, further hurting the risk-reward proposition of rental real estate.

Option 2: Invest in REIT Funds

Another option is to buy publicly traded real estate investment trust (i.e., “REIT”) funds like ETFs and CEFs. Probably the most popular such fund is the Vanguard Real Estate ETF (NYSEARCA:VNQ) and for good reason.

First and foremost, it is a truly passive investment. You do not need to know anything about investing, finance, or real estate to own it. All you do is set up a brokerage account, deposit the funds, and buy shares of VNQ. The fund does the rest for you. You can even set up a system through some brokerages whereby they will automatically deposit and invest a certain amount into VNQ every month for you from your checking or savings account and you can also have them reinvest dividends back into more shares of VNQ. In this way it is a truly 100% passive, one stop shop for real estate investing that does everything for you.

Another big plus is that VNQ is extremely cost efficient. In addition to the immense time and hassle savings that comes with investing in VNQ over buying rental properties, it also only charges a meager management fee of 0.12% of assets under management. As a result, you can invest $100,000 into this fund and only have to pay an annualized fee rate of $120. A $10,000 investment would only cost $12 annualized. It doesn’t get much cheaper than that in the real estate world, especially when you consider the incredible convenience provided by the fund.

Third, VNQ is highly liquid. In contrast to rental properties which typically take a lot of time, hassle, and expense to liquidate, VNQ can be sold in the click of a mouse. Furthermore, rental properties typically must be sold in their entirety or not at all. VNQ, meanwhile, can be sold in bite-sized pieces of ~$88 per share, making it a highly divisible and instantly liquid investment. With nearly $36 billion in assets under management, VNQ has extremely tight bid-ask spreads, combining with near universal commission free trading to provide investors with very low frictional losses whenever they trade shares.

Fourth, VNQ provides broadly diversified exposure to U.S. REITs. With over 160 REITs in its portfolio that tracks the MSCI US Investable Market Real Estate 20/50 Index, it provides far greater exposure to various property types, management teams, and various geographies than you could ever dream of getting with rental properties. As a result of tracking the small, mid, and large cap segments of the U.S. REIT equity market, it is one of the best possible real estate investments imaginable from a diversification standpoint.

Furthermore, by concentrating in U.S. REITs, U.S. investors do not need to worry about foreign exchange risk. If the U.S. Dollar gets exceptionally strong against foreign currencies, investors do not need to worry about the value of their investment eroding in dollar terms. This U.S. concentration also reduces other geopolitical risks that come with exposure to Latin American, Asian, and European REITs.

That said, the main drawbacks of investing in VNQ are:

(1) Due to its immense diversification, it also holds a lot of low-returning and low-yielding REITs. As a result, its dividend yield is rather uninspiring for passive income focused investors at just 3.6% and its total returns have been pretty mediocre over the past decade at just ~6.9% annualized:

(2) It is an incredibly volatile investment, which can be a major psychological roadblock for many investors. In 2022 alone, the fund declined by a whopping 28.9%, even worse than the S&P 500 (SPY):

This stands in stark contrast to rental properties, which typically enjoy lower volatility in their pricing and low correlation with the stock market.

Option 3: Invest in Individual REITs

We believe that option number three – investing in individual REITs – is the best option for building passive income through real estate. By investing in individual REITs, we believe investors can negate almost all of the cons presented by each of the first two options – except for the volatility issue – while retaining all of the pros and even adding a few more.

Individual REITs enjoy the same liquidity benefit offered by VNQ and – while investing knowledge and research are required to avoid investing in the losers – they still require far less time, effort, and hassle than rental properties. Furthermore, the investment education and research process can be streamlined through the use of online research services that specialize in REITs and other high yielding stocks. As a result, the need for investment know-how and research efforts are really not too much of a roadblock in the end.

Third, it is far more cost efficient than investing in rental properties – in which you have to pay expensive transaction fees as well as realtor and property manager fees in many cases – and even more cost efficient than investing in VNQ since you do not have to pay an asset management fee to a fund manager like you do to Vanguard with VNQ and individual trades are commission free.

Fourth, you enjoy similar passivity to investing in VNQ. Instead of dealing with acquisitions, sales, property taxes, lenders, lawyers, tenants, toilets, and trash, you can sit back and relax knowing that professional real estate management teams are carefully managing your real estate empire on your behalf. As a result, the income you receive is truly passive rather than active.

Fifth, you can enjoy similarly superior diversification benefits as that offered by VNQ. However, with individual REITs you get much more intelligent diversification. Instead of blindly buying the index in a market cap weighted fashion, you can craft your own portfolio to meet your unique income, total return, risk tolerance, and sectoral and geographic focus goals.

This leads us to the sixth and final pro of investing in individual REITs: you can typically enjoy superior risk-adjusted returns relative to VNQ and rental properties. Between the lower transaction costs and asset management fees, professional management, better and more intelligent diversification, lower cost of capital relative to rental properties, liquidity, and ability to capitalize on irrational market swings, you are bound to generate vastly superior total risk-adjusted returns. When you factor in the time savings relative to building and running a rental property portfolio, the real risk-adjusted return differential becomes even clearer.

With publicly traded REITs it is not uncommon to buy REITs at deep discounts to the private market value of the real estate, something that is nearly impossible to do consistently in the rental property market. This makes achieving long-term outperformance even easier.

As a result of these factors, it is unsurprising that actively managed REIT portfolios have outperformed private real estate investments by 2-4% per year on average.

In fact, today, you can buy numerous high quality REITs at discounts to their net asset value. For example, Simon Property Group (SPG) – an A- rated class A retail REIT with world-class management and assets – currently trades at just 92% of its net asset value despite posting very strong results throughout this past year. STAG Industrial (STAG) is another investment grade REIT that specializes in industrial properties – an industry that has enormous tailwinds right now – and has generated rapid growth via its lease spreads in recent quarters. However, it is trading at just 95% of its net asset value.

Both of these REITs offer much lower risk profiles than individual rental properties and are led by high quality management teams and have low costs of capital. Yet, you can buy them at a discount today and then sit back and collect totally passive income.

Investor Takeaway

Rental properties are probably the worst way to invest in real estate today given their historically high cost to purchase, finance, and maintain. Furthermore, the business model of rental property investing has several structural flaws that are resolved with the REIT model.

While VNQ is a decent option for investors who want complete passivity and do not need high returns or high yields from their investments, we do not see it as the ideal real estate passive income solution.

By either investing in a quality research service or investing in your own knowledge, you can build a well-diversified portfolio of high yielding REITs that trade at discounts to their private market value with relatively low risk. We believe that taking this path – especially today while REIT prices are discounted – will set investors up for long-term outperformance and a rich stream of reliable and growing passive income for many years to come. That is why at High Yield Investor we are allocating a significant portion of our portfolio of high yielding stocks to REITs.