Writing on the Wall - Are REITs a Better Investment for You?

When I was a young child I had many annoying tendencies. My mother explained to me that the most annoying was my need to write on the walls of every room. I would take my crayons and ruin wallpaper up and down the house. These actions did not go unnoticed or unpunished. I would be yelled at, I would be restricted to my room, I would have my crayons confiscated. When the punishment receded, I would return to my artistic roots and ruin the walls again. The calculation of damages is still ongoing.

My mother finally learned that I was incapable of controlling my drawing urge. So instead of trying to get me to stop, she decided to mitigate the destruction. She bought be washable markers and crayons. And her trips to pick out new wallpaper were turned in to sponging and washing excursions around the house. In the end, I got to express myself and she had walls that didn't make her cringe with embarrassment. It was a win-win.

What does this have to do with the financial markets or investing? I think that the average American has a similar problem, only they aren't excited by writing on walls, they are addicted to buying real estate. What I'd like to do is find an interim solution so that they can carry on with their investing and I can feel like I have done a little to save their walls (sorry, I always take analogies too far).

At cocktail parties I hear the questions, ‘should I 1031 my profits from my condo sale in to a four-unit apartment building?' Questions come in to this website, ‘Is it a good idea to take a second out on my house to go in with some friends on a small office building in the next county over?' My mother asks if she should do a land deal in Fresno – she lives in Los Angeles and has another job.

As someone who is a firm believer in the vicious competitiveness of the American capital markets, I would never suggest that an ill-capitalized novice should make an undiversified bet in something that they only partially understand. Through almost any analysis, that person should have their financial ass handed to them. But the American dream is always set squarely in our minds. So I have a solution, the washable marker if you will.

Readers, if you have the real estate investment bug, try investing in public REITs or (for the more single family residentially-minded) public homebuilders. The reasons for doing so far outweigh the few added costs. Real Estate Investment Trusts or REITs offer an excellent alternative to buying individual assets, they buy, manage and sell real estate. Public home builders typically buy large tracts of entitled land and build and sell single family homes.

Why REITs Are Better than Buying an Office or Apartment Building –

Liquidity -

The first reason is simple, liquidity. This is something that is dangerously overlooked by individual real estate investors (and in my job, I buy from those sellers). If you have plunged a significant amount of your hard earned cash in to a real estate asset and you then have a need for it, you are in trouble. Liquidating real estate is a slow, costly and difficult process. I understand that selling a home right now seems easy – but selling an office building or apartment building can be extremely difficult. Also, your ‘need for speed' will translate in to a lower price for your asset. Public REITs obviously don't have that problem, your shares are always liquid and your need to sell will likely not affect the price. [Unless of course you are trying to place hundreds of millions of dollars – in which case you should probably call me and we should date or at least party together.] Never underestimate the value of liquidity.

Diversification –

Because REITs are large, they typically own many different buildings, rather than just one. If you've read Seneca's article on diversification, then you can skip to the next paragraph. When you and your brother scrape together money to buy a single real estate asset, you are taking on a huge, undiversified risk. If that building has a tree fall on it, catches fire or even just has a couple of pipes burst, you are in a tricky situation. You have taken on a large amount of building specific risk. By investing in a REIT you get the value of their diversification. If one of Sam Zell's buildings catches fire, it is ok. Sam (chairman of Equity Office Properties – EOP) owns 699 others that probably haven't caught fire. He has spread his risk over far more buildings. Small real estate investors don't have this luxury.

Professional Management –

I know that it seems easy to run a building. You rent it out, collect the rent and spend the money. But it isn't that simple. I am a landlord for a real estate investment company and it takes time and energy to keep a building leased and operating. To run a building well takes expertise, experience, software, good contacts (among contractors, plumbers, lock smiths, brokers…) and lots of time. When you buy a REIT you get the benefit of their professional management. The slight drawback is that you pay for it. But unless you are planning to quit your day job to run your property, you too will be paying for management. Additionally, because REITs typically have large portfolios, they can run the buildings more efficiently. They can buy supplies in bulk and cut better deals with service providers. Try negotiating your leasing commission with a broker when you own one building – then imagine how much easier it would be if you owned 40 buildings.

Virtually Guaranteed Cash Flow –

REITs pay dividends (it is part of their corporate structure, they are obligated to pay out 90% of their taxable income to shareholders.) If you own your own building there are going to be times when you are funding capital needs and sitting with vacant units or suites. But REITs will pay you every quarter. Of course there have been situations where REITs have cut or suspended their dividends – but in general the cash flow from owning REITs is predictable. And yields right now are higher than one would expect.- as an example, EOP is yielding 6% (as of the date of this printing).

The Drawbacks –

There is one large drawback to investing in REITs, you cannot use your 1031 funds without first paying your capital gains. But with capital gains taxes at low levels, and the froth in the real estate market so high, this would be a great time to pay those taxes and move your money in to something a little less dependent on your own skill and know how. The second drawback is that you cannot take advantage of your own local knowledge. If you have better information than the market about a specific asset, then you should think about investing in that asset rather than buying a REIT. But be leery – often, like with hot stock tips, one usually isn't as smart as one thinks. Fees and overhead are also drawbacks. REITs have to pay great sums of money to accountants and lawyers to publish their results every quarter and comply with federal regulations. Additionally, they have to pay their brass large salaries to keep them interested and motivated (see my fly away article). And also, they have the disadvantage of having to disclose to their competitors their pricing and strategy – such is the plight of public companies.

Homebuilders –

Many of the arguments above hold true for the homebuilders as well. The one difference is that homebuilders are not structured as REITs and thus are not obligated to throw off cash. However they typically do offer dividends. They still offer liquidity, diversification and professional management.

In closing, when you are looking at an investment in real estate, be realistic about your competitive strengths and weaknesses. Be realistic about the time, energy and skill it takes to run a building efficiently. Have some foresight about your own cash needs and what would happen if you or your family had a sudden need for cash. REITs and public equities offer an excellent alternative to buying your own buildings. Give them a look.

J.S. Silver is a real estate investor and co-editor-in-chief at whatbubble.com. If you would like to post your own comments, or have any financial questions answered by an expert for free or if you would like to just read more on this subject please visit http://www.whatbubble.com.

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