Why buy an apartment building versus investing in an apartment REIT?

Question

As an individual investor, what advantages do I have in taking my capital and buying an apartment building myself versus just investing in a good apartment REIT?  

Asked by: AW - Missouri
Answer

REITs offer a passive approach to real estate investing with a cash-on-cash return on your money and some potential for stock appreciation. That's perfectly fine as a means of real estate investment choice and investment diversification as passive investors.  Direct ownership of apartments is never passive.  Real estate never sleeps. 

Owning and operating apartment properties is a serious business.  It has just as many moving parts as a Tesla, and today, the industry is applying technology at a rapid pace.  For example, insurance providers use satellite technology to determine property square feet and apply crime statistics within their rates and rating of "habitational" properties.  Owners have these same tools available also, although few avail themselves of these advances.

Just know multifamily apartments are a business and, as such, must be operated as a business, for-profit, and with preservation of capital in mind all the time.  Bringing professional property management with you to a transaction - before closing on a deal - will have you miles ahead of most small owners - new owners that buy an asset then try and figure out "what's next" (oh my goodness - this happens way too often) are often crushed to find out the business actually requires attention, focus, working capital, expertise, time, material focus and work.  Who knew?

Direct ownership of apartments offers:  

  • Rental Income 
  • Appreciation in Value
  • Depreciation 
  • Building Equity  
  • Opportunities to Enhance Yield 
  • Total Yield Calc

Rental Income - Cash

With appropriate leverage, real estate assets can deliver 10% or better cash-out (as a percentage of revenue).  Go ahead and complete the calculation for one of your assets: Determine your total cash in the deal, from the down payment to added capital. Then look at trailing 12-month cash out of the assets.  Divide cash-out by your investment (cash in).  For a recently acquired asset purchase, this number will likely range between 3% and 8% "cash-on-cash." The good news when you can implement rental increases, you get a raise!  

My example is relatively generic as actual results are affected by a dozen variables.  In recent years, namely, price.  Prices have been very firm for many years now, with yields plunging.  This run to safety (with the public buying hard assets) suppresses cash-on-cash returns.  But that doesn't mean the overall return is dampened.  Keep reading…

Appreciation in Value

Appreciation in Value is a gift and not right.  Appreciation in Value can be earned, however, through sweat equity, for example.  While appreciation is tied to inflation, demand has been the primary driver, along with housing supply restrictions in recent years.  In major markets, it's harder than ever before to build, starting with land availability.  Add to this increased environmental requisites, access to building materials, and skilled labor (specific to a market).  All of these factors make existing housing more valuable; these factors create appreciation in Value.  

Appreciation, in general terms, is an increase in the Value of an asset over time. The increase can occur for several reasons, including increased demand or weakening supply, or changes in inflation or interest rates. -Investopedia

Another positive to creating value through appreciation is when the gain on sale can be deferred using 1031 Exchanges.  Talk to your real estate attorney for guidance. Don't discount the financial Value of 1031 Exchanges.  They are a common financial tool anymore, so seek to determine if they have a place in your next asset sale. 

Depreciation 

The use of depreciation to reduce current Income as a tax benefit can be consequential.  Just remember there are two ends to every stick – and one or both can be pointy and sharp. In the short run, depreciation enhances yield.  But there is a day in the future where this benefit circles back to be a detriment. Talk to your tax counsel on how to best use depreciation in your long-term financial dealings in real estate. 

Building Equity 

Building equity occurs through mortgage paydown.  On every property with a mortgage, every month, a small percentage of your payment is applied to reducing the principal amount of debt outstanding. Over time, the portion of your payment that goes towards principal reduction increases.  These payments that lower your mortgage balance increase your assets (assuming asset prices remain stable). It's another component of the overall yield produced from direct ownership of real estate assets. 

Opportunities to Enhance Yield

This one is the real "ringer" in creating Value and enhancing yield or return on investment with real estate assets ownership.  That X-factor is you, the owner.  Unlike ownership of REIT stock, with direct ownership of the real estate, you have an opportunity to impact Value, yield, cash flow, and the future direction of the asset.  Those that struggle mightily here likely are over-leveraged.  

And yes, some markets can turn downward and lose Value or be impacted by adverse changes in demographics. Frankly, many owners become complacent; others are "new" and don't know what to do (or how to hire expertise).  Active management, by you or those you hire, is what makes all the difference to the outcome of your real estate investments. 

Total Yield Calc

Add up these components to calculate the potential yield on direct real estate ownership.  Investment results will be two or three times higher than a passive REIT investment.  But this comes at a cost – an opportunity costs to you.  Real estate doesn't manage itself.  And if you are not the direct manager, then you, the owner, are responsible for managing the manager.  This level of involvement takes time, resources, and a long-term commitment to creating a positive outcome. There's no free lunch here.  

The commitment necessary to owning and operating operational real estate assets can be advantageous, personally, professionally, and financially.  Granted, most people have other interests, and real estate is just one of many investments, or financial interests, in their lives.  

We have a hard time understanding how people can be so complacent about their real estate holdings for those of us that live-and-breath in this space.  It's in the same vein as an auto-mechanic that notices the check-engine light in his friend's car and wonders how they live with that!  

The multifamily business will never be a place to try and come in to make a quick buck: it's too complicated.  I can't deny that you will likely get more sleep with a REIT investment than even a small multifamily deal. But hopefully, you can see from my writing here that the potential rewards are exponentially greater. So too is the work necessary to gain access to these returns. 

My goal is not to talk you into buying apartments.  Look at this investment class as a potential rival to other alternatives and consider joining us on this side of the merry-go-round. 

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