I've been investing since I was 14. Somehow, that's the last 18 years (how can I be 32 already?). Over that time, I've always had a job and saved, read hundreds of books on investing, paid attention to stock market news, gotten degrees in finance, and more. TL;DR: I've spent a lot of time, energy, and money on the stock market.
The amount of money I've made investing in stocks in that time (through two full-blown bull markets) pales in comparison to the amount I've made with rental real estate. Of course, that isn't because I'm a genius real estate investor. It's largely because of timing and luck, but also because of the inherent leverage in rental real estate investing.
To illustrate this concept, and to show how some of the principles I've followed in real estate investing would've improved my stock market returns, I'm going to compare two investments I made around the same time. In December, 2014, I bought a 600-square-foot condo with the intention of renting it out after living in it for at least a year. In February, 2016, I bought 100 shares of Annaly Capital Management (NLY -0.85%), which is a mortgage REIT that often has a dividend yield over 10%. We'll start with Annaly.
Annaly is a mortgage REIT (real estate investment trust). It borrows money and invests it in mortgage-backed securities that are usually guaranteed by the government. It makes money on the spread between the two rates. As long as its borrowing rate remains low and the mortgages it buys aren't prepaid, it churns out cash to distribute to shareholders.
I bought the REIT as an income source. It had a high dividend yield and low volatility, so I sold covered calls on the position to juice the dividend yield. Here's a table showing all the transactions I've had on Annaly since that first purchase:
|Sum of Amount
Over the years, I've earned $566 in dividend income and $204 in option premium income from Annaly. The stock was called from me several times, and I usually bought it again soon after except for a two-year period where I didn't own it (and missed out on some good dividends). It's certainly possible that if I had ditched the covered call strategy and just held the stock the whole way, I may have made more money. Here's what Annaly's total return looks like since February, 2016.
Rental real estate
I purchased the condo in December 2014 for $90,000 with about $5,000 down (note that I'm using all round numbers for this example to make it simpler). I lived in it for over a year, which is required to purchase it as a residence, and then started renting it out.
Since I started renting the property, it has produced just over $12,000 in cash flow. My total investment is around $24,000 if you include the down payment and all the mortgage payments that I made prior to renting it out. That's a 50% yield in five or so years. But there's more to the return.
The real estate market has gone gangbusters in Utah, where I live, over the past five years. According to an appraisal I got in 2021, the condo is worth around $229,000 now. That's good for capital appreciation of 154%, or 14.3% per year. But wait, there's more!
I've been paying down the mortgage this whole time. For the first few years I paid personally, and that amount is included in the total investment of $24,000, but since it started renting, the tenant has effectively made those mortgage payments. Right now, the total debt on the property is $72,000. That means there is $157,000 in equity.
If you add it all together. I invested $24,000, received $12,000 in cash flow, and have $157,000 in equity. That means my $24,000 investment turned into $169,000. That's a 604% return, 48% annualized. Note that if I sold the property and had an average tax rate around 20% on the sale, taxes would reduce that annualized return to 39%.
Of course, if 48% annual returns were in any way common with real estate investing, no one would invest in anything else. There were a few factors that worked out in my favor that won't always (or even often) happen. Let's go over them:
- Capital appreciation: It isn't normal for the market price of a condo to go up 14% per year. A combination of low interest rates, Utah population growth, and limited supply all contributed to that price change.
- Interest rates: Interest rates helped me in two ways. They contributed to the price appreciation and also reduced my mortgage payment. This means I was able to keep more cash flow each month and more of my payment went toward principal reduction.
- Other expenses: Interest wasn't my only relatively low expense. Over the rental period, I replaced the AC unit, washing machine, and garage door. There were no other major expenses. For a 40-year-old condo, I could've have had far more problems and probably could've more vacancy as well.
In addition to getting lucky on a few rental factors, Annaly hasn't been a great investment. Even if I hadn't traded around the position with options, a 39% total return over more than six years is a big fat meh.
We'll finish with a modified scenario that's a little more duplicable. Let's say that you purchase a rental condo for $90,000 that receives $10,000 in cash flow and has market price of $150,000 after five years. Let's also say that instead of investing in Annaly, you invest in Prologis (PLD 1.13%), an industrial REIT that has performed better.
The Prologis total return would be 270%, and it peaked over 300%.
The $24,000 investment in the condo turned into $10,000 of cash flow and $78,000 in equity ($150,000 – $72,000), a total of $88,000. That's a total return of just under 270%.
Both strategies can be very profitable -- as long as you hold on. Moving in and out of my Annaly position probably halved the total amount of dividends I earned over the period. With Prologis, subtracting dividends would cut the return to 210%.
Now, an investor a pretty nice return by selling the condo. But then what? You'd have to pay taxes on the capital gain, miss out on months of rent, and then put the proceeds into a new investment. In stocks and rental property investing, it usually makes sense to hold for the long term.