Real estate can be an excellent investment, but there are certain problems with buying individual investment properties. For instance, what happens when your tenant moves out in a year and your property sits vacant while you find another? What happens if your property taxes skyrocket?
Investing in real estate investment trusts, or REITs, is one great way to get some exposure to the potentially lucrative world of real estate investing while taking much less risk.
It allows you to spread out your money
First, I freely admit that on paper it can look more profitable to buy an investment property than to buy shares of an REIT. For example, if you buy a $100,000 investment house with 20% down, earning $300 per month in profit after expenses (not unreasonable with today's low mortgage rates), you'll produce an annual return of 18% on your original $20,000 investment. Sounds great, right?
However, with high reward comes higher risk. A number of things can (and probably will) go wrong. The property can sit vacant for a length of time, and not only will you earn no returns, but you'll still have to pay the mortgage and other expenses. Or something major could break (like the HVAC unit), which could easily eat up a year's worth of profit.
By investing in a REIT, you are essentially diversifying your investment among a large basket of properties. If the REIT owns over 100,000 apartments, like Equity Residential (NYSE:EQR) does, it doesn't really matter if a few units sit vacant. Similarly, it doesn't matter if a few tenants have major maintenance issues. With that kind of diversification, such issues become quite insignificant.
It lets the experts manage your investments
I can definitively say that most people should not be landlords. Are you willing to spend hours meeting with prospective tenants and to wake up to your phone ringing in the middle of the night if a toilet breaks? If a tenant is late with rent, are you ready to be the "bad guy"? Being a landlord can turn into a full-time job, especially if you have more than one investment property.
If you have the time, patience, and personality to be a landlord, go for it. Otherwise, you'll need a property manager. This will cost you about 10% of the rent your property brings in, which can severely cut into your profit margin.
With REITs, the management is not only done for you, but thanks to economies of scale, it's likely being done at a much cheaper rate than you could obtain on your own. Plus, you don't have to worry about a thing.
Commercial real estate is now an option
On their own, commercial properties (such as a shopping center) can be prohibitively expensive for most investors, but they can make excellent long-term investments. Some of the most popular REITs, such as National Retail Properties (NYSE:NNN), specialize in commercial properties, and for good reason.
Commercial real estate can be much more predictable than residential, thanks to both the length of the leases and the expenses being covered by the tenant.
For starters, where most apartment tenants sign a one-year lease (two years is usually the maximum), commercial tenants commit to much longer periods of time, like 10, 15, 20 years, or more. In fact, National Retail Properties has 12 years left on its average lease. So shareholders don't really have to worry about properties sitting vacant anytime soon.
Also, commercial tenants cover virtually all of the expenses associated with the properties. Most commercial tenants are on a "net lease," which means the occupant is responsible for property taxes, insurance, and building maintenance. With apartment properties, the landlord has to pay all of these.
This creates much more predictable revenue and growth, as rental income doesn't fluctuate due to maintenance or other costs, and leases usually have annual rental increases already built in.
Great long-term potential
Finally, REITs like the ones mentioned here are rather good at what they do. It's hard to argue with the kind of performance they have sustained over long periods of time.
For example, over the last 20 years National Retail Properties has averaged an annual total stock return of 13.5%, easily beating the S&P 500's 9.6% average during the same time period. For those investors interested in the income REITs can provide, the company has increased its dividend for 25 consecutive years.
Before you buy your first investment property, you should take a long, hard look at the benefits of REIT investing. The safety and growth potential might surprise you.
Matthew Frankel owns shares of National Retail Properties. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.