House On Money

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Many people like to say that buying your house is an excellent investment, and that owning rental properties is even better. While it's true that your house is likely to increase in value over time, and rental properties can help you generate some income, there is a far superior alternative. I'm talking about real estate investment trusts, or REITs.

Why buying properties is not a great "investment"
While it's true that houses tend to increase in value over time and I've often written in favor of owning over renting, the characterization of buying a home as an investment is simply not true. The primary reason I say this is that your house doesn't generate any income. Rather, it requires a stream of mortgage interest, property tax, insurance, and maintenance payments out of your pocket. Your mortgage payments and increasing property value help you build equity, so at best I would call a house you live in a "savings vehicle" or an "appreciating asset."

On the other hand, owning rental properties meets the basic criteria of a good investment. They generate income and (theoretically) won't cost you more to maintain than they bring in. However, owning a rental property is a risky and inconsistent venture -- there's no way of knowing when a property will sit vacant or for how long, when you'll need to evict a bad tenant, or when you'll need to spend thousands of dollars on an unforeseen maintenance issue.

What is a REIT?
There are two main types of REITs. Equity REITs, which we'll focus on here, invest in properties.

Equity REITs are corporations that pool investors' money and purchase a portfolio of properties designed to generate income and growth. Some REITs develop properties from the ground up, while others prefer to acquire existing real estate. While REITs regularly sell properties for a variety of reasons, the main goal is generally to hold onto properties for the long term.

 Mortgage REITs are a completely different type of investment -- they invest in mortgage-backed securities and hope to profit from the interest.

Benefits of investing in REITs
There are several reasons REITs belong in every stock portfolio. Here are some of the most compelling reasons.

Great dividend income: By definition, REITs are required to pay at least 90% of their taxable income to shareholders. This allows REIT profits to avoid corporate taxation and pass straight through to investors, which is why REIT dividends can be rather attractive.

For example, popular retail REIT Realty Income, apartment REIT Equity Residential, and healthcare REIT Welltower all pay dividends far superior to the S&P 500's average of around 2%.

REITDividend Yield
Realty Income 4.56%
Equity Residential 2.81%
Welltower 4.98%

High growth potential: Commercial property values are primarily based on the ability of those properties to generate income. As rent rises over time, so do property values, and REIT stock prices rise as well. Many well-diversified REITs like the three I mentioned have delivered total returns that have handily beat the S&P 500 over time.

O Total Return Price Chart

Diversification: In addition to growth and dividends, REITs can be a great way to add diversification to your portfolio in several different ways. Most obviously, adding a REIT or two gives you exposure to another asset class besides stocks and bonds.

Also, since REITs split your money among a portfolio of properties, your performance doesn't depend on any single one. For example, if one of Equity Residential's 110,000 apartments sits vacant for a year, the company's bottom line would barely be affected. If one of Realty Income's tenants went bankrupt or broke its lease, a minuscule portion of the overall rental income would be affected. Or, if the HVAC system suddenly broke at one of Welltower's long-term care facilities, it would be a relatively minor expense for the company. However, if you owned one apartment property or one commercial building, a tenant leaving or a major unexpected repair could be devastating.

Finally, REITs add geographical diversity to your real estate holdings. The housing markets across the U.S. don't always move in the same direction. For example, if you owned a rental house in Seattle last year, its value would have increased by approximately 12.8%. On the other hand, if you had purchased rental property in Minneapolis, your annual gain would be just 3.5%. A REIT allows you to invest in real estate regardless of what your local market is doing.

Long/net leases: While apartments are generally on one-year leases, commercial properties tend to have much longer lease terms. For example, Realty Income's average lease is more than 15 years in length, and generally has annual rent increases built in. Additionally, tenants are on "net" leases, which means that they are responsible for taxes, insurance, and building maintenance. In other words, commercial landlords don't have to worry about most of their tenants leaving when the economy goes bad, and they also don't have to worry about most of the variable expenses of owning property.

Liquidity: Houses and other rental properties are not liquid investments. In other words, it can take days, weeks, or months to sell a house for a reasonable price. REITs trade just like any other stock -- you can buy or sell shares instantly at whatever the current market price is. Plus, the price of admission is much lower. You should plan on putting at least 20% down for an investment property, but can buy into a REIT for the price of one share.

Professional management: From my own experience I can tell you that managing your own rental properties is not as easy as it sounds. Unless you feel completely comfortable finding tenants, doing credit checks, scheduling maintenance, collecting rent, and dealing with bad tenants, and actually have the time to do all of those things, managing a rental property is probably not for you. Not only do major REITs have professional property managers, but they tend to have some of the best, brightest, and most experienced managers in their respective specialties.

No investment is guaranteed, but...
Investing in solid REITs such as the examples I've discussed here has historically produced excellent dividend growth and market-beating total returns over time. While past performance of an investment doesn't necessarily guarantee its future results, REITs are a smart way to add diversification to your portfolio while creating a reliable, growing income stream.

Matthew Frankel owns shares of Realty Income. The Motley Fool recommends Welltower, which Mr. Frankel also owns. 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.