A few months ago thrifty-wife and I finished paying off our mortgage and as a result found ourselves with some extra money every month.
This triggered some research into whether we wanted to increase our existing monthly ETF investments, purchase a 2nd property to rent out or begin investing in a REIT.
We already have a well diversified ETF portfolio which we contribute to every month on our journey to financial independence. A few months ago thrifty-wife and I paid off the mortgage on our home which we managed to do in 4 years. This got us thinking about what to do with the extra money each month.
My initial thinking was that we would always purchase a second property to rent out once we had paid off our primary home. But once that time came, we decided to do some digging and weigh up all our options before diving head first into a second property.
Property has long been considered an excellent investment. It offers some nice diversification when you're already invested in the stock market since property is affected by different economic factors such as interest rates compared to typical stocks.
The great thing is that investing in property doesn't just mean buy to let. There are other ways to benefit from property exposure in your portfolio such as REIT's and property ETF's.
A Real Estate Investment Trust is a company which owns and operates income generating real estate. The bulk of the income generated by these companies, which typically comes in the form of rent, is then paid over to investors.
A REIT will typically have a large portfolio of properties under their control and will often focus on specific areas of the market such as residential, commercial or industrial.
I like to think of REIT investing like being a landlord for hundreds of properties, collecting my slice of the rent while doing none of the work or admin. Awesome.
Property ETF's take the concept of listed REIT's a step further in terms of diversification. A property ETF contains a basket of several REIT's, allowing you to invest in a single ETF and gain exposure to thousands of properties managed by several REIT's.
Like I said, we recently found ourselves at a point where we wanted to add property to our existing investment portfolio. To decide on exactly how we wanted to gain that exposure, we did some research into the various options available to us.
First, I'll go through the pro's and con's of buy to let and then do the same for REIT investing.
Buying physical property allows us to take out a mortgage which means we're able to leverage our money. No need to pay for the house in full. Simply put down a deposit and it's ours.
Once we pay off a percent of the mortgage on the rental property, it would become easier to use that property as surety to get a mortgage for another property. In that way, we would build up a portfolio of rentals.
Renters typically don't care for their home in the same way that owners do. Finding reliable, trust worthy tenants who aren't going to damage our house and who always pay their rent on time is no small task.
The primary goal of buy to let is to earn rental income. If we don't have tenants, we have no rental income and are still on the hook to pay the mortgage every month.
Ongoing house maintenance is unavoidable. Hopefully these will just be small costs here or there if we've got great tenants. If not, this could be significant.
Buying a property means we're tied to a specific neighbourhood and have no diversification. Once we're in a position to buy several properties we can diversify into different areas, however that takes time while continuing to be exposed to location risk. In the mean time, a huge amount of capital has been directed into a single location specific investment.
Buying a property involves lawyers, agents and transfer fees. Everyone wants to be paid their cut. These are typically significant expenses and have to be paid when purchasing as well as when selling.
Property is an illiquid asset. This means that it takes time to buy and sell and can't be converted to cash quickly.
Liquid assets on the other hand are those that we're able to turn into cash quickly if the need arises.
Having some form of house insurance on rental properties is typically a good idea. This comes back to tenant risk and maintenance. Personally I wouldn't risk not having insurance on rental properties while hoping that our tenants don't trash the place or require ad hoc maintenance.
Although some may think of rental properties as passive income, that's not always true. The time it takes to manage a rental property including finding tenants, collecting rent, maintenance and general admin can be significant.
Dealing with lawyers, agents, tenants and all the admin of being a landlord takes time which we would need to fit in somewhere between our full time jobs and taking care of our new born son.
Not only would we be diversified across multiple properties in different locations, we would also be diversified across property types such as residential, commercial and industrial.
Investing in listed property involves minimal fees. There's no need to worry about lawyers, transfer fees or any other expenses. Buying listed property is as easy as buying any other stock or ETF.
Getting in and out of positions in the stock market is quick and easy. This extends to REIT's and property ETF's which makes them very liquid and easily convertible to cash.
Once we've purchased a REIT, nothing more is required in terms of admin or time spent to collect our 'rent'.
The REIT itself takes care of all the admin and logistics involved with property management while paying over the distributions to investors annually, bi-annual or quarterly depending on your country and laws.
Typically shares of REIT's and property ETF's are purchased without leverage. While margin and derivatives can be used, the more common scenario is to simply purchase the stocks or ETF's without leverage.
I've purposefully not discussed tax considerations since those can differ hugely depending on where in the world you live. Generally speaking though, rental income as well as REIT distributions are taxed at your marginal income tax rate. This is the case for us with respect to tax.
While perfectly valid arguments can be made for either option. My guess is that most people will continue to sit on the side of traditional buy to let. For thrifty-wife and I however, REIT investing is the way to go.
Real estate investment trusts offer the same benefits as buy to let while offering several others such as diversification, less time and admin, lower expenses and higher liquidity.
One last point to mention is that this will only form one part of a larger investment strategy which already includes ETF's focused around dividends, growth, local and international as well as bonds. Adding REIT investing to the mix is the right call for us at this point in our lives but who knows what the future holds.
Article by Brendon @ Money FI