One of the most common questions we get from beginner individual investors: should they invest in real estate rentals? Some want to take their first step in investing beyond stocks and bonds. Some see rentals as a source of passive income, in addition to their primary source of income. Some rent out their existing house when they buy a new house. Some are very much interested in real estate and want to take their first step. Reasons are varied and many.
Even though there is a lot of interest, real estate investing comes across as daunting for many. The reasons are again varied and many – high capital needs, time commitment, etc. The purpose of this article is to lay out three major ways to invest in real estate, including rentals. We will look into the characteristics of the different investment options and provide an approach to answer the question. The investor can then evaluate the pros and cons and decide whether rentals make sense.
Investing options
Real estate investors these days have a variety of options to start investing in real estate. Many of these were not easily available to a lot of individual investors even a few years back. The major options include investing in REITs, private placements, and directly investing in rentals. The good news is that there are so many ways to invest in real estate and get started that you don’t need to have a large amount of capital which used to be a big roadblock.
We’ll look at all three investment options through the lens of an investor, not necessarily as someone who wants to build a career in real estate. There are many ways for investors to get started with investing in real estate. Basically, it comes down to investing in the following three major ways illustrated and explained below.
Direct Ownership of Rentals
Direct ownership of rentals needs no introduction. Buying a rental property has been an “old school” way to invest in real estate for decades and even centuries. Almost everyone can identify with buying a rental property and having full control over the property. People buy a rental home and are responsible for everything – buying the home and managing it themselves.
Syndication or Crowdfunding Platforms
Investing through syndication or crowdfunding platforms has become very popular over the past few years. Someone you know may have done it through crowdfunding platforms like Fundrise, RealCrowd or CrowdStreet. The terms maybe confusing to beginners, but think of syndicates as capital pooled from tens or hundreds of investors. The property is bought, managed and sold by the sponsor. In essence, sponsor is the active landlord and you’ll be the passive investor as a limited partner.
REITs and Stocks
Real Estate Investment Trusts (REITs) are real estate securities that trade like stocks. REITs are run by large institutions and they typically manage a property type (e.g. office or multifamily) across a large geographic region. Some of the popular REITs are Equity Residential for Multifamily or Prologis for Industrial property types. In addition to REITs, investors can also invest in housing stocks or real estate mutual funds.
Comparison of Various Options
Now that we have an understanding of the major options to invest in real estate, let us look at the characteristics of each of them. We’ll look into the four key characteristics of the real estate investing options available – Ownership, Liability, Control, and Finances. The key characteristics are summarized in the illustration below:
Ownership, Control and Responsibility
When an investor invests in a rental property she will be the sole owner or one of the few owners. The investor is in full control. This is the storied mom and pop landlord that many of us are familiar with. The investor will be the sole responsible party as the landlord and she is responsible for all aspects of buying the property, getting a loan on the property, managing the property, and eventually selling it.
For private placements, the investor will most likely be a limited partner – one amongst tens or hundreds – in a given property. The investor will share the ownership with tens and possibly hundreds of other investors depending on the capital contributed. The investor will have limited or no responsibility, but she will have access to the sponsor and will get periodic distributions (usually quarterly or monthly) and reports.
From an ownership perspective, the investor will be one of the thousands of shareholders in REITs, funds, and housing stocks. The investor will hardly have any control over the property or management. The investor’s experience is the same as buying the shares of a public company in any other sector.
Liability and Financial Worst Case Scenario
When someone buys a rental property directly, they are fully liable as their name is on the title and all the documents. If a tenant sues the landlord because she hurt herself, the landlord will be fully liable and responsible. The investor also needs to get the debt (i.e. loan) and guarantee it. If things go south, the investor will lose her equity in the property and in addition, will need to pay off the debt as well. This is very important to understand.
For private placements, the investors will usually be a limited partner i.e. someone with very limited or no liability. The sponsor will be the general partner and will be responsible for all liability. The investor doesn’t even have to worry about debt financing, as the sponsor will be responsible for the loan. So, if things go terribly wrong, the worst thing that could happen is the investor will lose all their investment, but not more.
For REITs, the company management will be liable and the investor has NO liability at all. In the worst-case scenario, if the REIT does a poor job the investor loses all her money invested, but she won’t be responsible for the debt.
Investor Objective and Takeaways
We have looked into the major ways to invest in real estate and their characteristics. Now, let us come to the key question – Should you consider investing in rentals? Investors have different personal objectives, motivations, and situations. There is no one answer that fits all. We’ve seen the characteristics of the major investment options. Which one do you find appealing? The following questions will help you personalize the decision to your objectives and situation:
- What are your (a) personal and (b) real estate investment objectives?
- How much control/ownership do you want to keep or give to others?
- How much liability and responsibility (including time commitment) are you willing to take?
- Are the returns worth the risk?
Once you have understood the characteristics of the major investment options discussed earlier and answered the above questions, the choice will start crystallizing. Are you looking for passive income with minimal time commitment and headaches? Then, the options are REITs or private placements. Do you enjoy real estate or want to be more active in real estate? Then direct ownership in rentals may make more sense. After all, you know yourself the best.