Backdoor Real Estate

Steve Abramowitz

“I’VE GOT SOME REAL estate here in my bag,” croons Paul Simon, as he consoles his lover in the iconic 1968 song America.

The real estate industry’s marketing arm couldn’t have put it better. The industry’s message: If you want to feel secure and be prosperous, get yourself some real estate.

Problem is, many people can’t come up with the down payment for a home or rental property. The good news: There’s an alternative to direct ownership. Often referred to simply as REITs, real estate investment trusts are part stock and part real estate. Each REIT is a company that owns and operates perhaps 25 or more rental and commercial properties across the country.

In their early days, REITs were confined to an arcane corner of the stock market. But they’ve achieved a certain pedigree by virtue of their designation as a separate entity of the S&P 500. If I were starting over, I would undoubtedly supplement my privately owned real estate with REITs.

REITs don’t require a down payment or even a minimum initial investment. Subsequent purchases can be made in any amount and on your own schedule, which can be a boon to investors who fund their retirement accounts through dollar-cost averaging. Nor do REITs have to be bought and sold in one swoop. Say you need some quick cash. Instead of suffering through open houses and contract negotiations, you could simply sell a few REIT shares.

Here’s where REITs become not just an acquaintance but a staunch ally in your quest for financial independence: When you buy or sell by pressing a few buttons on your online brokerage account, you incur no commission. That’s right, zero commission and fees regardless of the size of the transaction, though you will lose a little to the bid-ask spread. This staggering advantage to REIT ownership has lured many investors, including those who could otherwise afford the down payment needed for a direct real estate purchase, to instead plunk for REITs as a hassle-free alternative.

Imagine this scenario: You want to sell your small duplex for $500,000 and an eager buyer snaps it up. Pretty awesome, right? But don’t forget to deduct the standard 6% sales commission, equal to $30,000, and closing costs of maybe 2%, or $10,000. So you walk off with $460,000, right? Not quite.

Remember that roof repair and all the primping necessary to get the duplex in shape to sell? There goes another $10,000, reducing your take to $450,000. Still quite an accomplishment. But if instead you’d sold $500,000 of REIT shares, you would have no commission, no closing costs and no annoying pre-sale expenses. You would keep all of the $500,000, the whole enchilada.

Another consideration: Do you have boundless energy and outrageous free time? Are you steeped in the legalese of local rental regulations? Will you have a meltdown when it’s raining and your prospective renter is a no-show? Investor, know thyself. If you just cringed, take refuge in real estate investment trusts.

Okay, so what’s the catch? How risky are these REITs? All investments carry risk and REITs are no exception. But large REITs are only about as risky as the broad stock market and both have averaged about 11% annual returns over the past 10 years. But beware the year-to-year swings. You should be prepared for at least one 30% up and one 30% down year during the next decade.

To neutralize the possibility that one bad apple could be your undoing, consider an exchange-traded fund that focuses on real estate companies. Since each REIT already owns a large number of properties, investing through a fund provides exceptional diversification across many different property types and locations.

The taxman looks kindly on both REITs and direct property ownership, though the tax breaks bestowed on in-person investors are usually thought to be superior. But these benefits are sometimes exaggerated. Take the vaunted depreciation deduction. Sure, private property owners get to take it on their tax return, but it’s ephemeral and must be paid back when they sell. I know, I know, it’s still a no-interest loan and it will receive capital gains treatment, but depreciation is not the boondoggle it’s often made out to be. And besides, do you really think all those buildings held by REITs are not being depreciated?

Every so often, the price of a single privately owned property takes off, but things can also go the other way. The fact is, the returns from direct investments are less predictable than those from REITs. They’re dependent on the landlord’s real estate aptitude, unforeseen developments and just plain luck.

Should inexperienced mom-and-pop investors dig deeply into their life savings to buy one rough-and-tumble piece of local real estate, or instead reap profits from hundreds of properties reaching from coast to coast and managed by industry experts with their own skin in the game? Should you hedge your bets across the two strategies? These are knotty questions that call for professional consultation.

Investing in real estate through REITs does not confer bragging rights. You won’t have a grand Victorian to show off. But as a longtime landlord who currently owns a dozen properties, let me remind you of the upside of hands-off real estate investing: You’ll be able to enjoy a life unfettered by late-night phone calls, deadbeat renters and legal nightmares.

Steve Abramowitz is a psychologist in Sacramento, California. Earlier in his career, Steve was a university professor, including serving as research director for the psychiatry department at the University of California, Davis. He also ran his own investment advisory firm. Check out Steve’s earlier articles.

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