Hands-On vs. Hands-Off: Real Estate’s Own Active-Passive Debate

It’s over. I’m done with it. Done with what? Ruminating about how well I negotiated for the new car? Nope. Leaving the cell phone in that overpriced restaurant? Uh-uh. Then what is it I’m done with? Well, after months of deliberation with Alberta and our son Ryan (and with myself), I’ve decided to hang on to the family’s small residential rental properties rather than sell. Tax considerations trumped quality of life. There, I said it, as preposterous as it may sound.

I thought readers might be interested in how I lurched to this decision, so I’ve prepared a review of how the features of owning real estate directly compare with those held indirectly through real estate investment trust mutual funds or ETFs (REITS). Just understand that I’m performing this analysis solely for readers’ benefit, not mine, because all that’s behind me now. It truly is.

Who’s at the Helm?

When prospective investors weigh the virtues and pitfalls of the active vs. passive approaches they invariably start with the hands-off vs. hands-on decision. Hands-on landlords assume responsibility for management of their rental, which requires much time, energy and expertise. The experienced property owner also recognizes the inevitable assaults on her family’s freedom from periodic interruptions and stress.

Active owners enjoy control over their investment. Who could possibly match the dedication and commitment of the self-interested landlord? But direct involvement exposes investors to liability, a nagging source of worry hands-off folks avoid. Such developments may entail numerous consultations with costly lawyers and accountants. People who elect instead to invest in real estate through REIT funds sidestep most of the foregoing trials of landlords.

Casting a Wider Net

While the pros and cons of adopting a hands-on or hands-off strategy might at first blush be considered a draw, the contest with regard to diversification is a no-brainer. Because of convenience and limited knowledge, most investors in small income properties stay close to home. They are thus vulnerable to the fortunes of the local economy and any climate risks like flooding.

Many REITS own over fifty properties spread out across the U.S. Some funds focus on residential real estate and others commercial. Importantly, several REIT funds incorporate international investments in their portfolio. No equivocation here, the diversification offered by REIT mutual funds and ETFs is far superior to the breadth achievable by the small investor.

Who’s in Charge Here, Anyway?

Management is another realm where the contrast between hands-on vs. hands-off investing is pronounced. The formula for the passive investor could hardly be simpler. You can buy shares in Vanguard’s real estate ETF and pay just .13 for management and associated expenses. In return, you get many of the most experienced and savvy real estate professionals in the country overseeing your investments.

The situation for the landlord could hardly be more different. She could, of course, assume all the responsibilities of management including minor fix-ups and repairs by herself. But doing so involves much more than the travails of renting her units and keeping her tenants happy with prompt attention to problems that arise. She’ll be doing a whole bunch of record-keeping and fostering relationships with workers, financial professionals and vendors.

If all of this proved too daunting, she could hire a property manager. This obviously takes some of the burden off her shoulders, but it’s no piece of cake either. You’ll want someone whose fee is reasonable (preferably well under 10%) and is cost-conscious as well as reliable. At a minimum, attention to cost begins with his willingness to set aside the urge to just get your repair order off his desk. He often needs to find a second-opinion and not hand the repair person or contractor a blank check. You should also require authorization from him before undertaking expensive maintenance projects. If you just cash your monthly check, bask on the beach in Hawaii and not manage your manager, you’ll fall way short of maximizing your income.

The Myth of the Indomitable REIT Dividend

A prime attraction of REITS is that they must pay our 90% of their taxable earnings as dividends.  The distribution of the Real Estate index ETF (VNQ) or mutual fund (VGSLX), the consensus standards for REIT investing, is 3.7%. But money markets now yield over 4%, as do many investment grade bond funds and dividend stock funds. By comparison, the S&P’s yield is only 1.3%

Even more, unlike those paid by qualified U.S. companies, the dividends from REITS are taxed as ordinary income. The only wise choice then is a tax-advantaged vehicle. You can say you heard it here: If your overriding goal is to maximize income, then feel free to look beyond REIT funds.

By contrast, depending on geography and the effectiveness of management, the net income (after expenses) earned by our hands-on counterpart will generally be higher than for the typical REIT or expressly dividend fund. It would not be outrageous to propose an income return approaching 10%. Of course, the effect of a missed dividend from one or two stocks in a diversified fund would be negligible, whereas the loss of several months of rent might necessitate a dip into our landlord’s cash hoard.

The verdict here is nuanced. I’ll put it this way. If you’re looking for moderately high steady income, you’ll want the REIT fund. But if you prefer to shoot for that higher but less dependable rental income stream, and are an independent-minded, hands-on type, you should consider owning your own property.

Hey, I Gotta Get Out of Here!

The next two features we’ll review are related and fall way in favor of passive REIT investing. Say your family is blindsided by a health crisis and you need to raise cash quickly and bail. If you’ve got a duplex on your hands, good luck. Unless you are resigned to give it away, probably weeks if not months will go by before you sell the property. Then chop off an unconscionable selling commission that could be as high as 6%. New regulations make it possible to negotiate a lower amount, but you should anticipate it will still be sizable.

What obstacles does the passive investor face? Not many. She can actually sell her REIT ETF shares online in about five minutes and incur no commission (but a tiny spread) regardless of transaction size. This far greater liquidity and zero exit (and entry) costs bestowed on the REIT fund shareholders are stark advantages over private ownership.

Over the Holidays Give Thanks to the 1031

“But you don’t get depreciation and you can’t take deductions with your REITS.” That insufferable neighbor Jerry leaned over the poker table and wagged his finger at me. “You threw away cash you could have used as a down payment on that attractive duplex down the street.

Jerry was right about the superior tax benefits enjoyed by hands-on owners, but not necessarily for those reasons. Why not? Because the managers of the REITS in your fund are claiming those deductions and taking that depreciation for you. You just don’t get to see it on your tax return.

Besides, there is widespread misunderstanding of the depreciation deduction. Yes, your investment is appreciating even as you depreciate it, but hear me out. In a calculation known as recapture, the deduction must be subtracted from your cost basis (at a 25% rate), substantially increasing your capital gain. More accurately, depreciation is an interest-free loan and paid back with cheaper dollars, taking advantage of the time value of money. But it’s not the free lunch it’s often made out to be.

So is there any tax advantage to the landlord who has devoted so much time and energy into maintaining his property with an eye toward enhancing its value. There is, but it’s less well-known than depreciating the building and expensing deductions. And it’s only available to sellers who don’t need to use the proceeds for living expenses, home projects or travel. If these owners are instead open to buying a similar kind of property at least as expensive as the one they just sold, they can take advantage of a monstrously favorable provision of the tax code. They can delay realizing the gain until the replacement property is sold.

Of course, there’s a hitch or two. The property to be purchased must be identified within 45 days of the sale and the transaction (including the closing) completed in 180 days. Not much time to poke around and deliberate. In fact, I know several people who opted to pay the capital gains tax because they couldn’t find an acceptable investment within the allotted time.

The 1031 exchange permits the cost basis of the investment to be stepped up to its value upon the owner’s death. If her heir elects to sell the property within a specified period of time, he will have no or minimal capital gain. Incomprehensibly, the benefits of the 1031 are conferred as well on the heir at his own passing. So it’s not depreciation or the deductions that are the real tax boondoggle, it’s the 1031 exchange.

Intergenerational Wealth vs. Quality of Life

The humongous tax break provided by the 1031 exchange has compelled our family to tough out the hassles and disruptions of private real estate ownership until Alberta or I (most likely) pass. By so doing, we acknowledge we are surrendering the much greater diversification and ease of selling inherent in investing in small residential income properties through a fund of REITS. We are also reluctantly aware we are inevitably eroding the family’s quality of life during Alberta’s and my senior years.

But, remember, I’m completely done with this dilemma. No more obsessing, no more Monday morning quarterbacking. I wrote this for you, not for me. As you can tell, I didn’t need the catharsis. Well, kind of.