Brett Arends's ROI: Don’t become a landlord — own these REITs instead

My first applicant turned out to be a violent felon who had been arrested for trying to strangle his wife.

Investing in real estate is a popular strategy for people saving for retirement, especially among the so-called FIRE brigade, who are racing for early financial independence and retirement.

The idea that you can get rich by owning real estate is also pushed by a lot of salesmen.

One of the main appeals in that of leverage: You can borrow, sometimes as much as 80%, against the value of the property. That can work really well, of course.

But generally only when borrowing is cheap — which it used to be, and isn’t right now.

And only if you bet in the right direction. Buying homes with borrowed money is much like buying stocks with borrowed money. Sometimes it works really well — as it has much of the time since the 1980s, as borrowing costs have come down. Other times, not so much.

But if you’re thinking of following suit and investing in real estate, don’t just scour the local listings at property websites like Zillow, or Realtor.com, which is owned by News Corp, parent of MarketWatch publisher Dow Jones.

Check out the stock market, too. That’s because there are established real-estate investment trusts, or REITs, that invest in residential real estate and will do all the landowning for you.

And they make a compelling alternative to direct investment — especially now.

Don’t believe me? Try these seven reasons.

They have been better long-term investments

There are at least eight residential REITs that have been on the stock market since 1995: AvalonBay Communities AVB, +0.59%, Elme Communities ELME, +1.10%, Equity Residential EQR, +0.82%, UDR UDR, +1.37%, Mid-American Apartment Communities MAA, +0.95%, Camden Property Trust CPT, +1.39%, Essex Property Trust ESS, +0.81% and Apartment Investment & Management Co. AIV, +2.79% (now split into two, with Apartment Investment REIT Corp. AIRC, +1.08% ).

Total returns since then? More than 2,000% — or nearly 12% a year.

During the same period average U.S. home prices, as measured by the Case-Shiller national home-price index, has risen by less than 300%.

Granted, Case-Shiller is a capital-only index: It doesn’t measure rental income as well as price gains. But even on an equivalent, capital-only basis, the traded REITs have outperformed home prices by an average of about three percentage points per year.

See: Miami and Chicago lead way as U.S. home prices rise in April, signaling a recovery in the sector

And in order to keep up with the total return on these REITs, a private landlord would have needed an average rental yield of 6.6% a year. Net of all costs.

They look a better deal right now

U.S. home prices, as measured by Case-Shiller, have come down a few percentage points from last year. But they remain 40% higher than they were at the end of 2019, before the pandemic and the lockdowns — when mortgage rates were barely half of what they are now, and cities were desirable locations where property crime was illegal.

Residential REIT stock prices, meanwhile, have been left behind. Many are still at prepandemic prices, or lower.

They have now underperformed national housing prices by a wide margin over several years. In the past, such underperformance has been followed by outperformance — because, over time, the two must move in much the same direction.

The costs are way lower

Real-estate brokers typically charge about a 6% fee to sell a home. Depending on the market, you may get a better deal. If you are buying, the broker will tell you that you aren’t paying the fee — but of course you are, really. It’s embedded in the price. Ultimately it costs about 3% of the home’s value either way. Then there are attorney’s fees, inspections and so on.

The costs of buying and selling a publicly traded REIT? About $ 5 or $ 10, depending on your brokerage. Sign up with a new broker and they will often give you a bunch of initial trades for free, saving you enough money, while you construct a housing portfolio, to buy not one but several cups of coffee.

From the archives (October 2019): There’s a downside to the disappearance of brokerage fees on online trades — yes, really

They are much less risky

No, “risk” doesn’t mean “volatility.” That’s the nonsense Wall Street peddles.

Risk, as any experienced adult can tell you, means the possibility of losing money.

Anything can happen to an individual apartment unit or a home. You can get a bad tenant who trashes the place or skips out without paying. A drug dealer can move in next door. The adjacent building can collapse, releasing clouds of long-buried asbestos, and leaving your building uninhabitable for weeks or months.

Don’t laugh. All of these things have happened to people I know well in recent memory.

Or you can invest in prime real estate in one of the richest, most famous, most desirable cities in the world, and wake up one morning to discover it’s San Francisco.

Unless you are very, very rich, how many different housing units do you expect to own? How diversified are they likely to be?

Meanwhile the two biggest residential REITs on the stock market, AvalonBay and Equity Residential, between them own 170,000 units in over a dozen states from coast to coast. A portfolio of residential REIT stocks offers the kind of diversification you just can’t get as a private landlord.

You can get out fast

There is an old joke about housing markets. In a slump they don’t fall — they vanish. I covered the real-estate collapse in Florida in 2008. People trying to sell didn’t just take a price cut; in many cases they couldn’t sell at all — at any price. Places sat on the market for years. The greater Miami market didn’t finally clear until the summer of 2011, about five years after it started to decline.

How long does it take to liquidate your REIT ownership? Between 9:30 a.m. and 4 p.m. Eastern time on most weekdays, about as long as it takes to click a mouse.

Professionals are managing it for you

No disrespect to any do-it-yourselfer. Actually, here at MarketWatch we are all on the side of the well-informed, sensible DIY investor.

But professionally managed REITs have teams of people finding, buying and selling investment properties. And managing them.

That includes lawyers to handle the paperwork and chase recalcitrant tenants, plumbers and electricians to turn up for emergencies at 2 a.m., and so on.

It doesn’t always mean they are better at it, but it does mean they have enormous economies of scale. And you, the stockholder, never have to deal with any of it. When you’re a stockholder, you never get called to deal with an emergency.

Meanwhile, if you are a private landowner, some day a pipe will burst, flooding the downstairs unit, and you will get a call. And it is all but guaranteed that this will happen on the morning of your daughter’s wedding, just when you’ve learned the limo has broken down.

You will probably pay fewer taxes

Own an investment property, and your net income is usually going to be taxed as ordinary income. That means the tax rates will be higher than they would be for long-term capital gains. You can write off mortgage interest and reasonable costs, but there is paperwork involved, and unless you are a demon at bookkeeping you will miss some of it. If your property is in a different state from your primary residence, you can add the joys of filing an extra tax return every year.

You can place property in a tax shelter, losing some benefits but gaining others, but the costs and complexities can be prohibitive — especially for a mom-and-pop investor. You’ll want to consult a tax expert at the very least.

Residential REITs? Cue laughter. You buy the stock in a 401(k), IRA or equivalent and … well, that’s it.

So, you may ask, if there are all these potential advantages to investing in real estate through publicly traded REITs, are there low-cost ETFs that will do it all for you really easily?

The answer: no. And avoid the various ETFs and mutual funds that call themselves “real estate” and track any kind of REIT “index.” That means most of them. These days the REIT indexes have almost nothing to do with residential real estate. They are dominated, weirdly, by the stocks of companies that own data farms, or cellular network towers, or distribution warehouses. Nothing wrong with all those businesses, but they are not what we are looking for here.

Furthermore, these indexes used to be dominated by office buildings and malls — investments that have been in deep trouble for years, due to internet shopping, working from home and so on. This is one reason the REIT indexes, and REIT index funds, have done so badly of late.

It would be great if someone out there launched an ETF that invested only in residential REITs, but they haven’t. (Actually, that’s good news — it means the sector isn’t popular enough to attract all the marketing departments, which means it is not overly popular.)

So until then, we do-it-yourselfers are left with the option of just buying the REITs directly.

This is simpler and less risky than one might imagine. As ever, the simplest strategy is almost certainly the best: Buy an equally weighted portfolio of established names, and rebalance once a year.

So I’m here launching my Equal Weight Residential REIT Portfolio. It consists of the 10 biggest residential landowners by market value. Average forecast dividend yield for the next 12 months: 3.7%.

• AvalonBay AVB, +0.59%

• Equity Residential EQR, +0.82%

• Invitation Homes INVH, +1.48%

• Mid-America Apartment Communities MAA, +0.95%

• UDR UDR, +1.37%

• Essex Property Trust ESS, +0.81%

• Camden Property Trust CPT, +1.39%

• American Homes four Rent AMH, +0.63%

• Independence Realty Trust IRT, +1.48%

• American Income REIT AIRC, +1.08%