AND THE PLAYERS GONNA PLAY PLAY PLAY PLAY AND THE HATERS GONNA HATE HATE HATE HATE.

Sorry, got a little distracted there. What are we gonna talk about today?

(Scrolls up) OHGODOHGODOHGODOHGOD!

No, that’s not true at all. Today’s post is gonna be a good one. It might even encourage a few amateur landlords (i.e. people with one or two condos in Toronto/Mississauga/other Toronto suburbs) to sell their units and do this instead. Unless they’re angling on the I’m gonna sleep with my tenant thing. Sure, that’s not gonna happen, but I can at least appreciate the fantasy.

Around here we all know I’m a fan of the leverage. It’s the easiest way for investors to supercharge their returns. I did it when I was a younger man, borrowing to buy rental properties. I’d pay one off, buy another, and so on. I stopped at three just because the market doubled in one year and after that the numbers didn’t make much sense anymore.

But what if I had of done something different? What if, instead of buying three rental properties, I bought shares in three of Canada’s largest REITS? Instead of putting down approximately 30% on each rental property, I borrowed $2 for every $1 of my own money, bought REITs, and didn’t have to lift a finger? How would the results differ over a decade, from 2004-14?

Let’s find out. But first, a few assumptions:

– Let’s assume a 5% net rental income of a $200,000 rental, with a $66,000 down payment. We’ll assume 4% interest for the life of the loan.

– We’ll assume 4% interest as well for the REIT buyer, who also put down $66,000 and borrowed $134,000. The REIT buyer bought three of the largest REITs in the country (RioCan, H&R REIT, and Dream Office REIT).

The rental investor

In 2004, the rental investor buys a nice townhouse in, oh I don’t know, Oshawa. That seems like a nice place. Over the next decade it goes up in value to $400,000, and on average he makes $10,000 a year after he pays the property taxes and has to ship out a couple freeloaders who didn’t bother to pay the rent.

  • Down payment – $66,000
  • Mortgage – $134,000
  • Interest rate – 4%
  • Total interest paid – $46,089
  • Principal still owing – $95,505

After a decade, our physical real estate investor is sitting pretty. His house is worth $400,000, he made $10,000 a year in cash flow, and all it cost him was a $66,000 down payment and $46,089 in interest. Here’s his profits:

  • Net rental income – $100,000
  • Appreciation on the property – $200,000
  • Less interest – $46,089
  • Total profit – $253,911

WHOO WE HAVE A WINNER THAT DUDE TOOK A $66,000 DOWN PAYMENT AND TURNED IT INTO A QUARTER MIL.

Not so fast, whoo guy. Let’s see how the REIT investor did.

Remember, the REIT investor would have bought equal parts of Dream Office REIT, RioCan REIT, and H&R REIT. For $200,000, here’s what he would have gotten back in September, 2004.

  • 3,882 shares of H&R REIT
  • 4,064 shares of RioCan
  • 2,779 shares of Dream Office REIT

(Not exact due to rounding, but close enough. Our physical real estate investor would have had closing costs which we didn’t count either.)

Here’s what our REIT investor would have, today.

  • $90,528 worth of H&R shares, plus $47,709 in dividends
  • $110,215 worth of RioCan shares, plus $56,115 in dividends
  • $80,618 worth of Dream shares, plus $59,153 in dividend
  • Total value of $444,338 including the value of shares and dividends

Or, to summarize it like our other investor above:

  • Share appreciationĀ – $81,361
  • Total value of dividends – $162,977
  • Less interest – $46,089
  • TotalĀ profitĀ – $198,249

And we have a winner. Over the last decade, even after using the same amount of leverage for each type of investor, the physical real estate investor comes out ahead. It’s easy to see why, it’s all in the capital appreciation. Dividends from the REITs were more than 60% higher than the hypothetical income from our physical investor, and would have been maintained without doing a thing.

Now let’s use the same numbers and assume the underlying real estate for the physical investor goes up 2% a year, a reasonable assumption for inflation going forward. How do the return numbers differ?

  • Net rental income – $100,000
  • Appreciation on the property – $50,000 (we’ll call it 25% after compounding)
  • Less interest – $46,089
  • Total profit – $103,911

This makes it really obvious that the physical investor was saved by the appreciation. Suddenly, when the value of physical real estate returns more of a traditional amount, the REIT investor trounces the other investor.

Aside: Here are some REITs I think are decent investments.

Here’s the question a real estate investor has to ask themselves. Over the next decade, will the value of your units rise, fall, or stay about the same. You guys all know where I stand on this issue, and I think that staying the same is a bit of a pipe dream too. If you think values are still going to beat inflation over the long term, the leverage involved in buying a physical property will end up being a wise move.

But if values stagnate or fall, a leveraged real estate investor will get killed. REIT owners shouldn’t do so bad, since it’s likely the REITs will continue making monthly distributions. In that situation, borrow to buy REITs, not condos.

The last decade has been as good as it gets for landlords. Sure, investing in a condo or two would have beaten three of the largest REITs in the country, but that’s during the biggest bull market in the history of Canadian real estate. It won’t do as well over the next decade. And even if you would have picked the REITs, you would have done well and not lifted a finger. It’s easy to see why you’d be much smarter to leverage and buy REITs going forward.

Tell everyone, yo!