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A better way to invest in rent property

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Location, location, location.

Looking to invest in rental real estate? Here's my advice on location: Try the stock pages.

I get a steady stream of e-mails from readers, asking about the virtues of investing in apartments and vacation homes. My response: If you really want to invest in rental real estate, buy equity real-estate investment trusts, or REITs, which make their money by purchasing and then renting out offices, shopping centers, apartments and other properties.

To be sure, if you invest in rental property, you could increase your returns with leverage and your rental income may dwarf the dividends you receive from REITs. Even so, I would still lean toward REITs, because there are fewer hassles, less risk and far lower costs.

Equity REITs have lately been on a tear, with share prices up a cumulative 31 percent over the 3 1/2 years through June 30, according to Washington's National Association of Real Estate Investment Trusts.

But property prices have also been rising smartly. If you had bought a rental property in late 1999 and it appreciated at the same rate as other homes, you would have made 28 percent over the same 3 1/2-year stretch, according to home-finance corporation Freddie Mac.

That 28 percent gain, however, isn't really comparable to the 31 percent return from equity REITs. One reason: REIT returns benefited from leverage. Currently, REITs have debt equal to a little under 50 percent of their total capitalization. That's like owning a $200,000 property with $100,000 left on the mortgage.

When folks buy rental properties, they often also use leverage. Suppose that, 3 1/2 years ago, you put down $100,000 on a $200,000 house and the home's value climbed 28 percent, to $256,000. Thanks to the leverage involved, your gain would be 56 percent, with your $100,000 down payment growing to $156,000.

Unfortunately, however, you wouldn't have pocketed nearly that much. Why not? First, there would be the often-exorbitant cost of first buying and later selling the property. Second, that leverage would come at a cost, in the form of hefty monthly mortgage payments.

People sometimes argue that rental properties are a better investment than REITs, because you can employ more leverage. But this argument doesn't impress Chris Mayer, a finance professor at New York's Columbia Business School. He points out that, if you really want a leveraged play on real estate, you could open a margin account at your favorite brokerage firm and buy REITs with borrowed money.

"To which people say, that's really risky," Mayer recounts. "To which I say, it isn't any more risky than taking out an 80 percent loan on a piece of rental property."

Comparing yields. While price appreciation gets all the attention, the biggest gain from both REITs and rental property is likely to be the yield. That yield is the dividends you receive from your REITs and the rent you get from your tenants.

Currently, equity REITs yield an average 6 percent. It doesn't cost much to collect that yield. If you invest through a no-load REIT mutual fund, there's no expense when buying and selling. Your only costs are the fund's annual expenses and trading costs, plus taxes if you held your fund outside of a retirement account.

What about rental property? The yield will vary from city to city. If you rent out a single-family home in Los Angeles, you might collect annual income equal to 6 percent of the property's value, figures James Joseph, owner of Century 21 Grisham-Joseph in Whittier, Calif. Meanwhile, Sean Conlon, co-founder of Century 21 Sussex & Reilly in Chicago, figures the yield in his city might be closer to 7 percent.

But once again, both leverage and costs come into play. If you took out a mortgage to buy your rental property, the yield as a percentage of your down payment would be higher than this 6 percent or 7 percent. But unfortunately, you would also face a truckload of ongoing expenses, including maintenance costs, homeowner's insurance and taxes. Add it up, and I suspect a lot of rental-property owners will find they could fare just as well with REITs.

Still, if you buy rental properties in depressed real-estate markets, the yields could be much higher than the 6 percent and 7 percent cited above. But high rents don't necessarily translate into high total returns. Indeed, a hefty yield may indicate that home prices won't rise a whole lot.

Considering risk. While you can't be sure whether REITs or rental properties will perform better, REITs do have one undeniable advantage: They are a lot less risky.

If you invest in a rental property, you are banking a ton of money on a single piece of real estate, rather than getting the diversification of REITs. Moreover, there is the problem of collecting those rent checks. "If it takes you three months to evict a tenant, you're out a quarter of that year's return," Mayer notes.

The bottom line: Owning REITs is not only less risky, but it also involves far fewer hassles. "It's easy to describe the difference" between REITs and rental properties, says William Bernstein, an investment adviser in North Bend, Ore. "One is an investment and the other is a job. It all depends on your tolerance for broken toilet bowls and psychopathic tenants."