Why REITs Earn Higher Returns than Private Real Estate? Should You Invest?

$Vici Properties(VICI)$ $Realty Income(O)$

In a recent articles, I explained why I’m choosing to invest in Real Estate Investment Trusts (REITs) instead of rental properties. In short, REITs are still significantly discounted, and I believe their lower valuations will lead to higher returns in the years ahead.

However, some of you may misunderstand the core advantages of investing in REITs due to common misconceptions. I noticed several comments claiming that REITs are less rewarding because they don’t benefit from leverage, they’re not tax-efficient, and investors are paying managers instead of being hands-on.

Misconception 1: REITs Don’t Benefit from Leverage

The first misunderstanding is the belief that REITs don’t benefit from leverage because you can’t personally take out a mortgage to invest in them. This is incorrect. REITs are inherently leveraged investments.

When you buy shares in a REIT, you’re providing the equity, and the REIT itself takes on debt to purchase properties. For example, your $50,000 investment in REIT equity might represent $100,000 worth of real estate assets. The reason you don’t see this directly is that what’s traded on the stock market is the equity value, not the total asset value. However, the benefits of leverage are built into the investment.

Misconception 2: REITs Are Not Tax-Efficient

The second misconception is that REITs lack tax efficiency, often because their dividends are classified as ordinary income. This is a shortsighted view that overlooks the many tax advantages REITs offer.

Here’s why REITs can be highly tax-efficient:

• No Corporate Tax: REITs are not subject to corporate income tax, eliminating the issue of double taxation.

• Retained Earnings: REITs typically retain 30-40% of their cash flow for growth, which is fully tax-deferred.

• Return of Capital: A portion of REIT dividends is often classified as a return of capital, which is also tax-deferred.

• Qualified Dividends: A significant portion of REIT dividends qualifies for a 20% tax deduction under current tax laws.

• Appreciation: REITs generate a large part of their returns from property appreciation, which is entirely tax-deferred.

• Tax-Deferred Accounts: You can hold REIT investments in tax-deferred accounts, like IRAs, and enjoy flexibility with zero taxes.

Additionally, REITs benefit from economies of scale, allowing them to employ in-house legal teams to minimize property tax increases, further improving their efficiency. In summary, REITs offer the benefits of leverage and can be exceptionally tax-efficient when compared to direct rental property investments. These misconceptions often prevent investors from realizing the true potential of REITs, and I’ll address more of these points as we continue.

Misconception: Management Costs Make REITs Less Rewarding

Some believe that REITs are less profitable because investors have to pay management fees. While it's true that REITs have management costs, these expenses are typically far lower than the costs associated with managing private rental properties, thanks to the significant economies of scale REITs enjoy.

Take the example of Realty Income: its annual management costs amount to only about 30 basis points (0.3%) of its total assets. In contrast, most private real estate owners face management costs that are three to four times higher. This highlights the cost advantages of owning real estate on a massive scale. As a REIT investor, you share in these efficiencies, which can significantly improve overall returns.

Now that we’ve addressed the misconceptions surrounding REIT management costs, let’s explore some studies that compare the returns of private real estate investments with those of REITs. I’ll also provide eight reasons why REITs are often more rewarding than private real estate investments.

Misconception: Management Costs Make REITs Less Rewarding

Some believe that REITs are less profitable because investors have to pay management fees. While it's true that REITs have management costs, these expenses are typically far lower than the costs associated with managing private rental properties, thanks to the significant economies of scale REITs enjoy.

Take the example of Realty Income: its annual management costs amount to only about 30 basis points (0.3%) of its total assets. In contrast, most private real estate owners face management costs that are three to four times higher. This highlights the cost advantages of owning real estate on a massive scale. As a REIT investor, you share in these efficiencies, which can significantly improve overall returns.

Now that we’ve addressed the misconceptions surrounding REIT management costs, let’s explore some studies that compare the returns of private real estate investments with those of REITs. I’ll also provide eight reasons why REITs are often more rewarding than private real estate investments.

Before we dive in, a quick reminder: we at [Your Investment Firm Name], specialize in REIT investing, and we’re currently offering a two-week free trial for our REIT newsletter. By signing up, you’ll gain full access to my REIT portfolio at no cost for 14 days. As part of our Black Friday sale, you’ll also receive a discount if you decide to stay with us after the trial. Simply click the first link in the video description to get started.

Studies Comparing REITs and Private Real Estate

• ERA Study (1977–2010) This study found that REITs delivered 3% to 6% higher average annual total returns compared to private real estate, depending on the investment strategy.

• Cambridge Study (25-Year Period) Over a 25-year period, this study revealed that REITs outperformed private real estate by an average of 4% per year.

• NAREIT Study (1979–2019) Spanning 40 years, this study concluded that REITs earned, on average, 3% higher annual returns than private real estate investments.

These results might come as a surprise to private real estate investors, but they make perfect sense when you consider the inherent advantages of REITs. Let’s explore eight reasons why REITs are often more rewarding:

Economies of Scale

REITs benefit from massive economies of scale, which go far beyond reduced management costs. Real estate is a low-margin business with low barriers to entry, so scale plays a critical role in lowering costs and improving margins.

For example, AvalonBay Communities (AVB) owns nearly 100,000 apartment units, allowing it to achieve significant efficiencies across all aspects of its operations, from leasing to maintenance.

• If AvalonBay owns 500 units in a single market and negotiates with a local contractor to replace 100 carpets annually, it can secure a far better rate per carpet than a private landlord replacing just one or two carpets.

• Similarly, AvalonBay employs in-house legal teams to handle tasks like evictions, drastically reducing legal expenses.

These scale advantages are prevalent throughout the REIT industry and have a substantial impact on returns, especially given the low-margin nature of real estate.

External Growth Advantage

Another significant reason why REITs often outperform private real estate investments is their ability to grow externally. While private real estate investors are largely limited to internal growth (increasing rent to boost cash flow), REITs can also leverage external growth strategies to enhance their performance.

How External Growth Works: REITs raise additional capital—primarily through equity sales in the public market—and combine it with debt to acquire new properties. As long as the cost of raising this capital is lower than the capitalization rate (cap rate) on new acquisitions, the REIT can generate a positive spread. This process increases cash flow and dividends on a per-share basis, resulting in accretive growth.

For instance, Realty Income has managed to grow its cash flow and dividends by about 5% annually, even though its rent escalations are only 1–2% per year. The extra growth comes from external acquisitions financed at favorable spreads. This growth strategy ensures value creation for shareholders rather than dilution.

Private real estate investors lack access to public equity markets, making it much harder for them to execute similar external growth strategies, putting them at a disadvantage.

Development Capability

Another reason REITs excel is their ability to develop their own properties. Most private real estate investors focus on stabilized properties, renting them out as-is or undertaking minor renovations to boost rents and property value.

In contrast, REITs actively engage in property development, adding substantial value by building from the ground up.

For example, First Industrial Realty Trust (FR) frequently develops new Class A industrial properties at cap rates of around 7%. In the private market, purchasing stabilized assets of similar quality would likely yield closer to a 5% cap rate. By developing properties in-house, REITs not only achieve higher yields but also create significant long-term value.

Why Can REITs Do This?

• Scale: Their size allows them to afford top talent, including architects, engineers, and project managers.

• Relationships: They maintain strong partnerships with local government officials, tenants, and contractors, enabling smoother project execution.

• Resources: They have the capital and expertise to navigate complex zoning laws and permitting processes.

This development capability provides REITs with a distinct edge over private real estate investors, making them a compelling choice for long-term investment growth.

Monetization

Another significant advantage of REITs is their ability to monetize their platforms to generate additional profits. REITs often provide value-added services to other investors, and as a shareholder, you benefit directly from these activities.

For instance, many REITs manage capital for institutional investors, earning asset management fees. Healthcare Realty Trust (HR) frequently engages in joint ventures when acquiring properties, allowing other investors to co-invest while charging fees for managing these investments.

Additionally, some REITs offer ancillary services, such as:

• Brokerage Services: Facilitating property transactions for third parties.

• Property Management: Overseeing operations for properties owned by others.

• Construction Services: Providing development expertise to third parties, leveraging their in-house capabilities.

These diversified revenue streams are unique to REITs, giving them a significant edge over private real estate investors, who typically lack the scale and resources to pursue such opportunities.

Bargaining Power

REITs also enjoy stronger bargaining power with tenants due to their size and diversification. This advantage allows them to negotiate favorable lease terms and achieve higher rent growth over time.

For private real estate investors, owning just a few properties creates vulnerability. Fear of tenant turnover might discourage them from enforcing rent increases, as a vacancy could significantly impact their income.

In contrast, REITs operate with much greater resilience:

• Diversification: With hundreds or thousands of properties, losing one tenant has minimal impact.

• Resources: They can quickly re-lease vacant spaces at minimal cost.

• Negotiation Strength: Tenants recognize the stability and reputation of REITs, often agreeing to rent escalations or landlord-friendly lease terms.

This bargaining power contributes to stronger long-term returns for REIT investors.

Off-Market Deals

Another reason REITs often achieve superior returns is their ability to secure off-market deals. Unlike private investors who typically buy properties through competitive brokerage markets—paying premium prices and high transaction costs—REITs frequently bypass this process.

For example, Essential Properties Realty Trust (a major holding in our portfolio) has an in-house team dedicated to sourcing off-market opportunities. This team reaches out directly to property owners, offering to purchase their assets and negotiate custom leases with favorable terms.

Off-market deals provide several advantages:

• Higher Cap Rates: Properties are often acquired at better valuations than those found on the open market.

• Lease Customization: REITs can negotiate longer lease terms, higher rent escalations, and minimal landlord responsibilities.

• Lower Transaction Costs: Direct negotiations reduce fees typically incurred in traditional brokerage transactions.

By leveraging off-market deals, REITs create substantial value for their shareholders, ensuring a competitive edge over private real estate investors.

Best Talent

The seventh reason REITs outperform is their access to the best talent. This advantage cannot be overstated. REITs can afford to hire highly skilled professionals—graduates from top schools with significant experience in private equity and real estate—who dedicate their careers to maximizing returns for shareholders.

Even though these professionals are well-compensated, REITs' management costs, as a percentage of total assets, remain far lower than those typically seen in private real estate investments. This efficiency is due to the economies of scale that REITs enjoy.

In contrast, individual landlords often juggle property management as a part-time effort, lacking the expertise and resources that REITs possess. Competing with REITs on strategy, execution, or operational efficiency is nearly impossible under these conditions.

Avoiding Disastrous Outcomes

The eighth reason is REITs' ability to minimize the risk of catastrophic outcomes, which has a profound impact on overall returns. In private real estate investing, outcomes tend to vary widely. While some investors succeed, others face significant losses due to:

• Concentration Risk: Over-reliance on a few properties.

• High Leverage: Exposure to financial strain during downturns.

• Liability Risks: Personal exposure in some investment structures.

• Social Component: Dealing with tenant issues or unforeseen problems.

These factors often lead to private real estate investors filing for bankruptcy. Such disastrous results skew the average performance of private real estate investments downward.

In contrast, REITs are designed to mitigate these risks:

• Diversification: Spreading investments across various properties and markets.

• Moderate Leverage: Maintaining reasonable debt levels.

• Focus on Class A Properties: Investing in high-quality, income-generating assets.

REIT bankruptcies are rare, with only a handful occurring over decades, primarily in niche sectors like low-quality malls. The stability of REITs ensures consistent returns without the extremes of private real estate investing.

Summary

To conclude, REITs generally provide higher returns than private real estate investments, as demonstrated by numerous studies and logical advantages:

• Economies of scale.

• Access to external growth opportunities.

• Stronger tenant bargaining power.

• Monetization of platforms.

• Risk mitigation.

At present, REITs are particularly attractive due to significant discounts, with many trading at 20-40% below the value of their real estate holdings. Additionally, REITs benefit from historically low interest rates, which are often locked in for years, unlike private real estate investments that face rising borrowing costs.

For instance, NNN REIT has an average debt term of 12 years with a 4% interest rate, while private investors in similar properties face mortgage rates of 6-7%. This makes REITs not only more cost-effective but also less risky and more liquid than private real estate options.

Even large private equity firms like Blackstone are aggressively investing in REITs, recognizing their superior value and potential. For individual investors, REITs offer an opportunity to diversify, reduce work intensity, and enjoy geographic flexibility—all at a discount.

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