Many people see owning a rental property as a ticket to prosperity. But wouldn’t it be nice if you could simply own an interest in a rental property, but not have any of the accompanying hassles? I’m far from an expert in this field, but let’s take a look at an REIT that invest in residential real estate.

What is an REIT?
REIT stands for Real Estate Investment Trust. From the National Association of REITs website:

A REIT is a company that owns, and in most cases, operates income-producing real estate such as apartments, shopping centers, offices, hotels and warehouses. Some REITs also engage in financing real estate. The shares of many REITs are freely traded, usually on a major stock exchange.

To qualify as a REIT, a company must distribute at least 90 percent of its taxable income to its shareholders annually. A company that qualifies as a REIT is permitted to deduct dividends paid to its shareholders from its corporate taxable income. As a result, most REITs remit at least 100 percent of their taxable income to their shareholders and therefore owe no corporate tax.

Since all the REIT income usually “passes through” straight to the shareholders, you are getting relatively direct exposure to real estate. You’re not investing in raw materials, a homebuilder, or some other derivative.

REZ Residential ETF
The iShares FTSE NAREIT Residential Plus Capped Index Fund (ticker REZ) is an ETF that tracks the FTSE NAREIT All Residential Capped Index. Here is the breakdown by industry breakdown and also the top 10 holdings.

As you can see, this is not the same as owning a single-family house, or even a bunch of single family houses. The fund holds interests in apartment complexes, healthcare facilities such as seniors housing communities and skilled nursing facilities, and also self-storage companies. For example, you can search online through the apartment complexes owned by Equity Apartments.

The annual expense ratio for REZ is 0.48%, which is on top of the built-in costs spent by each individual REIT. iShares also has ETFs focused on the different sectors such as Retail (retail stores, shopping malls) and Office/Industrial (office and industrial buildings).

ETF Advantages
One obvious advantage of owning an ETF instead of a single rental property is simplicity. You don’t have to spend time and effort dealing with finding tenants, maintenance issues, or problems with local government. You don’t have to search for properties to buy, negotiate prices, or obtain financing. You also don’t have to ever worry about keeping up cashflow, as there are no mortgage payment due each month.

Then there’s liquidity. If you need to sell, REZ has decent share volume so you can just type in a sell order and you’re done. You pretty much know the market price at all times.

Which One Is Better?
Here’s the tough question. Which will have the better return? With a single property, you are looking at monthly cashflow and property appreciation (plus possible tax benefits). With the ETF, you have your quarterly dividends and share price appreciation.

REZ currently has a current distribution rate of 5.11% based on its last quarterly dividend of 0.3003 cents per share, while the dividend yield listed on Yahoo! is 8.84% based on TTM (sum of all dividends paid out in the trailing twelve month period). According to the iShares page the Price/Earning ratio was 33 and the Price/Book ratio was 1.73 as 6/30/09.

The trailing 1-year total return of REZ is -39.64% according to Morningstar. (Too new for older numbers.) However, depending on how much your rental house was leveraged, many private investors could have done much worse. If you put $10,000 down on a $100,000 house and the house dropped just 5% in value, you would have essentially lost 50% of your $10,000 as well. I’m not sure what the total leverage of the REITs in this ETF are.

Also, we have to go back to the fact that this REIT doesn’t hold a bunch of detached single-family houses. Healthcare facilities seem like they would be a good source of income in a growing field. However, they could also be susceptible to political changes in Medicare rules.

I think its safe to say that any individual property could do worse or better than REZ. Perhaps a better question is how much you value diversification. Instead of putting your money into one property in one area, with an ETF you are instead owning a slice of thousands of different properties across the country. If you have high confidence in your abilities to select and manage a single property, that might be the better way to go.

When people talk about asset allocation, they usually refer to the relative amount of stocks or bonds in their portfolio (like the model portfolios shown here). But I am occasionally asked whether to include personal home equity in asset allocation. If you have a significant amount of home equity, does this mean you are overexposed to the Real Estate sector? Should you change your other investments to compensate?

Conspiracy Theory Argument
Professional portfolio managers are usually paid based on a percentage of assets under management, or when you make trades. Since they don’t usually control your home equity, they can’t charge you for it, which is why some say the industry secretly decided it shouldn’t be included in asset allocations.

I’m not so sure about this one. Most people don’t have professional money managers. And if they do, for example I’m betting that most advisors would include a huge 401(k) in their planning even they didn’t control it.

Pricing and Liquidity Argument
It is very hard to determine the true market value of an individual house. You can’t sell only a portion of it, which means you can’t rebalance relative to other asset classes. Because of these issues, some people say personal home equity shouldn’t be included.

Still, this is also true of investment/rental properties, which I think should be included in asset allocations just as much as owning any company with physical assets.

My Answer: It Depends?
I plan on staying in the same geographical area indefinitely. Once I’ve committed to buying a place, I’m mainly trying to pay off all “future rent” at once. If I never move, then obviously it won’t much to me what happens to housing prices. If housing prices in my area go up, then my house value will go up, and an alternative house I want to buy will go up. The opposite will be true if housing prices go down. Over the long term, prices should pretty much match inflation. So I don’t consider my house as part of my portfolio.

However, if I planned to sell my house upon retirement, and then use the money to move to a significantly cheaper home and use the difference to cover other expenses, then I would care about my house value because I would have to “cash out” at some point. Some people end up relying on a reverse mortgage to pay for things, which would be a similar scenario.

While going through some old boxes, I found an old CD case containing some audiobook recordings from a real estate program by Robert Kiyosaki and Dolf De Roos. I’m pretty sure they are from this set called Rich Dad’s Roads To Riches – 6 Steps To Becoming A Successful Real Estate Investor.

Kiyosaki is best known for his book Rich Dad, Poor Dad (my 2005 review). People tend to either hate him or love him, but to me he’s just a guy who has wrapped up a legitimate way to make money – investing in real estate – and tried to simplify and market it to the general public in a palatable way. You can read about most of the criticisms at this link, although it is a bit long (Reed really hates this guy.). I see his books as having the occasional nugget of wisdom buried in a pile of shiny happy fluff.

Luckily, I took notes when I listened to it the first time, so I didn’t have to go through it all over again. Here’s the stuff I decided was worth remembering.

• Avoiding Alligators. A general rule is that you should never invest in a home that does not immediately produce positive cashflow. In other words, the rent covers your mortgage plus other expenses, and you don’t have to keep making monthly payments out of your savings or income. A property that requires more money every month is called an “alligator”. Why? Because you have to constantly feed it and feed it. If you ever stop, it eats you.
• When To Expand. Along the same lines, if you keep buying alligators, you can only buy a finite number before all your money is tied up feeding them. If you buy cashflow-positive properties, it is much easier to keep buying them. Once your property value increases, you can extract the equity by refinancing and use to invest in another cashflow positive house. This way, you’re never in a bind with regards to cashflow.
• Tenant Screening Tip. When looking for tenants, always ask for the contact information of the current landlord and the landlord before that. This is because the current landlord might lie to you in order for you to accept their nightmare tenant, and have them move out peacefully. The previous landlord will be willing to tell you the truth.
• Treat It Like A Business. Don’t put up with tenants that chronically pay rent late. Maintain concrete rules for due dates, charge late fees when applicable, and if necessary, initiate the eviction process promptly. If you show them that you won’t tolerate late payments, this will either whip the wishy-washy ones into shape, or get rid of the bad ones as soon as possible.

The rest:

• The 100:10:3:1 Rule. This rule basically states that to find an appropriate real estate investment, you’ll need to look a 100 properties, makes offers on 10 of them, attempt to finance 3, and you may finally buy one of them. Basically: look hard and be picky.
• On Leverage. $10,000 can control $10,000 worth of stocks. If it goes up 10%, then you are up $1,000. Alternatively, $10,000 can control $100,000 worth of real estate through borrowing money (leverage). If your real estate goes up 10%, then you’re up $10,000. Of course, they don’t focus on the fact that if your home’s value drops by just 10%, you’re completely wiped out. The ability to leverage cuts both ways, but can help with cashflow.
• Property Manager. Hate the idea of fixing toilets at 3am in the morning? Hire a “good” property manager. Unfortunately, no tips were included on how to find such a mythical creature. (Similar to unicorns and the “cheap and prompt handyman”) Also, property managers usually charge about 10% of your gross rent.

I’m getting ready to pay some extra money towards my mortgage loan, and remembered that I have an option to re-amortize my mortgage loan if I make a substantial principal prepayment. This is also known as “recasting” a mortgage. Basically, my monthly payments are lowered slightly over the same remaining term instead of simply accelerating my loan payoff schedule. My interest rate and escrow payments stay the same, and I don’t have to pay any fees or closing costs.

Most loans that are sold off to investors do not allow recasting, as I imagine they don’t want the added complexity. However, some allow either a one-time recast, and other allow repeated recasting if the extra payment is large enough. Ask your lender about this feature beforehand if you’re interested in it. In my case, I get to re-amortize whenever I pay a lump-sum of at least $10,000.

My tentative plan, discussed briefly in my Quick & Dirty Plan To Reach Financial Freedom, is to make two extra mortgage payments a year. (If interest rates rise enough, the money will simply be placed into a long-term bond.) This will shorten my 30-year mortgage by an entire decade, so I’m mortgage-free in 20 years at age 50. The commonly discussed biweekly payment plan is the same as making one extra mortgage payment each year, and knocking off about 5-6 years.

For my mortgage, if I pay exactly $10,000, it would only lower my normal mortgage payment about $50 a month. Theoretically, if I keep my payments the same as if I didn’t re-amortize, my total interest paid would be the same, and my loan would still be paid off 10 years early. The lower required mortgage payment would simply provide an added bit of flexibility in case I run into financial trouble.

However, for my situation the $10,000 requirement would mean I’d have to wait and lump my payments every other year instead of making the payments whenever I like. I don’t think $50 a month is worth the added hassle, as I really do want to have this thing paid off in 20 years.

(As a reminder, I think paying extra towards your mortgage should only be done after you have maxed out your tax-deferred accounts like IRAs/401ks, as well maintaining an emergency fund or other liquid assets.)

I saw this LA Times article San Francisco beefs up renter protections over at SavingFreak, and it nagged at me all day as both a recent renter and possible future landlord.

Here’s the quick summary. City Supervisor Chris Daly introduced legislation to add the following additional tenant “protections”:

• Landlords cannot raise the rent above 33% of tenant’s income. An alternative amendment restrict this to situations where the tenant has a “hardship” – defined as being unemployed, having wages cut, or living on a fixed income and receiving a cost of living increase.
• Allows tenants to add roommates other than family to help pay rent, even if explicitly forbidden in the rental contract.

My take. I think this going too far, and I am glad the mayor seems to agree and will veto it. Already 88% of rental units in San Francisco are subject to rent control, with annual rent increases being capped at an average of 2% per year. Now a landlord must charge rent based on a person’s future income? How can they control that? And then tenants can bring in whomever they want as additional roommates, also creating more wear and tear on the place?

This is different from having the government provide unemployment benefits, or even “bailouts”. This is forcing individuals to directly subsidize other individuals arbitrarily. Imagine being a cabinet maker and being forced to accept a 50% discount to any customer who lost their job recently, regardless of your own costs or financial needs. I echo the concerns of this editorial:

We all like the idea of businesspeople doing the benevolent thing when their customers are hurting, but it is not fair for a public entity to force such behavior on a private one.

Am I missing something here? Let me know in the comments.