Properties are popular investment vehicles for retirement planning. Lets discuss whether it makes sense to buy REITs or physical rental property.

What are REITs? REIT stands for Real Estate Investment Trust. It is a trust that invests directly in real estate and issues shares that trade on stock exchanges. The rental income from the real estate are distributed to the share holders as dividends.

Quantitatively, does it make sense to buy REITS or your own physical rental property?

We will start off with the assumption that you have $200,000. You can choose to buy $200,000 worth of REITs or use it as a down payment to purchase a $1 mil rental property (20% down payment, 80% loan). We assume that the REITs pays 6% dividend per year and appreciates 10% after 10 years ($220,000) . For physical Rental Property, we assume that it is a 30 years mortgage, mortgage loan is at 3.5%, the rental is at 4% per year and the property is worth $1,100,000 after 10 years.

Using this simple example above, the IRR (internal rate of return) for REIT is 6.3% and Rental property is 8.38%. Having a Rental Property makes sense.

However, getting a physical Rental Property is more complex. In the context of Singapore, there is stamp duty and legal fees during purchase and sales of physical property. Rental income are also taxable. The property may also need to be renovated before it can be rented out. Assuming we take an additional 10% ($100,000) to cover buyer stamp duty, legal fees and renovation, and assume the personal income tax is at 10%, the new calculations are as follows.

Now the mathematics does not look as good for physical Rental Property.

Lets take a scenario that the property market is buoyant and property value increases 50% after 10 years. The new calculations are as follows.

Now the Rental Property looks more attractive.

Therefore, there is never really a clear cut answer to which is better. Physical property prices may go crazy in Singapore (which it did) and can appreciate more than 100%. Investing in physical Rental Property is also more complex. There is legwork involved in choosing the right property, finding a good tenant, making sure that the property is always rented out, fixing defects etc. We also come to know of property investors who have the MIDAS touch. Whatever they buy turns to gold.

If you prefer a more passive way of investing into property, REIT may be for you. Another advantage is that you can start small unlike physical rental properties. Most REITs can be purchased with hundreds or low thousand of dollars from the stock exchange.

The real difference between buying REITS or physical Rental Property is leverage – The ability to get relatively cheaper loans for physical Rental Property. One may argue that we can get loans to buy REITS as well but share financing usually come with higher interest rates.

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