The Passive Income Wars: Rentals vs. REITs
Tags: Dividend Investing, Unearned Income, Rental Properties, Reit, Passive Income

Appreciation: Which Income Stream Grows Faster?

Appreciation in terms of passive income is a bit different of analysis than sheer valuation. Our goal is to keep the passive income stream growing, not simply end up with a lump sum of cash that’s no longer making us money.

Rental Appreciation

It’s great if your $200k property is suddenly “worth” $300k (because pandemic?), but is your tenant equally suddenly willing to cough up 50% more in rent payment? A quick look at the 2021 housing market can tell you that’s not the case. Renters’ payments are predominantly flat, while homeowners’ property values have spiked right through our imaginative ceilings.

Honestly, this type of sudden value appreciation can be more detrimental to your passive income than a godsend — while you can’t assume your tenant will be able to cough up for your newfound fortune, you’d best believe the city expects you to. Property taxes do, in fact, go up in this scenario, so you’ll be back to the budget sheets to tally your margins long before you’ll be celebrating.

That property tax appreciation pretty much cancels out whatever inflationary increases in rent may be acceptable to pass on to your tenants.

That said, there’s a huge value argument to be made on behalf of rental properties — namely, equity.

Now, you may be thinking, “Wait a minute, I thought we only cared about passive income. Equity doesn’t count!” Well, let’s humor the thought!

Let’s say you’re 5 years into a 30-year mortgage on a $200k property. At 5% down ($10k) and 5% closing costs ($10k), we’ve exhausted our initial $20k and are doling out, quite conservatively, $1250/mo.

Redfin Payment Calculator Example

Unfortunately, you’re not deep enough in to get a worthwhile HELOC (most lenders won’t give you more than 80% of your equity). What you could do is refinance back out to another 30-year mortgage.

The exact numbers would obviously vary by your current and target interest rates, but the overall notion is the same: you can cough up 2–5% refinance closing costs on your remaining mortgage (yeah, don’t let that sneak up on you), bringing your mortgage payment down and sending your rental income up.

But if we look more closely, after 5 years, you’ll probably still owe ~$170k. The refinance costs would be ~$15k. Your new mortgage at $170k would be closer to $1050/mo. So, ultimately, you’re coming out of pocket $15k to make $200/mo extra — and that $15k is NOT going to your property/equity-like your down payment! ⚠️

If you’re still considering that a win, well…you’re not wrong…about 7 years from then, when those extra $200/mo’s have finally clawed back your $15k. Woohoo. 🤡

M️oral of the story? Unless you put in extra capital or successfully hike your rent, you’ll be pretty much tied to whatever margins you go in with for the life of your mortgage.️

REIT Appreciation

Stocks go up and down; we know that. And more often than not, the fluctuations have absolutely nothing to do with the fundamentals of the companies.

This is me setting the stage to say: when a dividend stock price falls, its dividend does not necessarily fall with it! Rather, oftentimes you’ve just found yourself a sale!

The opposite is unfortunately also true. Just because the price goes up, it doesn’t mean you’re going to be receiving a prettier paycheck that month/quarter.

However, in the case that you choose the right REIT with a history of dividend hikes, holding the stock through high and low can likely help you see some passive income appreciation in that same 5 year period.

The obvious tactic we haven’t mentioned here is dividend reinvestment (DRIP), which is intentional. I don’t want to make assumptions about how you want to use your income (yet).

Verdict

Rentals don’t leave much room to appreciate your revenue stream outside of hiking your rent upon lease renewal and hoping the tenants go for it. REITs, on the other hand, bare the possibility of natural appreciation, albeit completely out of your control, without further investment. Because hope isn’t a strategy, though, REITs stand to be too much of a gamble when it comes to appreciation, despite the potential.

Winner: Rentals