Wednesday, April 27, 2016

Dividend Stocks vs Rental Properties

Despite Twitter’s stock price falling 35% year-to-date, I continue to love the service they offer their users. Twitter allows me to view customized news feeds, drives a large percentage of my site traffic, and it provokes interesting conversations. Such an interesting conversation was initiated earlier this week when I received a tweet from Brian @rentalmindset asking me my thoughts on a post he wrote “The 4 Reasons Why Dividend Investors Should Own Rental Properties”.  Even though I disagreed with a couple of reasons he listed in the article, I found it a good read, and wanted to respond to his request more formally through a post of my own.

Brian’s four reasons why rental properties are better than dividends are outlined below along with my comments.

1.       Better Dividends

The comparison Brian makes is between the 9% cash return on his rental properties to the 2-3% dividend yield on the S&P 500 index. A key point to consider here is that Brian’s rental properties are highly leveraged since he pays a 20% down payment and leverages the remaining 80% of the property purchase price. His leverage ratio is 4:1, meaning his un-leveraged cash return on his rental properties is 2.25%. This un-leveraged return figure is pretty much in-line with the dividend yield of a broad-based index in North America.

2.       Better Financing

As discussed above, banks allow investors in rental properties to leverage up to 80% of their purchase. Brian makes the point that most stock investors do not use margin, and when a dividend investor decides to use margin, they are limited to 50%. I thought the 50% looked a bit low and checked my brokerage and found out it actually allows me to use up to 70% margin when buying stocks in my unregistered account. That said, instead of saying that better financing exists for property investors, I would say that higher leverage financing options exist. Not being a fan of leverage, I do not want to get caught up on this point, but the value of stocks and rental properties can both rise and decline. The ability to lose more money in a depressed housing/stock market is not something that interests me as I consider capital preservation to be of paramount importance.

3.       Better Taxes

Brian explains that he lives in California, where his combined federal/state tax rate is 37%. Although I do not feel comfortable disclosing my combined federal/provincial marginal tax rate, I can show you that in Canada, no matter where you live, your dividend income will be taxed at a lower marginal tax rate than your 'other income' which would be earned from rental properties.  From the federal tax rate table for Canada, you will notice that dividends are taxed very favorably at all levels of income. Similarly, in Quebec, where I live, dividends continue to be taxed at a much lower rate than other income. 

In Brian's defense, I would lump better taxes and more control together. If I was investing in rental properties, I would first form a corporation to buy them through (corporate tax rates are lower than personal tax rates in Canadea), then I would attempt to show $0 taxable income each year so as to avoid paying taxes on rental income profits. I would then dividend out myself any excess cashflow income in the corporation that I did not want to reinvest, which would be taxed at a lower marginal rate in my hands. Of course my aggressive tax planning might raise some red flags at the Canada Revenue Agency who might have a hard time understanding why a rental property business constantly shows no taxable income. 

4.       More Control

I am in total agreement with Brian’s argument that when I buy shares in a company, I have negligible control over their strategic direction. Although there have been times when I have been able to at least put a bug in a CFO’s ear of what I think of their dividend policy and ask about their operational strategies, I do not expect this kind of correspondence with C-suite executives. Sorry to all of those Buffet-ists out there who think that your 100 shares of stock means your voice should be heard by the executives at the company you invested in. Sadly, that level of minority shareholder rights simply does not exist, even for companies with small market capitalizations. For the record, I am fine with not having control over the management of companies I invest in. I do control my investment decisions by which I hope to avoid putting my capital to work in companies with management intent on building personal empires and ignoring their shareholders.

In contrast, Brian indicates that he has more control over his rental properties.  I agree with that statement, but only to a certain degree. By control, I assume Brian means that he controls the maintenance he performs on his properties, the property managers he hires, background and credit checks on prospective tenants, etc.. However, I would ask Brian if he has control over the neighborhoods he invests in, the municipal councils who zone the areas, local employers whose decisions impact the regional economy, the banks and mortgage brokers who lend to buyers, the future conditions of the US housing markets, etc.. 


As odd as it may sound coming from a dividend growth investor, I would agree that investing in rental properties is a faster way to achieving financial independence. However, the main trade off in my mind is that my dividend income is quite passive in nature, whereas investing in rental properties is much more hands on. Plus, the leverage involved to successfully and quickly grow a rental property business is scary to a more conservative investor like me. To conclude, I have a great deal of admiration for real estate investors, but it is simply not something that interests me.

To dividend investors - would you ever consider buying a rental property?  Why or Why Not?







7 comments:

  1. Thank you for taking the time to outline all your thoughts. Always good to hear multiple opinions! Let me comment on a couple individually (but I might have to do a longer reply on my blog)

    1 - Without a mortgage there is no debt service and the cash flow per month goes up. So un-leveraged would be expected to be higher than 2.25%, but we'd have to run some numbers to get a more accurate number.

    I like to think the swings of property value in locations away from the coasts are less than those in the stock market. A stock can go to zero, a house won't. But then again, both are somewhat risky with a 1 year time horizon. 10 years much more predictable. 30 really predictable.

    Definitely more hands on, but my hope is to encourage more people to run the numbers before deciding if it is worth the effort. I sure think so!

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    Replies
    1. Thanks for the thought provoking article and allowing me to post my perspective.

      As a follow-up, if you didn't use a mortgage, you would have a higher return, but it would likely be comparable to the 4-5% dividend yield I earn on my dividend investments.

      It's a fair point that stocks go to zero, while properties do not. That said, when your level of investment in a property is greater than the rent plus amount you expect to receive from selling, you would effectively be below zero.

      As you indicate, it's worth running the numbers and taking into account your own personal risk tolerance level.

      All the best in your rental property business Brian! I'll be cheering for you from the sidelines, dividends-in-hand.

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  2. Thansk for sharing this great article. Personally I will not invest in rental properties since I am not really confortable with managing them and I found that they are time consuming. It's not my kind of investment.

    I prefer investing in reits and getting their dividends.

    ReplyDelete
    Replies
    1. Agree that owning a diversified basket of REITS is less time consuming. I would also add REITS are more liquid and easier to diversify with.

      Etais tu deja un proprieteur d'une propriete d'investissement?

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  3. I guess you are asking if I am an owner of a rental properties.
    I had choose that I didn't wanted to be an owner after living in one place that we didn't had any problem for two years and in a year we had some noisy neighbors that the owner could not kick them out since he needed to go the court agains them and a couple that we had to call the police on them.
    Being an owner mean, one year everything is perfect and the other one can be completely different.

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