Surprise: REITs Aren't the Best Choice for Real Estate Cash Flow

With well-known real estate investment trust Digital Realty reaching all-time highs, it may surprise investors to learn that REITs may only be the second-best option for those seeking real estate exposure in their portfolios.

The crown belongs instead to turnkey rental properties.

These properties offer a hybrid between conventional landlording and totally passive REIT investing.

Like being a landlord, the investor is purchasing specific, individual properties. Like REITs, turnkey rental properties make the ownership of those individual properties entirely passive for the investor.

For many, it is the best of both worlds.

Turnkey rental properties have become popular due to their simplicity and to the inherent attractiveness of cash-flowing real estate as an asset class. But a bigger factor is the explosion in popularity of self-directed retirement accounts, which allow investors to buy turnkey rental properties using the money from their 401(k)s or individual retirement accounts.

"It's well established under the law that investors can use the capital in their self-directed IRA or self-directed 401(k) to purchase real estate. This typically includes turnkey rental properties," said Phoenix tax attorney Tim Berry.

"There are rules that must be followed to keep the [Internal Revenue Service] happy, but it is completely legal and achievable to buy real estate using your IRA or 401(k) funds," he said.

Another factor contributing to the growth of turnkey rental properties is the strength of the real estate market itself. As many local markets have fully recovered or exceeded their pre-Great Recession highs, such as Dallas, Denver and San Francisco, investors are widely choosing to take their chips off of the table in hot markets and redeploy their capital into markets with greater potential for cash flow and appreciation.

Among the hottest markets for turnkey rental properties is Birmingham, Ala., with RealtyTrac recently reporting that the city is the target of the highest share of institutional investors in the United States.

"When discussing investments with my friends, nobody guesses that I chose to buy in turnkey rental properties in Birmingham, Ala., which is almost like a foreign land to people here in California," said Dr. Paul Applefield. "But when they understand that I have to do nothing more to profit from these houses than if I owned a REIT, yet my real net yields are routinely in the double digits before considering appreciation or tax advantages, it becomes patently obvious why owning turnkey rental properties is such a great idea."

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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