Investing in income-generating real estate can increase your net worth. Returns over the last two decades prove this to be true. But what about the next two decades?
A slow-growing economy combined with aenemic wage increases and a huge run-up in residential real estate sale prices means that everyday investors are finding it hard to earn a profit when it comes to real property investments. Does that mean the boon of real estate investing is over? Not if you’re willing to let-go of the hands-on buying, selling and property management.
Investors still interested in real estate as part of their portfolio diversification should seriously consider investing in real estate investment trusts (REITs). REITs allow individual investors to pool their funds and profit in the management and value of real property, without having to buy, manage or finance real property for themselves.
Just like with any investment strategies, there are pros and cons to this type of investment. Do the risks outweigh the benefits? And what are some of the key considerations when deciding whether REITs should still have a place in your portfolio?
What is a REIT?
REIT stands for Real Estate Investment Trust and are companies that own, and often operate, real estate assets such as apartments, warehouses, office buildings, shopping centers, hotels, and other facilities.
These shareholders then distribute the generated cash flow back to the shareholders. The most reliable REITs generally have a good track record of paying dividends, making them an attractive investment option.
In the US, the concept of REITs sometimes referred to as “real estate stock” came about in 1960, when Congress decided that the large-scale, income-producing real estate that large or institutional investors were profiting from should also become accessible to smaller, retail investors. Canadian investors wouldn’t get a Canadian version of REITs until 1993. Through REITs, investors are able to buy shares in real estate portfolios, previously accessible only to wealthy individuals and large financial institutions.
REITs vs Direct Real Estate Investment
Various trends show that investing in real estate still remains a good investment strategy. In the last 5 years, both commercial and residential real estate properties have exhibited annual returns greater than 7%.
Currently, homeownership rates being on the decline together with vacancy rates, these trends show that the total number of renters is increasing.
Traditionally, people have sought investment profits in real estate through direct investments. However, this strategy is time-intensive and comes with a lot of headaches.
- The fix-and-flip investors need to make at least 30% above the original purchase price to be profitable and cover the repair and holding expenses, making it a risky investment.
- The buy-and-hold investors can traditionally expect to make average returns from 7 to 10% annually, depending on the location and type of the property. While some investors are able to make more profit, it is not unusual to see people lose money because of rising holding and repair expenses.
Although traditional, both of these strategies are high-risk and come with a set of downsides, including lack of diversification, high maintenance, a lot of work, and lower liquidity.
REITs, while offering the same benefits as direct real estate investments, can eliminate the negatives including the lack of diversification and liquidity.
REITs are much lower risk, with a proven history of outperforming direct real estate investing.
From 1977 to 2010, REITs have returned more than 12% annually. This is in comparison to the roughly 10% return of the S&P 500 and the 6% – 8% return of private real estate funds during the same period. (Forbes.com)
Another major benefit of a REIT is that the majority of the annual profits are not taxed at the corporate level and paid as dividends instead.
3 Types of REITs
To invest wisely, it’s crucial to recognize the difference between the three major types of REIT.
This is the most common type of REITs. They own and manage income-producing real estate, such as residential apartments, shopping centers, and office buildings. The equity REITs are favored for long-term investing with the profits generated mostly from rental income.
Instead of investing in properties, the mortgage REITs lend money to real estate owners or purchase mortgages or mortgage-backed securities. The profit is generated primarily by the net interest margins. The mortgage REITs can react quickly to changes in interest rates and are regarded as a good speculative investment when the interest rates are expected to drop. Approximately 10% of all US REITs are mortgage REITs.
The hybrid REITs are a combination of a mortgage and equity REITs. They both own property and make loans, therefore their revenue comes from both rent and interest.
3 REIT Markets
Most investors should only consider publicly traded REITs. This adds a level of due diligence to an investment that most Main Street investments don’t or can’t do. Due diligence is vital to making sure that the investment you buy will, at the very least, meet the standards tests when it comes to management, financial reporting and capitalization requirements.
Still, publicly traded REITs are only one of three ways to buy REIT units.
These REITs are not registered or traded with the Securities and Exchange Commission (SEC) in the US the Canadians Securities Administrators (CSA) in Canada. These REIT managers raise equity from individual persons and entities and, as a result, are subjected to fewer regulations than publicly-traded REITs. Private REITs are very common, particularly among hedge fund managers and high-net worth investors.
Publicly traded REITs
The publicly-traded REITs are required to be registered with the SEC or CSA and are traded in major stock exchanges, such as American Stock Exchange, New York Stock Exchange or the Toronto Stock Exchange. They offer great liquidity and can grow in value much like a stock.
Non-exchange traded REITs
There are some REITs that are registered with the SEC or CSA but they are not traded on public exchanges. However, private sponsors market these REITs to investors that seek more agility. They offer easy liquidity and are not that sensitive to the fluctuations of the market.
Pros of Investing in a REIT
Many financial experts say that REITs still have a place in your investment portfolio.
Real Estate Investment Trusts have unique characteristics that may make them attractive to both income and growth investors. (reit.com)
To understand why, it’s best to first consider the advantages REITs offer when held in your investment portfolio.
- Liquidity: publicly traded REITs are easy to buy and sell, just like stock, so the investor has much more liquidity than when buying a real estate property.
- Steady dividends: since paying 90% of the annual income as shareholder dividends requirements for REITs, these investments offer a high and steady stream of cash flow for decades. The cash flow from these dividends tends to be much higher than you can achieve with other investments.
- Diversification: REITs enable you to buy a piece of a large real estate portfolio that holds properties in a particular sector. This offers a greater potential for diversification than buying, in which case you could probably only finance a single property.
- Lower volatility: compared to traditional stocks, REITs have large dividends and are therefore less volatile. Having REITs in your investment portfolio can balance other high-risk investments that are more sensitive to the market and more likely to fluctuate.
- Increase in value: traditionally, REITs have increased in value together with the interest rates. In the current environment, the interests are expected to rise, which means you can expect the REITs to rise too.
- Long-term growth: because other investments like bonds, cash all act react differently to economic and market stimuli, adding REITs to your portfolio can produce a more appealing risk-and-return trade-off, balance the portfolio in order to secure long-term growth, as well as provide a steady cash flow alongside more risky and aggressive portfolios.
“Generally, REITs tend to do well in times of inflation, just because of their ability to increase rents and then pass that income on to [shareholders],” said certified financial planner Marco Rimassa, president of CFE Financial in Katy, Texas. (cnbc.com)
Cons of Investing in a REIT
As with any investment strategy, REITs don’t come without any disadvantages or risks. Here are the negative aspects of investing in REITs:
- Illiquid (especially non-traded and public REITs): unlike publicly-traded REITs which are easy to buy and sell, the private and non-exchange REITs need to be held for years in order to see potential gains.
- Lack of control: with direct real estate investment, as an owner, you are allowed to do whatever you want with the property. The disadvantage of REITs is that you are a passive investor without any ability of decisive power over what properties you want to buy. Therefore, you need to be careful to invest in REITs in the right sector with the management team you trust.
- Low capital appreciation: since REITs are required to pay 90% of the income back to investors, only 10% of the taxable capital can be invested back into REIT and other holdings.
- Tax burden: the income coming from REITs and its dividends are taxed just like regular income. With some REITs having high transaction and management fees, this can be a burden.
- Low growth: REITs need to raise cash by issuing new stock shares and bonds which might not always be bought by the investors, therefore, depending on the investors in order to buy real estate.
- Debt: REITs usually belong to the most indebted companies in the market. While they generate regular cash flows, most investors are comfortable with being able to pay off their debt payments.
- Non traded REITs: these types of REITs can be expensive, with a high initial cost and higher fees than publicly-traded REITs.
Potential Risks and Things to Consider
When considering any investment, it’s best to consider the risks and rewards. For REITs, here’s a quick checklist every investor should use before adding a trust to your investment holdings:
- Diversify: even though investing in REITs means you’re diversifying to an extent already, it’s still a good idea to research whether a specific REITs focus is on the type of property that would be vulnerable to a downturn. In general, a REIT should add diversity to your portfolio — either a different sector within the real estate market, a different geographical focus or exposure to a market cycle that moves independently of your major investment holdings. For example, If you own a home or invest in Canadian financials, you would already have exposure to the residential real estate market cycle. Adding commercial real estate exposure is a great way to diversity since this market moves independently of the residential real estate market cycle.
- Research REIT management: because with REITs, you are basically a passive investor, it is advised to select a management team that you can trust. Before purchasing REIT, make sure the management team has a personal stake in the company. This information should be made available to the public.
- Be wary of REITs susceptible to macroeconomic movements, such as retail REITs, where pandemic restrictions had a large and profound impact, as a recent Forbes article pointed out: Retail REITs make up 24% of all publicly traded REITs. As of this year, there have been over 8,000 retail store closures across the nation. Further, experts believe that between 50 to 80 large malls might also close over the next two years.
- Consider demographic information: factors such as economic activity, population, or employment growth in a particular industry or an area can influence rent rates and occupancy, which will then directly influence your cash flow and dividends.
- Be careful with past high yields: do not make the mistake of assuming that the past performance will guarantee you high yields in the future. The high income might have come from nonrecurring events or the REIT might be selling properties in order to generate cash flow, which will affect the future rental income.
- Consider post-pandemic changes: there are many unknowns emerging from the COVID crisis, with various types of real estate affected. The COVID-induced lockdowns have caused the closing of many retail centres and office spaces.
- Consider what type of real estate REIT invested in: it can be argued that a REIT with a diversified portfolio of a range of different residential and commercial buildings will have more profit than REIT whose investments are in retail.
“We’ve seen how successful online retail has been during the pandemic. Pre-COVID, there was a consensus that retail space was oversaturated. We could see an acceleration in the consolidation of retail space, or repurposed into other uses that may not carry higher rates.” (cnbc.com)
While direct real estate investment can be considered the most traditional way of increasing your funds in the real estate sector, historically, REITs have proven much better performance, less risk, and better cash flow.
When used in a diversified portfolio, REITs have many benefits in terms of better liquidity, lower volatility, better dividends, and good prospects regarding long-term growth. Due to these reasons, REITs used as a part of a diversified portfolio can be an appropriate retirement investment too.
Publicly traded REIT, especially, which grows in market value and can be purchased just like stock, can be a great addition to your investment portfolio.
As with any investment, there are negatives and risks to consider. REITs investments come with a lack of control, debt, tax burden, and sometimes low capital depreciation. As my former colleague, Jonathan Chevreau pointed out in a recent MoneySense.ca article: REITs “should not make up more than 5% or 10% of an investor’s total wealth, or not more than 7% of an equity portfolio.”
Before deciding to invest in REITs, consider the diversity of REIT investment, research the management, diversify, and consider the recent changes of the post-pandemic world that have heavily affected retail and office real estate market.