With real estate investment trusts, you can own property free of the headaches that come with being a landlord.
Real estate investment trusts (REITs) are companies that invest in the real estate market and allow owners to benefit from the rental income, capital appreciation, and return of capital without the hassle of being a landlord.
Real estate is one of the five main asset classes and provides investors with a long-term store of wealth, a hedge against inflation, and usually a steady stream of income. For many Canadians, their primary residence forms the basis of their entire real estate holdings; for others, rental income or recreational property augments their net worth.
One of the main benefits of real estate ownership is the ability to use large amounts of leverage to make the investment. Many owners start with a five per cent down payment and borrow the balance from financial institutions. As long as rental income or income from other sources covers the mortgage payments, real estate can be a sound method of building long-term wealth.
However, with ownership comes duties and responsibilities. Recreational properties provide owners with years of enjoyment but require maintenance and succession planning. Without proper financial planning, taxation issues force many families to sell the property upon the death of the original owners — and, in some cases, at inopportune times in the real estate cycle. Therefore, real estate owners as well as people contemplating real estate purchases should consult with a tax adviser and financial planner to ensure the long-term continuation of family-held real estate.
Rental properties have their benefits, but also carry the responsibility of being a landlord, which, for some, ends up being a full-time second job. In addition, real estate is not always a liquid investment, and during times of rapidly rising interest rates, some investors are forced to sell at a loss.
Real estate investments run the gamut from raw land, single-family dwellings, and apartments to large office towers, shopping centres, retirement homes, and timberland holdings. Most individual investors restrict their direct investment exposure to land or small income-producing properties, but by doing so they miss out on the other categories in which pension funds, hedge funds, and major corporations specialize.
{advertisement} With REITs, any investor can gain exposure to all property subsectors, and because most REITs trade on recognized stock exchanges, they have daily liquidity. Investors also have the option of buying REIT mutual funds, REIT closed-end trusts, limited partnerships, and REIT exchange traded funds (ETFs). By choosing one of these last options, investors reduce the need to research and monitor the ongoing business activities of each REIT held in their portfolio and gain diversification and professional management.
Most REITs are structured with a specific mandate to focus on one subsector of the real estate market. REITs start out by raising cash through the issuance of shares, and then use the cash proceeds to make real estate purchases that meet the investment goals of the trust. For example, Riocan is Canada’s largest REIT that invests in retail shopping centres. While I am not recommending this REIT, per se, investors should know that since 2001, its stock has more than doubled and income has risen from $1.07 per unit to $1.38. At the time of writing, the yield was 5.5 per cent, but investors should consult with their financial adviser or go to www.sedar.com and read the relevant information issued by the company.
Investors should also consider the tax consequences of REIT-derived income. In most cases, the distributions consist of rental income, return of capital, and capital gains from the sale of assets held within the portfolio. The main point here is that REITs have the potential to provide investors with attractive after-tax income and long- term growth.
Not all REITs produce the same investment returns. Some global REITs, for example, have seen their net asset values drop significantly in the past few years. Developers Diversified Realty went from $18 in 2001 to $65 in 2007, but has since fallen to $12 at the time of writing. Moreover, the income received is taxed less favourably than Canadian REITs. It can be quite the roller-coaster ride, which is why some investors should use professional managers or a diversified approach.
In a previous Douglas article (“The Efficient Market Hypothesis and How to Invest Your Portfolio,” May/June 2008), I discussed active versus passive management strategies. Active strategies are employed by fund managers who try to select the best REITs in each subsector of the market, and buy and sell each one according to a set of defined parameters. Top performers include Sentry Select, CIBC, and Vision Capital Corp.
Non-active managers, on the other hand, create a fixed basket using a set of defined parameters and then rely on the overall performance of the asset class to capture as much of the performance in the most cost-effective manner. Top performers include Ishares S&P Capped REIT Index and DFA Global Real Estate Sector. However, newer ETF providers have recently launched REIT funds but they are too new to provide an adequate track record. These include Claymore’s Global Real Estate ETF and BMO Equal Weight REIT Index ETF. In general, the management expense fee of ETFs is significantly lower than their active management counterparts, but both use a structure to pass through the income and capital gains achieved through the ownership of REITs.
In summary, REITs provide investors with sector-specific opportunities to own real estate assets without the headaches and issues of direct title ownership. Many of my clients in Western Canada have become wealthy by owning real estate assets but several have grown tired of the ongoing headaches of being landlords. However, many of them also remember losing a major part of their life savings in the ’70s and ’80s when interest rates skyrocketed and real estate prices subsequently crashed, forcing many to sell at the trough of the cycle. Furthermore, for investors in other parts of Canada, owning real estate has not always been a successful endeavor.
But by using REITs, investors gain sector and geographical diversification, professional management, tax-advantaged income, and liquidity.
Steve Bokor, CFA, is a licensed portfolio manager with PI Financial Corp, a member of CIPF.
