REITs vs Direct Real Estate

April 8th, 2011 by Potato

Macquarie research put out a comparison of REITs vs direct (condo) ownership in Toronto and Calgary. The story was picked up by the Globe and others. It’s an interesting comparison, especially the part about leverage, when another article this week warned of the dangers in leverage.

“Unbeknownst to most of these families, their theory of home ownership as a safe, low volatility investment is based on the often-mistaken premise of no or little debt. This is a crucial blind spot because the moment that a large amount of debt is used to buy a home, that safe investment theory goes completely out the window. […] What happens when that family buys that house with just 10 per cent cash down and a 90 per cent mortgage that promises an interest rate of 3 per cent to the bank over the long term? Amazingly, the equity in the house has now become dramatically more risky than before. The equity is now three times as risky as the overall market rather than 30 per cent as risky. This is more risky than an investment in nickel mining stocks or Internet start-ups.”

I was asked after these reports about REITs, and specifically if they’re as risky as the housing market, given my views there. Briefly, a REIT is a real estate investment trust, a type of investment that owns real estate that it rents out. The majority of the cash flow is paid out as a distribution to the investors. I tend to view them as a step up from fixed income: essentially all of the anticipated return will come from the distribution (rather than capital gains), and though that can be cut or expanded depending on circumstances, it should for the most part be stable.

I do invest in REITs (until late last year they were a huge part of my portfolio, but now are down to ~3% as I was selling as the prices appreciated), and don’t think that they’re in for the pain that residential housing is, due to several key reasons.

The first is diversification: both personally and for the REIT. Even if I wasn’t hugely negative on housing, I’d be somewhat uncomfortable having my house be the entirety of my net worth for the better part of a decade. With a REIT, I can get some exposure to real estate without risking it all. Also, the REITs themselves are diversified, holding many buildings all across the country. Even if I think Vancouver and Toronto are bubbles, Canada on the whole is not quite as bad.

The second is the sector: most REITs I invest in lease retail and commercial buildings (plus some industrial and government properties). Even the REITs that invest in residential apartments are not buying individual houses or condos. The housing market has been blown up by speculation and cheap-as-free CMHC financing, but those factors haven’t applied to multifamily residential (i.e.: apartment buildings of 5+ units) or industrial/commercial/retail buildings.

The third is return: REITs are investment vehicles for professionals, run by professionals. Before investing money, a building is evaluated for its investment return, and only its investment return (not how nice the school district is or how grown up you’ll feel buying it or how only scumbags rent or how pretty the countertops are). A common measure of investment return is the cap rate: the rent less the expenses divided by the price. The lowest cap rate I’ve seen on a REIT purchase in the statements I’ve read for the last few years was 5%, but 6-8% is more typical. For residential housing, buyers don’t evaluate it for its investment return (often at all, but certainly not as a top priority) — some people don’t even investigate what their housing alternatives are, and I kid you not, more than one person (on the internet, granted, so trolling is a possibility) didn’t even know that you could rent detached houses/townhouses/anything but apartments — and if they try, don’t typically do a very good job of it (innumeracy at work). In Toronto, a typical residential condo cap rate is something like 2% right now, with gross yields at 5%.

And the fourth is liquidity: if I buy a house and I’m wrong, I’m sunk: up to 10% just in transaction fees, and in a down market it can take a long time to sell (or a big discount). Even if I could recognize a downturn early on (say after only a 5% drop in prices), I’d probably lose 20% by the time I got out, not even accounting for the risk-layering of leverage. For a REIT, transaction fees are the same as for other stocks: small (for the position sizes I take, I try to keep fees to less than 1%). If I’m wrong, I can sell as soon as I decide to — again, if I could recognize a downturn after only a 5% drop in prices, I could get out losing only 5-7% (depending on transaction fees).

The third point in particular explains why I don’t think REITs are as prone to a real estate crash as residential housing: the over-valuation simply isn’t there in the first place. Plus, unlike residential housing speculators, they don’t rely on flipping property to make money: even if property valuations slide, as long as it’s not so far as to threaten the ratios on their loans, the income should continue to flow.

That said, REITs have had a big run up from the financial crisis lows, and since they are leveraged, they are somewhat interest-rate sensitive. They’re not without their own set of risks. For residential REITs, if rents come down due to competition from accidental landlords, they could take a hit. Even if there was zero spill-over from the coming condocalypse to commercial/retail values, REIT pricing could suffer if crowd psychology caused people to jump ship from anything with “real estate” in the name. A downturn in the economy that causes businesses and shops to close means they have higher vacancies, and thus less income.

There’s been some discussion over whether to hold individual REITs or the iShares REIT ETF XRE. XRE has a 0.58% MER, and not a great amount of diversification, with only a few names making up three-quarters of the fund (Riocan alone is a quarter!). For zero MER, one could buy the top one (or two or three) holdings and get the same basic exposure, it’s argued. Though the MER is a touch high for an ETF, it’s still nice to get the diversification… but I personally wouldn’t/didn’t go the XRE route for a different reason entirely: I just don’t like RioCan (REI.UN). It only yields 5.5% (as of today), and that’s with over-distributions (paying out more than cash flow as they hope that future income growth will close the gap). I know yield-chasing for the sake of yield-chasing isn’t a good thing to do, but there are other (smaller, ‘natch) REITs paying substantially more with, IMHO, the same riskiness as RioCan. Either way though, not a bad way to go for a part of your portfolio, especially as a renter without other real estate exposure.

16 Responses to “REITs vs Direct Real Estate”

  1. Patrick Says:

    The building I live in is owned by CAP REIT. I once owned a bit of it, before I lived here, but I don’t anymore. (For a couple of years, the only stock I’ve owned has been Pizza Pizza.)

  2. Katie Says:

    I agree with a lot of your views on REITs, especially that they can be a more sound investment than an actual piece of property that you have to be a landlord to. You mentioned diversification a Cole REIT could be good for you since that’s one of the top things you look for. They have a diversified portfolio of retail, office and industrial real estate and their portfolio is 97% leased.

  3. Rachelle Says:

    I disagree with you Potato. Investment properties values are linked to interest rates. Furthermore lost have been refinancing.

    So for example if a building generates $1,000,000 of income annually it is worth different amounts at different cap rates. This is assuming that the accounting isn’t funky (which it usually is)

    At a cap rate of 5% your $1,000,000 in income building is worth $200,000,000
    If you get an interest rate of 5% your income is $0 if your cap rate is 6% the value of the building is less and the owner makes 1% of the value of the building. Pretty narrow margins.

    In an era of rising interest rates, you’re in deep doo-doo because commercial mortgages aren’t nice friendly mortgages like the one you have on your house. If equity drops you can get your mortgage recalled and renewals are not automatic.

    I used to work in a building that changed hands 6 times during the commercial deleveraging and we’re headed that way again. Lots of these REITS are refinancing to pay distributions that are unsustainable. If rates go up well it won’t be nice. I also have it first hand from a mortgage broker that works for one of the major pension funds that REIT’s are pulling out a lot more equity then they’re advertising up to 85% of the assessed values at todays super low cap rates.

    No one will buy a 400 unit building with negative cash flow, so the end result is that when interest rates go up so does the spread on cap rates. Frankly any one who considers a spread of less than 3% is an idiot and one of the biggest deals ever in Canada was just done on a 5% cap rate for a complex in Vancouver. Considering their cost of funds is 4% this is nuts. When asked how they were going to make money, they stated they would implement operational efficiencies. That’s BS landlord talk for we’ll cut staff and not fix anything.

    All in all I don’t have any money in REITs and I don’t believe most people should either, not with the RE market we have today.

  4. Potato Says:

    I have a natural aversion to private REITs. Perhaps it’s entirely irrational, but there it is. Also not sure about private ownership of a US REIT (taxes, etc.) so that’s as far as I’m going to look into that one. Also not sure why you linked to their linked-in page vs directly…

  5. Potato Says:

    Rachelle: some good points.

    I did say they were interest-rate sensitive (one of the reasons they’ve gone from “huge” to 3% in my portfolio). I’ve been too busy with thesis stuff lately, but one of the things on my to-do list is to identify other interest-rate sensitive things (i.e.: highly levered companies) and re-evaluate exposure there. Debt levels have always been a consideration for me, but I keep thinking maybe it should be a bigger concern these days.

    Anyway, REITs aren’t as interest-rate sensitive because the interest rate differential won’t be as big: a CMHC-insured borrower can lever 80% at 2.3% (variable) or 3.5% (fixed) today to buy a condo, vs ~5%/~6.5% for each in 2007. But the REITs are still borrowing for the long-term at 4-5% for new debt, vs <6% in 2007, and only levering 60%. An absolute move of ~300 vs ~150 bp, and a relative increase of ~80% vs ~30%.

    Increasing leverage to over-pay is a good red flag to watch for, as is poor deal-making. The last REIT I’m left with has been reducing leverage this year, and the last few deals they announced were for properties with cap rates in the low-7% range (with financing at 4.5% for the new stuff, average of 5.5%).

    RioCan on the other hand has been doing deals at a cap rate of mid-6%, and though it gets better interest rates on its debt, it’s been increasing leverage while over-paying, and it’s not an especially lucrative distribution either (~5.5%). No thanks.

    That said, though I’m not huge on either, I’d still much rather have a REIT than a condo. If a condo’s at 2% cap rate today and a REIT’s building’s at 5%, and they have to go up to 8% to make sense as rates rise, the hit to the condo will be much worse. If the REIT has to sell buildings, it’ll take a bad hit, but if doesn’t it can just cuts the distribution until it delevers a bit. That’ll be a painful hit, but not a catastrophic one. A few of them are paying me to take that risk, but only a few (and that’s also why it’s an increasingly small part of my portfolio mix).

  6. Mike Holman Says:

    Interesting post, Potato.

    In my mind, investing in REITs and investing in a rental condo are two completely different things. The way a lot of people discuss this question is similar to the way they would discuss whether they should buy BCE or Telus.

    If nothing else, a REIT is mostly passive, the only thing the investor does is monitor to some degree what is going on (if they choose to).

    Buying a rental property is like starting up a business, albeit one that probably won’t take a lot of time compared to your standard storefront business or even a web-based home business.

    It’s not diversified, it’s risky and most of all – I think the landlord has to be really interested in being a real estate investor (ie have some passion).

    I’m not trying to suggest one is a better investment than the other – just that they are apples and oranges.

  7. Potato Says:

    Thanks Mike. You’re right: they are very different things… but I am trying to suggest one is better than the other ;)

  8. Mike Holman Says:

    Yes, I figured as much. :)

  9. Rachelle Says:

    All in all I’m down on the real estate market these days unless you purchase an investment that pays you (not a condo)

    So that’s it really, it’s a fundamental problem with people’s brains.

    Private REIT’s can be very good, or very bad. We all should know by now that being publicly traded doesn’t protect your funds very well. (Enron, Bre-X) but when I read Leagues full of sunshine and daisies promotional book, I threw up in my mouth a little. Plus the fact that they fired an auditor to get a friendlier one.

  10. Bud Davidge Says:

    In all of the discussion of REIT’s this is the first reference I’ve seen to League. I have found them to be fine in terms of doing what they say they
    will do and deposit payments regularly etc. It’s really hard to do due diligence other than to talk to others who have had experience with them. I would like to hear more commentary by anyone who has had experiences good or bad. Unlike the publicly traded REIT’s that are regularly talked about on BNN Market Call etc,
    privates are hard to get objective comment on. One thing for certain you can’t beat League’s payout and their Income Priority Units: seven years @9%. As for safety–well how are we supposed to determine that. Wish I knew.

  11. Glen Says:

    I much prefer the REIT. First off if I do not like how the REIT is behaving, I can sell it in an instant. I am not stuck with RE sales people and their commissions. Next, if it is a true Canadian REIT I get excellent tax treatment. Much of the distribution is handled as “return of capital”. This makes tax time much easier on me both financially (don’t need a tax accountant) and less time consuming.

    I do not have to pay someone to manage the property. I do not have to worry about the renter being on time with the monthly check. I do not have to think about buying a new fridge, replacing carpets, painting walls, or drains that are clogged. I get the benefits of a RE investment that is professionally managed with none of the headaches.

    REITs have treated my wife and my retirement portfolios very well.

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  13. gibor Says:

    I prefer REIT. First of all you’ll get in monthly dividends practically the same what you will get for renting your condo… and this is w/o headache to look for tenants , make sure they pay on time, pay taxes on income etc.

    If you don’t like XRE because of the RIO, you can invest into ZRE (weighted etf). imho, ETF is more secure than 1 specific REIT stock

  14. Yase Says:

    League may push sunshine and daisies but they’ve also paid me every month for 4 years now. Anyone have a tenant like that?

  15. Shane Bilose Says:

    Hi Potato!! Can you list some private REITs that investors can invest in, besides Centureion Apartments, League, Skyline, and Prestigious properties

  16. Potato Says:

    Hi Shane, thanks for stopping by. Unfortunately I don’t look at any private REITs. I’m not an accredited investor, and since they don’t trade there’s no opportunity to scoop them up when they’re undervalued.