REITs

(Real Estate Investment Trusts)

 

Not everyone can afford to buy a rental property with the goals of collecting a monthly cheque and having the property rise in value over time. Even those who can afford it and think it is a good idea may not want to become involved in the day-to-day details of maintenance, collecting cheques and making certain that insurance coverage is in place.

A second approach by those who are attracted to the real estate market is flipping houses. An investor will buy a property that they feel is undervalued, make some improvements and then attempt to sell the property for a profit. It can be rewarding but it might be more accurately considered an active business venture rather than a passive investment.

Knowledge of the local real estate market is only one factor. How will the project be financed? What are the real estate fees and legal fees? What permits will be required? Who makes the improvements? Is it something you can do yourself or will contractors be required? What will the costs be and when will the project be completed? It can become complicated very quickly but there is still a simple way for you to participate in the real estate market.

Real estate investment trusts, or REITs, are unique business structures that provide investors with access to a wide variety of real estate markets.

Some REITs own office towers, others own shopping centres, apartment buildings and so on. Still others are diversified among several different types of real estate holdings. Most pay a tax advantaged distribution similar to a dividend.

Generally speaking, the income generated from leases is distributed to the investors after such expenses as mortgage payments on the properties, property management fees, maintenance and so on. In many cases the tenants are signed to long term lease agreements where payments increase over time.

The units of publicly traded REITs can be bought or sold on the world’s various stock exchanges including the TSX in Canada. Despite the fact that the real estate market is very large, there were no REITs included in the S&P/TSX Composite Index in Canada as of the end of the 2012 calendar year.

When the stock market summary appeared in the financial media every day, the value of the various REITs in Canada was not reflected in that summary.

Investors who bought an index mutual fund that replicated the TSX index had no exposure to REITs.

What were they missing? Quite a bit, actually. In 2012, REITs provided better performance than the broad equity market and did so with much less volatility. In fact, the volatility of the REIT market in Canada has been consistently less volatile than the S&P/TSX index for a number of years.

Research by Ibbotson Associates (source www.reit.com) on the REIT sector in the United States found that:

  • An investment in REITs has historically increased the total return to an investor with a balanced portfolio.
  • An investment in REITs has complemented an investment in equities and bonds by reducing risk or volatility over time.
  • Growth in the distributions paid by REITs has outpaced inflation for the past ten years (2010).

 REIT Valuations

Many of the factors that affect the equity markets, such as earnings per share and investor expectations, also affect the value of real estate investment trusts and, as with equities, technical analysis can be used to examine their price movements.

The earnings of REIT shares are determined in large part by the stream of rental revenue. That revenue stream, in turn, can be affected by interest rates paid on mortgage and the rental rates. Occupancy rates are another concern.

Mortgage rates

Most of the properties held by a REIT have a mortgage and higher interest rates mean higher mortgage payments, thus reducing the stream of revenue available for distribution to investors.

Rental rates

The level of rents is usually determined by supply and demand but in many commercial buildings tenants sign long term lease contracts. Because the maturity of these contracts is staggered, a downturn in demand would have an impact on the lease agreements signed during that downturn. Of course, rates could rise during an economic boom.

Occupancy rates

A severe economic meltdown could not only result in reduced rates but a lower occupancy level for some properties.

Because many REITs are diversified geographically, weak economic conditions in one area could be offset somewhat by better economic conditions in other areas.

Diversification

Some REITs specialize in specific types of real estate including office buildings, commercial buildings, industrial buildings, hotels, retirement homes and apartment complexes. As with equities, diversification among different real estate markets, both by the type of real estate and geographically, will reduce volatility and risk.

At any point in time one geographic area of the country may experience strong economic growth while another area is weak. Having broad geographic exposure helps to ensure that you don’t have all of your eggs in the wrong basket.

The same applies to the type of real estate.

There are times when the demand for office space is weak but the demand for industrial space is strong and vice versa.

Prudent financial management would ensure that your investments are diversified rather than concentrated.

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