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The Downside of Owning REITs





This is written by our resident real estate guru Rachelle.

In many of my past columns I have discussed the problems of buying real estate in our current market. I have mostly decried that current prices, even at today’s interest rates, are too high to make a profit. I have also warned of the dangers of investing without including proper expenses such as property management, vacancy and maintenance expenses. I have said that it is possible to find properties that can be considered investments but the search will be long and arduous especially if you are buying in the larger centres such as Toronto.

Many investors want to invest in real estate but do not want to deal with the problems associated with owning property directly. Real estate is far from passive. Many people, FrugalTrader included, have bought and then subsequently sold their properties because of this. Let’s face it… you work, you’re tired and an extra rental house or two requires working some more, on evenings and weekends, when you’d rather be watching a movie and having a beer. The other problem with the extra work is that you’d make more at a minimum wage job. All in all it’s not worth it for many.

The Exit of Experienced Investors

In the last few year there has been an exodus of small landlords cashing out. I had one gentleman, a landlord for 20 years, tell me that it just didn’t make sense anymore. He could sell his house for $600,000 plus or rent it for $1600 per month with all the risks associated with bad tenants. There just wasn’t enough profit in the business and too much appreciation of the properties to maintain a rent/price ratio. For many longtime landlords this was the equivalent of winning a lottery. The skewing of the rent/value ratio is a sign of a out of balance real estate market.

The REIT Solution

One solution I hear over and over is why bother with buying my own properties when I can just buy a REIT? Usually this would work. You could profit from the asset class with out having to actually own and maintain and rent anything. You could watch your movies and have your beer in relative peace, however, there are problems with this strategy.

The REIT Problem

One of the major problems when buying REIT’s is the lack of control. When buying you make a number of assumptions that you may not be aware of such as the value of the assets they hold and the benefits of professional management. When you buy a share, that money is used to purchase real estate assets and they use the money generated by those assets to pay you a distribution. You have to trust that they are doing a good job and are not using Hollywood Accounting.

REIT’s Are Not Protected From The Real Estate Market

If you consider the indicators and the recent news that there are significant problems with the valuation of real estate in today’s market, you also have to consider that REIT’s will also take a severe hit if valuations of real property fall. I had lunch with a mortgage broker who works for a major pension fund a few weeks ago and she was saying that it is common place for REIT’s to have a 75% loan to value ratio on their properties. Some of these REIT’s claim they have a much lower loan to value ratio of 50%. She sees their mortgages so I’m inclined to believe her.

Lemming Behaviour affects the Stock Market

Even REITs with great, stable portfolios will not escape a real estate market adjustments. Once market sentiment turns and the fear takes hold, prices on REIT shares will go down. If the value of their assets fall then their ability to remain liquid and refinance will take a severe hit. Many industries are dependant on prices of real estate going up. Employment takes a hit along with building materials suppliers. The economy as a whole suffers.

Deleveraging

My very first property management job was in a multi res building that had changed hands 6 times as the real estate market deleveraged. As values fall companies must sell off assets to keep their loan to value ratios intact. Of course other potential buyers are also affected by the same market values and experience the same problems and a plummeting effect occurs. Lenders ask for more security as they suspect that prices may go down even further.

So Should You Buy A REIT?

Go ahead and buy if you think the real estate market fundamentals are healthy. If you think that current valuations of real property are too high, don’t buy REITs as an alternative…they’re just as vulnerable. They are listed on the stock market but the values of their assets are linked to the real estate markets. REITs are buying in the same real estate market as you are. They have even more pressure on them to buy than you do, every quarter they have to prove that they are wisely investing shareholders money, they can’t sit around with piles of cash even when they should.

What are your thoughts on current REIT valuations?  Would you buy at these levels?

About the Author: Rachelle specializes in renting property on behalf of landlords and is the blogger behind Landlord Rescue. She also works with investors to find good investments in Toronto and surrounding areas. Her passion is bringing multi res properties back from the brink and maximizing profitability. Check out some of her other real estate posts on MDJ.





14 Comments, Comment or Ping

  1. 1. Returns Reaper

    I don’t see the “problem” with REITs that you mention, specifically that they are not immune to changes in the real estate market. While everyone would love to own assets that only go up and never go down, this isn’t a realistic proposition unless you only own government bonds and other safe, low-return investments.

    The reason you would want to own a REIT is because you believe:
    a) real estate is a good asset class to complement your investment portfolio (i.e. it has a reasonable expectation to increase in value over a long time horizon and it is poorly correlated with other asset classes in your portfolio).
    b) you believe a REIT provides a good approximation of the real estate asset class in general.

    As a result, if the real estate market were to go down in value, you would expect the REIT to drop in value as well. If you’re unable to stomach the losses that the real estate market is capable of doling out, you’re probably best off to stay away from the asset class completely.

  2. 2. Rachelle

    I am very bad at predicting the future :)

    I am not happy with the real estate market, every day there are headlines about the residential real estate market.

    http://www.journalofcommerce.com/article/id40316

    I wrote this article with the goal of getting people to really think about RE as an asset class. It may adjust a lot more than people are comfortable with and a 64 year old on the verge of retiring with a portfolio stuffed with REITS may want to consider the possible pitfalls.

    This may be a time to rebalance as the market is stable IMHO. It may be OK or not, the repercussions of the later are quite frightening.

  3. 3. Mario

    You’ve basically written an article that could apply owning stock of any company or sector index fund.

    BTW, I work in the commercial real estate sector in BC, and on the purchase of commercial properties, we find that 60-65% loan to value to be pretty standard.

  4. 4. andrewbpaterson

    What about private REITs? By not being tied to the market, it makes sense to me that the worth of a REIT is tied to rental income. I’m just learning about all of this, but I don’t seem to recall anyone talking about their rent going down. It would just go up at various rates (or not all), but never down.

    A private REIT, seems to buffer from the market motion, driven by emotional investors or automated programs.

    Too bad you have be an accredited investor to buy private REITs in Ontario.
    =\

  5. 5. Echo

    I think the current REIT valuations are high, although many are still providing great distributions and their outlook remains strong. I personally own CUF.UN and REI.UN, and am pleased with the performance so far (although I purchased them in early ’09).

    I have also tried a rental property venture and the PITA factor was too high for my liking. Probably due to the fact that I am a candidate for the Canada’s Worst Handyman tv series :)

  6. 6. Sarlock

    As I look across the broad spectrum of asset classes available to invest in, the one that screams “bubble” the worst is Canadian real estate. We are very good at convincing ourselves that “Canada is different” but history has shown that we are not, and I strongly believe we’re on the edge of a very long and steep downturn. Once the rent-to-value ratios become more favorable for landlords, I’d consider Canadian REIT’s… until then, they seem way way too risky. You could lose a lot of capital and could take 10-20 years before you return to a break-even point.
    US REIT’s, however, could offer a lot more value. While their real estate market is still crumbling, it *has* to find a bottom at some point, and it doesn’t have nearly as far to fall as Canada does to reach this bottom.

  7. 7. Echo

    @ Rachelle

    When you say that you want people to think about Real Estate as an asset class, how much consideration or weight would you give to your own personal residence? Most people’s home values are worth much more than their stock portfolio, therefore already providing substantial weight towards Real Estate in terms of asset allocation.

  8. 8. Greg

    I agree with Sarlock. With the huge run up in housing prices in recent years and the end of low interest rates, there are going to be huge numbers of people who will have to remortgage in a couple of years at rates they can no longer afford. If you want to read someone who is hugely bearish on real estate, take a look at Garth Turner’s blog http://www.greaterfool.ca/

  9. 9. Rachelle

    @Echo

    My thoughts are that your personal residence is not an investment. It is a place you live that provides you with shelter. If it goes up so be it. It has the intrinsic value of keeping you out of the cold and wet regardless of its paper value.

    @Andrew

    Publicly traded REITs have the benefit of having some sort of scrutiny, reporting and auditing requirement due to their being on a stock exchange. A while back I ordered a blue book offered for free by a private REIT and it occurred to me that I did not like their marketing at all. It seemed rather loosey goosey, positive thinking mantra stuff I hate having mixed up with investment.

    Because of the income funds losing their tax preferred status and REITs continuing to have that tax preferred status including the great distributions I fear that many people are chasing the attractive yields because they simply are one of the best options out there.

    Unfortunately the entire system may have foundations on a shifting sand bar at the moment. My evaluation is that we are on the edge of a precipice where the real estate market may collapse or at the very least drastically slow down. The fundamentals that support the current housing market are simply not there

    Increased income – No
    More Jobs – No
    Great Economy – it’s ok but not really fantastic
    Interest rates going down increasing affordability – No
    Consumer confidence – So far OK
    Fear – Not yet.

    It makes me as nervous as a cat on a hot tin roof.

  10. 10. Causalien

    I’ve been bearish Residential REIT since 2009. What we have is not sustainable. Ask yourself this question, have your income increased in the past 10 years? Mine, have, but surely not at a rate that the house increased.

    The good thing about real estate is that you can see the truck coming from miles away. Two things that impacts the market. Interest rate and average income. We are seeing average income remaining flat while interest rate goes up. (Canada has a history of increasing rates consecutively once it started until the inflation cools, despite the shitty economy).

    What I’ve done, is actually investing in those that are commercial. Especially the ones who mainly rent out to Walmart and big chain thrift stores like that. Less likely to see their rental income disappear.

    Anyway, actions speak louder than words. I’ve recently sold my condo for Cash and is looking around for income securities to buy. Frankly, I don’t see anything good besides IPL.UN The stock market have fallen quite a bit recently, but none of these income securities have done the same. If you must buy a house. Look for a place with large land and a shitty house. Especially those that can be rezoned later. Land decreases less in value than the house.

    Though, the REIT, I bought in 2008/2009 is giving me 10% annual income, so I am not selling those.

  11. 11. Vytas

    In my opinion it is still not the right time to be in real estate. This market has to clean up of all unnecessary stuff that was created during the boom. Only then real recovery in the sector can start. There are too many unoccupied houses. One has to look for other type of investment.

  12. I think REITs are a bit overvalued right now; in general due to yield chasing.

    That being said, I think REITs are a great choice for investors who want RE exposure without some of the hassle. I find it interesting that many people who think RE is a great investment do not consider REITS. Perhaps many RE investors are actually “amateurs” caught up in the hype of the local market and don’t think of investment properties in the context of their entire investment portfolio

  13. 13. Andrew

    Yeah, I guess in theory, owning a REIT should help satisfy your desire to own real estate. One of the issues is “trust” as you mention, in that you need to trust a) that your money is being put where they say it is and b) that the decisions being made are not careless and they are buying valuable real estate. I’ve also look at REIT’s as being very volatile and in some ways random because of the nature of the real estate market.

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