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.
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.