What is a REIT?
A real estate investment trust (REIT) is a real estate company that offers common shares to the public (through listing on a stock exchange). In this way, a REIT stock is similar to any other stock that represents ownership in an operating business. A REIT however has two unique features: its primary business is managing groups of income-producing properties and it distributes most of its profits as dividends.
REITs are like ordinary landlords in most ways. They own properties--quite often dozens, or even hundreds, of them. Frequently, a company will focus on a particular type: offices, apartments, shopping malls, strip centers or industrial properties, for example. A REIT's revenue is the total rent coming in from the tenants. Its profit is what's left of this rent after its property managers, janitors, lighting companies, debt collectors and local property tax collectors take their cut.
Advantages of REITs
Professionally Managed Properties
In the case of direct ownership, an investor is required to look after the maintenance of a property. REITs allow investors to distance themselves from the day to day running of the property/properties as they can be managed by an industry professional that can leverage off their own funds to provide a better service.
Reduced personal risk
Under a traditional real estate investment model, if an investor wanted to invest in real estate, they would be required to take on debt to purchase a property. Either that or they would be required to sell off existing assets to fund the purchase.
As an example, a $2,500 investment in a REIT may result in the same pro-rated rewards as say a $80,000 direct investment in a property. In addition, the REIT investment would be diversified across a range of investments, rather than one single property.
Liquidity
One of the well-known disadvantages of direct real estate investment is the problem of liquidity; it is hard to shift property quickly. REITs offer far higher liquidity and prices can in fact fluctuate on a daily basis. Investors can quickly ascertain the value of their investment, unlike with a direct investment, where a daily or even weekly quote would not be possible.
A REIT would be able to quickly sell off their holdings to generate cash for other investments.
Cash flow for Retirement
REITs provide investors excellent cash flow for retirement because the cash dividends provide an income on which a retiree can live off.
Disadvantages of REITs
Volatility
Because REITs are quoted on the stock exchange, they are more volatile than a typical ‘bricks and mortar fund’. The main reason for this is that in addition to having an asset value, they also have a fluctuating share value.
The price of an REIT may fall due to negative feelings about the property market, even in the even event of stable property market prices.
Gearing
Some REITs use leverage to increase the potential returns for their investors, resulting in both higher gains and losses.
Income not guaranteed
Past dividends/distributions cannot be guaranteed for the future, unlike say a fixed rental arrangement with direct investment
What to look for when investing in REITS
Experienced Management: Check the prospectus or annual report for managers who weathered several real estate cycles.
Ownership Stake: Get a hold of the annual report to determine whether management owns a sizable position in the common stock.
Diversification: Examine the annual report to understand what the REIT owns, i.e. the different types of properties (shopping malls, apartments, office space, etc.) in various geographic areas.
Sustainable Growth: Look for annual increases in a REIT's cash flow, listed in the prospectus as adjusted funds from operations.
Low Levels of Debt: Institutional investors recommend that debt be no more than 35% of total capitalization. As a general rule, the lower the level of variable-rate debt, the better.
Recent Performance of REITs
2008 will be remembered with little pleasure by investors in the REIT sector however since the early March 2009 trough, REIT prices have shown broad signs of recovery along with US financials. Europe was the strongest performing region for the period, followed by North America. Asia Pacific’s real estate securities markets cooled (with the exception of Australia) as investors shifted their attention to the improving conditions in Western economies.
Are these gains sustainable? To answer that we need to consider trends from past cycles and the changing real estate market fundamentals.
Lessons from past cycles
Over a period of 30 years we have seen a consistent set of linkages between sharemarkets, real estate markets and the real economy. It is a pattern that applies globally.
Overall, sharemarkets (including REITs) seem to provide a reliable guide on the direction of economies and real estate markets (magnitudes of declines in physical markets are typically overstated by REIT cycles).
Historically, residential markets have tended to be more responsive, recovering earlier because of lower mortgage rates and improvements in sharemarket sentiment.
For commercial real estate sectors, office markets have traditionally trailed the economic turnaround, responding to drivers like share prices and business conditions, with rents generally showing longer-running
adjustment. Meanwhile, trends in retail and industrial markets (particularly in Australia) seem to be dependent on the housing market with a lag, with cycles typically trailing both the residential and commercial office sectors.
Sunil Khemlani
StoneBridge Securities (NZ) Limited
Email: sunil.khemlani@stonebridgegroup.co.nz
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