REITs – Pros and Cons of “Virtual Property”​ investment?

So, what is a REIT?

A “REIT” (Real Estate Investment Trust) is, quite simply, an investment asset type in the same way that a “Bond” or an “Equity” is an investment asset type.

Just as an “Equity” (e.g. as identified by the ticker “MSFT”) generally relates to a legal corporate structure known as a “limited company” (e.g. as identified by the company name “Microsoft”), a REIT relates to an alternative type of legal corporate structure which is distinguished by the fact that it primarily invests in property.

First established in the US in 1960, the “REIT” structure now exists in many countries globally with, for example, Singapore, Germany and the UK having their own variations defined. What is common to these is that, like the definition of a limited company, the definition of a REIT includes a number of regulatory checks and balances, put in place to ensure that the REIT is run responsibly e.g. a minimum number of owners, and a maximum gearing threshold (so that the REIT does not take undue risks via the size of its liabilities). Most positively, for potential investors, the definition of a REIT usually mandates that:

1. 90% of taxable income is distributed to unit holders, and
2. REITs are publicly listed and tradable on recognised stock exchanges.

Property as an element of Portfolio construction

One of the reasons to consider REITs as an element of any portfolio is to diversify across asset types (the advantage of which I described in a previous article here, which coincidentally contains a 20 year chart of annualised returns of different asset types, with REITs in poll position).

Having an element of property-related exposure in a portfolio therefore increases diversification.

Potential Risks of REITs and how to mitigate them

1. A REIT is effectively a single company so investing in a REIT runs the same lack-of-diversification risk as buying a single stock. One effective way to counter this, clearly, is to buy a number of REITs and/or to simply buy a fund or ETF which contains a number of REITs.
2. If overly-leveraged (e.g. up to the maximum threshold of 45% which currently stands for the Singapore definition of a REIT), the REIT will be more sensitive to any interest rate rises as the increased costs of servicing debt (think “mortgages”) will damage profitability. One effective way to counter this is to target REITs with lower levels of leverage.
3. Demographic changes: a move to online shopping causing a decline in the revenue of physical malls would damage the profitability of a REIT which predominantly holds retail-related properties. This can be fairly simply countered by choosing REITs which have a low-to-zero exposure to retail. Fortunately REITs are available which invest in sectors such as Healthcare, Storage, Commercial, and Hospitality (although the latter might also be best avoided if AirBNB is considered an existential threat to hotels).

Conclusion

Speaking as an investor who holds property-related funds (investment trusts, ETFs and single REITs) and who has also had the experience of investing in physical property over the years, I have to say that my preference is to gain exposure to income and capital growthfrom the former. As one example: the yield on my London apartment is around 2% whereas one of the REITs I hold pays me nearly 7%!

Additionally, the diversification (across multiple properties and locations), liquidity (e.g. ability to buy a REIT on Monday and sell it on Tuesday), low initial costs (no solicitor involvement, low-to-no stamp duty), and ability to invest via a platform which can shield me effectively from income tax, capital gains tax and inheritance tax really do make this an investment worth considering, especially when compared with physical property.

I always say that investing involves a mixture of quantitative analysis and emotional response. For property investment, the quantitative advantages seem very clear to me. The wildcard, then, is how emotionally attached the investor is to the idea of owning their own “bricks and mortar” directly. Personally, I’ve long since fallen out of love with bricks and mortar, and would therefore propose that REITs are a preferable solution for gaining property investment exposure.

Written by Michael Davidson