Don’t Go Overboard Investing In REITs…

dont-invest-in-reits

REITs or real-estate investment trusts allow us to invest in real estate (sort 0f…) without actually going through the process of acquiring real estate. You don’t have to go out prospecting for tenants once you own a property or fix a leaky toilet or collect rent. The REITs managing these properties do all of that on your behalf. You don’t need tens or hundreds of thousands of dollars to invest in real estate like you would if you were to buy a rental property on your own. You could become a real estate mogul with just a few thousand dollars spread across multiple properties and many types of properties in this country and beyond. Plus REITs are traded daily on the many stock exchanges making liquidity a non-issue. Try doing that with a traditional real estate transaction fraught with complexity, effort and expense.

So with so many things going for it, why the fuss? Because by design, these investments are required to pay out 90% of the income they generate in the form of dividends. And therein lies the issue, at least in the current market environment. These investments are a de-facto proxy for bonds and investors use them to enhance the yield they would have otherwise received on a typical bond portfolio. We all know that interest rates over the past many decades have done nothing but go down…

long-term-interest-rate-history

And as interest rates tumbled, bond prices increased and increase they have. REITs did about the same though with more volatility and generally higher growth rates. That outperformance can be attributed to their equity type entity structure and hence stock market volatility in either direction ends up getting reflected in the prices of REITs. But that almost parabolic spike before the last bubble and the spike we are under the spell of now are kind of unsettling and when the value of an investment category goes up like that, reversion to the mean could be equally abrupt and violent.

bonds-vs-reits-historical-returns

Plus now we are at a stage where interest rates can’t go any lower and hence expecting bond prices and in turn REITs to do what they have done over the past several decades is borderline delusional. When and not if, when interest rates rise, bond prices will decline and that decline will reflect in the prices of REITs. The extent of the decline in REIT prices could be far more severe due to their stock like structure and this fact is corroborated in an NYU Stern School of Business study published in May of last year (link). An excerpt from that paper below…

“REITs may be impacted by interest rate fluctuations because real estate greatly relies on investment from borrowed finances. The overall real estate value is affected by the cost of financing, consequently impacting demand and affordability. Therefore, if interest rates increase; a reduction in the aggregate demand for real estate, lower real estate values, and increased cost of debt financing may ensue. Furthermore, real estate investors may require a greater rate of return if interest rates increase, resulting in lower real estate values. Additionally, during periods of heightened interest rates, real estate development is more costly due to the associated carried interest.”

That does not in anyway mean that you should exclude this asset class from your portfolio. If you are a homeowner, your home is most likely your single biggest asset so you have some indirect exposure to REITs already. Plus most cap-weighted indices own quite a bit of REITs in them. That information is not very evident or easily accessible on the many investment sites so we text mined that data just for you, deep-diving into the many thousands of holdings of these indices and extracting the information we needed. Our findings…

Large company stocks ~ 2.5% exposure to REITs.

Mid-cap stocks at 6.3%

Small-cap stocks at 11%.

That we feel is plenty exposure already.

Plus investing in REITs is not exactly the same as owning rental real estate as a lot of the tax benefits and the added boost due to leverage that make real estate investing even come close to other investments do not directly accrue to you.

So direct ownership of real estate is still the preferred route but then it requires a lot of capital, time and effort to manage. And because leverage is involved, things look great owning real estate on the upside but a few wrong moves and you get wiped out. And that is why we are working on this partnership where we leverage our network and expertise to de-risk owning real estate through capital, location and property-type diversification. We (7 partners for now) are still in the capital accumulation and preservation stage of this aspect of our portfolios and we will wait…and when the time comes and when the math is compelling enough, we will strike.

We will write more on this and all the mechanics around it in the coming months and about the several check-marks you as a family would have to adhere and abide by and all the associated documentation you will need to have ready if you want to engage and partner with us on this life-long endeavor so stay tuned.

Image credit – Gui Seiz, Flickr