Real estate investment trusts: a portfolio perspective
What is a REIT?
A real estate investment trust (REIT) is typically a business that invests in, and operates, income-producing properties. Originally modelled after the mutual fund industry, REITs give investors the opportunity to share in the income potential of a property without the need to directly own the property.
REITs can be structured a few different ways with each offering a different risk profile:
- Equity REITS own, and may operate, the properties (usually with some level of debt outstanding) similar to an individual who rents a condo or home with a mortgage.
- Mortgage REITs execute a mortgage on a property and become the lender to the property owner with the return being the interest income from the mortgage.
- A hybrid REIT is a combination of equity and mortgage REITs.
Compared to direct ownership, this form of indirect real estate investing has some key advantages. First, there is far more liquidity and transparency because REITs trade on stock exchanges and are priced daily. Second, a REIT invests in potentially hundreds of properties, providing greater diversification than most individuals could achieve by owning real estate directly. Lastly, direct ownership of property can be a labour-intensive endeavour unless the investor is willing to spend extra money to hire a property manager. The manager could then deal with ownership issues such as attracting and keeping good tenants, property maintenance and tenant disputes.
Residential and commercial real estate prices are driven by supply and demand based on the property type and location and may also be tied to the prevailing interest rates at the time. REITs, by design, pay out their residual income after operating expenses and loan interest to shareholders; therefore, a change in interest rates can impact the value of the REIT. Similar to direct ownership, if investors pay additional interest on their rental mortgage, it won't follow that the tenant will pay higher rental rates to compensate.
REITs as a separate asset class
REITs are a small sector; they make up only 2 to 3 per cent of the North American equity market. Historically, REITs have exhibited low correlation with equities meaning that REITs don't move in sync when the overall stock market moves up or down. This provides investors with an additional diversification benefit. In the last 20 years, that correlation has averaged about 0.5 on a rolling 12-month-return basis when comparing Canadian and US REITs to the broader market. For residential and commercial real estate, rental incomes tend to be fairly stable because people need places to live, and commercial businesses, such as grocery stores, will continue to operate even when markets are weak. Defensive sectors, such as consumer staples, utilities and REITs, aren't immune to a stock market decline but have shown greater resiliency historically. Having a good representation of these defensive sectors will allow investors to benefit from this lower volatility as the diversification should provide them with more consistent positive returns.
Investing in REITs outside of Canada
When looking at equities, ATB's philosophy is to be well-diversified geographically and across different sectors. Companies like Microsoft, Visa and Johnson & Johnson aren't found in Canada, so to have them in your portfolio you must diversify outside of Canada. With that in mind, is it also necessary to diversify outside of Canada for real estate? Does a company that owns a portfolio of malls or apartment buildings in Canada differ from a company that owns a portfolio of malls or apartment buildings in the US or overseas?
If we look at the US REIT market compared to the Canadian market over the past 20 years, returns correlate by about 0.9 year to year and total returns have remained very close. However, throughout most of the last 20 years, Canadian REITs have also traded at more attractive prices to dividend multiples compared to US REITs. Should that valuation trend reverse, US REITs may provide a compelling reason to include them in the portfolio.
REITs: solid investment, good diversifier
When added to a portfolio, REITs make good diversifiers. The Canadian REIT universe isn't very large (the top 20 companies make up more than 90% of the sector, but keep in mind that each REIT is a portfolio of many real estate holdings across an array of property types).Despite this, Canada offers sufficient diversification. The addition of global equities fundamentally makes sense for the opportunity to buy unique companies, but for REITs at this point in time, the addition would not appear to add anything besides more complexity.