Investing in REIT’s or buy-to-let?
When considering the virtues of buy-to-let as an investment, you may also want to consider the benefits of owning REIT’s as an alternative.
What is a REIT?
REIT’s, or Real Estate Investment Trusts, have been around for over fifty years, with the former president of the United States; Dwight D. Eisenhower signing legislation into place in 1960, giving the man on the street access to owning a share of the property market that was previously only reserved for intermediaries, institutions and the ultra-wealthy. According to NAREIT (National Association of Real Estate Investment Trusts): currently over 80 million Americans utilize REIT’s as investment vehicles.
REIT’s are companies that invest directly in at least 50% real estate debt through the use of mortgages (mortgage REIT’s/ mREIT’s) or equity REIT’s, that have at least 50% of their assets in the real estate equity market or a mixture of the two, known as hybrids. They may be private, public and traded on the stock exchange, or public and not traded on exchange. REIT’s invest in or finance a wide variety of property types; from timber or agricultural land, retail, medical and industrial to other mixed commercial use properties.
To qualify as a REIT on the JSE in South Africa, the REIT must own at least R300m in property, debt must be below 60% of its gross asset value, at least 75% of the income must come from real estate activities, and a minimum of 75% of the income they receive must pass through to investors (90% in the US). This way the investor pays tax on the dividends and not on the REIT.
REIT’s are classed as total return investments providing both capital appreciation and dividend income. Returns are largely achieved through the stable income from rental properties or gains from property sales. When we compare the performance of the FTSE NAREIT US Real Estate Index (a family of REIT-focused real estate indices which span the commercial real estate industry) to that of the Russell 3000 Index (about 98% of all US Incorporated equity securities) from 31 December 1978 through March 2016, we find that the total returns for exchange-traded equity REIT’s averaged 12.87% per annum as opposed to 11.64% per annum for equities.
When we compare returns over rolling ten year periods, starting from December 1978 until 1988, with the last period from 2006 until 2016 we see that performance is split equally with one outpacing the other for exactly 50% of the time. Returns on REIT’s were more dependable with less downside. This return on REIT’s came with lower volatility (measured as standard deviation) of 7.9% as opposed to 16.9% for the Russell 3000. (www.reit. com)
*Courtesy of www.reit.com
When we compare real estate returns in the local environment we see that property enjoyed double digit returns for over a decade until 2017, having outperformed both the All Bond Index and All Share Total Return Index. A precipitous decline followed with three year returns in the lower single digits. Allegations of accounting fraud, BEE scams and over-stated assets were levelled at some of the largest asset owners. The local listed SA Property Index had a strong start to the year, however it seems to have stalled with yield around 8.96% at the time of writing and still offering a discount to their net asset value.
*Courtesy of IRESS & Bridge Fund Managers
Measuring the performance of listed REIT’s is easy enough. However, tracking the performance of rental returns for privately owned property is more challenging. Turning to the likes of FNB or the quarterly published Rode Report, FNB in 2018 suggested buy-to-let had remained steady despite the relative size of buy-to-let investors having gone from making up as much as 25% in 2004 to around 8% since 2010. Rental gross yields were 7% for free hold properties and 9% for sectional title. The most recently published first quarter Rode’s Report (www.rode.co.za) suggested office rentals were lagging inflation with vacancies in both office and residential lets remaining high, whilst industrial rentals tended to outperform. Overall there has been a largely negative outlook based on both the local environment and the prospect of slowing global growth.
First it is important to differentiate between fees and costs. The fees of buying a property are relatively straight forward, however they are not cheap.
Buying: Transfer fees which will include; bank initiation and inspection fees, electronic document generation charge, post petties, deeds office search fees, bond costs and conveyancer fees. A recent article in January of 2019 on Private Property (www.privateproperty.co.za) suggested that a purchaser should have between 8-10% of capital over and above the purchase price and deposit available to cover fees.
Ongoing: Monthly insurance, monthly rates and taxes, monthly levies.
Selling: Estate agent commission, electrical compliance certificates, partial or full bond cancellation fees.
Costs incurred for owning the property are things I would deem as necessary for general upkeep or the unexpected. This may consist of security enhancements, a refurbishment upon purchase or periodically; once every 5–10 years or something as simple as a lick of paint. The unexpected costs are those things such as lightning strikes knocking out your electric gate motor, or a burst water geyser. Not to mention the cost of one thing you cannot put a price on; your precious time.
Gearing and Debt
Utilising a bond to purchase your buy-to-let property means you are borrowing capital (leverage) to enhance the return/loss of your investment. In South Africa, investors who qualify for a bond will still have to put down at least a 10% deposit for their purchase, meaning they are leveraged ten times and paying back a minimum of the principal, plus interest of prime or prime minus 1%; which is currently at 10.25%. REIT’s utilize leverage or borrowing in the same way, however depending upon their assets under management and geographical location may be able to secure lending at a lower cost.
Risk of Loss and Default
Risk of loss, and risk of defaulting on payment are risks you take on as an individual investor when you acquire a property in your own name, this in turn could mean being blacklisted and/or losing more capital than you put down – given that you have leveraged or borrowed capital and will owe money on the principal amount and the interest outstanding. Unless you bought a leveraged REIT product (such as an ETF), then the leverage or borrowing is controlled by the REIT itself and you are only subject to the loss of the capital you put down as your initial investment.
Interest Rate Risk
Buy-to-let investors take on interest rate risk for properties that have interest rates linked to local floating rates, so if local rates increase by 1% then the interest rate associated with your bond will normally increase in line with this, reducing your rental income and vice versa. REIT’s address interest rates internally and will attempt to hedge out their own risk, meaning it may not have a direct impact on your cash flow, but a potential secondary long term impact on your investment return within the REIT itself. Generally speaking REIT prices in the US have risen in line with rising interest rates (indicative of a higher demand for credit) and improving economic growth, boosting REIT earnings and the value of underlying REIT assets.
Volatility risk is inherent in exchange traded markets for REIT’s but less observable in privately trade property owing to how often prices are reported based on property sales. The less often prices are reported, the less the observable volatility and the smoother the prices may appear, this does not mean it does not exist.
Vacancy risk for buy-to-let investors is the largest risk faced for prospective owners. This can turn your income generating asset into a loss making liability overnight if your tenant leaves, cancels their lease or refuses to pay. Other more subtle or unforeseen risks, such as increasing crime levels, noisy neighbouring long term construction or general neighbourhood decline may reduce your asking rental price. On the other hand, choosing a property in an area earmarked for improvement or with the potential to attract high-end long term rentals may significantly increase your stability and yield i.e. corporate leases or residences for foreign cultural attachés. Finding a tenant requires time and effort as advertisements, showings, interviews and references will require your attention. This can be outsourced but will then lower your yield as you pay away a fee to the real estate investment company for sourcing a tenant. REIT’s on the other hand handle this process themselves.
Rental Income and REIT Distributions
Neither private property nor REIT’s guarantee rental income and distribution. There may be an argument to be made for reputation risk and the effect of negative market sentiment on publicly traded REIT’s, and how or whether this may increase the rate of price selling, leading to further declines. Arguably, because this is a major concern, it becomes a core area of focus to attract and retain investors, thus reducing the risk. This is unclear.
Given the high associated costs of buying property, diversifying as an entry level buy-to-let investor is challenging. Diversification through REIT’s is far easier and can be achieved according to sector (i.e. medical, industrial, retail, office or residential) or geography, both locally or internationally. This can be achieved by utilising local and offshore preferred and regulated financial service providers, examples of which may be your wealth manager, banking partner or specialist stockbroker. Further to this, varying types of growth opportunities and income streams or capital appreciation are available through various managers such as: Vanguard’s Real Estate ETF (VNQ); Schwab’s US REIT ETF (SCHH) or iShares Global REIT (REET). Other more specialised REIT’s based out of the US that may be worth exploring are the likes of the Alexandria REIT (www.are.com) or Rexford Industrial (www.rexfordindustrial.com), both of which form part of the Schroders Global Cities Real Estate Fund.
Liquidity risk is one of the more obvious risks in physical property, with property being known as a “lumpy asset” – meaning it is not something that is easily divisible and therefore challenging to turnover quickly. Often, and in order to secure a sale, a seller may have to accept a discounted price to conclude the deal. Conversely the buying and selling of an exchange traded REIT can be done relatively cheaply online through a regulated/registered broker or investment platform.
Buying-to-let is a very traditional and challenging way of gaining access to the property market; requiring more capital with additional cost; it has lower flexibility; lower diversification potential; higher hands on administration and upkeep; with potentially higher risk, especially if you are leveraging yourself or borrowing money in the form of a bond or mortgage. REIT’s on the other hand give you the potential to gain instant access to a diversified global property market, at relatively low cost, with up to date pricing through accredited and regulated financial intermediaries. You can avoid the headache of repairs and upkeep, negligent tenants or the risk and stress of having to subsidize your property in the event of it being vacant. International REIT’s can help you diversify your local portfolio exposure to political and economic risks by giving you dollar denominated income returns, and exposure to growing sectors such as industrial, storage and the life science industry. We live in a global economy with global investment opportunities, as savvy investors we should be taking advantage of the access, transparency and professional service offered to us by the combination of technology and trusted advisers, and an investment into a well-researched REIT should be a part of that conversation.