Owning Real Estate vs REITs

Dec 17, 2019 | Elaine Law


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Could REITs be right for me?

There is a quote by the late Louis Glickman, a famed real estate investor and philanthropist: “The best investment on earth is earth.” Many of us find real estate to be an attractive and reliable investment. However, there are risks involved that are worth taking a closer look at. Let’s consider several factors involved in real estate ownership, and whether REITs may be a suitable alternative.

Canadian Household Debt

Canadian household debt has been increasing dramatically in recent years. According to Statistics Canada, credit market debt totalled $2.25 trillion in the second quarter, including $1.47 trillion in mortgage debt and $782.9 billion in consumer credit and non-mortgage loans, which means over 65% of our total debt is due to mortgages. Canada is among the highest five economies in the world for household debt to GDP, coming in at 101.3%. A deeper look at the dangers of Canadian indebtedness reveals that not only do Canadians have to set aside unprecedented amounts of their income for the servicing of debt (see chart 1), Canadians are also saving less (see chart 2). This means that many Canadians are highly sensitive to interest rates and economic cycles, due to lack of “wiggle room” in their budgets.

Source: Statistics Canada, Veritas Research
 

Source: Statistics Canada, Veritas Research

Is Real Estate Risky?

In general, real estate investments require a large amount of capital. People usually leverage when it comes to buying real estate. Leveraging is so common that most real estate investors do not think of it as a risk. In fact, this is analogous to having a margin investment account, i.e. borrowing money to invest in the equity market. Risk-averse investors may cringe when they think about using leverage to buy stocks, but the same investors usually believe that borrowing is very reasonable when it comes to investing in real estate. In reality, it’s the same risk. When your stock prices fall, you get a margin call; when your real estate prices fall, you have negative equity! Also, with real estate, it’s not easy to diversify your risks by owning property in different sectors and geographic regions, due to the capital required. Real estate is generally not as liquid as other types of investments such as stocks and bonds, and you cannot easily sell off a fraction of an investment property.

What about Canadian real estate in particular? A recent survey by Veritas found that half of the participants indicated that they did not generate positive cash flow after mortgage and other ownership expenses. 18% of participants broke even, and 32% had negative cash flow. This survey also found that over 84% of participants did not plan to sell in the next year. This may suggest that if everyone who is cash flow negative were to suddenly try to sell, the real estate market would get a supply shock, which may cause a real estate price correction. Click here to read the survey

What are REITs?

Those who are considering buying real estate may also consider Real Estate Income Trusts (REITs). These are investment vehicles that own and manage a portfolio of income-generating real estate properties. One of the key advantages of investing in REITs is the tax-efficiency of the distributions. REITs are tax-exempt at the company level, provided that the company pays at least 90% of their pre-tax income to the unitholders annually. Therefore, REIT distributions are not subject to the same double taxation that is applied to corporate dividends. Diversification is another key advantage of REITs. It is far more feasible to gain exposure to different types of real estate in various geographic regions through REITs than through physical property ownership. If real estate is attractive to you, it may be worthwhile to ask your advisor about REITs as a potential addition to your portfolio.

 

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