It’s hard to imagine that the iPhone was introduced just over 10 years ago. This small, seemingly inconsequential device has brought about a goliath-sized transformation in the way we communicate and do business, while also impacting the infrastructure we use daily.
Tracing back through time we can see how innovations in technology have changed our lives. The flow of capital into these innovations has been a powerful catalyst for the continued expansion of the economy, and the improvement of our lives.
This capital is usually derived from investors placing their money in either equities or bonds. As the capital markets have also expanded, other alternative asset classes have attracted investors’ attention. One of these is real estate investment trusts, known as REITs.
The REIT structure has typically been used by owners of shopping malls, some residential properties (usually multi-family buildings), and office towers. Think of the owner of the Empire State Building that leases space to its occupants, the owner of that iconic building is a REIT. Over the 10 years since the introduction of the iPhone, the economy has changed and more capital has flowed into the realm of REITs, and so that realm has expanded to include in other areas of interest.
One is mobile communications infrastructure. As we see the increased penetration of cell phone use, cell towers are also becoming more widespread. The companies that build these towers lease their infrastructure to the mobile technology industry. The cell tower companies are structured as REITs, and these companies have delivered good returns in gains as well as income. These REITS focus only on building and maintaining the actual towers, while the mobile phone companies are responsible for maintaining their equipment on the tower, creating a simple business model for the REIT owning the towers.
Another fairly recent and growing sector for REITs is data centres. These are large storage buildings that house masses of computer equipment that is used for data storage. These centres consume considerable quantities of electricity in powering and cooling the computer equipment. Businesses that use data centres are billed by the amount of energy they draw, instead of what would normally be billed as square footage. Again, a simple business model, with a good income stream, and strong growth trajectory.
Although the REIT sector has gone through significant changes in the past decade with the increased flow of capital, and the evolution of the economy as mentioned above, the structure’s investment characteristics remain relatively the same.
REITs have traditionally been considered not quite a bond, nor a stock, they are a bit of both. They deliver a consistent income stream, like a bond. But they can also renegotiate their lease rates which can increase the cash flow, unlike a bond. REITs also offer growth potential of the underlying security, similar to a stock, but the growth is limited, and one mustn’t expect the same growth pattern associated with equity investments.
The risk profile of a REIT is also attractive relative to both bonds and equities. This is of particular interest at a time when most investors are seeking an asset class that can provide some protection in the event of a market downturn. Where a direct correlation of one asset class to another is 1:1, REITs have demonstrated 0.55:1 correlation to global, and US equities. When compared with global bonds, their correlation is even lower at 0.28:1. So REITs can deliver a buffering effect during periods of market volatility. When included in a balanced portfolio of equities and bonds, REITs can lower the overall volatility, while enhancing returns.
Buying real estate directly poses attractive returns, but with costly transaction fees and very low liquidity. On the other hand, REITs are purchased in the same manner as one would purchase a stock over a recognized exchange. Trading costs are the same as trading equities, and liquidity would depend from one issue to the other, but is generally far greater than participating in direct real estate purchases.
Though Canada offers some attractive REIT solutions, the largest market for REITs by far is in the US. The US market offers a broadly diversified range of REITs, including the specific sectors mentioned above. The capital flows are much greater than any other market, providing increased liquidity, along with greater diversification and growth potential.
REITs can be purchased as individual securities, or as pooled funds. That latter offers diversification in the sector, along with professional management that is attuned to evolving opportunities as well as managing the existing holdings. Generally, the REIT sector appears quite simple, but it doesn’t take much for it to become very complex. There are a few excellent REIT fund managers with established track records and strong returns. This is the route that I believe is best taken when investing in this asset class.
The traditional portfolio mix focuses on equities and bonds, but increasingly we are seeing alternative asset classes coming on the radar screen. While alternatives encompass a very wide spectrum, with varying risk profiles, a small allocation to REITs has typically been able to enhance returns while providing greater diversification and risk mitigation. Increased capital flows in an evolving economy will only add to the attractiveness of this asset class.