In the first part of this series, I’ve painted a pretty nice picture of REITs, don’t you think? But there is nothing perfect in this world and REITs are not even close to perfection. There are several things you must look out for before considering investing in any REITs:
Be Careful – the Tax guy has an eye on you!
As opposed to dividend stocks, distributions from REITs are mostly considered as income with a portion of return of capital (ROC). Remember that income from REITs is fully taxable while ROC will reduce the average also distribute a part of their income as dividends. There are no official rules, and it is important to verify each REIT before making any purchase.
Remember that chances are you will pay higher taxes on REITs distribution than dividend stocks. Therefore, it will be important to include your REITs in your RRSP or TFSA. Holding REITs in a non-registered account will result in much higher taxes!
Interest rate could hurt
The cost of financing has risen significantly since 2008. It might sound counterintuitive as interest rates for personal consumers have never been so low. However, a 6 billion REIT doesn’t go to the branch on the corner of the street to get financing. It usually has to issue bonds at a “commercial rate”. This is how cost of financing in this industry has risen because it is considered riskier than it previously was. Prior to 2008, financing was easy to get as banks thought they were able to manage all the risks and still remain well capitalized. Now that the capitalization rules are going toward Basel III, banks will charge a higher interest to finance any commercial activities.
The effect of a higher cost of financing has been amortized by the existing long term debt structure. Most REITs have already secured their lower rates for several years (read 15 to 20). Therefore, the immediate impact on income from a rise in interest rates is minimal. Over time, it will definitely reduce income distribution abilities.
Your are not the landlord
Not being a landlord and not having to deal with tenants from hell is an advantage, if you like to control your investment with a close eye, investing in REITs will be a great deception. The management philosophy as presented to the investor is usually vague. Therefore, you blindly give the power to the management team and your investment return will depend on their ability to deliver.
Higher fluctuation than Real Estate
How can investing in real estate asset classes be more volatile than investing in… Real Estate? The fact that REITs are accessible through the stock market like any other stock is a great advantage, it is also a source of higher fluctuation as explained in the first part of this series. Units value will be following stock market trends and you will see those drops in value on your investment statement. Such situations don’t happen if you own your triplex, as the only statement you receive is your mortgage statement! The value of your triplex is not assessed on a daily basis as opposed to the price of your REITs units.
Finally, the uncertain future of retail stores
Another situation worries me now. The state of retail stores. I’ve made an extensive study on Amazon (AMZN) Vs Target (TGT) and Wal-Mart (WMT) lately. The outcome of this study was clear: brick & mortar stores are having a very hard time. Growth in the retail stores is being found nowhere but online. Therefore, what will happen with all those empty stores?
In Canada, Zellers closed their doors a few years ago. Their empty leases found a new company… Target (TGT). Do I have to tell you the end chapter of this story? Those leases are now empty again!
In the U.S., the situation isn’t better. The next two graphs are alarming:
Many retail stores had the brilliant idea of leasing their space to REITs. This is a great way to diversify the risk and concentrate on their business while REITs benefit from a wide experience of managing properties. However, REITs have little to no control over who rent their space. If a big retail chain has to close 200 locations, the REITs will be affected once the penalty of the contract will be assumed by the renter.
Because of their structure and business model, it is almost impossible for a REIT to move quickly and transform their business. Therefore, all retail-focused REITs will enter in a business-model-changing era in the following decade. Will they be able to sustain their dividend payouts in the future? This is a very hard prediction to make.
In other words, REITs aren’t bulletproof
I can’t stress this point enough; REITs are NOT bulletproof. The main reason why you should invest in a REIT is because of its stable distribution. That doesn’t mean a REIT cannot cut its distribution or that its units won’t severely drop in value. A bad investment, rising interest rates, or a bad economy (leading to a high number of bad tenants) could results in some serious financial problems for the company. I understand they pay juicy yield, but there are still businesses and they must remain profitable. Remember that REITs must distribute a minimum of 90% of their revenue. This leaves very little room for mistakes or a volatile real estate market.
A special thank you note to Income Surfer who wrote the State of Retail and found those 2 graphs!
I hope the travels are going well Mike. I’m glad you liked the post and the charts. Retail real estate is one niche I know pretty well from years of consulting. While there are some amazing REITs out there…..there are also some lemons. In the US we are facing the fact that we are “over retailed”. We have dramatically more square feet of retail space than any other developed country. Coupled with the trends in online shopping, there will need to be a lot of consolidation. The top locations will be fine, but many others won’t. The other risk is interest rates…..both because many income investors use REITs as bond proxies…..and because the REIT business model has a ton of debt. If rates were to spike, we’d really have some fun.
Talk to you soon
-Bryan
Hey Bryan,
We just left Florida today. We are going north to the Great Smoky Mountains tomorrow 🙂
Not all REIT’s are the same. I do like agricultural REITs. After all, people have to eat and there is only a certain amount of high quality soil and prime location for some of these places. I particularly like ASX:RFF which I do hold. I think they are a long term winner.
I don’t think we do have agricultural REIT in Canada… how does it work? they rent land to farmers?
cheers,
Mike.
Mike, I liked both parts of this article. Presents a well balanced review of REITs. At 15% of my diversified dividend stock portfolio, I feel comfortable with this sector allocation to REITs. That is distributed among 5 REITs, majority in health care, and one has multiple tenants in restaurants and core retail (drug stores etc) which I am confident about. I agree that upto 30% is the right allocation for most investors.