Real estate is an extremely popular asset class because it provides (in theory) consistent, predictable and uncorrelated returns to the broader stock market – with returns being sizable, especially on a levered basis (purchasing a property is rarely with only personal cash and equity, and usually involves a degree of bank debt in the form of a mortgage).
Investing in real estate is very different for individual investors and for institutional investors. We cover residential and commercial real estate at the asset level in our investing section, while real estate investment trusts and real estate operating companies are covered in our industries section.
Real estate as an asset class has a cash flow profile that resembles fixed income much more closely than equities. The stream of cash flows is well known (monthly rent over known leases) with refinancing risk (inability to fill the end of a tenancy will result in vacancy) and default risk (tenant’s failure to pay) and the leases are long-lived. Real estate prices also move inversely to interest rates. Higher interest rates mean that rents must increase to capture the same return for investors. If rents do not move, prices must fall.
Owning and Renting Out Real Estate
Due to the relative stability and security of bonds versus stocks, bonds tend to yield lower returns over a long-time horizon. However, despite bond like characteristics, real estate has outperformed stocks over long-term time horizons. So why is private real estate investment not widespread?
- Liquidity – Purchasing a stock is easy – one share of Starbucks is $50 and 100 shares of Starbucks is $5000. Brokerage fees have fallen immensely since the advent of the internet age (Interactive Brokers charging a dollar per trade while Big 5 Canadian banks have had trading fees fall to $7.50 to $9.99), making transactions less obstructive.Purchasing a house will set someone back a few hundred thousand for the equity portion alone and less creditworthy business plans will have a person on the hook for default. Real estate agent fees are 1-5% of a transaction, substantially more than $10. Due to the lack of liquidity, a life event or other trigger forcing a sale may mean that the seller has to accept a deep discount to the market value of the property.
- Ongoing Business – Real estate is difficult – someone will have to clean, collect rent, file paperwork and perform myriad other tasks, none of which are free. Bootstrapping and DIY real estate is never stress free.
- Operational Risk – Assuming the landlord does not own 100 properties, there is high asset-specific risk. If the building burns down or there are legal repercussions with the tenant, that cash flow stream is halted with possible large cash outflows required for any judgment or repair.
Additionally, individual investors like real estate because it is fairly simple to figure out and the cash flows are obvious. Cliché, but true, the key to real estate is location, location, location. A well-managed, pristine building in an awful location is going to do poorly and a dilapidated building in a high-traffic, underserviced area is going to do very well. Real estate is less of a “build it and they will come” but a pragmatic purchase with an understanding of underlying trends in the community where the plot is located.
Historically, a characteristic of real estate is that it is illiquid (it takes a significant personal investment to purchase property, relative to annual income). However, with the growth in popularity of REITs and ETFs, real estate exposure is available even to investors with small amounts of capital.
How to Invest in Real Estate
For an investor looking to gain exposure to real estate, private and public options available include:
- Direct physical investment – buying properties and collecting rent as an operating business, whether independently or with a property manager as an agent of the company
- Pooled Real Estate Funds or Investment Groups: Small, private mutual funds for rental properties
- Real Estate Investment Trusts – REITs are a special corporate structure popular in the US and in Canada where they do not pay taxes at a corporate level provided they distribute all their taxable income to unitholders/shareholders (US – 90%). This is attractive to Canadian investors, as the companies are not subject to double taxation.
- Canadian REITs are predominantly a retail vehicle while US REITs see more institutional demand. A potential investor should consider the benefits of dividend tax credits before concluding that REITs are necessarily a go-to investment.
- Canadian REITs tend to stick with core subclasses of real estate – office, multifamily residential, industrial and retail (there are other subclasses represented but liquidity is low and size is small) where the US has a variety of esoteric options
- Canadian REITs tend to lever up at the asset level while US REITs have pragmatic and sophisticated treasuries that take on more debt at the corporate level
- Real Estate Operating Companies – Companies that develop and operate real estate; there are no special tax implications and these companies are taxed like any other corporate
- Sector ETF – ETFs traded on the TSX easily available to Canadian investors include: iShares S&P/TSX Capped REIT Index (XRE), Vanguard FTSE Canadian Capped REIT ETF (VRE), BMO Equal Weight REITs (ZRE), iShares Global Real Estate Index ETF (CGR)
Unfortunately, the benefits of private real estate do not translate perfectly into public real estate investing. The leverage is already embedded into the valuation of the real estate company, so unlike owning a physical property (which tends to be good collateral), an investor will not be able to enhance returns through a mortgage or cheap debt.
Additionally, there is the burden of management and staff that do not come with a private property. As a result, diversification benefits through investing in public real estate are muted and public real estate is often subject to the vagaries of market swings.
Related Reading for Investing
Investment Asset Classes
Fixed Income – An introduction to bonds and other fixed income instruments
Index ETFs – An introduction to index ETFs and why they make sense versus most mutual funds
Avoiding Exchange Rate Fees at Banks for Investing and Travel
Taxes – All investors have to deal with taxes but it is important to know how to minimize tax drag on your investments through understanding TFSAs and RRSPs