In previous articles we looked at the upsides and downsides of real estate as an investment, however this looked at direct investment in real estate which is not the only option that is on the table.
An alternative way to get exposure to the real estate market is by investing in a Real Estate Investment Trust, or REIT.
REITs are essentially a collective investment in real estate that is owned by the REIT shareholders and the income generated by the properties is distributed among the shareholders.
First let’s take a step back and think about how a direct investing into real estate works:
- Imagine we have an investor, George, who has $200k in cash and wants to make a direct investment in real estate.
- George purchases an apartment for $200k and rents it out to a tenant for $12k a year.
- Each month, George gets $1,000 in rental income from his tenant.
- After 1 year, George sells the apartment for $220k.
George’s investment in real estate has returned him $22,000 ($12k in rent + $20k in capital gains)
This is a very straight forward, and easy to understand, investment in real estate.
What many people find comforting about real estate is that you can see and touch your investment property, and you can fully understand the stream of revenue it produces (the rental income).
Equally, many people of our parents generation have purchased their real estate many years ago and watched the price of the property sky rocket.
However, the many downsides to direct real estate purchases can be off-putting for many investors (maintenance, insurance, property management, illiquid asset, etc)
Equally, a direct investment in property is not possible with a small investable amount as a single property will cost in the hundreds of thousands of dollars. This means any investor would either have to deploy a large volume of money or take out a mortgage and borrow a substantial amount of money.
Both of the above issues make direct investment in real estate unappealing, but what if you want exposure to the real estate market without investing hundreds of thousands of dollars into a property?
Real Estate Investment Trusts
In this scenario, a Real Estate Investment Trust (REIT) is a great investment option that is available.
A REIT is essentially a collective pool of investors that own a portfolio of properties and share the returns on that investment. The fund issues shares and trades on a public exchange, just like and ETF, and can be bought directly from your brokerage account as you would any other fund or stock.
Typically a REIT is required to pay out 90% of the rental income to shareholders, keeping 10% for management of the properties, etc.
- An example REIT will offer shares to investors at $10 a share, and sell 1 million shares.
- With the raised money ($10 million) the REIT will purchase 20 properties @ $500k each.
- Each property is rented out and earns $20k/year in rental income.
- $360k ($400k – 10%) is distributed to investors in the form of dividends.
So in the above example, we can work out the numbers as follows:
- $10 per share
- $360k in dividends per year
- $360k divided by 1 million shares = $0.36 per share
- $0.36 divided by $10 = 3.6% yield.
By establishing the investment trust, an investor can buy in to the investment for a low price (in the example above, as little as $10 for a single share) and still benefit from the growth of the real estate market and gain rental income.
In addition, investing via a REIT has the benefit of being more diversified than direct real estate purchase, insofar that the investor owns a share of multiple properties (in the example above, 20 properties) rather than a single property.
This greatly reduces the unsystematic risk, such as having a property flood, or burn down, etc…
Furthermore, the diversification reduces the impact of having a property lying vacant.
If you are invested directly into one property, then having that property vacant results in a 100% loss of rental income.
With the diversification of your investment over numerous properties, a single property being vacant will have a very negligible impact on your rental income.
In the example above, a single vacant property would represent a 5% reduction in your rental income, but in reality big REIT’s hold thousands of properties withing the portfolio and as such the impact of a single unoccupied property would be <1%.
Another important benefit of investing in real estate through a REIT is the possibility to have your investment diversified over multiple markets, either nationally or internationally.
There are many globally diversified REIT’s that trade as ETF’s and are very well diversified internationally.
A particular favourite of mine, and part of my own portfolio, is IWDP from iShares which has a very broad international diversification across: United States, Hong Kong, Australia, Japan, and many more…
This global diversification protects investors from any downturn in a national real estate market.
If, for example, the real estate market in United Kingdom were to crash then the impact would be less than the impact of being directly invested in property in the UK, as the diversification of the holdings would limit your exposure to the downturn.
However, the same is also true of a booming market. The diversification of the portfolio will limit the returns that your investment would see, in comparison with being directly invested into a booming real estate market.
Equally, one could choose to invest in a REIT that specifically covers a specific market.
For example, if you were looking for exposure to the real estate market in the United Arab Emirates, a good choice would be to invest in the Emirates REIT which owns several properties in and around Dubai.
Finally, one of the other big advantages of a Real Estate Investment Trust is the liquidity of your investment vs direct property ownership.
a REIT that is traded on an exchange as an Exchange Traded Fund gives the investor the ability to buy and sell his or her investment whenever the markets are open.
This makes the asset highly liquid and it can be liquidated instantly, at the current market price, unlike the time and regulation that is required to sell a property.
This allows any investor to increase or decrease his or her exposure to the real estate market very quickly with very low costs (trade commissions) as and when they choose.
So there we have it, REIT’s present a great opportunity to invest in real estate markets without taking the route of direct investment into a property.
More information, and a great video explanation, on this topic can be see over at Investopedia
Disclosure: Long IWDP
Cover photo: Emmanuel Cole