Real Estate - Down, but Never Out

Observers of the recent housing bubble and the ensuing severe market downturn of 2008 may question the sanity of real estate as an investment possibility. Indeed, real estate has suffered a lot in the past year and the past five years, as seen in the bigger drop in the iShares REIT (Real Estate Investment Trust) ETF (TSX symbol: XRE) compared to the TSX Composite in these Google Finance chart.
One Year

Five Years

Real Estate Investing - what it isn't and what it is
Real estate for the online investor excludes the private individual residential housing which has fallen so mightily in the USA and to a lesser degree in some Canadian cities. Your own house may be an investment in part, though it is mainly a place to live, but there is no market or tradable securities for investing in people's private houses.

Similarly, the direct ownership and renting out of property as a business and an investment, while feasible and sometimes attractive for individuals, is beyond the scope of this blog's focus on online investing in securities.

Real estate investing for the online investor includes companies or funds that own and manage office buildings, shopping malls, industrial and commercial buildings, apartment buildings, hotels and nursing or retirement homes.

Why consider Real Estate in a portfolio?

• regular, high income - most companies in the sector give off monthly or quarterly cash distributions and sustainable yields from 5% to 12%
• tax-advantaged income - half or more of the distribution cash flow to the investor is made as a Return of Capital, which gives the investor two benefits: 1) it effectively defers tax until the investment is sold and; 2) the income is taxed as a capital gain
• possible capital gains - apart from the tax benefit, another form of capital gain may occur if the properties managed by the real estate company rise in value and that gets reflected in the price of the security
• diversification - real estate returns have a low correlation with stocks and fixed income / bonds, which means a portfolio kept in balance that includes all three types of assets will experience lower volatility without suffering lower returns (see Richard Ferri's book All About Assets Allocation for detailed explanations of past correlations and volatility reductions). The usual suggested allocation to REITs is about 5-10%.
  

Risks and Current Conditions

• risks - despite their objective to provide steady income, real estate companies have business risks too and it is necessary to be aware of them. Deloitte's fine The Canadian REIT Guide includes much useful info, especially the How to Evaluate a REIT on page 52.
  
• real estate values are depressed but Canada is faring better than the USA, according to an industry sentiment survey released by the Real Property Association of Canada in August 2009. Some companies have suspended distributions, such as Holloway did on July 21.
  

How to invest

• Individual Canadian Company REITs (Real Estate Investment Trust) - all companies are structured as income trusts to enable the tax benefits. Happily, REITs were specifically exempted from the federal government's decision to begin taxing income trusts as corporations in 2011, which means those benefits will continue. There are 24 such publicly traded REITs listed on the TSX, led by the dominant giant RioCan (TSX symbol: REI.UN) - see list with annual yields at Investcom.com)
• Closed-End Funds - there are a few CEFs containing a collection of REITs e.g. First Asset REIT Income Fund (symbol: RIT.UN) and Split REIT Opportunity Trust (symbol: SOT.UN)
• Exchange Traded Funds - the iShares Canada REIT Sector Index Fund (symbol: XRE) contains the 11 largest REITs in Canada); there is a much larger collection of US-traded funds covering US REITs and international real estate funds, providing further diversification opportunities - summary articles and groupings at Seeking Alpha's Real Estate ETFs.
  
• US REITs - There are over 100 REITs in the S&P US REIT index. Yields on US REITS are generally several percentage points lower than those of Canadian REITs. The National Association of REITs lists publicly traded US REITs. Canadians holding US REITs do not benefit from favorable tax rates on Canadian dividends and non-registered accounts will have US witholding tax levied by US authorities (see page 27 of KPMG's Taxation of REITs).
  

It is always difficult to know when a market bottom has been reached and market excesses have been wrung out but it is certain that REITs are a valuable and enduring element of the investing universe.