Monday, 27 October 2014

Ins and Outs of Managing Your Own Portfolio of REITs

As we mentioned a couple of posts ago when we started looking at Canadian REITs again, it is quite feasible for an investor to build a reasonably diversified portfolio of individual holdings instead of buying an ETF. There are several possible reasons to do this: 1) to save the ETF's fees known as the Management Expense Ratio, which get charged year after year, while the investor pays nothing for direct holdings; 2) to be able to customize the companies and/or weights of the portfolio holdings. There are various factors to consider, pro and con. The factors inter-act and the matter becomes a balancing act. Disclosure: this blogger has been wrestling directly with many of the issues, having taken the step of selling his REIT ETFs in 2013 and buying individual REITs instead at that time.

A minimum allocation to REITs of about $25,000
We don't believe it is worthwhile to start buying individual REITs unless there is a fairly substantial sum available. It's really something to consider for larger portfolios of around $125,000 or more, i.e. 10% to 20% of a total balanced portfolio like the Smart Beta or Swensen Seven). Why so?

Cost, for starters. The 0.39% annual MER of the lowest cost ETF from Vanguard (TSX symbol: VRE) on $25,000 is about $98 per year, which is the same cost as 9 trades at $10 each once a year to keep the portfolio in balance if 9 REITs are individually owned. MER is an unavoidable annual cost in an ETF. On the other hand, the DIY investor holding REITs directly pays a one time initial trading commission and then has the opportunity to control further costs for rebalancing, reinvestment and other purchases or sales.

There is a trade-off between the single trade for an ETF to rebalance with the total portfolio once a year versus the multiple trades for a collection of REITs. Stingy Investor provides a free calculator to compare the cost of owning ETFs versus individual stocks for a whole range of sectors, including the iShares REIT (Symbol: XRE). The tool demonstrates, using the higher 0.6% MER of XRE, that longer holding periods, less frequent trading and larger portfolios favour holding individual REITs over the ETF. Note that the tool's selection box titled Dividend Reinvestment really represents the cost of trading commissions of any kind, whether for reinvestment, rebalancing or purchases/sales of units. Most of the REITs offer a free dividend reinvestment program (DRIP), as our comparison table below shows. For that reason, we suggest entering "1" in the "Dividend Reinvestment" box to represent a single annual rebalancing trade, which is the base case frequency advice for managing a portfolio (see our rebalancing post).

An investor (such as retired person) who intends to simply buy and hold REITs, receiving the cash distributions to spend and not to reinvest, nor to do any rebalancing, in other words to do no trading and therefore not incur any commissions, will save the MER every year. The savings on avoided MER really add up over time as Stingy's tool shows.

Reducing individual company risk to achieve diversification
The more companies held, the less the investor's fortunes, good or bad, are determined by any single REIT. Our table below shows that anywhere from five to eight REITs are required to replicate about 50% of the weight of the three main REIT ETFs. BMO's ETF with symbol ZRE requires more due to its scheme of equally weighting all holdings. 75% replication requires eight (for XRE) to thirteen holdings (for ZRE). For the investor who is only trying to mimic the ETF and isn't trying to assess and select the best REITs (as we took a stab at doing last week with considerable time and effort) we believe the 75% replication level is preferable.

Broader coverage of the various REIT sectors results from more companies and higher replication e.g. with 50% replication the cap-weighted XRE and VRE do not include any apartment REITs like Canadian Apartment Properties (CAR.UN) and Boardwalk (BEI.UN), but at 75% replication they are included.
(click to enlarge image)

The diversification vs cost and complexity trade-off
There is a trade-off - as the number of REITs and diversification rises, which is good, the trading costs and complexity of rebalancing rise too. With more holdings each individual holding is smaller, and rebalancing trades can involve quite small amounts - e.g. a 13-holding equally weighted $25k portfolio mimicking ZRE would hold 100%/13 = 7.7% in each, or $1900 for each one.

On top of that, a $1900 holding yielding 6% annually, or 0.5% on the monthly basis that all the REITs use for payout frequency, gives only $9.50 per month, which is insufficient to buy a single share unit of all but one of the REITs. Thus, too many REITs with too small a monthly distribution means being unable to take advantage of the commission-free DRIP. At prevailing yields and unit share prices, it takes a holding of around $6000 to receive enough to buy at least one share on the monthly DRIP. That's another reason we think the minimum overall REIT allocation needs to be at least $25,000. Of course, investors who merely want to receive and spend the distributions need not worry about missing out on the free DRIP.

Strategy for company selection and weighting - cap-weighted or equal weight, or maybe one's own?
It is important to have a strategy, otherwise you will not manage the portfolio, it will manage you.

Cap-weighting is the traditional standard method and requires the least effort to manage. It is only necessary to swap in or out the lowest weight REIT holding every year, or on whatever rebalancing schedule is chosen. For instance, cap-weighted XRE is reviewed quarterly by iShares but a less frequent semi-annual or annual trade would likely suffice. We do have a concern about cap-weighting - too much concentration. The largest holding RioCan is already a hefty 19% in XRE and adjusting its weight in proportion for only eight holdings boosts that to 26% (see table above for weights and dollar amounts of each REIT for 75% replication of XRE).

Equal weighting spreads company risk evenly but more stocks are needed to reproduce the same proportion of the ZRE ETF that has adopted that strategy. The biggest challenge with equal weighting is deciding how often to do rebalancing trades. As soon as they are purchased the REITs' market prices start heading in opposite directions. Quarterly rebalancing is too often. Even ZRE only rebalances twice a year. We feel that annual rebalancing is sufficient for the individual investor, a trade-off between accuracy, cost and effort.

As DIY investors we can of course do whatever we want. We can select the best looking stocks with methods such as we used in our post last week on the individual REITs. We decided that Artis REIT fell into the less attractive group because it had net losses in two of the last five years, yet mechanically taking the top holdings of ZRE would see it included in a 75% replication portfolio. Deciding to drop it or include it or any other becomes a challenge of stock selection. As investors we would therefore be obliged to become analysts, with the extra time and effort initially and on-going, as well as the uncertain success such an approach entails.

Flexibility to take advantage of DRIPs, discounts, SPPs, tax loss selling
The DIY investor in the process of building up investments can also focus his/her portfolio on REITs with worthwhile additional features. The majority of the big REITs offer plans to reinvest distributions in additional units for no cost (called a DRIP - Dividend ReInvestment Plan). One that does not is Boardwalk.

Some offer attractive cash discounts on the purchase of DRIP units, such as RioCan, H&R, Canadian Real Estate REIT and Calloway. Yet others offer plans that give bonus units when the investor DRIPs, though the size of holding required to get even one share at a discount can be very substantial, as our table below shows. ETFs do not participate in the REITs' DRIP discount or bonus plans - the ETFs' DRIPs merely buy shares on the market. An ETF REIT investor therefore loses that benefit.

Many of the big REITs also offer Stock Purchase Plans (SPP), which allow the investor to periodically buy more units for no commission. Canadian DRIP maintains handy lists of all the DRIP and SPP details, like SPP minimum purchase amounts and allowed frequency of extra purchases. The following table summarizes the DRIP and SPP offerings of the top REITs.
(click to enlarge)

Investors holding REITs in taxable accounts can also more easily take advantage of tax loss selling (see our post on this topic) when holding a number of individual REITs. Chances are, some REIT will have a price decline even when the sector is swinging up. A downside is that there is a multiplication of book-keeping required for multiple individual REITs versus an ETF in a taxable account. All the REITs distribute a lot of Return of Capital (ROC), which is not taxable in the year of receipt, being in effect deferred capital gains. On-going yearly ROC means careful time and effort to properly track Adjusted Cost Base (ACB; see also our ever-popular post on ROC). It may be worthwhile to use a pay service such as ACB Tracking Inc to help do it correctly.

Psychological challenge of on-going portfolio management
Managing a portfolio is not just mechanical effort. There is considerable effort of discipline, both to not do anything or to actually go ahead and do whatever one's intended strategy requires. The stock market is good at inducing mind tricks - "Yes, I know my strategy is to rebalance to equal weights per the ETF now but this REIT has had several bad quarters, its price is way down and the analyst commentary and recommendations are negative. Should I not sell out and buy another REIT instead of buying more? Besides, it's only a few hundred dollars rebalancing amount, it isn't worth the commission." Before we know it, our own strategy rules are not fixed but arbitrary.

Bottom line: Buying and holding a portfolio of individual REITs instead of an ETF offers the potential for appreciable cost savings and flexibility for those with at least $25k to invest in REITs. However, it requires extra time, effort and discipline.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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