Real estate-without the bricks and mortar
In the process of building personal wealth, many Canadians contemplate whether they should invest in real estate beyond their personal residence. After all, from a historical perspective, real estate has proven to be one of the most reliable asset classes when it comes to building wealth over time. For those who are already invested in other assets, such as stocks and bonds, real estate can provide an excellent source of diversification.
Many people associate real estate primarily with owning a rental property of some sort. Yet owning the “bricks and mortar” directly comes with its own risks as well. Issues that property owners must address include the high cost of purchase, the ongoing upkeep of a property, potentially high levels of taxation and changing environmental laws that could add to the cost of ownership. Investors holding rental properties experience their own set of problems in the form of tenant conflicts and vacancies that have the potential to undermine cash flow and the overall return on the investment. In addition, real estate is not a very liquid investment and can sometimes take considerable time and effort to sell. Seen from this perspective, real estate can be considered “high maintenance,” which is why many forgo investing in property beyond their own home.
There are two ways to invest in real estate and avoid many of the downfalls associated with this asset class – publicly traded real estate companies and Real Estate Investment Trusts (REITs). REITs are a growing class of securities that trade like stocks within the global marketplace and can include underlying investments in income-producing real estate, such as apartments, shopping centres, offices and warehouses.
Because REITs trade like stocks, they are highly liquid investments that can be bought and sold with relative ease. They have much of the same investment potential as owning property directly, without the ongoing maintenance or associated costs, and they can provide a steady stream of tax-advantaged income that can help you fund your retirement years.
INCOME AND POTENTIAL LONG-TERM CAPITAL GROWTH
Perhaps one of the most attractive features of REITs is that they pay a regular stream of income. Due to their unique structure, a REIT must distribute 85 to 100 per cent of its earnings to unitholders annually, making it an attractive source of income. This income is tax-advantaged when compared to the cash flow generated from rental income, bonds, GICs and dividend-paying stock investments. In fact, a REIT was the only type of income trust that maintained its tax-advantaged status in Canada after the federal government revised the taxation of income trusts in October 2006.
From a capital gains perspective, REITs have also proven to be excellent investments over recent time periods. Their distinctive combination of long-term growth potential and regular income has led to strong returns and relatively low volatility when compared to growth-oriented asset classes, such as equities, in a low interest rate environment.
While past performance is not indicative of future returns, REITs have experienced healthy returns over the past decade. What’s more, with much of the Western world aging from a demographic perspective, the demand for securities that produce regular income and the potential for long-term capital growth are likely to grow.
AFTER-TAX INCOME COMPARISON
Factors that affect the price of real estate in Toronto are often quite different from factors that influence other markets, such as London, Tokyo or New York City. Beyond geographic diversification, REITs are also broadly diversified by economic sectors that include office buildings, hotels, apartment buildings, shopping centres and warehouses.
An additional reason for including REITs in your portfolio is their low correlation to other asset classes. In other words, global REITs tend to rise and fall in value at times that are different from stocks and bonds. So, incorporating REITs into your portfolio not only provides the potential to increase your returns, but may also reduce volatility over time.
A GROWING INVESTMENT OPPORTUNITY
REITs first made their appearance in the United States during the 1960s, and since that time they have become a global phenomenon. Yet UBS Investment Research estimates that only 11 per cent of the world’s real estate market has been made available for investment by retail investors, with the rest held by private investors.1 Nevertheless, the growing trend of countries adopting REIT-like structures and the tendency of certain types of privately held companies to convert to the REIT model suggest there may be many new, high-quality opportunities for investors in the future.
ARE REITS RIGHT FOR YOU?
It is important to note that REITs may not be appropriate for every type of investor. First of all, the income stream from a REIT is not guaranteed. Secondly, the performance of REITs can be highly cyclical in nature. For example, during times of low interest rates, REITs can perform very well.
In economic environments where interest rates are rising, REITs can underperform and may prove to be quite volatile. Furthermore, selecting the right type of REIT for your investment portfolio may be risky since you’ll be relying on the fortunes of a single company to generate a consistent and reliable income stream.
To help you avoid some of the potential pitfalls of investing in REITs, it would be prudent to consider investing in a mutual fund that specializes in selecting a portfolio of global REITs. A professional asset manager has the insight and research tools that are necessary to choose the companies with the best long-term prospects for success. Keep in mind that a REIT’s performance is highly influenced by local market conditions. Your investment may be subject to risks if you do not have the time or ability to research the various factors that affect individual real estate markets around the world. By relying on a professional asset manager to allocate and monitor a portfolio of REITs on your behalf, you can achieve instant diversification – and that can help smooth out your investment performance over time.
SPEAK TO YOUR ADVISOR
If you would like to take a closer look at the benefits of adding a mutual fund that specializes in global REITs to your investment portfolio, speak with your advisor. He or she will discuss the benefits and risks of REIT investing and help you determine which mutual fund might be the right choice for your personal situation. Only by examining your current portfolio in detail will your advisor be able to tell you if global REITs should play a role in your long-term financial plan.
FAST FACT: The global real estate market has grown internationally and is expected to reach a total market capitalization of US$1 trillion by 2010.2
1UBS Investment Research, June 2005
2FTSE, December 31, 2005
Content provided courtesy of Manulife Investments
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