REITs -- Passive Income Opportunities for Your Portfolio
But not a substitute for physical real estate investment
Real Estate Investment Trusts ("REITs") were born in the United States in the 1960s, aiming to democratise real estate investment. Since then, REITs have mushroomed globally and are prevalent in over 40 countries.
REITs, listed on global stock exchanges, offer investors a simple way to participate in large-scale real estate investments and earn passive income from the underlying properties.
Below, we explain the intricacies of REITs and their advantages and disadvantages.
Introduction to REITS
A REIT is a company that owns and operates income-generating real estate on behalf of shareholders. Properties owned by REITs can include office blocks, apartment buildings, warehouses, data centres or shopping centres. Hence, REITs are effectively funds that invest in physical real estate instead of financial assets such as equities and bonds.
One key appeal of REITs is that they are listed on stock exchanges, enabling investors to buy and sell shares quickly and cost-effectively.
Moreover, when investing in REITs, professional management takes care of all the management of the underlying properties. Rental income, less property and financing expenses, is distributed as dividends.
The REIT market
According to Nareit, there are over 900 listed REITs globally with a combined market capitalisation of over US$2.0 trillion (as of December 2023).
Below, we look at some examples of REITs worldwide and discuss some of the advantages and disadvantages of REIT investments and the associated risks.
Examples of listed REITs
Advantages of REITs
Low capital requirement: REITs allow investors to invest in real estate on a fractional basis with much smaller investment amounts than when directly investing in physical property.
Liquidity: REITs are listed on stock exchanges, allowing their shares to be bought and sold quickly and at relatively low costs.
Passive Income: REITs are required to distribute their rental income (less expenses) as dividends, providing investors with a source of regular distributions.
Scale: REITs' large scale provides tenant and location diversification. Additionally, REIT investors can access properties that may typically be out of reach for retail investors, such as shopping malls, warehouses, and data centres.
Professional management: REITs employ full-time professional management to oversee leasing, maintenance and accounting functions.
Diversification: REITs can benefit your portfolio, given a low-to-moderate correlation to other asset classes. The relatively stable income stream could also act as a buffer against volatility in other asset classes.
This is demonstrated in the table below, which compares the performance of different asset classes from 2020. (Note: the REIT performance reference an index of REITs listed in the United States.)
Analysing REITs
Below are some of the things you must consider when evaluating REITs:
Property Portfolio: Are the properties in desirable locations and of the appropriate type of assets for the current scenario?
Management Quality: Track record of the management in operating the properties transparently and efficiently. History of enhancing the value of the property portfolio and creating shareholder value.
Funds From Operation: This is a key metric for REITs and gives investors an idea of cash flow generation and the ability to support dividends.
Dividend Yield: The annual dividend payments divided by the current share price. Can be compared to other REITs and yields available on other income generating assets such as bonds
Net Asset Value (NAV): This is the estimated market value of a REIT's assets net of its liabilities. The NAV per share shows the value of the REIT's assets attributable to each outstanding share. Comparing the share price to the NAV per share can provide a key reading on its valuation.
Debt-to-Equity and Interest Coverage Ratios: The debt-to-equity (debt divided by equity) and interest coverage ratio (EBIT divided by interest expense) indicate the level of leverage risk for REITs.
RISK FACTORS:
For all the positives, investors in REITs need to consider the following factors:
REITs are listed equities, and hence, their prices could be volatile. Market prices may trade above or below the value of underlying property portfolios.
Investors in REITs do not have direct control over decisions regarding the management of the properties and portfolio changes.
REITs employ leverage to enhance property returns. However, when rental incomes are under pressure and/or interest rates are climbing, financial risks for REIT investors can increase.
Currency Risks: Investing in REITs that invest in overseas properties exposes investors to currency risks.
Agency and Governance Risks: As REITs are passive investments, investors rely on the appointed management to manage the properties efficiently and for the benefit of shareholders.
Investors should consider expense levels in REITs, including the managers' fees and interest costs.
Taxation: Investors must assess the tax implications of investing in REITs versus physical properties based on their circumstances.
In summary, REITs offer investors an indirect way to invest in real estate for income generation. However, REITs are equity investments and not direct physical property ownership, so they are subject to market, agency, and corporate governance risks.
Investors should consider REIT investments like other equity opportunities. This means keeping allocations to individual investments at reasonable levels and diversifying among different REITs.
For the above reasons, REITs should not be seen as a substitute for physical real estate ownership but as a potential allocation within an investment portfolio.
Disclaimer:
All content, information and opinions provided on Fincoaster are for informational and educational purposes only. Nothing contained herein is investment advice or recommendations. No guarantee is provided about the accuracy or completeness of the information provided. Readers should consult their financial advisers to ascertain the suitability of any investment.
Contributors to Fincoaster may, from time to time, have positions in any investments discussed.
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