A lot of financial planning models say that you should have 5% of your portfolio in Real Estate Income Trusts. Recent thoughts are to increase it to between 15 and 20% of your investment portfolio. Why? Well, REITs have a history of out performing the stock market in general. The FTST Nareit All REIT Index has beaten the S&P 500 in 17 of 25 years. Additionally, real estate holdings tend to do well when the economy is expanding, so there is a fairly strong correlation between an increasing stock market and increasing REIT prices.
Intuitively, it would make sense to split some of your portfolio exposure between a number of sectors. Investing in real estate, beyond your personal residence, can be a capital intensive, illiquid endeavour. By investing in shares of REITs, you can have investments in commercial real estate without having to go out and buy an apartment building. As an added bonus, the duty of fielding the midnight calls from tenants falls to someone else.
Let’s compare the liquidity of a traditional rental property to that of a REIT.
Buying and selling commercial property is similar to, but more expensive than, buying and selling real estate as a principal residence.
Commissions
All real estate commissions are negotiable, but the seller can expect to pay the real estate broker between 4 and 6% of the sale price.
Costs
There are fewer state and federal protections when selling a commercial property compared to selling a residential property. Because of this, the cost of due diligence is much higher in buying and selling a commercial property.
Assessing the value of the property is relatively straight forward in a residential property sale. There is likely a history of sales of comparable homes in the area in which an assessor can compare purchase prices.
With commercial real estate, there likely aren’t going to be as many comparable property sales to judge value. Additionally, because much of the value of a commercial property comes from the profit that one is likely to derive from it, the cost of the property will be based, in large part, on the income producing potential of it. Determining the income of a property for the purposes of a sale, from unaudited financial statements becomes an exercise in verification of the information. Going through leases with a fine-toothed comb is vitally important to the sale of a commercial building. Clauses found within leases with commercial tenants can have a material impact on the new buyer. Determining the payment history of current tenants will help the buyer create their cash flow projections and give an idea of the risk that they will be subjecting themselves to. Doing this research will take time, and can have a considerable cost to both the buyer and seller of the property.
Physical due diligence is another area in which a residential property is typically more straightforward than a commercial property. If you’re buying a house, you can hire a home inspector at a cost of a few hundred dollars. They’ll inspect the property and produce a report that will highlight some of the potential concerns that the new owner may have to deal with. In a commercial property, there could be hundreds of units to inspect. There will be a cost to inspecting each unit as well as the physical infrastructure of the building. An environmental assessment will be required to ensure that the new buyer will be limiting their exposure to risk to liabilities due to changes in construction standards (lead paint, asbestos, wetlands impacts, etc.) or previous uses of the property (underground tanks, soil contamination, etc.). Limiting liability and getting an accurate as possible picture of the property is not a simple endeavour and will increase the time that it will take to close the property and increase the costs associated with it.
Taxes
The sale of a commercial property is subject to capital gains taxes based on the adjust cost basis of the building (simplified, it’s the cost of purchase less the amount that the owner has depreciated the building) and the newly agreed upon sale price. The capital gains rate changes based on your income (or the income of your household). Additionally, the length of time that you hold an asset can have an impact on the capital gains that are due. If you’re selling a commercial building and buying one of the same asset class, you may not have to pay capital gains taxes. Practically, this means that engaging the services of a good accountant is an important step in the sale of a commercial property.
Real estate transfer taxes vary by state, but can be upwards of 1.5% of the sale price of the property.
Depending on the complexity of the property sale, closing costs vary, but can be as high as 10% of the sale price of the property. Added to realtor fees, the cost of closing the sale could reach 15%.
The costs associated with selling a commercial property, as well as the potential difficulty in finding a qualified purchaser, mean that it can be a tremendously illiquid asset.
As a comparison, buying shares in a REIT takes much less time and costs are reduced enormously. Buying shares in a publicly traded REIT will incur you broker fees. Discount brokerages can charge as low as $5 per trade with account maintenance fees of 0.5%. With an average daily sales volume of $7.5 billion in September 2017, finding a willing purchaser of shares in a REIT will likely be a fairly smooth process.
The cost of buying and selling shares in a REIT, and the share sales volume in the industry, mean that it is comparatively an extremely liquid investment.
Diversification
Creating a portfolio that is properly diversified will help to mitigate risks and ensure that your portfolio has a proper asset allocation. It is important on the macro level, making sure that your portfolio isn’t weighted too heavily towards any sector or class of investments. It is equally important on the micro level, making sure that each class of investments isn’t too heavily weighted in any one sector towards any one investment.
The three main classes of assets are stocks, bonds, and cash. Consider an investor with a high-risk tolerance, and a longer time horizon. Their most appropriate portfolio would be more heavily weighted towards stocks (or equities). They would have some exposure in bonds (or fixed income) and cash as well. An aggressive investor would aim for holding 65-70% of their portfolio in equities, 20 – 25% in fixed income, and 5 – 10% in cash or cash equivalents.
Conversely, an investor that has a lower risk tolerance, with a shorter time horizon will want to be more conservative in their investments. A conservative investor would have different asset allocation goals. They would aim for holding 65-70% of their portfolio in fixed income, 15-20% in equities, and the remainder, 5-10% in cash or cash equivalents.
Monitoring the portfolio is an important job because there is a natural tendency for equity investments to grow more quickly than fixed income or cash. Without rebalancing a portfolio, or selling some investments in an investment class to buy investments in another class, a conservative asset allocation will become more exposed to equity than is optimal.
The challenge that an investor who holds most of their equity investments in physical properties has is that rebalancing a portfolio means selling buildings. Because of the illiquidity of the investment, there can be a significant lag, and a significant cost, in selling assets to maintain your ideal asset allocation.
REITs share characteristics with both equity and fixed income investments. Because of the requirement to pay out 90% of their earnings, they create an income stream. Because they can be traded on the stock market, they can have swings in value that affect the capital that you hold in them.
On a micro level, a savvy investor will not want to hold all their investments in one investment class in a few investments. Holding all their equity investments in one company has more risk exposure than holding all their equity investments in a number of stocks, in a number of industries, across a number of different geographical areas. Similarly, holding all of their fixed income investments in one bond would be less ideal than spreading the risk across many different fixed income instruments.
An investor can conclude that some of their holdings should be found in real estate. In order to ensure that their real estate holdings are diversified, optimally, they would be looking to have holdings in real estate in a number of different sectors, in a number of different areas, that are used in a number of different industries. Ensuring that an investor’s real estate holdings are properly diversified is an expensive and illiquid endeavour. The average investor simply does not have enough capital to have a properly diversified real estate sub-sector in their portfolio. The cost of commercial properties, especially blue-chip ones, means that owing enough individual properties to spread risk will crowd other sub-sectors of their portfolio out.
Mutual funds became an average investor’s answer to diversifying their portfolio without a large capital stock. Comparably, REITs have become an average investor’s answer to having commercial real estate holdings that can be spread across many physical buildings, across many industries, and across many geographical areas.
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Tax Benefits
REITs are tax advantaged in several ways.
Their distributions are spread between ordinary income, long term capital gains, and return of capital. Ordinary income is taxed at an investor’s marginal tax rate. Long term capital gains are taxed at a lower rate than ordinary income. Return of capital isn’t taxed at all. It’s important to note that the return of capital portion of a REIT’s distribution doesn’t mean that your investment is dwindling. Rather, it comes largely from the depreciation of the assets held in the REIT. As a practical matter, it’s an accounting measure rather than an actual decline in the value of the property.
The fluctuation in the value of the investments can lead to capital gains and losses. If an investor holds an investment for more than a year, appreciation becomes a long-term capital gain and is taxed at a lower rate than ordinary income. Conversely, if the value of the shares in the REIT drop, selling them will lead to a capital loss. Those capital losses can be used to offset other gains. A strategy of tax loss harvesting can help reduce the taxes that an investor owes the government.
REITs are an eligible investment in Roth IRAs. It means that the investor is purchasing shares in the REIT out of after tax dollars, but by holding REIT investments in a Roth IRA, the income that is derived from the investment, and the capital gains, would flow to the investor tax free.
At the REIT level, generally speaking, as long as they distribute over 90% of the income that is generated to shareholders, they are not taxed. As far as the IRS is concerned, the only taxes that are due come from the investors that hold shares in the REIT. A traditional company that issues a dividend leads to taxes being applied twice. The corporation pays taxes on their earnings and then the investor pays taxes on the dividends that they receive from those already taxed earnings.
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Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
Hi Gavin,
Great article! The section on IRAs apply to the USA environment. Those investment vehicles are somewhat different in Australia and as far as I am aware not available in New Zealand. If they are, let me know.
Australia doesn’t really have any REITs, maybe a couple of small ones, not sure about NZ. All the tax details in the article are US specific, so you would need to check the local rules. You can invest in US REITs through Interactive Brokers.