Thursday, December 20, 2007

why no REITs

According to Wikipedia, a real estate investment trust or REIT is a tax designation for a corporation investing in real estate, that reduces or eliminates corporate income taxes. In return, REITs are required to distribute 90% of their income, which may be taxable in the hands of investors. The REIT structure was designed to provide a similar structure for investment in real estate as mutual funds provide for investment in stocks.

Why I Do Not Invest in REITS
The reason for my not investing in REITs is simple. As previously described, our house value already makes up about 73% of our total assets. We are grossly overweight in real estate investments already. Yes, we may live in our house for the time being, but that does not take away from the fact that it is a part of our asset mix. We could sell our home tomorrow and rent another house or condo.

When we borrowed the money to buy our house, we took out a loan in the form of a mortgage from a bank. Compared with our previous life experience with money, the dollar amount of this loan was overwhelming. Even though we had plans to live in our new house, which we do now, we made an extremely large investment in Brantford, Ontario, Canada residential real estate. I prefer not to add to my real estate investments (which already make up 73% of our total assets), by buying REITs. Similarly, if we were renting a condo and we had a $250,000 portfolio of stocks and mutual funds, I might consider adding some REITs or even buying a house.

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9 comments:

Jake said...

I have to disagree with you. There are many different types of REITs. Apartments, entertainment, storage, warehousing, etc. Also, these companies do purchase real estate, but their money comes from the rents. This is much different than your house. I have had very good success with REITs to date.


-Jake (The Dividend Investing Blog)

MG said...

jake, REITs are all real estate. Do you know of any REITs that are not involved in real esate?

I am not saying you might not have success wtih them. That is beside the point.

John said...

Yes, the majority of REITs are involved in real estate.

But it is also used to provide beneficial tax status for companies that are willing to pay out a large percentage of their profits as dividends. This is a requirement in order to maintain the REIT status, although I don't remember what the required percentage is.

Thornburg Mortgage and Capital Source are two companies that are structured as REITs even though they have nothing to do with owning or renting out real estate.

Because they pay so much of their earnings out as dividends, REITs (whether related to real estate or not) can be very attractive to income investors.

-John (Investing for Everyone)

pitz said...

Good logic MG, residential real estate directly competes with Commercial Real Estate for the same pool of materials, equipment, and labour for its construction. Logically, prices are fairly well correlated.

jake, past experience is not indicative of future experience. Further, REIT peddlers invent funny metrics to describe their businesses, and don't tend to conform to GAAP measurements. This was behaviour that typified the high tech sector back at the peak of its bubble.

Further jake, mg's house does pay rent -- its an imputed amount that is paid, tax free, every month, to mg. How can you call that any different from a REIT?

john, you taken a look at the P/E of REITs lately? There is no "E", so they aren't paying out earnings -- they are, over time, equity stripping the assets, in hope of future capital appreciation. Its pretty hard to see much capital appreciation occurring in commercial or residential RE since cash flows aren't even covering carrying costs anymore.

Sami said...

There are many classes to REITs that can vary from your home ownership and may have a place in a portfolio.

However, REITS investing is not like dividend investing. I am always weary of any business that derives its value from a tax structure or government given structure, as any change of government regulation to taxes can destroy my ownership.


Pitz, PE is not a useful tool for REIT valuation. you need to use P/FFO or AFFO as REITs write off a lot of depreciation on the properties they own. and they pay close to 80-90% of funds generated from operations. Some reits will issue equity or take debt to pay dividends but this is not indicative of all reits.

4Life said...

MG: You make an interesting observation in classifying your house as an investment. I have never thought of my house as an investment since the return is so lousy - I could never justify on paper buying the house that I own.

I do own REITs and classify them as real estate in my asset allocation model. However, I find they track more closely with the industry in which the operate, housing, health-care, et. al.

Best Wishes,
Dividends4Life

MG said...

Personally I do not think there is any doubt whether one's home is an investment. The return is irrelevant.

Your home is something major that you bought, which could be rented out, resold, etc. In my opinion, saying your home is not an investment is like saying that a rec. cottage is not an investment. If it is not an investment then what is it? Just a purchase that you made that can potentially be sold for a capital gain, and could potentially produce income in the form of rent....sounds like an investment to me...

pitz said...

"Pitz, PE is not a useful tool for REIT valuation."

Why not? Its a GAAP metric. Its provides for depreciation on the buildings, as buildings are assets that eventually wear out and require expensive maintenance.


you need to use P/FFO or AFFO as REITs write off a lot of depreciation on the properties they own.

So do traditional corporations. This doesn't mean we run out and use non-GAAP measures.


and they pay close to 80-90% of funds generated from operations.

Which is only sustainable if buildings continue to appreciate at unsustainable rates. Once the appreciation stops, then such amounts are completely unsustainable and represent a loss in value.

I'll stick to GAAP measures, thank you.

Sami said...

Pitz,
Who said P/E is a GAAP measure. It is a valuation multiple that accounting have no opinion on. Actually I do not like PE as a valuation measure at all as the earning side of it is open to manipulation by management within the GAAP rules.

And off course REITS account using GAAP. Any public company has to use GAAP to prepare its books. Distinguish between adjusting a valuation measure to the particular of the industry to GAAP accounting, and in this case FFO is just that making accommodation to a reality that REIts and non REITs real estate companies for that matter book so much depreciation that earnings are understated and almost meaningless.

as for as the payout, the appreciation of real estate does not play a factor. FFO does not contain gains on sale of properties. Actually FFO is as close to cash generated from operation as you can get, which in my opinion, all investor should use rather the "GAAP earnings".

what happen sometimes is REITs will have a shortage in cash flows or funds from operations that they will have a payout exceeding the 100%, which in turn finance by mortgaging their properties.