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What’s the best way to invest in real estate?

Investing-Homes-Houses

Michael Missaghie,
Senior Portfolio Manager, Sentry Investments

Stance: Go REITs

If you’re not well versed in the risks and challenges of property ownership — and you’re contemplating exposure to real estate — REITs (real estate investment trusts) are a better choice.

Public Canadian REITs traditionally invest in commercial real estate and rental apartments. Commercial REITs own office, retail and/or industrial assets, leased to tenants for terms of five to 10 years. During periods of economic uncertainty, longer lease terms better protect cash flows and the value of assets.

Residential REITs invest in rental apartments with lease terms of about one year. They have little overlap with the condo markets as they compete in a lower rental bracket. This asset class is generally viewed as defensive because of historically stable occupancy levels, little new supply and CMHC financing.

Public versus private

Direct investment in real estate usually comes with headaches if you’re not used to managing assets. Maintenance is a time- and capital-intensive business. With REITs, you’re able to participate in the cash flow and long-term capital appreciation while having properties professionally managed. Management includes capital expenditures (both for maintenance and revenue growth) and tenant needs such as moving, leasing and rent collection.

REITs also provide you with a share of large, high-quality assets that would be difficult to acquire directly because of the capital required. Diversified across geography and asset class, REITs also let you diversify holdings, rather than own just one asset. Historically, REITs have exhibited more short-term volatility than private investments, but over time they more closely reflect the overall net asset value of the properties.

Over longer time horizons, REITs have provided relatively good long-term diversification. Between 1990 and 2012, REITs had a correlation of 0.45 with the S&P 500 over 24-month time periods. Over five-year periods, the correlation drops to approximately 0.10. Correlations have been more consistent with the general markets during periods of uncertainty, such as the financial crisis of 2008–2009, when it was closer to 1.

REITs aren’t designed to deliver outsized returns. They provide income and visible cash flow growth that compounds over time. With more than 60% of total returns historically coming from the monthly income REITs provide, this sector is ideal if you’re a buy-and-hold investor looking for tax-efficient monthly income and moderate cash flow growth.

Catherine Ann Marshall,
CFA, Vice-Chair, Toronto CFA alternative assets committee, former research director, CPP investment board

Stance: It depends

The decision depends on what safety means to you. If you want to control all decisions that can impact the performance of the investment, then you should invest directly. For instance, investing in a condominium unit gets you more involved. You make decisions about who to rent it to; what to charge; whether or not to increase the rent; and how to market the unit.

But while there’s more control over performance of the physical investment, the diversification is missing. An intermediate way to get exposure to real estate is to invest in a real estate fund of Canadian direct investments run by qualified investment managers. You’re diversified against the risk of any one market or property type, and the investment team works to minimize the risk of vacancy and borrowing rates.

If you want well-diversified portfolios of real estate — Canadian or global — you could invest in real estate securities focused on REITs. The only decision you’d need to make is when to buy and when to sell. You will, however, be exposing your investments to the volatility of the securities markets.

Multiple choices

Hard assets:

An investment in hard assets offers two choices: commercial or residential.

Commercial real estate makes more sense for institutional investors. The size of investments can run into millions of dollars.

Residential real estate falls on a carefree-to-complex continuum. A small condo unit is a carefree investment if you’re an average investor who knows very little about real estate. However, you must screen tenants because leases protect tenants more than landlords. If you don’t want that risk, you could consider using professional managers with experienced leasing teams.

A house is more complex and is best considered by handy investors with the business acumen and capital strength to withstand periods of vacancy. Multi-family units fall a notch higher in complexity; as soon as you exceed six units, you’re verging on commercial.

When supply and demand are in balance, real estate has always proven to be a safe and conservative investment. You could buy an average one-bedroom condo and do well. It’s riskier when there’s a surfeit of supply.

The moment your city’s skyline becomes dotted with cranes, it’s time to become cautious. You could make a good investment even during periods of high supply, but only if the unit offers something above the competition, such as three spacious bedrooms or a large, south-facing terrace.

Other funds:

Physical assets form a limited part of the overall investable real estate universe. Stocks and real estate products are other viable choices, and they include equity funds, private funds and real estate mutual funds.

For more on REITs and how to evaluate them, read more here.