REITs right for you?

Real estate transactions have been recorded long before financial markets were created. So, individuals have experience in buying and selling real estate well before understanding stocks and bonds. But investing in real estate needs large capital, making it difficult for many to invest directly in properties. Here, we discuss whether REITs (Real Estate Investment Trusts) are an optimal alternative to direct real estate investments.

The trade-offs

There is an emotional satisfaction of owning a physical asset. You can also continually raise rent to keep pace with inflation. The flipside is this investment is lumpy and illiquid. If you are a working executive, investment portability is crucial. This means the ability to move investments when you relocate for work-related reasons. For these reasons, it is worth considering REITs as an alternative to direct real-estate investments.

REITs are like mutual funds that invest only in real estate. They primarily earn rental income and pass on the income to unitholders every year. REITs are required to distribute 90% of the net distributable cash flows (NDCF) to its unitholders at least twice a year; NDCF refers to cash flows after deducting operating expenses and taxes. REITs can, hence, provide stable income to unitholders, assuming they have consistent occupancy rates. Importantly, the investment size in REITs is small. You can buy one unit of a REIT through a trading account. So, REITs convert lumpy illiquid investment into an affordable liquid asset. You must, however, be mindful of two factors before investing. One, REITs are not a direct bet on real estate as they are listed securities. So, they can fall in price when stock markets tank even if rental incomes are consistent or even if there is a robust demand for rental properties. Two, REITs can’t provide significant capital appreciation as they cannot significantly expand property portfolio as they distribute 90% of NDCF to unitholders annually.

Conclusion

Direct investment in land helps in generating capital appreciation whereas investment properties primarily provide rental income. You can consider REITs as an optimal alternative to rental properties, as they can provide stable income. Note REITs investing in commercial properties can have higher cash flow volatility than income earned from direct investment in residential properties. That said, before investing, you must analyse the portfolio of properties REITs hold, geographic mix, occupancy rates and past distributions.

(The author offers training programmes for individuals to manage their personal investments)