Proponents of investing in real estate directly, typically through limited partnerships, frequently contend that publicly traded real estate investment trusts (REITs) are too volatile, acting more like stocks than as real estate. Hence, these pundits contend, investors are better served by owning real estate assets directly.
There is no question that publicly traded Canadian REITs have volatility similar to that of stocks. From January 1998 to July 2015, the S&P/TSX capped REIT index (symbol: SPREIT) had volatility (as measured by annualized standard deviation) of 16.3% – slightly less than the S&P/TSX composite index’s volatility of 16.6%. However, there was nothing stock-like about the returns of REITs. The annualized return of SPREIT was 11.5%, far ahead of the 6.9% of Canadian stocks.
The long-term return of SPREIT was driven by the performance of its underlying real estate. During the 17 years ended Dec. 31, 2014, the annualized return of the REALpac/IPD Canada quarterly property index (which measures direct commercial real estate returns from 2,351 institutional-grade properties across Canada collectively valued at $124.8 billion) was 11.2%, slightly less than the 11.7% return of SPREIT.
These returns are consistent with the findings of several academic studies. REIT returns, dominated by stock market influences in the short term, are most influenced by real estate market dynamics in the longer term. This is a critical finding for long-term investors, particularly those looking to fund their retirement. Many of the benefits that pension plans pursue in adding direct real estate holdings to their portfolios – long-life assets matched to long-term liabilities; an inflation hedge; and stable, growing cash flows – are available to REIT investors.
REITs also have advantages over direct real estate. Volatility is a disadvantage, but it also brings the offsetting plus of liquidity, which reduces transaction costs and allows ease of portfolio rebalancing. At certain times, such as today, volatility creates excellent buying opportunities because REITs can trade significantly below the value of their underlying real estate.
The broad assortment of REITs available in Canada allows geographical, sector (office, industrial, retail, residential) and management diversification. Contrast this with the concentration risk typically associated with real estate investment funds that often focus on a single sector and/or region with a single manager. Direct investors who lost properties to mortgage foreclosures in Alberta in the 1980s energy bust can attest to the value of diversification.
REITs also allow Canadians to invest in global real estate. An increasing number of Canadian REITs focus on the U.S. or even Europe.
Direct real estate investing has its advantages: the ability to focus on distressed markets, execute unique strategies, as well as greater control over leverage and tax deferral. Direct investing also offers lower volatility – although research has found that part of this is an illusion created by appraisal smoothing.
For most investors, however, REITs are a practical answer for efficiently building the diversified real estate component of a multiple asset-class portfolio.
Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office and investment-counselling firm. The company, its principals, employees and clients may own the securities mentioned herein.
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