Wednesday, 16 January 2013 19:29

Four Risks to investing in REITs

Written by  Dennis Mitchell
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Real Estate Investment Trusts (REITs) are all the rage with investors looking to diversify their portfolios in a rocky market. But are they necessarily a safer bet than the good old buy-a-property-and-rent-it-out approach?

CREW caught up with Executive VP for Sentry Investments Dennis Mitchell for his list of four risks to weigh before investing in REITS.  

1.    Interest rates. When you’re talking about the risks of investing in REITS, everyone focuses on interest rates and that is appropriate, however interest rates impact everybody. Interest rates are valid, but people seem to be hyper-focused on them when it comes to REITs, and I always make the example that most people have mortgages on homes, and nobody cares about mortgage rates until their mortgage is about to renew.

So extending that concept to REITs, it’s not as if all their debt matures every year. People who are concerned about interest rates and cost of debt going up have to be cognizant that only 8 per cent to 10 per cent of a REIT’s debt matures in any one year. In times like this when interest rates are exceptionally low, most REITs extend the duration of their debt so that when rates do go up next year or the year after, they don’t have to worry for seven to 10 years instead of five to six. So while the real estate hang-up is valid, it’s not nearly as cataclysmic as people make it out to be.

2.    Recession. The bigger risk that I see is recession. When you go into a recessionary time period, the demand for commercial real estate shrinks. And the reason is because companies start to reduce their headcount with layoffs. When their lease expires, if you’ve lopped off 20 per cent of your workforce, you don’t need as much space so you give it back.

Companies that go bankrupt in a recession don’t occupy any of the space that they were in previously. Occupancies start to come down, rents start to come down and cash flow of the REITs start to come down. That is the bigger risk we see, especially when you talk about North America growing at 2 per cent on an annualized basis.

3.    Confusion. A lot of risk comes down to the fact that real estate is a specific sector that people don’t understand a lot about. I still have a lot of people talking to me about earnings, which are completely irrelevant when it comes to a REIT. And the reason I say that is this: we’re not talking about something that you just compare between one company and another. Let’s say you have a capital intensive business, for example, a newspaper.

Those printing presses are only going to print so many copies before they have to be replaced. There, the earnings matter, because depreciation is real. But when you’re talking about real estate, say it cost $1 billion to build the office block I’m in right now. Forty years from now I’m going to carry it on my books at $0, but in reality it’s probably going to be worth $1.5 billion to $1.6 billion. So with the newspaper business, you’re appreciating assets that depreciate in value. In real estate, you’re depreciating assets that appreciate in value. So if you try to compare the earnings of those two companies, the newspaper has better earnings quality.

The earnings more accurately reflect cash flow. On the real estate side, the earnings have no resemblance to cash flow. So using earnings to value that business is completely useless. So that’s why I say a lot of people are looking at the wrong metrics, they don’t know how to value these businesses. They think they do, because real estate is pretty simple. But in terms of the actual accounting, people have to understand that adjusted funds from operations are what matters. That metric – we call it free cash flow – is an earnings metric that’s unique to real estate, and it more accurately captures the earning power of a REIT then does traditional cap earnings.

4.    Tunnel vision. People get caught up in what sector or what geography, but really if you do a subjective analysis of Canadian REITs, what you’ll find is the best performing REITs are not lumped in one sector or geographical area. What we use to determine if a REIT is a quality REIT or not is the MAPL Strategy: management, assets, payout ratio and leverage. For management, you’re looking for a team that has a measurable track record, and then management decides the other three.

The assets are what they are – you either own quality assets in core markets, or you don’t. For payout ratio, if you’re paying out more than you generate in free cash flow, it’s unsustainable. And if your leverage is too high, you can’t be supported by the baseline cash flow of the business and you’re going to run into troubles, either payout or bankruptcy. Those are the metrics we use to evaluate a successful REIT.

Last modified on Tuesday, 22 January 2013 10:16

2 comments

  • Rosemarie Beresford Wednesday, 20 February 2013 13:11 posted by Rosemarie Beresford

    How can one find a quality Management Team for a REIT and in which, private or public REIT sector, is there most choice?

    Also how is an individual investor placing their money, is it a one-time investment, or are funds invested periodically, and what determines the process? Are private REITS purchased freely, that is, as a retail investor, not with a broker of Investment company? How is this done?

  • Brampton-Homes Monday, 04 February 2013 01:42 posted by Brampton-Homes

    This is extremely well thought out. Definitely gives people something to think about in terms of real estate investments.

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