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Real Estate Investment Trusts: An Innovation in Irish Property Investing
Investing directly in physical property has been the more popular way for people to employ their savings in Ireland and most likely because it's an easier investment to understand. But, as we learned during the country's banking and fiscal crises, direct property investing has above-average risks: over-concentration in just one asset, the requirement for high borrowing levels in most instances, and low liquidity can lead to a permanent loss even if an investor is careful and has studied the risks involved.
However, following the introduction of REIT legislation in Ireland in 2013, there is now a way for investors to invest in properties in Ireland while mitigating these particular risks.
The aim of this article is to explain to investors what REITs are, how they better control some of the major risks in property investing, and why we have a preference for investing in REITs over, say, direct (i.e. physical) property or the open-ended unit-linked funds that are invested in property available from Irish life assurers.
What are REITs?
REITs, or real estate investment trusts, are investment companies set up by legislation to invest in property. They are listed on stock exchanges and, in exchange for complying with requirements governing use of rental income, borrowings, and investments, they are exempt from corporation tax.
REITs are a particularly useful way of gaining exposure to property and, to our minds, there are a number of advantages to investing in REITs that are listed on stock markets: (i) diversification; (ii) low administration needs; (iii) access to leverage or borrowings; and (iv) liquidity.
Diversification - or, more specifically, lack of it - can be a significant risk for investors. By concentrating all of their eggs in one basket, investors can expose themselves to the possibility of something going wrong with that particular asset, and the risk of this happening can only be controlled by having a sophisticated understanding of the asset class in question: something retail investors often don't have the time to acquire.
While this lesson is well-heeded when buying shares in the stock market, investors often ignore this advice when investing in property. REITs are, we feel, a very adequate solution to the problem of how to diversify within property; the table on the right, which shows how many properties the three listed Irish REITs each own, demonstrates this point clearly.
For an investor who invests even a small sum (say €1,000 into each REIT), they can gain diversified exposure to a portfolio of properties spread across office, retail, industrial, residential and development sites for very little effort and at minimal cost. As such, an investor's risk is spread across five different sectors of the Irish property market.
In addition, the REITs can be bought in small lots which compares positively to direct property investing, where an investor needs to make a large upfront investment. With REITs, an investor can build up a significant property portfolio brick by brick over time, rather than having to make a large lump-sum investment at a single point in time.
Ease of Administration
Anyone who owns property can attest to the onerous hours that need to be put in in order to maintain an apartment - sourcing tenants, repairs, dealing with letting and service agents, taxes, etc. With REITs, the properties don't have to be maintained or managed as this is all looked after by the REIT's management team. Moreover, REIT managers can use their scale to reduce the total costs that are needed to maintain properties which is beneficial for property owners overall.
(To be fair, unit-linked funds also have this advantage, but they lack the gearing or liquidity that the REITs offer as we discuss below.)
The use of borrowings to magnify returns is another attractive element REITs possess over unit-linked funds in particular which, due to their open-ended structure, are unsuitable for taking on debt. While investors can also typically borrow when buying physical property, borrowing within REITs is better controlled, in our view.
The main reason to use borrowings is to enhance returns for investors. However, borrowing also entails risks, including the fact that excessive debt can lead to a permanent loss even when there are no fundamental problems with the portfolio itself (as many investors in physical property found out in Ireland following the country's banking and fiscal crises in 2007/8).
The risks attached to borrowing are better controlled within REITs for two reasons:
- Borrowing is limited by legislation to 50% of total assets, which helps ensure that gearing levels aren't out of control.
- REIT managers, being experienced investors, should in theory be able to use gearing to enhance returns at attractive points in the property cycle which helps to minimise the risks that debt will be used at the wrong point in a cycle.
The final advantage that REITs have over direct property or unit-linked funds is that they are listed on stock exchanges, meaning that their shares can be traded at any point during the day. For investors who need fast access to cash, this is a particularly important quality.
Having listed shares also has its downsides: REITs are priced according to market whims, meaning that during market downturns investors may have to sell out at a discount to net asset value, and also that the share prices of REITs may decline heavily in a market selloff even if their property fundamentals don't change.
However, we feel that the benefits of liquidity outweigh the disadvantages - particularly if one is a long-term investor, whereby discounts or market declines are of smaller importance than buying into quality funds and holding for long periods of time.
The disadvantage of share prices being separate to their underlying net asset values can also be an advantage: investors may be able to sell out at a premium to net asset value, while other investors may be able to buy in at a significant discount to the fund's underlying value.
24th February 2016