Individuals can invest in REITs either by purchasing their shares directly on an open exchange or by investing in a unit trust that specialises in public property.
It is easy to see why buy-to-let is an attractive investment: you can see your property, and manage it in a way you just cannot do with shares. However, it is easy to overlook the real investment risks associated with buy-to-let, the considerable costs you might incur, and the drain this type of investment has on your time. If you want to have the laid back life as a property investor, property stocks are the way to go.
Gearing and cost of debt
If a bond is used to purchase your buy-to-let property, this is essentially gearing or leverage (i.e. the use of borrowed capital to generate/increase the potential return of an investment). By investing in REITs, your gearing is still achieved, however, at a much lower borrowing rate due to the borrowing being done by the REITs. Where individuals are able to borrow at prime or prime less 1%, REITs are able to borrow at a rate of at least prime less 2%.
- Default and loss of risk: When buying-to-let, any borrowing to acquire your property is done in your personal capacity thus introducing the risk of default, being blacklisted and potentially losing more capital than you put in (i.e. the amount you borrowed, the amount you put in and any outstanding interest). When buying property stocks, the borrowing is done by the REITs themselves. Therefore, there is no debt in your personal capacity and thus no risk of default.
- Increasing interest rates: Interest rates are at historically low levels and may rise in the coming years. The rise in interest rates will directly impact your borrowing rate, and as such your risky monthly re-payments.
When investing in REITs, the interest rate needs to be addressed by the REIT and not by you. Many of the REITs are hedging or have already hedged a portion of their interest rate exposure to minimise their risk in an increasing interest rate environment.
- Volatility risk: REITs are subject to stock market volatility, however, house prices also fluctuate, although less frequently.
- Vacancy risk: When you own a property, you face the risk of your tenant leaving, cancelling or not paying. When any of these things occur, you face the risk of losing rental income and the cost of turnover, this can lead to having to outlay cash to fund other expenses or savings that your rental income ordinarily has covered. REITs also have vacancy risks and these cannot be avoided. REITs generally have management companies that assist in the alleviation of vacancies.
Rental income versus REIT distributions
Both rental income and distributions from REITs are not guaranteed. REITs, however, are affected by market sentiment coupled with market reputation that significantly reduces the likelihood of decreased or no distributions.
With the price of property and all the other associated costs of buying, diversification of any sort is exceptionally difficult. REITs provide immediate diversification by the nature of the various property portfolios. These often consist of investments in a number of property types, including industrial properties, warehousing, offices, shopping centres and many more. To further diversify, they are in different geographical regions (this includes offshore exposure) with different opportunities, tenants, growth possibilities, income streams and capital appreciation potential. It is simple to gain more exposure to particular property types by investing in REITs that have more exposure to the property type you favour.
Rental properties are not liquid. It can take months or even years to sell a rental property. If you need to sell it quickly to raise cash, you might need to drop the price below the current market value to attract a buyer. REITs, by contrast, are liquid investments, can be easily bought and sold online. They can easily be converted to cash timorously and without paying excessive fees.