- Investment Workshop 59: Are Robo-Advisors Compatible With FIRE? - June 22, 2020
- Reader Case: Grounded in Vancouver and Dreaming of FIRE - June 19, 2020
- Real Estate Agent Gets Crushed by Real Estate Math - June 8, 2020
Since FIRECracker started a food fight on Monday by calling out the Toronto Home Boners, today’s article will be about…
…the real estate we own in Toronto.
Wait, back up a minute. Say what?
What I am referring to is, of course, Real Estate Investment Trusts.
What Is a Real Estate Investment Trust?
A Real Estate Income Trust (or REIT) is basically a corporation that owns and manages investment properties all around the country. Those properties can be office buildings, commercial storefronts, shopping malls, and in some cases residential apartment buildings. The REIT owns the building, takes care of maintenance, collects rent checks, and then distributes that rental income to shareholders.
REITs can be owned directly, but we prefer to own it through an ETF that tracks a REIT index. The ETF trades just like every other ETF on the stock market, and by buying an index, you own a piece of many different REITs, which in turn own a piece of many different properties.
Wait, YOU Own Real Estate?!?
This may sound hypocritical, but despite all the yelling FIRECracker does about real estate, the truth is we love real estate! It’s the best!
We just don’t own it directly.
Owning real estate via a REIT gives us all the advantages that real estate aficionados often use to argue with us.
- It’s a real asset rather than a piece of paper
- Land is a fixed resource
- It’s monthly cash flow
But a REIT has none of the downsides to owning real estate.
- You don’t have to deal with bad tenants
- You don’t have to worry about a pipe bursting or your roof leaking
- You don’t have to go into massive debt since you don’t have to buy an entire building. You can buy shares.
- You aren’t locked to one address, so a bad neighbour can’t make your life a living Hell
- You can partially sell it as part of normal portfolio rebalancing so you don’t have to time the market
- You don’t have to pay 5% real estate commissions every time you buy/sell
- You can own it inside a 401(k)/RRSP, making the income non-taxable. Rent from directly owning real estate is taxable at your marginal rate
And again, because we own it through an ETF, we are effectively indexing real estate! It’s the best of both worlds!
Also, and this is completely an emotional response, I admit to getting a little kick every time I walk into a building we are part owners of. In Canada, the biggest REIT by market cap is called RioCan, so of course our biggest holding in the REIT ETF is RioCan. Turns out, RioCan owns a LOT of famous buildings in Toronto. Once you know to look out for the name, you find it popping up all over the place.
For example, here’s a picture of Scotiabank Theatre in Toronto’s entertainment district.
Back when I lived in Toronto, we’d go to this place all the time with our work friends because of all the cool bars and restaurants nearby. Look directly right under the red “Michael’s” sign.
Last time we were back in Toronto, we went out to the movies and noticed this for the first time. That’s when FIRECracker realized: We’re part owners of the building! So as we were watching the movie, I kept smiling and caressing the armrests saying “Hee hee. We own this!”
Other buildings around Toronto RioCan owns: Kennedy Commons, Lawrence Square, The Yonge Eglinton Centre, The Yonge-Sheppard Centre. That’s pretty cool.
And because you buy this as shares rather than one giant purchase for a building, I was able to buy exactly as much as I wanted, no more, no less. Without any debt whatsoever.
In fact, I even called Questrade at one point when I was evaluating brokerage accounts for our Investment Workshop last year to figure out how their margin accounts worked. He explained that depending on how much money we had in the account, Questrade could lend us money to buy shares. The shares themselves were the collateral. If we couldn’t pay the interest, or the shares went down in value too much, the brokerage would take ownership of the shares.
“So hypothetically,” I asked. “If I had $50k I wanted to invest in a REIT (for example), how much could I borrow?”
“How much do you want?”
“Oh…how about…” I did some quick math in my head. “$950k?”
The sales rep nearly spit out his coffee. “Are you nuts?!? You want to go 20x leveraged on a single purchase? No. That’s crazy.”
“Why?” I asked all innocently.
“Because of the market drops just 5%, all your money will be gone!”
But here’s the thing. Every single person who buys real estate directly is doing this. When people purchase with the minimum 5% down payment, they are doing exactly what the sales rep correctly identified as a bonkers, crazily risky trade. Only an idiot, he told me, would do something like this.
How Do I Do This?
So now that you know why we own REITs, let’s go over some specifics.
There are tons of individual REITs out there, ranging from REITs that own shopping malls, to apartment buildings, to old folks homes. But as with all investing, we prefer to index.
|iShares S&P/TSX Capped REIT Index ETF||XRE||Canada||4.93%||0.61%|
|iShares Core U.S. REIT ETF||USRT||USA||4.5%||0.08%|
Standard disclaimer: I am not recommending either ETF for your personal situation since I don’t know what that is. We own XRE, but I do not own USRT. Do your own research!
Both ETFs are run by BlackRock/iShares, and you can get a pretty attractive yield from these things, around 4.5%-5%. The Canadian REIT does have a higher MER, and again this is OK when you’re building your Yield Shield because you’re only going to be owning this temporarily, and you need the yield. The US ETF’s MER, however, is surprisingly low. Not sure how they managed to do that.
Note that a REIT’s yield is taxed as rental income, so it’s taxed at your marginal rate. Fortunately, you can own it inside an RRSP or 401(k), making the rental income tax-free. You can’t do that with a house 🙂
REITs are considered closer to equity than fixed income, and as such as more volatile. They are also sensitive to interest rate changes. Since REITs typically use mortgages to acquire property, higher interest rates will mean higher interest costs, which lower profitability. That being said, when the economy’s doing well, like right now, landlords like RioCan can increase rent on their tenants like Scotiabank Theatre to make up for this. And because these are commercial tenants rather than regular people, these tenants can afford that since they’re making more money themselves.
In our personal portfolio, we took about 25% of our Canadian equity allocation and swapped it for REITs. So we currently have a 20% x 25% = 5% exposure to real estate. This had the effect of increasing our yield, and increasing our overall portfolio’s MER, but that’s OK since we’re planning on returning back to a pure indexing approach over time as our portfolio grows and our dependence on our Yield Shield goes down.
Interestingly, this didn’t have the effect of increasing our portfolio’s volatility. Because we swapped our Canadian Index ETF for the REIT ETF, both ETFs have about the same levels of volatility, so we didn’t have the same volatility increasing effects as we did when we swapped bonds for Preferred Shares. If anything, overall volatility went down a bit since REITs are generally uncorrelated with the TSX.
So that’s how we have exposure to real estate, and how we used it to build our Yield Shield. Questions or comments, or more fighting about real estate is welcome below.
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