The Yield Shield: Real Estate Investment Trusts

Wanderer
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Wanderer

The Wanderer retired from his engineering job at a major Silicon Valley semiconductor company at the age of 33. He now travels the world, seeking out knowledge from other wealthy people, so that he can teach people how to become Financially Independent themselves.
Wanderer
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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?!?

Yup.

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.

Photo By DXR @ Wikipedia.

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.

RioCan Hall.

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.

Name Ticker Country Yield MER
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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32 thoughts on “The Yield Shield: Real Estate Investment Trusts”

  1. REITs are indeed a great way to invest in real estate completely passively and with the ease of diversification. Not to mention easy access to large commercial properties. As with any investment, but especially index funds, low costs are key.

  2. “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.”

    That’s funny

  3. our friend from TO just came to our house in buffalo last week. every time she comes over she says “this house in TO would cost way over a million bucks!” but we only paid 96k or something like that. all that said, i stay the hell out of that debate when one of you if fired up over it.

    i own a reit index in my american 401 and it’s down about 5% from where i bought it. do you worry about having to wait for the xre to come back to your purchase price in order to sell? in my case it doesn’t concern me as it usually cycles within a range.

  4. I’m confused. In the last few posts, you mentioned you want to reduce your yield shield. My question is why bother? If the dividends, interest, capital gains and return on capital continue to grow every year, would it not be in your best interest to stay the course and let the distributions grow and outperform inflation? This way, you’re never forced to sell a part of your portfolio in a bad market and neither are you overly concerned if the overall portfolio value drops as income steadily comes in regardless. Right now, my yield is 3.20% which gives me about $33,000. As I continue to grow the portfolio with intention that I receive about $40-45,000 annually without having to sell off parts of my portfolio, I’ll have hit my sweet spot. If the distributions grow 4-7% annually, I’m laughing. That’s why I don’t see a reason to drop the yield shield. Please show me the error of my ways. I’d rather know sooner than later if I’m not properly optimized. Thanks.

    1. They’re lowering the yield shield in exchange for higher overall growth. The portfolio growth is allowing them the safety to take on higher volatility.
      I don’t believe there’s anything wrong with taking the higher yield as you see it. The advice is always best to math “stuff” up and optimize to our own comfort level. And that comfort level can change over time like it has with FC and W.

      1. What Joe L said.

        Yield = short-term income, but it trades off for longer term gain. Once the short term income needs are met, and then exceeded, I’d want to reduce my Yield Shield in order to get my long term gain back.

        Of course, this only makes sense because I’m in my thirties. If I were in my seventies, I care far less about long term gains and more about short term income.

  5. I think REITS are prudent and fulfill your investment needs well. We own four properties (no leverage) and rent them out. This provides a steady cash flow that is tax deferred (depreciation). Our properties have increased in value quite a bit, but it is true that this is just timing the market. If I knew what I know today about investing, would I have bought the properties?

    Not sure.

    1. I looked into tax deferral for our rental property, however from my understanding of tax law, if the house goes up in value, you may be ask to pay up all that tax that was deferred… at a higher rate. That plus paying capital gains when selling, we decided to not do the tax deferral and to sell our property asap. It’s a lot of tax to pay every year at your marginal rate.
      Wanderer – I’m new to this investment stuff… can you tell me if you can invest in REIT through a tfsa?

      1. They posted a link at the bottom for the best places to invest REITs versus US equities, bonds etc.

        https://www.millennial-revolution.com/invest/how-to-pay-no-tax-on-your-investments/?relatedposts_hit=1&relatedposts_origin=8905&relatedposts_position=0

        I’m not sure what you mean for tax deferral for an investment property. My understanding is you don’t pay capital gains tax on your property until you sell (hence it’s deferred).

        Regarding marginal taxes. The number of times I’ve had to explain to people that turning down overtime because it pushes them into the next tax bracket doesn’t suddenly mean they’re paying an extra 2% taxes on all the money they earned so far (yup – as if that extra shift would suddenly mean that you now owe the gov’t all the money you earned that shift an then some)! Rental income (through direct ownership) isn’t for everyone – it certainly wasn’t/isn’t for me with the headaches.

        Additional income is additional income – looking for tax efficiency is important, but watch out that you aren’t trying too hard to save taxes such that you don’t get the returns you should. Personally, I’d rather “begrudgingly” pay an extra $1,000 in taxes on $10,000 income, than proudly say I only paid $50 tax on an extra $5000 income – because there’s a $4,500 difference to my pocket. But – will I do the most possible research to make sure I “only” had to pay $1,000 tax – of course!

        That said – you selling your rental – you’ll find a lot of support on this blog readers for that. Then you’ll need to decide how you want to invest the net proceeds from your sale (AFTER keeping some aside for your tax bill – talk to an accountant). I’d strongly suggest reading the investment workshop here – given you are talking TFSA I’m assuming you are Canadian!! Good luck!!!

  6. OK now only Closed-End Funds (CEF) are still to be discussed on the yield-shield topic. Looking forward to read about them anxiously

    1. Don’t hold your breath. We don’t own any CEFs.

      Also, why? It’s just a mutual fund with lipstick. ETFs are far more flexible and liquid.

  7. So when you were building your portfolio did you own this REIT? Or did you acquire it for the yield and income when you are traveling the world?

    1. I pivoted into REITs closer to my retirement date. I don’t think it makes sense during the accumulation phase, especially if you’re 10+ years away from retirement.

      1. FIRECracker, in that same vein, does it make sense to hold Preferreds and Corporate Bonds during the accumulation phase?

  8. By default when we moved out of our first home, instead of selling it during a bit so good market, we turned it into a rental property. Fortunately we have been blessed with wonderful tenants but I have been considering to sell it.

    Perhaps I can put part of my proceeds to a REIT. Why would anyone want to invest in a REIT on a taxable account, if you can put it in a 401k to have it grow tax free?

    I am curious how you choose a good REIT index. Assuming the index is the same type of investment property, are low fees and high rate of return the things to primary consider? Thanks!

  9. For REIT exposure, I have VNQ in my portfolio but it has an expense ratio of 0.12%.

    Should I replace it with USRT since the performance of both has been pretty similar? Another question is where can I trade USRT commission-free?

    1. Don’t know anything about VNQ, but if you have no problems with VNQ I wouldn’t bother over 0.04%. Unless your brokerage account allows you to trade commission free or something.

    1. Yup. Though I would put this in an RRSP/401(k) if I were you since equities tend to grow more. Higher capital value in an RRSP is a pain in the ass when you need to melt it down.

  10. Thanks for the detail on this! I’m still in the accumulation phase, so no REIT’s for me right now. Interesting option for the future though.

    Can I make a request? Any chance you could include a chart on how each of these moves affects your yield shield? You shifted 5% of your portfolio, but what affect did that have on your income? Quick math of $1M x 5% allocation x 4.5% dividend = $2,250 per year. What was it before?

    It looks like your making small changes to incrementally increase your yield / income. It would be interesting to see them all stack up to a final number.

    Thanks for another interesting post!

    1. That’s an upcoming article! I have to introduce all the different types of higher-yielding assets before we do a lets-see-how-it-all-comes-together wrap-up.

  11. Garth recommends holding 20 % in US $ in a balanced ETF portfolio

    how does one do this ? and is it worth it ?? i have million dollar portfolio too

    thanks

    or have you addressed this issue before ?

  12. Great article about REITs, but I have a couple disagreements that are purely semantic in nature.

    First, you don’t own real estate. You own a business that owns real estate. Real estate crowdfunding is what allows you to directly own real estate. Whichever method of ownership is better (REITs, direct ownership through crowdfunding, or traditional direct ownership) will be forever debated here on this blog, but with REITs, you own a business as you do with any other stock. The company’s product inventory just happens to be office buildings, the same way the product inventory for Anheuser-Busch just happens to be canned urine.

    Second, when it comes to the concept of indexing actual properties and completely ignoring my previous point, owning a single REIT takes care of that. You have a diverse portfolio of properties with the risk spread out, all done with one security purchased off the stock exchange, exactly like an ETF. REIT ETFs are like indexing indexes. Which isn’t a bad thing, I’m just sayin’.

    Again, all of this is simply semantics. None of it actually matters.

    And I, too, get a psychological kick out of buying/using products from companies that I own and when others do the same. Underneath my kitchen sink are bottles of Palmolive, Ajax, and Fabuloso dishwashing liquid and in my bathroom is a tube of Colgate toothpaste. Washing the dishes and brushing my teeth is slightly less of a chore than it would otherwise be because I know that, as a Colgate-Palmolive shareholder, I’m part owner of those brands and the money spent on the products will come back to me in the form of dividends. It’s a nice feeling 😉

    Sincerely,
    ARB–Angry Retail Banker

  13. Correct me if I’m wrong. Do you have a rental property in the Midwest? I thought I heard about it in a podcast with my frd.

      1. You’re probably right. I had a fi chat with my friend yesterday, he was adamant you had a rental in Midwest and I’m told him, “how is this possible? this negates their (your) philosophy? His response was ‘ I’m pretty sure I made a podcast with them. Maybe they’re only against personal home ownership?’ ”

        But if one were to buy real estate/rental, buy based on location, not yield — that was his advice after telling me his rental in a bad Location in Midwest is really stressing him out right now.

  14. I don’t know where this idea about REITs not having returns as good as the overall stock market comes from.

    20 year trailing returns for VINIX, the cheap Institutional share class of the Vanguard S&P 500 Index fund: 6.88%.

    http://www.maxfunds.com/funds/data.php?ticker=VINIX&pg=d

    20 year trailing returns for VGSIX, the investor (aka “most expensive) share class of Vanguard’s REIT index fund: 8.35%

    http://www.maxfunds.com/funds/data.php?ticker=VGSIX&pg=d

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