Q. Over the years I have done well investing in a private Real Estate Income Trust (REIT) and I wonder why they are not recommended more often by advisors. Am I missing something? And where can I find more information on REITs?
A. This is a great question, Jeff. For those who aren’t familiar, a REIT is a fund or company that earns income through its investment in real estate. Investors may choose a public REIT ETF or mutual fund REIT, which can be bought and sold daily; or a private REIT, which is not traded on an exchange.
So why would anyone invest in a private REIT? There are two main reasons: the first is diversification from traditional equities; and the second is to reduce portfolio volatility—or, at least, try. Here’s how those two objectives break down:
1. Diversification. Most investment portfolios traditionally consist of stocks and bonds—stocks to generate returns and bonds for stabilization. Then the two are combined into a portfolio to match a financial plan and risk tolerance. A private REIT provides a possible third investment option for your portfolio. Historically, private REITs have had similar returns to stocks but with a very low correlation. In other words, you may get equity-like returns but without the same up-and-down pattern of an equity index; when stocks go down, chances are private REITs will be up.
2. Reduced volatility. Public REITs, which are normally in the form of ETFs and mutual funds, are valued daily as their shares are traded in the open market. If you looked at your investments every day, you’d see a lot more price movement than if you only looked at your investments once a month or once a quarter. And when the stock market drops it’s not uncommon for public REITs to follow the market down, even if the rents collected by the REIT haven’t changed or the value of their property holdings has held their value. By contrast, private REITs are generally valued monthly or quarterly by an independent evaluator. This hides daily fluctuations, creating a smoothing effect on investment returns (although some investment experts have argued that if private REITs were valued daily, they’d likely be just as volatile as public REITs).
Reducing volatility is also a possible way to offset sequence of return risk for anyone relying on a regular income payment from their investment portfolio.
Now, let’s get back your question, Jeff: If private REITs are so good, why aren’t they recommended more often and why don’t more people hold them in their portfolios?
- Until recently, private REITs were really only available to accredited investors, people with a high income or a million-dollar-plus investment portfolio. Things changed a few years ago, and now some private REITs are available to eligible and non-eligible investors, which includes almost everybody, but you’ll have to check your provincial securities regulator to see if you are an accredited or eligible investor.
- They’re not as commonly discussed or as available as traditional equity and bond investments.
- Private REITs aren’t without their own set of risks and they’re not as heavily regulated as mutual funds and ETFs.
The risks associated with private REITs include liquidity, leverage, and management/company risk, and most are classified as medium-high to high risk.
1. Liquidity: It’s not uncommon for withdrawals not to be permitted in the first year and in some cases even longer. And, when you are permitted to make withdrawals, it may only be monthly, quarterly or annually. It’s even possible that under certain circumstances redemptions could be temporarily restricted.
2. Leverage: Borrowing money to invest within the portfolio is common in private REITs and, as you know, borrowing to invest can magnify gains and losses.
3. Fund management/company risk: With a private REIT, you’re putting your faith in the management team and the financial stability of the company. To help minimize management and company risk, your investment dealer will have done an analysis of the company, including its management team, before making the REIT available to investors; however, this does not eliminate the risk.
Jeff, for investors like you, who are looking to learn more, unfortunately there aren’t as many articles on private REITs or other alternative investments as compared to the number of articles and books on traditional equity and bond investments. Hopefully, this will change because, depending on your investment profile there may be benefits to holding alternatives in a portfolio, as well as risks, and individual investors like yourself need the information to help make good investment decisions.
Pension funds are increasingly adding alternative investments, such as private REITs, to their portfolios. As a matter of fact, 51.6% of the CPP portfolio was private equity. What’s also interesting is that individual investors have historically incorporated the investment strategies pensions adopt.
Right now, the average individual investor has about 5% of their portfolio in alternative investments. It’s been suggested that investors who start investing in alternatives now, adopting the pension investment-style strategies, may earn higher returns than those who wait until they become mainstream. Maybe, maybe not?
Allan Norman is a Certified Financial Planner and Chartered Investment Manager with Aligned Capital Partners Inc. in Barrie. You can email Allan at firstname.lastname@example.org
This commentary is provided as a general source of information and is intended for Canadian residents only. Allan offers investment advisory services and products through ACPI
MORE FROM ASK AN INVESTMENT EXPERT:
- The best TFSA investment for a time horizon of 3 to 5 years
- She’s 34 and wants to retire at 65 with $70,000 a year. Can she?
- How your tax bracket decides whether a TFSA or RRSP contribution is best
- An advisor is charging 1.95% for an ETF portfolio. That’s too high.
The post What are the pros and cons of investing in private REITs? appeared first on MoneySense.