Buying a flat is treated by many as a safe investment. Especially during an economic storm. No matter the turmoil on the stock exchange – we will own a sure asset which price does not change so rapidly and can insure us against a rate of inflation. If you hate risk – investment in real estate seem to be great choice for you.

The big picture is quite different when we look at a real estate investment from the return on investment (ROI) point of view. Many people falsely claims that buying a flat for renting guarantees a profit for us. On the visible side we have a rent being paid every month by our tenants and we register it as our revenue. What is unseen is a calculation behind this venture and figuring out what is the real profitability of renting out a flat.

Let us assume that we have property worth 500 000 USD. We rent it out for 2 200 USD per month and this gives us 26 400 USD per annum. Dividing this rent by property value we get return of 5.3% annually. In comparison to bank deposits this is quite a remarkable return. It does not look so good when we do further analysis. The Rent that we are paid from our tenant have to cover our property’s costs.

Example:

+ 2 200 USD; Rent paid by a tenant;

-     400 USD; Communal costs paid by us;

-     150 USD; Lump sum tax from our revenue (here 8.5%);

-     200 USD; Down payment for future renovations;

Assessing this sensible numbers we see our revenue melting from 2 200 USD to 1 450 USD. Still we did not include costs of building getting older each year. It goes without explaining that everyone likes to live in fashionably refurbished building, district. Presuming that the building will lose each year 0.8% of its value we need to decrease our revenue further by 400 USD.

Finally we end up with 1050 USD (not 2 200) and compared to the original value of our property (500 000 USD) makes the real return on this flat rental agreement 2.5%. This is a general profitability of renting out and it is low due to a bunch of reasons.

Firstly, it is quite easy to buy a flat and find a tenant. Risk is lowered, price goes down.

Secondly ‘cheap credits’ all around the world are a part of a speculative bubble. Prices are now on acceptably ‘safe’ levels but nonetheless they are high partly due to interest rates and those are on record low levels. This does not sound ‘safe’ at all.

How to get better exposed to real estate market with bigger returns?

As a result of sheer amount of residential properties and generally low problems associated with finding a tenant, returns are low. Commercial properties are a different story.

Bigger expertise of the local market, higher level of engagement and high threshold of prices being a natural entry barrier makes this market more rewarding.

Everything what I said above may tell you that there is no way to invest in those kind of properties unless you pass knowledge requirement and have enough capital to invest. This is not the case. There are specific types of investment funds called REITs giving desired exposition to real estate market.

What is a REIT?

The Real Estate Investment Trust is nothing else but an investment fund that invests in rental properties. Shopping centres, hospitals, hotels or apartment buildings, they all are targets being invested in by those trusts. Most of them operate in already developed markets like US, Japan, Canada and Western Europe. Now we can see emergence of Singapore and Honk Kong REITs.

Design of a REIT is what makes them unique among other investment funds. They have to allocate at least 75% of their capital in a residential rental properties and 90% of their profits have to be given back to shareholders. Shareholders do not need to pay any income tax from that.

How does REIT word?

Upon creation of a REIT shareholders transfer their capital. Sometimes trust uses this money to invest in erecting a shopping centre or apartment building by developer. Otherwise, trust buys rental properties available on the market. Costs of servicing the trust including managing all properties level at around 5-10% of rental revenues. However they may vary from 3.44 to gargantuan 24% - you can see in the table below prices of REITs traded in Singapore.

REIT vs REIT’s ETF.

REIT can be compared to a single enterprise having its shares traded publicly. Investing in single REIT bears similar risk as buying shares of just one company.

Particular solution is to buy a REIT’s ETF. Those ETFs are investing tens of different REITs all over the world and thanks to that problems stemming from just one trust are minimalised.

Disadvantages of REIT investment.

Shares of respective REITS or REITs’ ETFs are not that easy to buy (comparing to buying stocks). Right now prices of majority of REITs are very expensive and this makes their dividend very low. When revenues from rentals are stable and share price is rising, automatically the dividend is falling (percentage-wise).

Below I give you chart showing Simon Property Group REIT capitalising on big shopping centres in the US (blue) and the S&P 500 index (red).

Source: Stockcharts.com

You can see for yourself that the REIT above is highly correlated with the S&P index. Just like shares this REIT is very expensive making its dividend percentage-wise very low – 3.3%. At the beginning of 2009 it peaked over 13%.

Situation is comparable to behaviour of index mirroring changes of global REIT prices and developed countries stocks index where over 90% of REITs operate.

Source: Stockcharts.com

Basically all over the world we can see overpriced real estate and REITs prices. This is confirmed by low dividend.

Source: Self made

Summary

By investing in REITs relatively easy we can be exposed to property market and start counting our returns. The most important factor is timing. Now most of REITs is terribly overpriced and consequently their dividends are low. One exception is Asian REITs where in Singapore we can see 6-8% dividend being paid. The catch is the global recession when prices can nosedive violently. Dividend levels then will not matter when price of our trust is losing double or triple the levels of our gain.

Relating return on renting out a flat with return of overpriced REITs it is the latter that is higher. Whatever your decision maybe *now* is not the time to spend your money due to very low interest rates, demographic problems in developed economies and overpriced REITs after 5 year boom.

The best available option is to wait and be patient until stock prices fall making real estate to follow and in 12-18 month perspective take position on discounted REIT ETFs. The right moment of entry can secure double digit dividend and further increase of REIT’s price during next boom.

Trader21