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TORONTO (GlobeinvestorGOLD) — It may have been the 17th century French philosopher Rene Descartes or Brady Bunch patriarch Mike Brady who said: "Wherever you go, there you are." Either way, it's a profound sentence that best sums up why real estate gives investors an advantage not available in any other sector. When it comes to yields, real estate is the grandfather of income because everyone always has to be somewhere — and most of the time we pay for being where we are.
At its most basic level, real estate produces a yield when a homeowner finds a use for unutilized property. Empty nesters, for example, may decide to generate a little extra cash by renting out a room in their principal residences — often in the form of a basement apartment. It's hard to know how many basement apartments exist in Canada because in many cases the income is not reported.
Those who do keep their rental income above board can deduct expenses like heat, electricity and parking — and the rest is taxed at their regular rate.
Some homeowners go a step further by renting out a secondary property such as a house or a condo. The same tax rules apply to rental income but when the time comes to sell your secondary property any appreciation gained over the original purchase price is subject to capital gains tax, minus maintenance, repair and improvements. Profit made from selling a principal residence is non-taxable.
But as most landlords will tell you, being on the supply end of the rental market has more than its fair share of headaches. The resale and rental markets are cyclical and landlords could go through long periods of time with no tenants. When units are occupied the landlord is ultimately responsible for maintenance and repair, which could become expensive and time consuming.
In addition, the rental housing market is heavily regulated by municipal and senior levels of government. Tenant protection laws and rent controls could make collecting rent and evicting undesirable tenants difficult.
There is a way, however, to reap the rewards of rental income without incurring the headaches of being a landlord through Real Estate Investment Trusts — or REITs. A REIT is a corporation or trust that uses pooled capital to manage income property and mortgage loans. Basically, you pay the fund managers to find the tenants, collect the rent, make the mortgage payments and change the light bulbs. REITs trade on stock exchanges like stocks or other income trusts.
Investors love REITs because they are granted special tax considerations and are very liquid. Most REITs are also RRSP eligible which brings an added tax benefit. REITs have been around for a long time but record low mortgage rates and a strong real estate market have sparked a resurgence in the sector.
A recent study on REITs by Dominion Bond Rating Service (DBRS) attributes the recent growth in the REIT market to increased investment by pension funds and large foreign institutional investors. The average market cap for a Canadian REIT has grown to $1-billion dollars, which gives fund managers a great opportunity to diversify in order to reduce risk and maximize return potential. REITs invest in commercial, industrial and residential real estate from Vancouver Island to Gander.
The study rates seventeen REITs on several criteria. RioCan (REI.UN TSX) scores the highest for what the study considers superior operating characteristics, asset quality and market position. DBRS says RioCan has relatively low risk with moderate diversification and growth. RioCan REIT has managed to return 26 per cent so far this year — well above the eleven per cent for the average real estate mutual fund.
The REIT to receive the lowest rating is Royal Host. DBRS cites weak operating characteristics, market position and growth — as well as moderate asset quality and diversification. Royal Host still managed to outperform the average real estate mutual fund with a year-to-date return of 19.8 per cent.
On the overall REIT market, the DBRS study calls for a continuation of "solid fundamentals and stable cash flows" in the short to medium term. It says broad economic growth will continue to support demand for space.
However the study points out some risks in the real estate sector including the increased use of borrowing on assets to make new acquisitions. It says the average leverage is expected to exceed 60 per cent of debt-to-gross book value. Interest rates are expected to rise and when they do mortgage rates will follow. Higher lending rates mean more of that yummy yield will have to go toward servicing a higher debt.
Other risks according to DBRS include a high level of condominium development driving down occupancy rates and rising real estate values making new purchases less attractive. The study also says a trend toward bank mergers could create a lot of excess office space in big cities like Toronto and Montreal. In addition, the hotel industry has yet to recover from 9/11 and vacancy rates remain high. Consumer spending remains fairly strong in Canada but a slowdown in the retail sector could weaken demand for real estate in shopping centres.
DBRS says the outlook for industrial real estate looks good for now but the rising Canadian dollar could hurt export-related industries.
The study, however, doesn't mention Descartes or Mike Brady — but we can all assume the outlook for everyone always being somewhere looks pretty darn good.
Dale Jackson has been a producer at Report on Business Television since its launch in September 1999.