On Tuesday, I started talking about the rise and fall of listed property: “Let’s talk about South African REITs. Because they do so well.”

And right at the end, I mentioned a follow-on post.

This is that post.

The Awkwardness of Individual Property Investment

Consider this scenario:

1. You’re in your late 20s/early 30s
2. You’ve decided that you like the idea of property investment. It comes with dividend yields and capital appreciation – which seems somehow both more solid than the vagaries of share investing, and more lucrative than those savings products at your bank.
3. The trouble is: you can only maybe afford to buy a small flat to rent.
4. That seems very risky. Because what if you can’t find a tenant. And what if the area goes through a dip. I mean, have you driven through the centre of Johannesburg? There’s a lot of residential flat that someone once believed in. Fail.
5. You’d like to own offices. Because you know that business-tenants don’t like to move – it’s a hack that involves letting everyone know that you’ve moved and transferring telephone lines and providing new proof of addresses to the bank(s) and to SARS and to your cellphone providers and oh so much admin.
6. You’re also open to the idea of shopping centres. Because then you get to earn rental plus a percentage of sales. Tasty.
7. But, boo – that is so far outside the realm of what you can do as a such a little person.
8. Unless you’re the blessed offspring of a magnate. But if you were, then your money would probably be managed by fund managers while you circle the globe in an effort to play golf on every famous golf course.
9. So back to cruising property24.co.za in the search for a small flat.

Even think about a Pension Fund. A Pension Fund might like to invest in properties for those nice returns – but that would entail actually running a property portfolio. Which is a bit outside the realm of what a fund manager would like to do. He/She doesn’t want to run a business – someone else must run it, making good use of the pension fund’s money. Consider a second scenario:

1. You’re a property developer that wants to build a shopping centre.
2. If you build a small shopping centre, then it’s not going to be a very good one – because not a lot of people will visit it, which means you’re not really going to get too many good shops and restaurants as tenants, which means even fewer visitors, which means even fewer shops/restaurants, and so on until you’re left with a large construction of To Let signs.
3. If you build a giant shopping centre with lots of big brand stores, then it’s going to be a magnet for people on weekends, which means more stores trying to get in there, making it more of a magnet, leading to higher rents and before you know it, circling the globe in an effort to play golf on every famous golf course!
4. But that requires money. More money than any individual bank is willing to take on as a risk.
5. If only you could access all the little guys that would rather own a small bit of a large shopping centre than own a single flat in its entirety…

And the Real Estate Investment Trust was born

Real Estate Investment Trusts are the property version of unit trusts (or, rather, they’re a quite specific type of unit trust) – and they’ve stepped in to fill the gap between those two scenarios above. They generally work something like this:

1. Someone establishes a REIT with lots of units.
2. Small investors and large institutions buy up those units in exchange for cash.
3. The REIT manager takes that cash and buys up prize pieces of income-generating property (offices, shopping centres, housing estates).
4. The REIT manager than oversees that property portfolio, making sure that vacancies are kept low and rents are collected and maintenance performed and generally doing all those other tasks that are associated with owning investment property.

Sounds good so far. However, a REIT is not exactly like a unit trust. And here is why:

1. A Unit Trust generally invests in liquid assets (shares, bonds, derivatives, cash).
2. Meaning that Unit Trusts are easily able to deal directly with their unit-holders (investors).
3. When a unit-holder wants to cash in his units, the Unit Trust just sells a few shares (if it doesn’t have enough cash on hand), and hands the money over to the unit-holder the next day.
4. But REITs invest in highly illiquid assets.
5. When a unit-holder wants to cash in his units, the REIT can’t just sell some property (well – it could in theory – but in practice, that would be extremely costly).
6. It’s actually easier for the REIT to find another investor to buy the units from the unit-holder wanting to sell.
7. Hang on.
8. Idea.
9. The stock exchange would allow the unit-holders to sell and buy between themselves.
10. Which is why REITs tend to be listed.
11. And if a REIT isn’t listed – then it likely involves minimum buy-ins and lock-in periods and basically, it’d be reserved for those magnate offspring.

Some Implications For Distributions

If you’re thinking about investing in a REIT, then you need to know something about your distributions:

1. You know how companies declare dividends? Well companies can’t claim their dividends as a tax deduction – dividends are paid out of after tax profits.
2. REITs, however, generally get to deduct the dividends (distributions) that they pay to unit-holders in their tax calculation.
3. And because REITs generally try to distribute almost all their net proceeds, you’ll find that REITs don’t pay very much tax. There’s also no dividend withholding tax on the distributions paid to investors (except for foreign investors – but that’s a separate issue).
4. However, because the tax man giveth on one hand, and taketh away on the other – this means that the investor will include the distributions he receives from the REIT in his own taxable income as though it were direct income in his hands.
5. That is: any money that you receive back from your REIT investment will be taxed at your marginal tax rate.
6. If you don’t earn a lot of money every year, this does mostly work to your benefit. But if you’re in the top tax bracket, you could end up paying tax on REIT income at 40%.
7. I’m just saying that you need to watch out for this in your tax return.

In the next post, what I’d be looking at if I were buying a REIT. And how to buy them. And perhaps a look at some of the bigger ones listed on the JSE.

To be continued.

Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.