Lately, I received a series of questions relating to asset allocation between REITs and physical properties via email by Ms. C, a subscriber of DividendVault.com & a regular at KCLau.com. The email is written in Mandarin Chinese. So after I had read her email, I would first offer a scenario that is relatable to these questions. Then, I would translate and offer my replies in English to all these questions.
So, let’s begin:
Here, I’ll limit my discussion to Malaysians who are below 35 this year and have RM 100,000 in investable capital to begin with. Therefore, in this situation, they could choose between Option A and Option B.
Invest in a REIT Portfolio that is worth RM 100,000.
Invest in a residential property worth RM 400,000 in the Klang Valley. With this, the RM 100,000 in capital shall be deployed as follows:
a. 10% Down Payment = RM 40,000.
b. Estimated Transaction Costs = RM 10,000.
c. Estimated Renovation & Furnishing Costs = RM 25,000.
d. Buffet of 12-Month Property Expenses (include mortgage) = RM 25,000.
Let’s assume that this mortgage rate is 3.7% a year and its tenure is for 35 years presently, the mortgage installment works out to be around RM 1,600 a month.
The stock price of REITs may decline over time if their fundamentals are poor. In the case of a physical property, its investment performance may be mediocre, if its rents and price appreciation are weak. Hence, would it be fair to say that the investment risk of REITs and a physical property is ‘kind of the same’?
Nope, I don’t think so.
This is because REITs own multiple properties that generate rents from multiple commercial tenants in multiple locations, either in a country or globally. Thus, if you invest in a REIT, you’ll enjoy a greater level of diversification in respect of its tenants, properties and locations. Whereas for a residential property, its source of income is limited in terms of number of tenants and geographical location. In this respect, I would say REITs have an advantage in terms of diversification and thus, may carry lesser risk (if risk is measured based on income diversity).
Income Diversity = REITs > A Residential Property
In a bear market, the price of REITs may fall and this would cause their investors to incur capital losses. Meanwhile as for residential properties, owners may not be aware of the current valuation of their properties as they do not hire valuers to estimate the valuation of their properties on a yearly basis. So, in this case, is it fair to say that residential properties could also fall in prices in a bear market? If so, does it mean that the investment risks between the two are ‘the same’?
Let’s start with the first question.
Yes, I agree in principle. Property prices may fall in a bear market. Obviously like most property owners, we don’t engage valuers on a yearly basis. But, we could have a rough estimate of the current valuation of our properties with Brickz.my, a portal that compiles actual transacted property prices in Malaysia. As such, I’ll say that it is best to check out Brickz.my to substantiate this theory of ours. This would prevent us from making conclusions out of assumptions.
Next, to our second question, I would disagree.
The financial impact of a 10% decline in REITs is hugely different from a 10% fall in the price of a physical property. For instance, if you choose Option A and had invested RM 100,000 in a particular REIT, your capital loss is RM 10,000 if this REIT fell by 10% in stock price. But, if you had chosen Option B and put RM 40,000 in down payment for your RM 400,000 property, the amount of capital losses that you would incur is RM 40,000 if the price of your property fell by 10%.
This difference in impact is caused by the use of leverage.
So once again, I would say that their investment risks are different.
The purpose of asset allocation is to mitigate risks. But as mentioned, REITs and physical properties may fall in prices during a bear market. Therefore, in view of this, there is little mitigating effect by having both REITs and physical properties in our portfolio. However, if a financial need arises in a bear market, REITs could be disposed of quicker in parts as compared to a physical property. Thus, in this case, are REITs more practical an investment than a physical property?
Well obviously, REITs have more liquidity than physical properties. Investors can dispose of their REITs in parts to raise cash quickly to meet their financial needs immediately.
With such liquidity, REITs have higher price volatility as compared to properties. For instance, in a bear market, some who are into trading and speculating could sell off their REITs in an instance, causing their prices to fall quickly. But, when it comes to physical properties, their prices could be stabler as they are illiquid. In a bad market, most property owners do not sell off their properties to ‘cut loss’, especially if they reside in their respective properties.
This means, being liquid and illiquid have their own pros and cons.
Just to add on, for savvy real estate investors, it is common for them to invest in properties that may capitalize in both bull and bear markets. The properties are often middle-priced and located in a middle-to-upper neighborhood.
Why? This is because in a bull market, these properties would be desirable for a group of buyers or renters who want an upgrade in lifestyle. Whereas, in a bear market, these properties would still be desirable for buyers who want to have a downgrade in their lifestyle. This means, the demand for these properties could be stable in all market conditions.
In that sense, it is not so much about REITs versus physical properties. Rather, it is about your game plan in both of these asset classes.
There are four situations given for investing in a REIT. They are as follows:
If I invested in a fundamentally solid REIT at a wrong price, can I ‘Average Down’ to lower my investment cost per unit of the REIT?
Yes, you can.
If I’m not sure if a REIT is undervalued, can I invest in it on ‘stages’?
Yes, you can. Let’s say, you intend to own 10,000 units of a certain REIT. You can choose to buy 2,000 units each transaction if you believe that it is possible for it to fall in prices after purchasing them.
If I bought a fundamentally poor REIT, can I dispose of it and recoup my capital? Then, can I reinvest the capital recouped into fundamentally better REITs?
Yes, you can.
If I’m unsure of the REIT’s fundamentals, could I diversify my investments into a portfolio of a few REITs? After all, it is unlikely that all REITs that I would buy are fundamentally poor and turn out to be mistakes.
Well in theory, yes, you could do so.
But, with that being said, I would not advocate diversification as a protection or insurance towards folly. I prefer to have a system to identify REITs that are good in terms of their fundamentals and separate them from poor ones. So, a system when investing is my foundation to avoid unnecessary investment mistakes, not diversification.
It would be risky for anyone to invest without having an investment system.
Residential properties in Malaysia are often priced at 6-or-7 figures, at least. So, it is hard for most people to have a diversified portfolio with physical real estate today. The exception is obviously for the cash-rich. As such, most investors treat physical properties as ‘All-In’ kind of investments. Is that risky?
Yes, this is true if you measure risk based on income and capital diversity. Yes, it seems that buying a physical property is likened to placing lots of your eggs into one basket.
Here, I would offer one additional observation.
Less people screwed up in real estate, because most people treat it with a lot of respect and reverence. After all, who wants to make mistakes with their biggest investments in life? That is why most people ask a lot of questions when buying properties. These questions are helpful to avoid mistakes or impulsive decisions in property investing.
More people screwed up in the stock market, because stocks are viewed lightly. Small capital means ‘fun money’ or ‘money that they could afford to lose’. So in this case, more people don’t ask serious questions when buying stocks. Instead, they may just want to have fun with their money just like they are in a casino. It is nothing serious and this mentality would be a downfall to many people in the stock market.
If more people treat stocks more seriously, their investment outcomes could be quite different.
Investing experiences could enhance the chances of investment successes. So if most people can afford 1-2 properties in their lifetime, is it possible for them to make wise property investing decisions as they lack the necessary experiences? Also, it would be a financial setback if one purchased the wrong property. So, in this case, are REITs better for newbie investors to build on their experiences?
REITs can be more forgiving as investments as compared to physical properties.
In terms of investing experiences, some feel that they will only start building on them once they purchased an investment, be it REITs or physical properties. For me, I think this is only true to a certain extent. I believe we all can start building our experiences by actively seeking and assessing investment deals on a regular basis.
For instance, I want to buy a piece of property. But, this is not a done-deal thing on an immediate basis as it involves a plan stretching 2-3 years. In that moment of planning and searching, I would have actively sought, viewed, and assessed a total of 20+ or 30+ properties in the vicinity of my choice.
That is investing experience.
It is the same with stocks. How many stock deals have you viewed and assessed before deciding on one?
So, the experiences may not entirely be on the ‘buying’ of an asset. Instead, we all can start building our experiences by active assessments of investment deals today, be it REITs or physical properties.
All in all, although it seems that the argument today is in favor of REITs, but, I’m not into choosing sides between REITs and properties. I firmly believe that both of these assets have their unique attributes and could build investors’ wealth in the long-term. But, this is provided that investors have a strategic game plan for investing in them successfully in the long run.
Be it REITs or physical properties, the basic principles of investing are the same. If the fundamentals of these assets are good and undervalued, we would boost our chances of profits by investing in them.
In conclusion, instead of choosing sides, I think for us to understand our unique attributes and financial status, appreciate the differences of the two assets, and structure your investments based on what is more suitable for yourself.
At the end, your plan should determine what you should be investing in.
Here, if you wish to learn more on the art of stock investing, here’s a free training you can attend: