The Ultimate Guide to REITs with Martin Karcz

About Martin:

Martin is Sr. Vice President and Portfolio Manager at Karcz Wealth Management Group (of Canaccord Genuity). The company builds relationships and manages financial affairs for a group of families whose investment philosophy matches theirs. The families’ ultimate goal is to enjoy their wealth with peace of mind. Martin works with a team of four people with combined investment experience of over 60 years.

On what REITs are and why they exist:

REITs, or real estate investment trusts, have been around in Canada for 25 years (and 45 years in the US). They are companies that own and finance real estate in different sectors. They must meet certain requirements, are usually listed on the stock exchange, and offer many benefits to investors. They came out of a crisis where, due to Toronto’s market crash of condos from the late 1980s, Canadian financing and investment dried up in the early 1990s. REITs fixed this and Canadian legislation was put in place. REITs were put on the stock exchange and provided the needed liquidity in the real estate market.

On how REITs operate:

They are as real as it gets. Some companies invest in portfolios of regular bricks and mortar buildings, and REITs allow individual investors to put money into any sector or building for a fraction of what it would have cost to buy, say, a condominium. This can be across Canada, the US, or Europe.

So, diversification is key, barrier to entry is easier with less money, and REITs keep your money potentially appreciating in the real estate system?

Yes. REITs offer benefits that individual ownership of large real estate does not. Initial investment is small; it doesn’t need to be hundreds of thousands of dollars. You can also buy and sell at no cost and they provide geographical diversification (for instance, Karcz Group are part-owners of data centres in the US, hotels in Holland, and Amazon and Google headquarters in Germany and the Netherlands). REITs provide fairly high income, typically at 8% per annum or more which is hard to find in real estate.

Another benefit, contrary to popular belief, is that investing in REITs has been more profitable than buying even the hottest real estate in West Vancouver or on the west-side (minus the leverage).

Leverage seems to be the biggest difference between REITs and other real estate—the 8% return would be on the $5,000 invested, not from a down payment of, say, 10% and getting the full leverage of the property value?

True, but you can finance, without a loan, of up to 70% of the value within any full-service or discount brokerage. So, in order to buy $1 million of REITs you need to put $300,000 down. There will be market fluctuations and the risk of margin call, which isn’t recommended. 30-50% is possible over the long-term. Martin does not recommend borrowing to invest, but it may be the only way to do it when you have additional monthly income to cover borrowing costs.

On the process to select properties and locations:

They look for management teams that operate individually-listed companies on the stock exchange. These vary in different sector. Karcz Group meets with the management team and looks at income in the sectors they believe are the future of real estate (specifically in Vancouver, but also in the rest of North America and Europe). The hottest sector over the past 10 years has been residential REITs, just as residential real estate has been.

During the financial crisis, Martin bought a nice property with a view in West Vancouver for $1.5 million. Today, the property has probably doubled in value and provides great returns. However, when he calculated the returns of a core holding (a Canadian apartment building) as though the same amount of money had been put into it, today it would be worth $8 million. Even Martin was surprised at how well it performed. Both properties were undervalued, especially as listed securities dropped 70% (residential real estate in West Vancouver did not drop as much). Opportunities do exist in publicly listed real estate.

On the income generated by REITs:

REITs operate in a straightforward business model. You buy a building, get tenants, and collect rent. By leasing and renting space, the company generates income which gets paid to the investors. In most cases, the income is tax efficient. It’s high due to the commercial nature of the buildings, which rent to large companies with long-term leases, like Ikea, FedEx, and the Bay. The company needs to pay out distribution, which comes in three forms: income, return of capital (no taxes are paid until you sell), and dividends. On average, there is a 50% benefit from receiving income generated from a REIT instead of a private investment portfolio, which is taxed as pure income.

On the real estate sectors and locations Martin is excited about:

REITs operate in residential, light industrial, hotel, retail, and specialized properties (for instance, buildings that house servers for Amazon). The number one area has been residential in core markets (Toronto, Vancouver, Montreal, Halifax). Another area with a lot of activity is light industrial. There has been very low initial investment per square foot, but leases with large tenants, like Canada Post or FedEx, are not going away.

Commercial brokers have been talking about the rise of Vancouver’s commercial real estate for ecommerce.

Yes. There is nothing different between the trends in publicly listed REITs and brick-and-mortar transactions. Identical assets with a different structure. Apartments were top-performing, another was a company recently taken over, called Pure Industrial, that specialized in ecommerce fulfillment centres. They offered shareholders over 100% gain in four years.

On the risks of REITs and if they’re the same as with traditional real estate:

There are two skepticisms we always face. The first is the term “stock exchange” which, in many real estate investor’s minds, has negative connotations. Martin has heard the comment, “I love my buildings, but I’m allergic to the stock market.” Though there is a risk since they’re listed on the stock exchange, with REITs you can own real estate with proven lower correlations to it (research has shown only 50%). However, it’s a small price to pay to have performance, liquidity, and geographical diversification. The other skepticism is about performance, but publicly listed REITs outperform even the hottest real estate markets (for instance, in the last 20 years in Vancouver we saw a 9% return for a detached house, and for REITs the compounded return was 11%). So, you must live with something that fluctuates on a daily basis. The flipside is if buying a home today, you might wait longer to see real returns (you may need to hold it for 10-20 years). Get paid while you wait, and the property appreciates.

On the percentage of his clients’ investment holdings that are in REITs:

Because the majority of Martin’s clients are comfortably retired, over 30% of their investments are in REITs or related investment bonds and convertible bonds linked to real estate. The rate is much higher than a GIC and the security is the physical real estate.

In Canada, there is strict legislation for leverage on publicly listed [property]: 60%. This means if you buy a building, you need 40% equity.

On whether people should work with a fund manager when looking at REITs, and what to look for in a good REIT:

The popular real estate saying, “location, location, location” should be at the top of your list. REITs are geographically diversified. Some focus on core, or A-class, properties both in residential and office. Some smaller REITs invest in small towns, which have underperformed compared to those in faster-growing markets like Toronto, Montreal, New York, and Chicago. Another thing to look for when investing within venture capital is “the three Ms: management, management, management.” If it’s internalized management, ensure the interests of management and shareholders are aligned. Look at their experience, commitment, and passion. There are fees, but internalized management is the best way to go as there is incentive to find good deals because those managers get a share of the asset and maybe bonuses as well. Outside management has less incentive to perform well and will likely just acquire assets to grow their real estate portfolio. You must look at quality of assets: you can own 50-year old buildings that require a lot of maintenance, or brand-new buildings that will last decades. Unlike private real estate, REITs tend to trade at a discount to the net-asset value. If you have a $1 million building and convert that price to a number of shares, the value can be discounted by, say, 10-15%. Up to 2007-2008, REITs were trading at a premium to their intrinsic value (because of liquidity), but since then have been discounted, especially over the past few years.

Five-wire:

1. Favorite neighbourhood: Kitsilano
2. Favorite bar or restaurant: Belgard Kitchen in the Settlement Building
3. First place Martin takes out-of-town guests: Queen Elizabeth Park, to see the skyline from the south shore, then Grouse Mountain to see it from the north shore (Martin’s best grouse Grind time is 34 minutes, 12 years ago.)
4. Downtown penthouse or west-side mansion: downtown penthouse
5. An item Martin bought in the past year for under $500 that’s changed his life: electric lift for his TV that hides in the bedroom ceiling. It was only $209 plus installation. Now, Martin doesn’t have to get out of bed to watch TV!

• Karcz Wealth Management