Similar to a true gold bug’s aversion to mining stocks and preference for physical bullion, institutional real estate investors know that REITs are far too closely correlated to the equity markets on which they are listed. For these managers, nothing beats the real thing: a portfolio of physical real estate holdings.
Since real estate’s role is to stabilize the overall portfolio, the lower the correlation to equities or bonds, the better. And despite the traumatic nature of the occasional real estate market downturn, the standard deviation on the real estate index is lower than that of both the long-bond index and the TSX, according to Catherine Marshall, CFA, senior vice president, research and strategy, LaSalle Investment Management.
How can that be? For institutional investors, real estate is seen more as a fixed income investment, with capital gains being a nice equity kicker which is seldom realized, because the investor is in the market for the long haul.
The average retail investor will not have the wherewithal to invest in real estate the way a pension fund can. But there are ways for wealthy investors to achieve the similar goals of portfolio stabilization.
There are a handful of different structures which allow wealthy investors and their advisors to assemble a portfolio of real estate holdings and each structure has its own advantages and draw-backs.
At a recent conference hosted by the Toronto CFA Society, Frank Baldanza, CA partner, real estate & international tax services, Deloitte and Touche, outlined these various structures.
This type of arrangement is probably the easiest to understand. For the sake of simplicity, let us assume the group of investors consists of two people, each with a 50% stake in the investment.
Each owner must report their own proportionate share of the income or loss from the property. The two owners can deal independently with their stake unless they are limited by contract with their co-owner. This structure is relatively easy to manage but one major pitfall is that the co-owners assume unlimited personal liability, proportionate to ownership, but this liability can be mitigated with insurance.
Note the absence of the term “partner”?
The preferred form of partnership is the limited partnership, as the structure limits each investor’s liability to the amount they contributed to the partnership — perhaps the greatest attraction of this structure. One drawback is that to maintain that “limited” status, partners must not actively manage the partnership.
There are tax advantages to the LP as well, Baldanza says. Losses accrued by the partnership can be flowed out to the partners, but this is limited by the CRA’s “at-risk” rule, which disallows claiming tax losses greater than their stake. Like the co-ownership, the partners are responsible for taxation, not the partnership itself.
Baldanza points out that the partnership can be structured in such a way that it includes different classes of partners. For example, if one of the partners is a tax-exempt entity and the other is a HNW individual, capital losses can be flowed entirely to the taxable HNW partner. But arranging such a structure must be done in good faith, or the partners risk running afoul of the anti-avoidance rule.
Despite Marshall’s warning that REITs do not offer the same diversification qualities as the Investment Property Databank index, not all REITs are created equal. Marshall was referring to the well-known REITs listed on the TSX, which are largely driven by the retail market. These REITs are traded frequently by investors basing decisions on the spread between the REIT’s distribution yield and the risk-free yield of a Government of Canada bond.
In the U.S. and Britain, Marshall says REITs are much better proxies for the IPD index, as they are more illiquid and more widely held by institutional investors.
A body of wealthy investors can launch their own private REIT, according to Baldanza, so long as they conform to certain requirements. Private REITs must have at least 150 unitholders and must be open-ended trusts, allowing investors to redeem their units for cash.
This differs from publicly listed REITs, which are closed-end trusts, meaning investors who want out must find a buyer for their units, rather than the REIT being responsible for buying their interest.
Baldanza says the open-ended structure was common in the early days of REITs, but the collapse of the real estate market in the 1980s wreaked havoc on the structure. This was corrected by the creation of closed end REITs, eliminating the redemption requirement, restricting unit-holders to selling through the stock market — since there is always a buyer, the trust need not sell assets to maintain liquidity. There are still some open REITs today
The advantages of the trust structure have become well-known over the past five years as income trusts in general have gained in popularity. The REIT pays no corporate income tax provided it pays out its income to unit-holders.
They also offer elements of tax-deferral for the investor, as part of the distribution is considered as return of capital. When the investor sells their units they will have to pay tax on the difference between proceeds they receive and their adjusted cost base, which is eroded by the return of capital.
Unlike normal legal trusts, REITs and other income trusts are not subject to 21-year deemed disposition rule. Unlike a partnership, a REIT cannot flow losses out to the partners, but can carry-forward losses and apply them against capital gains in the future.
There are disadvantages to the REIT structure, however, which affect both the public trusts listed on the market and the private REIT you’re trying to set up for your 150 wealthy clients.
REITs may only invest in capital property, not inventory property, which means holdings must be long-term in nature — no flipping houses. Baldanza says REITs may not enter tax-deferred rollovers, making conversion from a corporate structure to a REIT “a little bit tricky.”
Wealthy investors may want to consider a corporate structure for their real estate holding. While it is less tax-efficient than a REIT, Baldanza points out that the federal government is expected to adjust its treatment of dividends to put corporations on an even footing with trusts.
Like the REIT, the corporation cannot flow its losses out to investors, but the corporation can generate losses, allowing the investor to claim capital depreciation. Investors using the corporate structure can also benefit from lower capital gains inclusion rates when they sell their investment.