The hordes of homeowners who leveraged their principal residences to purchase rental properties during the real estate boom are getting squeezed between a massive hike in borrowing rates, and declining home values.
Wannabe landlords were the fastest growing segment of the red-hot residential real estate market a year ago, according to Equifax Canada. Now, they are among the most vulnerable.
Earlier this month, the CEOs of Canada’s largest banks warned many of their clients could default on their mortgages as they struggle to keep pace with higher monthly payments.
There’s a lesson for anyone wanting expand their investments beyond a home to the wide world of real estate; real estate investment trusts (REITs) are the safer way to make money.
REITs are publicly traded companies that own or finance income-producing real estate. They have not been immune from the global real estate slump brought on by higher borrowing rates, but the sector is already showing signs of recovery as the end of the central bank hiking bonanza winds down.
The benchmark iShares S&P/TSX Capped REIT ETF has advanced nearly 7 per cent so far this year, stemming the decline to 15 per cent since the rate increases began last winter.
SAFETY THROUGH DIVERSIFICATION
The risk from investing in individual real estate holdings like secondary properties are concentrated in one sector (residential real estate) in one geographic region (that location).
In contrast, REITs have many real estate holdings diversified by sub-sectors, including residential, commercial and industrial.
There’s no limit to how diversified a REIT can be. InterRent REIT and Killam Apartment REIT, as examples, hold multi-unit residential properties across Canada. BTB REIT holds commercial, office and industrial properties concentrated in Quebec. RioCan and Smart REITs hold traditional bricks and mortar retail businesses.
REITs can further hedge risk by offsetting sub-sectors against each other as the real estate landscape changes. Bricks and mortar retail REITs hit hard by the pandemic and accelerating online shopping trend, for example, can be offset with retail REITs that hold industrial properties specializing in warehousing, logistics and distribution.
Other REITs capitalize on shifting demographics by investing in seniors housing as the influx of baby boomers ages.
In addition to being diversified, REITs are a natural fit with other sectors and asset classes in a broader retirement portfolio. Equity in an individual property can also compliment a broader retirement portfolio but determining how it interacts from a diversification and tax perspective can be difficult.
While capital gains on the sale of a principal residence are not taxed, half of capital gains on secondary properties are taxed; just like most other equity investments.
One tax advantage a REIT has over a secondary property is its ability to avoid taxation all together if it is held in a tax-free savings account (TFSA).
Contributions to a REIT in a registered retirement savings plan (RRSP) can also be deducted from taxable income and grow tax-free over several years until it is withdrawn.
Those tax advantages can be multiplied by homeowners who leverage the equity in their principal residences to make large investments in REITs instead of secondary properties.
Most smaller landlords know the burden of having to deal with faulty plumbing in the middle of the night, but it’s just the tip of the iceberg when it comes to legal liabilities and endless government regulation; not to mention the need to retain paying tenants or the nightmare of having to evict deadbeat ones.
All that becomes the REIT manager’s problem. Administration and maintenance are part of the operating budget.
Annual fees on most REITs are far below one per cent, but investors are more than compensated by annual yields from rental payments that often top five per cent.