Real Estate Investment Trust vs Direct Purchase Properties
Updated: Dec 24, 2020
Purchasing a piece of real estate might be one of the biggest purchases that Singaporeans will make in their lifetime. This can cause significant stress should they be unable to make loan payments. Real Estate no doubt remains one of the best vehicles for investment due to their long-term stability, due to its ability to recover quickly from financial crises and a huge room for capital appreciation. My points are reinforced as evidenced by the Private Residential Property Price Index, which had increased on average 10 percent over the last 10 years and a greater average increase should you factor in the 2007-2008 global financial crisis.
To capitalize on the strongest points of holding real estate and excluding some of its greatest encumbrances comes a unique form of investment called Real Estate Investment Trusts (REITs).
REITs are investment trusts that own or operate real estate properties for its shareholders, which operates similarly to publicly traded stocks but with a property added twist.
How Do REITs Purchase Their Properties?
A portion of funds received from investors are made to purchase the properties, while the remainder might be done through leverage of existing debt or through equity financing (i.e. Issuing discount stocks to selected parties)
How Much Will the Returns Be?
Dividends tend to have returns of 5 to 8 percent while Return on Equity (ROE) has returns of 10 to 20 percent. Dividends are distributed on a quarterly basis.
To better understand what are REITs, please review it from the following articles
Main Points of REITs
Professional Management: Hands-off approach
The funds which you have invested in will be handled by a REIT manager, which a portion of it will be used for their professional fees.
This is the true definition of making your money work for you.
Caution on Leverage Taken from REITs
Due to a large number of funds being in place to purchase properties, there are two modes of obtaining funding. This is called debt or equity financing.
In a nutshell;
Debt Financing = Taking secured/unsecured loans from a financial institution (aka gearing a loan)
Equity Financing = Using their existing equity to raise capital
Good REIT management will use a balance of both financings, as each potentially provides advantages. However, investors will need to look at the debt-to-equity ratio as this serves as how risky will their investments be due to a higher default risk from the REITs.
The current debt-to-equity ratio, or leverage limit, is currently 45 percent for Singapore REITs. As an investor, you should remain prudent in your investments but understand that a certain amount of risk is required. If the debt-to-equity ratio is too low, this will reduce the spending efficacy of the REITs, leading to the slow growth of their portfolio. What this means for you as an investor is that you will experience slower and lower ROE.
To place this into comparison with direct purchases, most individual property investors will implement just debt financing, which is an umbrella term for mortgage loans. In this event, most banks will provide you with a secured loan, which the property purchased is the asset. However, this means that should you fail to make your repayments on time, there will be a foreclosure, or in other words, a bank fire sale.
To prevent this overleveraging of direct purchases, the government had over the past few years implemented various measures which includes the Total Debt Servicing Ratio (TDSR)/Mortgage Servicing Ratio (MSR), stamp duties and Loan to Value (LTV) ratio which is akin to the debt-to-equity ratio for companies. This had worked as reported by a press release from Credit Bureau Singapore
“Latest statistics based on new mortgage loan applications show that in December 2018, there were 4,423 new applications. This represents a 64.9 percent decline from 12,619 applications in July 2018 and a 54.0 percent decline from 9,611 applications in December 2017.”
- Credit Bureau Singapore
Less Initial Investment
You are able to start your investment from as little as $100 per transaction. However, it depends on how much it is to purchase a single lot.
Comparing this as compared paying upfront the downpayment for your HDB, which is 10 percent CPF and/or cash, which might amount to easily five figures, there is a lower barrier to entry for REITs.
Diversification of Real Estate Investments
Most homeowners are residential real estate investors; however, the real estate market consists of other variations such as commercial and industrial properties. Some might shun away from investing in these variations as it requires a deeper understanding of economic forces that affect these specific economies.
Investing in REITs means that you do not have to make these scary decisions all by yourself as the REIT managers who are specialized in this will be able to make wise decisions pertaining to your investment. If you have always been interested in trying out these other sectors of real estate investing, REITs are for you. Furthermore, REITs do have a specialization such as Healthcare REITs, Hospitality REITs, and many others so there is further diversification in your portfolio for protection against more challenging times.
The 90 Percent Rule
This is probably one of the most famous reasons to get into REITs, as these trusts will gain a tax transparency benefit. What this means is that the trustees who are legally holding the property for you (the beneficiary) will not be taxed, and the liability will be borne by you instead.
Needless to say, selling away your shares of a REIT is much easier with just a click of the button, whereas, for property transactions, you will need to handle more intricate matters involving but not limited to legal paperwork.
Main Points of Direct Purchase
No Management Fee/More Control
While it is true that direct purchase properties do not have management fees, it does include other fees such as from your real estate agent and legal fees. In regards to your loans, a small percentage of it is given to the banks as a commission which is expected.
However, directly purchased properties can have a management fee. This is for landlords who hire a property management company/agent to manage their existing properties.
In terms of the scope of their works, property management companies/agents are being paid to actively generate rental income for the landlord by ensuring the unit is consistently being rented out. In addition, they might be given a reserve to work with so as to deal with regular maintenance or bigger. Their list of duties does not end here, they are also required to address tenant’s concerns, enforce leases and conduct regular but reasonably timed inspections of the premises.
This is similar to Management Corporation Strata Titles (MCSTs) for condominiums in Singapore, which are property management companies that provide for the services mentioned above, but for strata title owners.
Hiring a property management company/agent at a reasonable rate can be a good tradeoff as it will give you peace of mind to manage other financial investments or to simply have a hands-off approach. The usual rates of hiring one will range between 5 to 10 percent of your gross rent.
In comparison to REITs, this is similar to operating your own private REIT, which you will be playing the roles of the shareholder, trustee, and sponsor.
Potentially Higher Returns from Inefficient Market
Real Estate has always been an inefficient, decentralized market, and will always be. When a seller and buyer come together to proceed with a transaction, the prices agreed upon are usually based on each party.
An efficient market means that the value of a transacted product is an accurate reflection of pertinent information.
Investing in an inefficient market is a benefit for you as an investor as the other part in the transaction might potentially not have all the “right” information in regards to the property and you can come off with a fantastic deal. That being said, a reversed situation can apply to you also. Be sure to do your homework on transactions that you come across before proceeding.
For REITs, they are more efficient as they are being watched by many professional investors, this results in the value of the transacted product, which are shares, to be more accurate due to the wealth of information provided.
However, do take note that price volatility can still be affected by the REITs companies’ internal operations, like overleveraging, which might present altogether a different level of risk.
Costs in Fixing The Place
Directly purchased properties are a tangible asset, this means that it is susceptible to regular wear-and-tear by the occupiers of the premises. Be prepared to regularly fork out money to conduct regular maintenance to the unit.
Taking an Equity Loan on Properties
Direct Purchasing of properties is akin to starting a barbeque. The initial phase might be a slow start, as you are required to heat up the charcoal. Once it is hot and glowing, you are ready to start grilling and feed into your investment!
That being said, while you are still serving your mortgage repayments, the net returns from the rental income after repayments and expenses might be a small sum. The gradual repayment of your mortgage however, builds equity in your property, which enables you to better manage your finances by paying off other high-interest loans.
Please refer to this article for more information on equity loans.
Actually Just Staying There
In the event that there comes a financial crisis that brings about the collapse of global economies into an unrecoverable scenario, which is 99.99 percent unlikely in case my sarcasm is lost in transcription, your directly purchased property will still function as its main purpose. That is a shelter for its occupiers.
There are currently no statistics available comparing the risk/benefit degree of REITs vs Direct purchase as these two methods of investing do not have a common factor between them.
However here are my suggestions
- If you have little free cash flow (i.e. less than a downpayment for a house)
Invest in REITs first as this will only be the only option available for you at the moment, there are other methods possible for you to gain financing with other joint-investors to directly purchase properties but it goes beyond the scope of my article and I generally do not recommend it unless you understand the risks involved.
- If you are having are looking for a new FIRST home and not looking at Investing
Consider investing in an Executive Condominium in Singapore as these properties bring about one of the most secure real estate investments. With potential returns of almost double your initial investment and no capital depreciation based on past data, this should be your pick. The only downfall is that if you are still early on in your career, cashflow might serve as a potential issue when you are making repayments.
- If you have residential properties and are averse to investing in commercial/industrial properties
REITs are a good option to get your feet wet in these alternative real estate forms. The properties chosen by these REIT managers are experts in their field and will certainly make your investment grow
- You simply want to enjoy retirement and do not want to actively manage your investments
Go for REITs or consider hiring a property manager/agent to manage your direct purchase properties.
Besides writing articles for my readers to enjoy, I am a real estate agent that is practicing in Singapore. Buying a new home or property can be a very tedious decision as it involves huge sums of money. Feel free to contact me at +6596329840 or at Joshua.firstname.lastname@example.org for any inquiries!
The views, thoughts, and opinions expressed in the text belong solely to the author, and not necessarily to the author’s employer, organization, committee or other group or individual. The author does not accept any responsibility whatsoever for any harm or loss arising from accessing or relying on information contained in this blog post.