Investing in REITs vs. direct real estate

Whether it’s the family home, an investment property or indirect ownership through a listed real estate fund, housing has a valuable role to play in a diversified portfolio.

Sure, rising interest rates have taken the heat out of the physical property market, and Australian real estate investment trusts (A-REITs) are facing a double whammy of higher debt costs and lower property values. But as always, times of uncertainty can provide buying opportunities for the right asset.

The question is, where are the best opportunities?

Determine your investing preference

For the sake of this analysis, we’ll look at both options purely from an investing perspective. The family home has been a major wealth creator in Australia, but more on this another time.

The first question facing property investors is, how hands-on do you want to be?

Consider this continuum of real estate investments, put together by Morningstar research analyst Jeremy Pagan. It identifies different property investing options by the degree of personal involvement and responsibilities.

The pros and cons of each

Investors don’t need to choose between one or the other but knowing the benefits and drawbacks of investing directly in real estate and through REITs will help in setting a strategy.

Investing in REITs

REITS are companies that own, and in general manage and lease, investment-grade, income-producing real estate. Some of the largest companies listed on the ASX include Goodman Group, Stockland, Dexus and Mirvac according to the Morningstar Australia REIT index.

Unlike in the US, where 150 million, or more than 45% of American households own REITs (according to the National Association of Real Estate Investment Trusts), just 2% of Australian adults, or 490,000 people own this type of investment according to Finder.

Yet REITs can be a good way for investors to get the diversification benefits of real estate without the commitment and responsibilities of directly owning property.

And according to Morningstar’s latest outlook report, REITs look undervalued.

“We’ve long expected higher interest rates would prompt declines in commercial property prices, but not to the extent implied by listed markets,” says Morningstar equity analyst Alex Prineas.

He says market pricing still implies large falls in REIT net tangible assets (NTA) – that is, the value of a REIT's assets minus its liabilities – and very little value beyond the NTA.

“Despite likely pressure on commercial property prices and net tangible assets, we think REIT security prices already factor this in.”

3 undervalued REITs on the ASX

Mirvac, Dexus and Charter Hall are three REITs Prineas points to as undervalued.

1. Mirvac (MGR)

4-star Mirvac is a developer and manager of residential, retail, office & industrial property, and is currently trading at a 27% discount to Morningstar’s intrinsic valuation of $3.10.

Prineas says Mirvac’s residential development business is one of Australia's best, at a time when weaker rivals are exiting the sector.

“Higher interest rates should continue to pressure house prices, but Australia appears headed for a dwelling shortage, which should moderate the damage to earnings,” he says.

2. Dexus (DXS)

4-star Dexus is trading at a 26% discount to Morningstar’s fair value estimate. As a diversified Australian REIT, Dexus generates income from charging rent, managing property for clients, funds management, and development and trading.

Prineas says Dexus' office portfolio looks to be near the lows, with lockdowns in the rear-view mirror, and office supply likely to moderate from elevated levels in 2021 and 2022.

“We expect higher interest rates to put downward pressure on office valuations, but not to the extent implied by the Dexus security price,” he says.

3. Charter Hall (CHC)

Narrow moat Charter Hall manages retail and institutional listed and unlisted property investments. As of January 25 it was trading at a 15% discount to Morningstar’s valuation.

“Charter Hall has no debt on its balance sheet, and look-though gearing (including debt in its funds) is a modest 25%, so we think Charter Hall is well-prepared for tougher conditions,” Prineas says.

“We think the security price more than discounts expected weaker operating conditions, and its development pipeline is likely to continue to add to funds under management.”

Investing directly in real estate

On the other hand, if having agency over an asset is important to you, then directly purchasing a property could be an option.

Investment properties come with generous tax advantages, such as property depreciation (which can be substantial on newer properties), as well as interest, management and maintenance costs. Net losses can also be offset against an investor’s assessable income, known as negative gearing.

There’s also a wider range of potential outcomes, depending on your property’s type and location, relative to diversified REITs. New infrastructure projects, council rezoning plans or gentrification can add value, just as the closure of a major employment source or natural disasters can reduce it.

Physical housing is also less liquid. If you need cash, selling a property can take months and be costly.

Returning to Pagan’s continuum of real estate investments, this next table can provide a guide on whether you choose to invest in real estate directly, through a REIT, or both.

If you don’t have time to deal with tenants or maintenance, Pagan says passive investing is likely the right choice as REITs minimise time and effort while “improving risk-adjusted returns in a mixed-asset portfolio.”

“Sophisticated or wealthy investors could consider becoming a silent partner to an active investor, which could generate higher returns but comes with substantial risk,” he says.

2. A flexible professional

Early careerists or those with flexible jobs may consider making real estate into a part-time job or hobby.

“Risk appetite, liquidity needs, and your willingness to earn sweat equity will inform the appropriate choice,” Pagan says.

For those who’ve already built equity in their family home or other investments a rental property can also make sense.

“Your spare time and capital can be invested into a specific asset in the right market, and you can leverage real estate’s tax treatment to boost your after-tax returns,” Pagan says.

“Choosing tenants and working with maintenance providers is the time cost of actively investing in real estate.”

3. Retired or self-employed

Professionals planning for retirement or without guaranteed income may lean toward real estate for steady income, Pagan says.

Although investing in direct property for the purpose of cashflow often means investors need to look to regional and remote locations, which typically offer lower growth and are more susceptible to cyclical shocks – such as a mining downturn, drought, or the closure of a major employer.

“Shifting your investment strategy to REITs might be appropriate if free time is important to you but you desire a steady income,” Pagan says.

“Perhaps you already have a passive income stream or a sizable investment portfolio. Taking advantage of diversified REITs is a strong choice for keeping your real estate assets liquid and easily investing in properties in various markets.”

Taking an active approach

From personal experience, taking an active approach to property through construction or ‘fix-and-flip’ can be incredibly rewarding – and profitable – but it’s also expensive, hands-on, and highly risky in the current environment.

Wednesday’s CPI data showed new housing prices – that is, the cost of building a new home – have surged 17.8% over the year to December.

The official cash rate has also jumped by 3 percentage points since May 2022, adding hundreds, if not thousands of dollars to the cost of a variable home loan each month. And the RBA isn’t done yet. APRA’s bank capital framework means investors typically pay a higher mortgage rate than owner occupiers.

That doesn’t mean there aren’t opportunities. Anecdotally, real estate agencies have been reporting fixer-uppers and development sites are taking longer to sell. If you can find a bargain and the numbers work, it could be a good strategy.

If not, passively investing in property may be the best option.