Sunday, February 25, 2007


Real Estate And The Media

Analysing how headlines, cover stories, newspaper reporting and more or less biased media exposure can serve as indications of real estate markets trends.

The role of the media is to report news and opinions, not to make predictions and forecasts.

Predictions and forecasts are better left to the storytellers and the experts respectively. Specifically when it comes to important fields such as Real Estate, it would be ideal if media reporting were as objective and as analytical as possible, for the common good. Unfortunately this is not always the case, at least not when it comes to the general media. We would surely expect to see stories about Real Estate featured in the financial press, such as The Wall Street Journal in the U.S.A., the Financial Post in Canada or The Financial Times in the U.K.

On the other hand, when a feature article on the real estate markets appears in general-circulation publications the likes of Time, Newsweek, MacLeans or U.S. News and World Reports we should take note because the story has begun to circulate well beyond the inner core of the usual financial circles. This may indeed reflect the fact that the general public may be about to imitate the ‘experts'. The interesting thing about such stories is that they invariably occur after a substantial price movement has already taken place or a price trend, whether upward or downward, has initiated. The article may explain why prices have increased or decreased so much thereby reflecting conventional wisdom, and hence dispensing onto the general public some powerful reasons as to why they should buy or sell, as the case may be.

When market stories reach the front pages of general-purpose newspapers or the covers of magazines and publications, the implications are far greater than if the stories appear solely in the financial press. Independent studies have revealed, for example, that there is a significant correlation between Time cover stories and major trend reversals in both Real Estate and the Stock Market. According to statistical research, the appearance of the story breaks pretty close to the final peak. In the Stock Market, for example, when a bullish cover is featured the market usually rallies at an annualized rate of about seventeen percent for three months or four before the peak. Conversely, when bearish covers are featured, the decline begins within the subsequent couple of months.

Needless to say, the media has an impact on Real Estate as well, but only at major turns of the market. It would be unrealistic to expect a widely published story to signal a short-term turning point. This is so, because to make the front cover of a publication the article has to reflect news to which more or less everyone can relate.

Cover stories sometimes focus on interest rates. In March 1982, for example, an article entitled ‘Interest Rate Anguish' appeared on the cover of Time featuring Paul Volcker, the then Chairman of the Federal Reserve Bank. Treasury bills were yielding 12.5 percent at the time, but a year later they had fallen to 8.5 percent. And so had mortgage rates. Likewise, cover stories that do not appear to have any direct bearing on Real Estate, but that refer to the general state of the economy can also help discern the markets' mood. For instance, features about the President in the United States or the Prime Minister in Canada can often reveal how we think about ourselves. Covers reflecting upbeat and confident leaders typically reflect a similar mood in the country. The opposite is also true.

But here is where the analogy between Real Estate and the Stock Market diverge. If the nation, whether the United States or Canada, either directly or indirectly through its elected officials is reflected in a cover story as ebullient and confident, then expect the Stock Market to decline and Real Estate to pick up. On the other hand, if the story reflects a lack of national confidence and will tackle its seemingly insoluble problems, then expect Real Estate to decline and the Stock Market to pick up.

It must be said, however, that one should not rely on cover stories with mathematical precision. It is always important to examine the facts and to come up with various alternative forecasts, as cover stories cannot invariably be relied upon as exact timing devices, especially in Real Estate. They do, however, offer general indicators that give a good historical perspective of when an extreme has been reached, whether high or low. When all pieces are more or less consistent, it is possible to come up with credible scenarios and forecasts outlining with reasonable approximation the chances that Real Estate is about to reverse its prevailing trend.

Luigi Frascati

Real Estate Chronicle


Tuesday, February 20, 2007


Real Estate And The Year Of The Pig

Gung Hay Fat Choy! (Happy New Year)

The Lunar New Year dates from 2600 BC, when Emperor Huang Ti introduced the first cycle of the Chinese zodiac.

Because of cyclical lunar dating, the first day of the year can fall anywhere between late January and the middle of February. On the Chinese calendar, 2007 is Lunar Year 4704-4705. On the Western calendar, the start of the New Year falls on February 18, 2007 - The Year of the Pig.

The Year of the Pig is of particular importance for North American real estate markets, since the level of interest rates is in direct function of how China's Central Bank will direct the investment of its USD 1 trillion in foreign exchange reserves.

China's foreign exchange reserves are at twice their level of two years ago and amount to more than one-fifth of all global foreign exchange reserves in American Dollars. To put things into perspective, this humungous amount would be enough to buy all the gold sitting in the vaults of all central banks or, put differently, it would be almost enough to buy all residential property in the London Metropolitan Area. This massive hoard of foreign cash reserves is growing exponentially to the tune of some USD 20 billion per month.

China's foreign exchange reserves already far exceed the minimum level required to ensure financial stability. As a rule of thumb, a country needs enough foreign exchange to cover three months of imports. The reserves of the People's Republic are already enough to cover five times as much - 15 months worth of imports. This is the direct and proximate result of the country's large current account surplus, significant foreign investments and big inflows of speculative capital, especially over the past couple of years. In theory, strong flows of foreign capital into China should have pushed up the Yuan to astronomical levels, but Beijing has resisted this by refusing to allow its currency to float freely, thus forcing the Central Bank to buy up the surplus foreign currency.

How this stack of money is invested has big implications for the world economy, not just for China. But no place is more dependent on the decisions that the Central bank will make in the Year of the Pig than North America. This is so because approximately seventy percent of the country's foreign reserves are invested in American Dollars, mainly in US Treasury securities. This has propped up the Dollar and reduced American bond yields by as much as 1.5 percent.

China's Central Bank, however, has now signalled its intention to switch from Treasury bonds to American mortgage-backed securities and corporate bonds in an attempt to earn higher yields. What's even more important, Chinese officials are also debating the need to diversify reserves out of American Dollars in order to reduce the exposure of a big drop in the value of the Greenback, and to invest a larger slice into Euros and the emerging Asian currencies.

Clearly, a big shift out of the Dollar could therefore push up bond yields and hence mortgage rates, thus damaging further the already weakened North-American housing markets. And this is the reason why the Year of the Pig promises to be a pivotal year and of great repercussions here in North America.

Luigi Frascati

Real Estate Chronicle


Saturday, February 17, 2007


Real Estate Outlook 2007: The Great American Iced Lemonade!

What do California sunshine, the citrus industry, an excess surplus of ice cubes and Nancy Pelosi all add up to? Find out ...


Did anyone out there ever coined the phrase ‘The New Era Of American Socialism' yet?

Well alright, that is unfair. After all Real Estate was sliding downwards even before the Democrats took over the House and Senate, and Nancy Pelosi became the Speaker to be. However, it can be safely stated that the recent mid-term elections have not exactly shed a ray of hope on the already faltering housing prices. So now, in light of the entirely new and revolutionary political landscape in Capitol Hill, what are mundane folks like you and I supposed to do?

Sure, the social agenda of the Democratic Party in general, and the personal ‘socialist' agenda of Congresswoman and Speaker of the House Nancy Pelosi (D-Cal.) in particular take somehow the breeze out of the investment world, both as it relates to Real Estate and the Stock Market. But when it comes to Real Estate, however, there are some positive notes worth mentioning.

Housing supply is produced using land, labour, and various inputs such as electricity and building materials. The quantity of new supply is determined by the cost of these inputs, the price of the existing stock of houses, and the technology of production. Essentially, the production of real estate output depends on the accumulation of capital, which requires a constant supply of labour force that can conserve and add value to inputs and capital assets, thus creating a higher value.

The rationale behind this is that labour adds value by satisfying demand through production, since when people work and acquire income they tend to invest it, and the more people that work and acquire income the more people that tend to invest it. Therefore, there is a correlation between capital and employment in real estate or, if you will, between income and labour. An increase in levels of consumption sets forth an increase in prices caused by a corresponding increase in demand, in itself generated by a commensurate increase in the income-employment factor.

It follows, therefore, that growth is derived by the equilibrium of capital and investment with labour and employment. And since, furthermore, production is in direct function of consumer-spending which increases as unemployment falls, it follows that capital accumulation increases as employment rises and capital accumulation decreases as employment falls.

Therefore, seen from this perspective, the Democratic agenda of both increasing minimum wages and put people at work through more direct governmental intervention than the Republicans otherwise would like to see, finds in fact its long-term benefits in Real Estate. It is a statement of fact that, in retrospective, many workers in North America have missed out and are missing out on the rewards of globalization, so trumpeted about by both the present Chairman of the Federal Reserve System, Prof. Bernanke, as well as the former Chairman, ‘Maestro' Alan Greenspan.

Rich countries have democratic governments, so continued support for the globalization process will depend in large part on how prosperous the average worker feels. Yet in the United States real wages have been flat or even falling these past few years while, at the same time, capitalists and large corporations have never had it so good. In America specifically, profits as a share of GDP are at an all-time high of about 15.5 percent, and Corporate America has increased its share of national income from seven percent in 2001 to thirteen percent this year.

In fact the primary culprit and cause of the slowdown in Real Estate is the ratio between wages and real estate market values. This ratio is entirely skewed to values. Whereas market values in metropolitan areas have appreciated an average of fifteen percent per year through 2005 inclusive - or a total of seventy-five percent since 2000 - salaries have increased an average four percent per annum - or twenty percent total. There is, therefore, a fifty-five percent gap, which accounts for the problem buyers are facing today when it comes to go to the bank and qualifying for a loan. In this sense, therefore, a redistribution of income from capital to labour is now due.

The flip side of the Democratic agenda, however, is that it is going to take a long time for government economic intervention to get a foothold in the economy, in order to make workers earn income sufficient enough so that they can go to the bank, get a loan and go shopping for real estate. Thus, it is going to take equally long for demand to jump and prices to increase as well. This is so because demand is in direct function of underlying personal income. An increase in personal income will encourage investment to a higher degree, which, in turn, will spur demand causing a proximate levitation of prices and subsequent economic expansion.

A second but equally important flip side is how foreign investors and debt-holding nations are going to view this sudden shift to the left of the American behemoth, and whether emerging economies such as India and China will continue to finance America's spending habits. Confidence in the U.S. Treasury is out of the question, but how convenient is it going to be for foreigners to continue investing in an America tilted definitely to the left?

Many economists have long been expecting America's widening current account deficit to cause a financial meltdown in the Dollar, and the main reason as to why this has not happened yet is that emerging economies have been happy to finance the deficit. In 2005 India, China, South Korea and Japan (not an emerging economy but a very important debt-holder nonetheless) ran a combined current account surplus of about USD 2 trillions, a large chunk of which was reinvested in American Treasury securities. It is all to be seen, however, whether the Asian Tigers will continue to find the convenience in investing their foreign cash reserves in American securities or if instead they are going to withdraw their support of the American capitalistic system, especially if such system will be perceived increasingly as shifting much too much to the left.

By purchasing Dollar assets the Asian economies and Japan are subsidizing American consumers, encouraging too little saving on our part and too much spending. But should they decide not to buy anymore and in fact to cash in, the American economy is likely to suffer a real hard landing. This is the reason why it is important to monitor and understand how developments in the world economies affect the balance between domestic demand and supply. Exchange rate movements tell something about economic developments that may be having a direct impact on aggregate demand.

By monitoring the fluctuations of the Dollar in the forthcoming months it will be possible, therefore, to anticipate whether the Central Bank will ease or tighten monetary policy by stimulating the economy through lower interest rates or by reducing the stimulus through higher interest rates. And, therefore, it will be possible to predict the impact that anticipated shifts in interest rates will have on demand for domestic real capital assets. Clearly, in the eventuality that demand for U.S. Treasury bonds will abate, the Federal Reserve will have no other choice under the present circumstances but to raise interest rates, so as to continue to attract foreign capitals and thus contributing to a further slowdown in the domestic housing markets.

Should a forced rate increase actually take place in 2007 to maintain the momentum with foreign debt-holders, that would really fly in the face of all those analysts and commentators who have assumed that a vote for the Democrats would contribute to a rate settling.

Certainly we are entering into a period of financial uncertainty, all the more remarked by what promises to be an economic - if not political - stalemate between a conservative White House and a liberal Congress. And should this stalemate translate into higher interest rates, the soft landing that Chairman Bernanke was mentioning only this past July may very well become in 2007 a distant, wishful dream.

Luigi Frascati

Real Estate Chronicle


Tuesday, February 13, 2007


Shifting Gears: The Increasing Power Of The Emerging World

Examining the change of the world's economic power structure.

Globalization - unquestionably a democratic concept that puts all mankind on the same platform.

In Economics there is a special sentence to describe this process of equalization, referred to by politicians as ‘globalization': economists call it ‘Democratization of Wealth'. The democratization of wealth among nations is theoretically almost a perfect concept, save and except for only one drawback: as poorer countries are getting richer, richer countries are getting poorer.

Economics and politics have been always integrated, dependent and intertwined with one another, but whereas politics - and politicians - focus on momentum and balance of power in hopes of writing history for posterity, economists provide the backbeat. Economics does not determine history per se, but it does provide the environment for politicians to move around and, thus, write history - or trying to.

Let me make an example. Only a short fifteen years ago or so the world looked much, much different. The political landscape consisted of two powerful, monolithic assemblies of nations: us - the ‘Free World' - and them - the ‘Communist Bloc'. The United States and Western Europe formed the bulk of the countries of the Free World while Soviet Russia, Eastern Europe and Maoist China formed the bulk of the Communist Bloc. As to the remainder of the countries, which did not belong neither to the Free World nor to the Communist Bloc, they were collectively referred to as the Third World. If Western strategists during the Cold War era can be found guilty of something, it is that they probably spent too much time worrying about the Soviet Union's military clout and too little time analysing its economic frailties. But it was economics, not politics, which ultimately brought the soviet bear down to its knees.

And another lesson that politicians never seem to learn, is that history - far from being new and exclusive - invariably repeats itself. For instance, until the mid-19th century China and India were the world's biggest economies. Then the West, through technological prowess, spirit of freedom and sound economic principles took a giant leap ahead. But today we are assisting at the restoration of the old order.

The emerging world already accounts for over half of global economic output measured in purchasing-power parity, which allows for lower prices in poorer countries. And, moreover, a barrage of statistics shows that economic power is shifting away from the ‘developed' economies - such as North America, the Euro Zone, Japan and Australasia - towards emerging ones, especially in Asia. Developing countries chew up over half of the world's energy and hold most of its foreign-exchange reserves. China has amassed more than USD 450 billion in foreign-exchange reserves and India too has seen a marked rise in international reserves, to roughly USD 200 billion.

The share of exports of the emerging economy has grown exponentially from twenty percent in 1970 to forty-five percent today. And although Africa still lags behind, the growth is fairly broadly spread. They may be the most talked about, but according to the World Economic Council Brazil, Russia, India and China account for only two-fifths of emerging world's output.

Clearly, no social or economic change of such an enormous size can take place without friction, and perhaps the most evident and ominous sign of it is the uproar about jobs being ‘outsourced' to India, China and, to a lesser extent, Mexico and South America. Not surprisingly, many perceive the growing competition especially from China and India as a significant threat. And some are wondering how anyone can compete against countries that have such huge pools of cheap labour and, at the same time, access to the latest technologies.

It was a combination of demand for inexpensive products and domestic competition that has spurred companies to open subsidiaries to produce goods and services in China and India, so as to take advantage of an almost inexhaustible pool of cheap human resources. Outsourcing, however, from a strict economic perspective is not an entirely negative phenomenon. Robust economic growth in Asia, which is lifting hundreds of millions of people out of poverty, is creating more demand for goods and services from the industrialized countries, thus providing a much-needed boost to global economic growth. Indeed, preliminary data suggest that China has vaulted into third place among the world's most important importers, behind only the United States and Germany. Globalization is not a zero sum game: Mexicans, Indians and Brazilians and Chinese are not growing at the expenses of Americans, German, Japanese and the British.

There are, furthermore, wider ramifications of a political nature as well. For one thing, China's rise has helped push India and even Japan closer to the sphere of influence of the United States, and South Korea farther away from it. Likewise the West, as well as hundreds of millions of people in the developing countries, has benefited and continues to benefit from the growth of the emerging world. Besides political alliances, as consumers of the emerging countries get richer they will become more educated and their societies more stable. In a way, democratization of wealth is also democratization of societies, and perhaps the greatest contribution to the annihilation of those few tyrannical political systems that still pervade the planet and enslave their own people into submission.

The world is on course for its fastest ever decade of growth in GDP per capita, which has been powering ahead at an annual rate of 3.2 percent since the onset of the millennium - one of the most accelerated ever in the political and economic history of humanity. Let us only hope that our great leaders and politicians of all colors be wise enough to appreciate the fact that a world in which most people enjoy prosperity and opportunity is surely better than one in which eighty percent of them are mired in economic stagnation.

And let us further hope that our great leaders and politicians - and indeed the leaders and politicians of all nations - may come to terms with the ultimate truth that cooperation and dialogue, not confrontation and war, are the solutions to mankind afflictions.

Luigi Frascati

Real Estate Chronicle


Thursday, February 08, 2007


American (or Canadian) Dream 2007: Keep Those Real Estate Properties Financed!

The untold secret of homeownership.

If you had enough money to pay off your mortgage right now, would you?

Many people would. In fact the American Dream is to own a home - and to own it outright, with no mortgage. Imagine owning your home without having to send a cheque to the bank every month, the feeling one will enjoy when - after thirty long years - the moment finally comes to make one last payment so that the house is paid off, at last. Being so fortunate must evoke a sense of security, gratification and well-being that anyone only can dream of.

But if in fact the American Dream is so wonderful, how come thousand of financially successful people - folks who have more than enough money to pay off their mortgages right now - refuse to do so? Why is it that a small group of Americans and Canadians, who are invariably among the wealthiest five percent of the population, insist on carrying on a mortgage even if they can afford to wipe it out entirely today? Because they are aware of the biggest untold secret of homeownership: a mortgage is primarily a loan against the borrower's income, not primarily against the value of the house. It this was not the case, then naturally anyone with a $30,000 annual income would qualify to purchase a multi-million dollar mansion.

All of which, then, makes the whole difference in the world when it comes to a process known in Economics as the accumulation of wealth. Prosperity in any society and at any given time is the epitome of financial stability, reliability, and security. Specifically in Capitalism, additional capital value (commonly referred to as ‘surplus value') is what drives the accumulation of wealth. Although capital accumulation does not necessarily require production, ultimately the basis for it is value-adding production which makes net additions to the stock of wealth. Capital can accumulate by shifting the ownership of assets from one place to another, but ultimately the total stock of assets must increase. Other things being equal, if surplus value fails to grow sufficiently, the level of debt will increase, ultimately causing a breakdown of the wealth accumulation process.

This is exactly the reason why saving money has never made anyone rich. For some obscure logic people generally tend to equate the concept of saving money with that of making money, yet the two are not synonymous. As people want to save money in interest payments, they will go the extra length to pay off their mortgages. With that issue out of the way after a considerable number of years, they then start focusing on saving for retirement and do their best to save regularly. As a result, they fail to accumulate wealth and cannot figure out why.

The issue is relatively simple, though not necessarily transparent. By prioritizing mortgage repayments, they fail to consider the role that mortgages play in their wealth building process. The battle to reduce interest expenses is won, but the wealth accumulation war is lost. The reason is that every dollar they have returned to the bank is a dollar they have not invested.

Mortgages today cost anywhere between 5.5 percent to 6 percent annually. Over the next thirty years, on an annual basis, will alternative investments earn at least that much? Of course they will. Even government bonds pay nearly that amount, and stocks have been averaging 10 percent a year since 1926. Thus giving money back to the banks to save 6 percent denies people the opportunity to invest that money where it might earn 10 percent. Which means that, rather than actually saving money, those who opt to pay off mortgages factually lose money. And which, furthermore, goes to explain why bi-weekly mortgage payment plans are not a great idea - because they speed up the process of mortgage repayments.

Specifically as it relates to real estate, furthermore, the irony is that people somehow feel they are making a ‘good investment' by paying off their home loans. In fact, all they are doing is burying money under a mattress - they are not investing at all. Consumers, and a great deal of them, strive to pay off their mortgages as quickly as possible so they will be able to borrow later on against their equity to pay, among other things, for their kids' tuition bills. But isn't that refinancing? Talk about bizarre strategy! Consumers struggle to give banks their money back now, so they can borrow it again in the future. Why don't they just invest their cash, so that it earns competitive returns and, at the same time, remains available whenever needed?

Their homes will grow in value over the next thirty years whether they have a mortgage or not. When it comes to selling a home, does any Buyer care about what the Seller's mortgage outstanding balance is? Of course not. And neither does the IRS (Internal Revenue Service) or the CCRA (Canada Customs and Revenue Agency) when it comes to calculating taxable capital gains, losses or recaptures.

The simple truth is that mortgages do not affect home values. But being primarily financial instruments anchored to income, they do affect the wealth maximizing process of investors and market participants by opening up a host of possibilities to invest liquid money derived by consumers' own income elsewhere, for higher rates of return. Which is what the wealth accumulation process is all about.

Luigi Frascati

Real Estate Chronicle


Sunday, February 04, 2007


Real Estate Investment Trusts

An in-depth look at an ever popular form of real estate investing.

Royalty trusts, in Finance, are classic flow-through investments vehicles. The trust, like a mutual fund, holds a portfolio of assets, which can be anything from producing oil and gas wells to power generating stations to interests in land. The net cash flow, i.e. the total cash flow minus revenues, is passed on to the unit-holders as distribution.

The purpose of a Real Estate Investment Trusts is to reduce or eliminate corporate income taxes. In the United States, where they are generally more widespread as investment vehicles, Real Estate Investment Trusts pay little or no federal income tax but are subject to a number of special requirements set forth in the Internal Revenue Code, one of which is the requirement to distribute annually at least 90 percent of their taxable income in the form of dividends to shareholders.

Real Estate Investment Trusts are, therefore, a special type of royalty trust. They specialize in real property, anything from office buildings to long-term care facilities. For illiquid assets like real estate, closed-end funds of this type make good sense. Open-end or ‘mutual' real estate funds are subject to new money and redemption problems, entirely absent in closed-end trusts. The first Real Estate Investment Trust was introduced in the United States in 1960. The vehicle was designed to facilitate investments in large-scale income-producing real estate by smaller investors. The US model was simple, enabling small investors to acquire equity interests in vehicles holding large-scale commercial property.

But the birth of Real Estate Investments Trusts as a mass investment vehicle can be traced directly to the liquidity crisis encountered by open-end real estate mutual funds all the way back to 1991-92, during the slowdown of real estate that characterized those years. Faced with redemption demands on the part of unit-holders, real estate mutual funds were presented with the unpalatable option of selling valuable real properties into a distressed market to raise cash. Many of them, therefore, chose to close off redemptions and converted into Real Estate Investment Trusts, since then most commonly known as REIT's. Only a few open-end real estate mutual funds continue to own real estate directly. Most now invest in shares of real estate-related companies.

The typical REIT usually distributes about 85 to 95 percent of its income (rental income from properties) to the shareholders, usually on a quarterly basis. This income gets a special tax break, because REIT's shareholders are entitled to a deduction for the pro-rata share of capital cost allowance (depreciation on the real properties). As a result, a high percentage of the distributions are normally tax-deferred. However, the amount will vary from year to year and will differ depending on the particular REIT.

As with royalty trust, the value of tax-deferred income will reduce the adjusted cost base of the shares owned. For example, if an investor purchases 1,000 units at $15.50 per unit, receives $3,000 ($3.00 per share) in aggregate tax-deferred distribution over time, and the sells the shares for $17.50 each, the capital gain will be calculated as follows:

[1,000 x ($17.50 - $15.50 + $3.00)] = $5,000 before adjustments for commissions. In Canada, this gain will be subjected to capital gains treatment, so only 50 percent or $2,500 will be included in income and taxed accordingly. In fact, Canada allows preferential tax treatment to REIT's by making them RRSP-eligible and by not considering them foreign property (which would be taxed at a higher rate), so long as the real estate portfolio does not contain non-Canadian property in excess of the allowable limit.

REIT's yields and the market price of units tend to be strongly influenced by interest rates movements. As rates drop, prices of REIT's rise thus causing yields to drop. On the other hand, when interest rates rise, prices of REIT's drop thus causing yields to rise.

For example, when interest rates were pushed up by both the Federal Reserve Board and the Bank of Canada all the way back in 2000, the typical REIT was yielding close to 14 percent as prices per share fell. When interest rates subsequently dropped, yields fell to less than 10 percent as demand for REIT's increased thus pushing share prices higher.

This is a very important consideration to be kept in mind when investing or otherwise trading units involving this type of trusts. If interest rates appear to be poised to rise, investors may want to defer purchases, and those who own this type of shares already may consider reducing their exposure by selling and take in some profit.

There are typically two catches with REIT's. The first is that since investors are ‘unit-holders' rather than shareholders, they are potentially jointly and severally liable together with all other unit-holders (plus the trust itself) in the eventuality of insolvency. Instead of limited liability, investors rely on the REIT's management to have property, casualty and liability insurance, prudent lending policies and other reasonable safeguards in place. Nevertheless there is always the possibility of a problem - say a catastrophic fire or a building collapse - that is not covered by insurance. This may have seemed like a very small matter prior to the attacks on the World Trade Center in 2001. Since then, however, it is something that has to be taken seriously.

The second problem with REIT's is less transparent. All real estate properties depreciate in value over time (not the land, only the buildings). Depreciation can be somewhat slowed down by earmarking at times significant amounts of money for maintenance and renewal of facilities. Since most of the REIT's income is being distributed and the capital cost allowance is being allocated to investors, investors are factually getting their own capital back over time. As such, the book value of the underlying real properties will be steadily depleting.

Obviously, if real estate markets are on the upswing the depreciation factor will not be overly important, since it will be offset by the appreciation of the underlying assets. But in essence, the point is that the long-term income stream is quite variable, certainly more variable than some managers would have investors believe.

As stated above, the inverse relationship between interest rates and prices of REIT's shares plays an important role. On average, it is safe to assume that interest rate increases are likely to be met by REIT's price declines in the Stock Exchange, because increasing rates correspond to a slowdown in the economic growth and less demand. But out of the context of the frantic buy and sell of Wall Street, even a slowdown in the market for single-family houses can actually benefit REIT's. This is so, because even though real property prices are in decline, it is still cheaper to rent than to own, especially during a period of rising interest rates. And REIT's thrive on rentals. In fact, no city is a better environment for REIT's to operate in than New York City, where some 70 percent of residents rent.

Luigi Frascati

Real Estate Chronicle


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