Last month, I wrote about the golden opportunity to buy commercial properties at 30 per cent below market. You can do so by investing in REITs instead of buying a physical property. In December 2008, there was a huge discount of over 30 per cent to the REIT’s Net Tangible Asset (NTA), with yields of over 12 per cent per annum.

Based on the closing prices as at January 12, the prices of the three REITs I wrote about have improved slightly. The table below indicates the discount to the NTA. Even at these prices, the discounts are still extremely attractive and the yields are still over 10 per cent per annum.

Let’s assume you have RM100,000 set aside to invest in a property in the next few months. Should you use this amount as a down payment to buy a physical property, or should you use it to purchase a REIT instead? To answer this question, we will have to make some assumptions:

1. The physical property you purchase from the resale market is a condominium for rental returns. This will give a fairer comparison instead of buying a landed property for capital appreciation or buying off-the-plan properties from developers. The purchase details are:

2. You use the RM100,000 to purchase a combination of the above three REITs. All the REITs are giving yields of 10 per cent per annum or RM10,000 per year. To simplify matters, we shall assume the annual dividends are not reinvested. The properties in the REITs also appreciate by 5 per cent per annum. Hence, the NTA of the REIT also appreciate by 5 per cent per annum.

Let’s see how these two investments perform in the future:

Five years later…

The property has appreciated by five per cent per annum from RM400,000 to RM500,000. The original loan of RM320,000 has declined by 15.3 per cent (see the last column in the table) or RM49,000 (rounded up) to RM271,000. Your net worth has increased to RM500,000 (new property value) minus RM271,000 (outstanding loan) = RM229,000.
Your initial investment of RM100,000 has increased to RM229,000.

The NTA of the REITs have appreciated by five per cent per year from RM100,000 to RM125,000. You will get dividends of RM10,000 per year or a total of RM50,000. Hence your net worth has increased to RM125,000 (new REIT value) plus RM50,000 (annual dividends) = RM175,000.

Once the current economic scenario improves, there is a good possibility that the prices of the REITs may go back to their NTA level. If that happens, there could be a potential upside of another 30 per cent or approximately RM30,000. Hence the total upside could be RM200,000.
Your initial investment of RM100,000 has increased to RM200,000.

Looking at the above figures, it is obvious that an investment in a physical property would make more sense. However, we have to bear in mind that physical properties come with tenant and property management problems. For example, the property could be vacant for a few months or it may need repairs, repainting, etc. Also, the entry cost is extremely high at around five per cent of the purchase price. In addition, properties may take weeks to sell at a fair price and another few months to realise the money.

In REITs, you would not have these issues to worry about as the REIT managers take care of everything. The entry costs are negligible at less than one per cent. Also, REITs are actively traded and they can be easily liquidated in less than a week. If all these factors are taken into account, the difference between the two investments narrows down.

Ten years later

The property has appreciated by five per cent per annum to RM600,000. The original loan of RM320,000 has declined by 35.8 per cent or RM114,500 (rounded up) to RM205,500. Your net worth has increased to RM600,000 (new property value) minus RM205,500 (outstanding loan) = RM394,500.
Your initial investment of RM100,000 has increased to RM394,500.

The NTA of the REITs have appreciated by five per cent per year from RM100,000 to RM150,000. Your dividends of RM10,000 per year totals to RM100,000 over 10 years. In fact, your original investment is fully recovered just via dividends. Hence your net worth has increased to RM150,000 (new REIT value) plus RM100,000 (annual dividends) = RM250,000.

Let’s add back 30 per cent NTA discount or RM30,000, hence the total upside could be RM280,000.
Your initial investment of RM100,000 has increased to RM280,000.

It is obvious that the difference between the two investments in Year 10 is much more pronounced compared to Year Five. Even if we take into account the tenant, property management and other issues, the gap is still fairly wide.

This gap will widen even further in later years as the loan is being reduced at a faster rate. In the first few years of any loan, the bulk of the instalment is used to pay interest costs. It is only after the first five years, when more and more of the instalment is paid to reduce the principal loan amount. See the last column of the table under Percent Repaid.

The conclusions we can come to are:

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Article Contributed by:

Milan Doshi
Financial Trainer and Best Selling Author of
“How You Can Become a Multi-Millionaire Real Estate Investor!”
For more information, visit www.milandoshi.com

Copyright 2008 by Milan Doshi