Investing in Canadian REITs (Real Estate Investment Trusts) isn’t for everyone, but by the same token, there are many investors who swear by real estate.
I’ve met many who will only invest in real estate, as they want to own real assets that they can see and touch and manage. They don’t trust those crazy stock markets. They will own residential and vacation properties that they rent out, and often manage.
For many others, being a landlord is a headache that they don’t want. Fortunately, there is a middle ground available. Investors can buy REITs and own a basket of properties that are managed for you and other shareholders. You will then share in the income that the real estate generates. There will also be the possibility of capital gains if the value of the buildings and properties increases over time.
Canadian REITs own (mostly) commercial properties. They will fall into these categories.
- Retail (Apartments)
Investing in Canadian REITs is fairly easy, given that they are typically very liquid and trade on the Toronto Stock Exchange like stocks. The mechanics are quite easy as you can buy an ETF that holds a diversified basket of REITs from various categories. You can also choose to hand pick a few individual REITs if you want to focus on a certain type of asset.
A Wonderful Portfolio Asset
Investing in REITs is a wonderful portfolio diversifier, and portfolio managers consider REITs a distinct asset class. An income producing building that collects rent is certainly unique compared to a stock such as Apple that produces a product and sells them through other retailers.
REITs are considered a real or “hard” asset and they behave differently (compared to stocks and bonds) in certain economic conditions. Generally, an investment in a Canadian REIT offers a decent hedge against inflation, just as would your personal residential property and vacation property. And of course REITs by design, can offer a generous income stream. REITs are mandated to distribute 90% of their profits to shareholders.
How to Evaluate a REIT
The majority of REITs are equity REITs. They must invest the majority of their assets (75%+) into real estate or cash equivalents. In other words; they cannot produce goods or provide services with their assets. REITs must also receive 75% of their income from those real estate assets as a form of rent, interest on mortgages, or sales of properties. REITs must also pay a minimum of 90% percent of their taxable income in the form of shareholder distributions each year. In exchange REITs pay no corporate taxes. This is key to understand, since the tax liability for these earnings will fall to you when you invest in Canada REITs.
Therefore, classic earnings per share and dividend payout ratios cannot be considered to gauge the financial health of a REIT.
Instead we use the Funds From Operations and Adjusted Funds From Operations (FFO & AFFO for short). Those are the more relevant and most useful tools to analyze a REIT’s financial health and potential for performance moving forward. Those two metrics replace the earnings and adjusted earnings that we would use for a traditional stock.
While it’s different metrics, it’s all about cash flow and the REITs’ ability to sustain and increase their dividend payments.
Here’s a good primer on FFO.
It is important to consider not just the (A)FFO but also the (A)FFO per unit of ownership. One of the REITs’ favorite methods to finance their new projects is to issue more units. We need to make sure that the operations are not being funded (to an excessive degree) by creating more units, because this will dilute the value of the units that you hold as a current investor in the REIT.
Management has to make sure that any new properties it buys are still accretive to investors, meaning that the additional AFFO growth is enough to offset the dilution it took by issuing new shares to fund the property acquisitions.
In other words, AFFO per share needs to continue growing in order for the dividends to grow in a sustainable and secure manner.
More units means more shareholders, and that reduces your share ownership of the entire operation. And then there are more shareholders that are in line for those dividends. The total dividend obligation increases. For example, if there are an additional 500,000 shares created, there would be an additional 500,000 shares that would be in line for any ongoing dividends.
There are simply more mouths to feed!
Investors in Canadian REITs should keep an eye on the free cash flow generated by any new properties, and then the total free cash flows per unit. If the FFO per unit drops, that may signal that the REIT may have difficulty increasing or maintaining its dividend.
How are REITs Taxed?
This is an important distinction. While ordinary dividends from Canadian bank stocks or Canadian Telco stocks qualify for the dividend tax credit, REIT distributions come from many sources and each source can receive a different tax treatment.
Related post: Best Canadian Dividend Stocks for 2021.
The REIT distributions are usually in portions of eligible dividends, capital gains, return of capital, foreign income and other income.
Dividends are reported on a T5 form while distributions are reported on a T3 form. Your T3 form will break down the various forms of income.
Given all of the tax reporting and tracking complexities many will choose to keep their REITs in registered accounts such as the TFSA, RRSP and RRIFs. Those accounts grow tax free, there is nothing to track.
That said, REITs can also be quite tax efficient for taxable accounts. But you will have to have to have a good tax game, or hire an accountant to help you keep track.
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What About Rising Interest Rates?
There is much chatter these days about inflation and the potential of rising interest rates. It turns out that REITs might offer a good hedge against that risk. REITs could perform well as core stock markets and bonds take a hit.
From this Cohen & Steers research note.
“Beginning in mid-2004, the Fed raised the federal funds rate 17 times, from 1.25% to 5.25%, during which time the U.S. annual gross domestic product increased from $11.5 trillion to $13.4 trillion. Over this period, REITs had a cumulative return of 57.9%, compared with just 15.5% for stocks and 5.9% for bonds.
While the current environment is not identical, there are key similarities, including strong job growth, an expanding economy and a general expectation of higher interest rates.”
That is some very good performance for a period (rising rates) that will often put a scare into investors. And while the study is based on US REITs, asset classes can share performance characteristics across borders. And of course, you can the option of investing in US REITs by way of ETFs or individual REITs.
And once again, REITs are known for the potential to offer some protection against modest inflation.
In the name of diversification we want assets that don’t always move together. We want some zig to go with that zag. It’s about portfolio teamwork.
Investing in Individual Canadian REITS and REIT ETFs
You can pick and choose your favourite Canadian REITs. And given that, you might pay attention to those categories of REITs. Due to the pandemic and the stay at home and work at home economy, office REITs, retail REITs, and Seniors Housing REITs were hit hard, and that stress continues today. A risk averse investor might avoid those areas. That said, there may be incredible value in those REITs should we see a robust economic recovery and life somewhat goes back to “normal”.
When it comes to investing in Canadian REITs, I like looking to ETFs and fund managers that I trust. On my site I covered the CI First Asset REIT, ticker RIT. That is Canada’s best performing REIT ETF and it is actively managed. That is a very good one-stop ETF option for Canadians. You may also decide to use that list for candidates for individual holdings. You might then conduct additional research. You’ll pay attention to that free cash flow from operations.
The go-to Canadian dollar International REIT is iShares CGR. That is a US and Global REIT.
A couple of interesting names that make Morningstar’s Sturdy Canadian Stocks were CT REIT (that is the Canadian Tire real estate properties) and Killam Apartment REIT. Those REITs had to jump through a lot of hoops to make that list.
In the retail category you might look for a REIT with a very strong recession-proof anchor such as Smart Centre that is anchored by Walmart.
Final Thoughts on Canadian REITs
An Investment in Canadian REITs offers a nice combination of generous income and that all-important portfolio diversification. Many portfolio managers will suggest that you add a 10% portfolio weighting, and that your REITs will include Canada, plus some International diversification.
It’s an easy and potentially profitable way to be a landlord without having to collect rent, listen to tenant complaints, and fix the plumbing.
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