How about REITs?

How might Real Estate fit into diversified investment portfolios? And how might Real Estate Investment Trusts (“REITs”) be a good way to passively invest in real estate?  This post will explore what REITs are and how investors might use them.

Printing Dirt

The real estate investor Phil Ruffin once said that “you can print money, but you can’t print dirt”. He was referring to the inflation protection that real estate provides. Governments can print more money thereby creating inflation and the erosion of purchasing power. But the supply of land is mostly finite. So, in many ways real estate is a good inflation hedge.

Canadian culture strongly supports owning your own house. Many Canadians come from places where governments became deeply indebted and inflation took hold, thereby eroding the purchasing power of wage earners. Owning your own house is an easy way to protect your family from this inflation risk.

What about other ways to invest in real estate?

Some investors choose to become landlords and build a portfolio of rental properties. This is commonly done as a residential landlord, but some Canadian investors own plazas and warehouse buildings too. The challenge with directly owning real estate is the responsibility and expertise required. Most individual investors might one a few rental properties passively, but otherwise being a landlord is a full-time business. Directly owning real estate is not totally passive, even if property managers and other service providers are used.

Real Estate Investment Trusts

Real Estate Investment Trusts (“REITs”) were created to encourage investors to passively invest in real estate funds. As will be explained below, they are most suitable for individual investors with registered accounts (RSPs, TFSAs, etc) and non-taxable entities such as charitable foundations, pension funds, and governments.

REITs require their own set of tax rules. Prior to the mid 1980s, as mutual funds gained popularity in Canada, investors could purchase mutual funds that owned real estate. The sector soon learned there is a mismatch between the liquidity demands of investors (i.e. their desire to make deposits and withdrawals at regular intervals) and the illiquid nature of the underlying investments. With a mutual fund owning stocks and bonds, a portion of those investments (shares) can be bought or sold in fractional quantities on liquid markets (stock markets) when investors deposited or withdrew funds. But if lots of investors in a real estate fund wanted their money back at the same time, the fund wouldn’t be able to sell properties quickly (or cheaply) enough to satisfy their demands. This happened to several real estate mutual funds in Canada and so the REIT structure was created to solve this problem in 1986.

Tax Aspects

REITs are trusts setup to hold income producing real estate. Without going into specifics, a substantial portion of the assets of a REIT must be held in real property (including look-through entities) and most of the income produced by a REIT must be distributed to unitholders. If these conditions are met, then the REIT itself won’t be subject to income tax. However, the unitholders who receive distributions will be taxed on those distributions at their highest marginal rate.

With these tax rules in mind. Individual investors are best to hold REITs inside registered accounts such as their RSP, TFSA, RESP, RIF, RDSP, etc.

Public vs Private

Many REITs are traded on the TSX. The largest REIT in Canada is Canadian Apartment Properties with a market cap of $8.7 billion at the time of writing. But there are many other REITs that are distributed privately and not traded on an exchange. Skyline is an issuer of private REITs for example.

There are many pros to investing in public REITs traded on exchanges. The first major benefit is liquidity. Investors in REITs traded on the TSX can generally buy or sell units anytime as supply and demand allow. This also gives investors price discovery by knowing how the REIT is valued by the market day-to-day. Investors in private REITs will have some constraints on their ability to sell their investment. Commonly investors in private REITs might be able to get liquidity on a 30 day or quarterly basis. Private REIT investors will get a NAV and other financial metrics from the private REIT issuer, but not a market-based valuation like those traded on exchange.

Because of the liquidity of the public markets, REITs traded on exchange also tend to be larger. This is an advantage because they become more cost efficient with scale. Larger REITs can spread fixed costs over a larger base of properties.

Sponsors

Some REITs are connected to other corporations. For example, the fifth largest REIT in Canada called Choice Properties was spun out properties owned by Loblaws and is now majority owned by George Weston Ltd. A similar structure is found with other retail REITs such as Crombie (Sobeys/Empire), CT REIT (Canadian Tire). Other REITs are connected to a parent corporation that “drops down” developments into the REIT. Examples of this are SmartCentres, and some DREAM REITs. Some REITs started from a parent corporation but are now separate such as Granite (Magna).

From an investor’s perspective, having a corporate sponsor has some pros and cons. In certain cases, the parent corporation provides a backstop or type of guarantee (usually implicit). This reduces this risk that the REIT defaults because the parent corporation or sponsor will provide capital to support the REIT in times of stress. Its hard to imagine a scenario where Brookfield, Weston, or Canadian Tire would let their REITs default (especially as many parent corporations are anchor tenants and majority owners).

External vs Internal

Most public REITs are internally managed. This means the REIT employs its own management team and does not pay fees to an external manager. But some REITs are managed by a corporate sponsor like a mutual fund is. The trend in Canadian public markets is away from externally managed REITs. However, most private REITs are externally managed.

High Yield

Since REITs distribute most of their income to unitholders, they are generally higher yielding investments. This is why REITs appeal to income-oriented investors such as retirees and charitable foundations.

Analyzing REITs

There are many different types of REITs. Some REITs invest in apartment buildings, others own shopping malls. The valuation of a REIT and whether its a suitable investment for you will be partly based on the type of strategy the REIT has.

At the time of writing, the largest REIT in Canada is Canadian Apartment Properties (CAP REIT) which owns apartment buildings. CAP REIT pays a monthly distribution to investors at the time of writing of 3.01%. The second largest REIT in Canada is RioCan REIT which mostly owns retail plazas. Its current distribution yield is 4.60%. Which is better?

At first glance, 4.5% seems better than 3%, but there is more to the story. CAP REIT has a much more diversified tenant base (individual residential tenants) compared to RioCan. The revenues of CAP REIT are also more highly regulated and consistent. Its much more likely that a resident in an apartment building pays their rent compared to some retail stores, especially in a bad economy. CAP REIT is also harvesting income and doesn’t have major plans for capital investments into their properties (other than building up-keep). Whereas RioCan is embarking on a transformation where large parking lots will be converted into office & residential towers in the coming years. The current valuation of retail plazas (with the trend to online retail) is lower than apartment buildings (which do not compete against the internet).

Other Factors

Here are some factors to consider when analyzing REITs

• Leverage, how much debt does the REIT carry against its portfolio?
• FFO / AFFO, funds from operations. These metrics are used to determine the income a REIT generates.
• Payout Ratio, how much of the REITs earnings are being paid out to unitholders, and how much are being re-invested into future growth or development?
• Distribution yield, what % does the REIT yield to investors, and how might this payout change over time?

How might REITs fit into your investment portfolio?

Both income oriented and inflation sensitive investors should consider an allocation to REITs. At the time of writing the distribution yield of the iShares Canadian Corporate Bond Index ETF is the same as the iShares S&P/TSX Capped REIT Index ETF. But within these indexes, investors may find higher yielding opportunities. For example, the distribution yield of Choice Properties REIT is 42% higher than the REIT average and SmartCentres REIT is 82% higher.

Your family office should create an Investment Policy for you that considers your objectives for income, capital appreciation and/or capital preservation. Your investment policy should consider your holding structure and therefore the taxes you might be subject to. The benefit of creating an investment policy with your family office compared to your investment advisor is your family office does not get paid on investment commissions. This takes away a conflict of interest that your investment advisor has.

Charitable Foundations

Charitable foundations should consider holding REITs as a portion of their portfolio. This is because charities are not subject to income tax, so there is a direct tax advantage to having REITs. Also, charitable foundations are required to distribute 5% of their capital to charity each year. Many REITs provide enough income to satisfy this requirement without having to erode invested capital.

Your Family Office

A good family office will come to you with new ideas to improve your investment returns. For example, our family office will suggest sectors for investment that other advisors may overlook. We can then search out investment managers to present you with new ideas based on our recommendations. Whether you should invest in REITs, preferred shares, common stocks, private equity, infrastructure, or any other asset class depends on your investment goals as outlined in your Investment Policy. If you don’t already have one, your family office should be drafting an investment policy for you. This ensures that your investment managers can make independent recommendations to you based on your stated objectives, not the objectives they define for you.