How to invest in REITs

With analysts predicting that the Bank of Canada will cut its policy interest rate sometime this summer, 26 per cent of potential homebuyers sitting on the sidelines in anticipation, and more than 85 per cent of renters and home owners finding housing costs to be more expensive year-over-year, Canadian property values are positioned for a near-term upside surprise, making it a prospective time to learn how to invest in real estate investment trusts (REITs).

How to invest in REITs

1. What are REITs and how do they work?

A real estate investment trust owns, operates or finances real estate properties that generate income for their investors, who benefit from buying shares in the company while sidestepping the hassles of buying, managing and financing individual properties.

REITs are popularly sought after for their high distributions, a feature tied to their legal obligation to pay out 100 per cent of their taxable income in Canada and 90 per cent in the United States, which might come from rent, asset sales or management services.

The TSX REIT Index generated an average annual return of 9.7 per cent from 1997 to 2013, well ahead of the TSX’s approximately 7 per cent, while U.S. REITs achieved an 11.4 per cent return over the past 25 years, outperforming the S&P 500’s 7.6 per cent effort, with outperformance positioned to continue if borrowing conditions fall back in line with the post-Great Financial Crisis average.

2. What kind of REITs can you buy?

Most REITs can be classified as equity REITs, which operate as large-scale landlords, collecting rent in exchange for accommodations, customer service, and long-term property maintenance and upkeep. The nature of property portfolios is as diverse as there are passions to pursue, spanning retail (malls, self-storage, businesses), residential (single and multi-family, hotels), infrastructure (fibre cables, telecom towers, energy pipelines), healthcare, offices, or a diversified focus across multiple sectors.

You can buy equity REITs on major securities exchanges like you would a single stock, with the tickers being distinguishable by their .REIT or .UN endings. According to Edward Jones, 43 REITs were listed on the TSX as of December 2019.

If a budding real estate entrepreneur isn’t interested in property management, he or she can found a mortgage REIT instead, which lends money to facilitate acquisitions and holds a loan portfolio either directly or through mortgage-backed securities. Hybrid REITs, for their part, practice a strategy that borrows from their mortgage and equity counterparts.

Investors can also buy ownership stakes in private REITs, which aren’t registered with securities authorities, and can therefore have more lax governance standards compared with publicly listed companies. Private opportunities, often limited to institutional and accredited investors, aren’t attractive investments for most people, unless they have specialized real estate knowledge and are prepared to make a substantial allocation.

Investors can allocate into these four varieties of REITs through individual companies, or through funds, such as mutual funds or exchanged-traded funds (ETFs), that build and own portfolios based on mandates that will differ in terms of investment style, geographical reach and sector-specific focus.

3. What are the risks and benefits of investing in REITs?

Like any investment, the particular mechanics of REITs will only apply to certain investors based on their financial goals, risk tolerance and time horizon. We can broadly characterize these investors as:

• Income-seeking, meaning they might be retired, unable to work full time, or simply require a certain minimum income to meet their spending needs.
• Requiring of stock exposure, as publicly listed REITs have provided returns above the TSX and S&P 500, while suffering from comparatively less, but still substantial annual volatility, averaging between 10-20 per cent.
• REITs’ propensity to track stock market volatility, despite being about 25 per cent less volatile over the long term, according to data from Hartford Funds and Ned Davis Research, means they require long time horizons for investors to stand a decent chance at making money. Morningstar provides probabilities for losses tied to 20- and 30-year minimum holding periods for prospective stock investors.

With this ideal REIT investor framework in mind, let’s turn our attention to the benefits you could enjoy and the risks you must take by holding REITs in your portfolio.

Benefits

• Easy to buy and sell, supposing they trade on public exchanges, saving investors the headaches and high capital requirements of buying physical properties and screening tenants to fill them with.
• Diversification into an essential industry that is arguably underrepresented in the TSX at only 2 per cent, given Statista‘s forecast that the Canadian real estate market will surpass US$8 trillion in 2024.
• Real estate offers a strong case for low correlation and long-term outperformance compared with stocks and bonds.
• The potential to outperform broad-market stock indexes like the TSX or S&P 500, should your funds or individual REIT picks turn out to be winners (more on how to pick REITs in the next section).
• Stable income to fund your short-term spending needs, contingent on management operating the property portfolio efficiently and cost-effectively.

Risks

• Little to no capital to pursue expansion opportunities without diluting shareholders or taking out debt because of their high income payout requirements, making it more difficult to achieve share-price appreciation.
• Sensitivity to interest rates, given REITs’ propensity to lend money and issue debt, leading to periods of heightened volatility, such as during the COVID pandemic, which saw property values soar in anticipation of higher rates, only to fall back down to Earth as rates reached a generational high.
• Sector-specific risks, like hotels suffering during economic downturns and office space suffering during the ongoing post-COVID work-from-home trend.
• Potential tax complexity, if held in a non-registered or brokerage account, considering that REIT distributions may classify as dividends, capital gains, income, or return of capital, and often include all four.

Now that we’ve covered the basics about how REITs work and what they offer to investors, we can carry on to explaining how to pick the best REITs for your portfolio.

4. How should you evaluate REITs to invest in?

From a bird’s eye-view, putting your hard-earned money to work in a REIT depends on the probability of its business plan working out over your time horizon. This probability must be expressed as a percentage range, because investment research is by nature part art and part science and can be delineated by considering the following factors:

• A profitable track record measured by reliable distribution increases and consistent adjustedfunds from operations, which is calculated as net income minus the sale of property, capital expenditures and non-cash deductions such as depreciation and amortization. The largest Canadian REIT by market capitalization, Choice Properties REIT (TSX:CHP.UN), at C$9.38 billion, has been profitable in each of the past four years, raking in more than C$2 billion combined, while generating a return of 6.69 per cent since 2014, on top of a 5.8 per cent annual distribution.
• A debt-to-equity ratio that is controlled or shrinking, demonstrating responsible borrowing practices.
• A debt to-EBITDA ratio below 1, such that the REIT’s leases generate enough cash to cover distributions and debt payments. Investors can use Yahoo Finance’s stock screener to isolate real estate stocks based on debt-to-equity and debt-to-EBITDA to align themselves with leverage appropriate to their financial situations.
• A net interest margin, or the spread between interest earned on mortgage loans and the cost of funding the loans, that is stable or rising, demonstrating efficient evaluations of client creditworthiness.
• An occupancy rate that has improved over the long term and is free of any glaring gaps. Granite REIT (TSX:GRT.UN), a logistics, warehouse and industrial specialist in North America and Europe, scored the highest in terms of occupancy rate, coming in at 99.6 per cent in a September 2023 study by The Globe and Mail detailing 18 safe and undervalued Canadian REITs.
• A management team with multiple decades of experience in their real estate sub-sectors of choice, and a history of closing deals in line with the business plan they’re selling you.

If individual company research isn’t a rabbit hole you’re prepared to dive into, you can invest in REIT funds that offer exposure to broader portfolios with dozens or hundreds of holdings. Here are key factors to consider when choosing a REIT fund:

• Fees: The lower the fees you pay, the more of the fund’s potential returns will end up in your pocket.
• Performance: The longer a fund has generated a return sufficient to meet your financial goals, the more likely it is to continue doing so, all things being equal.
• Investment strategy: Certain REIT funds, such as iShares’ S&P/TSX Capped REIT Index ETF (TSX:XRE), practice an index-based strategy that invests in a group of stocks meant to represent an entire market, in this case, the Canadian REIT market. Other funds, like the CI Canadian REIT ETF (TSX:RIT), take a more active approach, using proprietary research processes to chose REITs on your behalf that will outperform compared with their peers and the market as a whole.

Despite there being ample evidence in support of index investing’s superior long-term returns compared with active stock pickers, a disciplined approach with a strong tolerance for volatility, as RIT demonstrates, can outperform the broader REIT market over time.

5. How do you buy shares in a REIT?

Once you have a list of REITs you’d like to own, simply head over to your online investment platform and place your orders. Remember to chose a limit order and to set a per-share price one or two cents above the ask price to make sure your orders are filled. Market orders, more appropriate for traders, will buy or sell at the quickest available price, which might be well above or below the current bid or ask price, and should be avoided by long-term investors.

If you haven’t opened an investment account yet, check out Questrade or Wealthsimple for low-fee options with seamless user experiences. These are the main accounts you can open in Canada depending on your circumstances:

• The Registered Retirement Savings Plan, or RRSP, where each dollar you contribute can grow tax-deferred and be knocked off your taxable income in the current year, or any future year you choose until you turn 71.
• The Tax-Free Savings Account, or TFSA, where owners keep all of their investment gains without having to pay taxes on them.
• A non-registered or taxable account, which obliges investors to add 50 per cent of all capital gains and 100 per cent of interest accrued (including REITs) to their taxable income. Investors can also use capital losses to reduce taxable capital gains in the current year, any future year, and up to three years in the past.
• Canadians can also benefit from the Registered Disability Savings Plan and Registered Education Savings Plan subject to eligibility requirements.

Having made your purchases, and positioned yourself to benefit from exposure to the universal need to have a roof over our heads, all that’s left to do is manage your investments according to your needs. This means not letting your REIT allocation grow beyond a balance between your risk tolerance and financial goals – whether that entails trimming your holdings or buying during periods of undervaluation – and transitioning to safer instruments such as cash and bonds once your investments grow enough to fund your original purpose for investing.

Now that you’re a property owner, you might want to expand your real estate knowledge to other sub-sectors poised for value creation. To this end, you can check out last month’s How to invest in home-building stocks and A near-term catalyst for Canadian real estate stocks.

Join the discussion: Find out what everybody’s saying about how to invest in REITs on Stockhouse’s stock forums and message boards.

The material provided in this article is for information only and should not be treated as investment advice. For full disclaimer information, please click here.