Since REITs are a different type of corporate structure, they deserve to be addressed separately. REITs are tax-advantaged investments. They pay no corporate tax, but in return, they must meet certain guidelines. They must invest primarily in real estate and must pay out most of their net income as dividends.
Canadian REITs can be good investments because they typically offer above-average dividend yields and can give an investor exposure to real estate without the typical difficulties of owning real estate directly (low liquidity, responsibility for maintenance, etc.).
Real Estate Income Trust Basics (REITS)
REITs are not only popular because they distribute generous dividends, but also because they are easy to understand. Investors can picture an apartment building or an office tower and see how tenants pay their rent monthly. They are willing to purchase units of those businesses in exchange for the income and peace of mind.
The concept of being a landlord and having tenants is comparatively simple to understand. The company owns and manages Real Estate in exchange for receiving rental income from properties such as apartment complexes, hospitals, office buildings, timber land, warehouses, hotels, and shopping malls.
Most REITs are equity REITs. They must invest most of their assets (75%) into real estate or cash equivalents. In other words, they cannot produce goods or provide services with their assets. This is how REITs must also receive 75% of their income from those real estate assets in the form of rent, interest on mortgages or sales of properties. REITs must also pay a minimum of 90% percent of its taxable income in the form of shareholder dividends each year. Therefore, the classic earnings per share and dividend payout ratios cannot be considered the sole gage of the health of an REIT.
There are several types of REITs:
Equity REITs own and invest in property. They may own a diversified set of properties, and they generate income primarily in rent payments from leasing their properties.
Mortgage REITs finance property. They generate income from interest on loans they make to finance property.
Hybrid REITs do a bit of both, as they own property and finance property.
In general, REITs offer great investment opportunities by their nature. A growing economy leads to growing needs for properties. REITs can grow organically as the population requires more industrial facilities, healthcare centers, offices, and apartments.
|REIT – Diversified||REIT – Mortgage||REIT – Specialty|
|REIT – Healthcare Facilities||REIT – Office||Real Estate – Development|
|REIT – Hotel & Motel||REIT – Residential||Real Estate – Diversified|
|REIT – Industrial||REIT – Retail||Real Estate Services|
REITs Greatest strengths
REITs are unique as they distribute most of their income. In fact, they exist to pay generous distributions. This makes them one of the retirees’ favorite sectors! Since these businesses must give most of their profits to shareholders, it is easy to understand how most of them offer a relatively high dividend income. This is one of the rare sectors where you can find “relatively safe” stocks paying 5%, 6% even 7%+. Investors must be careful not to get too greedy, though. We have seen several REITs cutting their dividends due to poor management or economic downturns.
REITs are not only popular because they distribute generous dividends, but also because they are easy to understand. Investors can picture an apartment building or an office tower and see how tenants pay their rent monthly. They are willing to purchase units of those businesses in exchange for income and peace of mind.
REITs usually bring stability in a portfolio along with higher yield. This is a great sector to start with when you are looking for additional income. Real Estate brings great diversification to your portfolio. Research has proved that REITs are not directly correlated to stock market movements over the longer term.
Finally, since most of them operate with escalator contracts, they offer great protection against inflation. Many Income trusts will include yearly rent increase in their rent to insure rental income matches inflation. Some REITs also operate under a Triple-Net business model. In this case, tenants take care of insurance, taxes, and maintenance costs, reducing the REITs expenses (and risk of unexpected charges!).
REITs Greatest weaknesses
One of the REIT sectors’ favorite ways to finance their new projects is to issue more units. Therefore, if a company purchases a property generating $20M per year but needs to issue more units to finance the purchase, you must look at the net outcome for unitholders. If the FFO per share drops, this is not necessarily good for you as it will affect the REIT’s ability to increase its dividend in the future.
Another downside related to their business model is their lack of flexibility. We have seen many times where REITs try to shift their focus from one industry to another. In most cases (H&R, RioCan, Boardwalk and Cominar to name a few), the change of trajectory comes with a dividend cut and a loss in value for unit holders. A REIT wishing to get rid of their shopping malls to buy more industrial properties will likely have to sell properties at a lower price and pay a hefty one to buy more appealing assets.
Finally, do not make the mistake of thinking REITs are safer than other sectors. Those are companies facing challenges while benefitting from tailwinds. While you may argue that an apartment building can’t go anywhere, I would answer back that if you have one hundred empty apartments due to an oversupply in a neighborhood, your money will also go nowhere.
How to get the best of REITs
While REITs are part of a short list of sectors that are perfect for retirees or other income seeking investors, it is important to understand that they cannot be analyzed using the same metrics as other sectors.
The Funds from Operations (FFO) and Adjusted Funds from Operations (AFFO) are probably the most useful tools to analyze a REIT’s financial performance. Those two metrics replace the earnings and adjusted earnings for a regular stock. While those are different metrics, it’s all about cash flow and the REITs ability to sustain their dividend payments. Fortunately for us, we can find those metrics inside each REIT’s quarterly report and subsequent press release. It is important to not only follow the FFO/AFFO in total but also to follow the FFO/AFFO per unit of ownership.
FFO = Earnings + Depreciation (Amortization) – Proceeds from Property Sales
AFFO = Earnings + Depreciation (Amortization) – Proceeds from Property Sales – Capital Expenditures
The use of the loan to value ratio (LTV) is a great tool to analyze the REIT’s future ability to raise low-cost capital. The LTV is easy to calculate from the financial statement, as you only need 2 measures of data:
LTV = Mortgage Amount / FMV of properties
You certainly don’t want to invest in a REIT showing a high LTV. This means that their credit rating may be at risk and the price for future debt will be higher. In other words, it could mean less money for future dividends.
The last metric you must follow that is specific for REITs is the Net Asset Value (NAV). The NAV (usually shown by units) can be translated to the equivalent of a Price to Book ratio.
NAV = Total Property Fair Market Value – Liabilities
The idea is to compare a few REITs from your list against one another. This is how you should be able to find the ones with the best metrics. A lower than industry NAV is either a riskier play or a value play. The AFFO and LTV will tell you which one it is.
The REIT sector is best for income investors.
Target sector weight: For income-seeking investors, you can aim at 15% to 30% (if you invest in various industries). For growth investors, REITs could represent a 5%-15% portion of your portfolio.
Do not use the payout ratio to determine the REIT’s dividend safety
Trusts have a special tax structure and they are required to distribute 90% of their taxable income. Therefore, using the payout ratio (which is based on earnings) will not be of help. The metric you are looking for is the Funds From Operations (FFO) and the Adjusted Funds From Operations (AFFO) payout ratios.
Funds from Operations Payout Ratio
Formula: DIVIDEND PER SHARE (DPS) / (ADJUSTED) FUNDS FROM OPERATIONS (FFO) PER SHARE
Utilization: Real Estate Income Trusts (REITs).
Since REITs are required to distribute at least 90% of their net earnings, the utilization of the adjusted funds from operations (AFFO or FFO) is a more precise metric. Like the payout and cash payout ratio, it’s preferable to look at a long-term trend.
Pros: Similar to the cash payout ratio, you get a clear picture of how much cash the company has to pay dividends.
Cons: In most cases, you can’t calculate the FFO payout ratio yourself or find it in general finance websites (therefore we try to mention it in our DSR Stock cards). You must rely on the company’s information found in their quarterly earnings reports. It requires additional time to establish a trend over several years.
Valuing a REIT is like valuing any stock. Much like with MLPs, I generally utilize the Dividend Discount Model to value them, since most of their profits are paid as dividends.
There are, however, a few key metrics to know.
Net Asset Value is another estimate of intrinsic value. It is the estimated market value of the portfolio of properties, and it can be determined by using a capitalization rate on the current income that is fair for those types of properties. This can potentially understate the value of the properties because properties may appreciate rather than depreciate over time. Compare the NAV to the price of the REIT.
The Funds from Operations (FFO) are far more important than net income for a REIT. Due to their tax structure, earnings mean almost nothing, and instead, it is all about the cash flow. To determine net income, depreciation is subtracted from revenues, but depreciation is a non-cash item and may not represent a true change in the value of the company’s assets.
So FFO adds back depreciation to net income to provide a better idea of what the cash income is for a REIT.
Adjusted Funds from Operation (AFFO) is arguably the most accurate form of income measurement of all regarding REITs since it takes FFO but then subtracts recurring capital expenditures on maintenance and improvements. It is a non-GAAP measure, but a very good measure for the actual profitability and the actual amount of cash flow that is available to pay out in dividends.
Overall, it is good to look for REITs that have diversified properties, strong FFO and AFFO, and a good history of consistent dividend growth.
REIT Advantages and Disadvantages
The advantages and disadvantages of REITs are like that of MLPs. They typically have high dividend yields, but their dividend growth rates are generally on the lower side. They rely less on issuing new shares.
-REITs typically have above-average dividend yields.
-REITs serve as good protectors from inflation. If inflation occurs, property values and rents should increase over time, but fixed-interest debt that is used to finance the properties will not.
-Real Estate, if managed conservatively, can be a very reliable investment in terms of cash flow and in terms of dealing with recessions assuming rents are paid by the REIT’s tenants.
-REITs often have low dividend growth.
-REITs generally utilize debt to add to their property portfolio, but they typically make up for larger debt loads by using that debt for conservative, appreciating assets.
-Since REITs must pay out most of their income as dividends, they have little downside protection from recessions. They may have to trim the dividend if their cash flow dips below their distribution levels. There are, however, some REITs that have developed good track records of consistent dividend growth.
Based on a mix of diversification, growth perspective, and dividend growth, we have identified three Canadian REITs that we like:
GRT used to be an extension of Magna International (MG.TO). In 2011, Magna represented about 98% of its revenues. It is now down to 28% as at August 2022 (with Amazon as its second-largest tenant with 5% of revenue). Management has transformed this industrial REIT into a well-diversified business without adversely affecting shareholders. GRT now manages 127 properties across 7 countries. Each time we review this stock card, the number of properties increases while the exposure to Magna Intl reduces. The REIT also boasts an investment grade rating of BBB/BAA2 stable. With a low FFO payout ratio (around 77%), shareholders can enjoy a 3%+ yield that should grow and match or beat the inflation rate. This is among the rare REITs exhibiting AFFO per unit growth while issuing more units to finance growth. Granite is also part of the best monthly dividend REITs.
CT REIT (CRT.UN.TO)
An investment in CT REIT is primarily an investment in Canadian Tire’s real estate business. If you think this Canadian retail giant will do well in the future, but you are more interested in dividends than pure growth, CT REIT could be a good fit for you. Canadian Tire has exciting growth plans that will eventually lead to more triple-net leases for CT REIT. The fact that CRT pays a monthly dividend with a yield of approximately 5% is highly attractive to income-seeking investors. On top of that, CT REIT exhibits a decent dividend growth rate policy matching and beating inflation. This makes it a perfect candidate for an income-focused portfolio. Canadian Tire has done well during the pandemic thus far and has proven the resilience of its business model. It’s a sleep well at night REIT that should please all income-seeking investors.
IIP is what we describe as an “active REIT” where the company actively buys, improves, and recycles properties. This was a lucrative business model to manage in two growing provinces (Ontario and Quebec) over the past few years. InterRent seeks to acquire properties that have suffered from the absence of professional management. This is how they can buy at a lower value and relatively easily profit from their investment. Although IIP seems to exhibit a solid business model, we should keep in mind that things weren’t so successful over the 2008 financial crisis. The REIT has continued to demonstrate the resilience of its portfolio throughout the pandemic. With an occupancy rate hovering around 95% and the ability to increase rents by 5-6% per year on average, IIP is well-positioned to fight inflation in your portfolio. It hasn’t slowed down its appetite for growth and the REIT has managed to keep its dividend increase streak alive.
Those REITs are great, but there is more!
We are now in market correction territory, and the fear of losing more money is growing. What will happen if we keep up with continuous high inflation?
If you look at past performances, Real Estate Income Trust is one of the best performing classes during high inflation periods since the 70s. Unfortunately, not all REITs are created equal and you must do adequate research to make sure you buy the right ones.
In this webinar, I will answer questions like:
- How about REITs paying a 10% yield
- How to make sure the REIT’s distribution is safe
- Which metrics to consider during my analysis?
- Should I consider mortgage REITs?