Investing in Real Estate Through REITs

Real estate investment through REITs (Real Estate Income Trusts) is not only popular because REITs distribute generous dividends, but also because they’re easy to understand. We can easily picture an apartment building or an office tower and imagine tenants paying their rent. Investors are willing to purchase units of those businesses in exchange for income and peace of mind.

REITs are landlords; they own and manage real estate in exchange for rental income. They have properties such as apartment complexes, hospitals, office buildings, timberland, warehouses, industrial facilities, data centers, hotels, and shopping malls.

By their very nature, REITs offer great investment opportunities. 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.

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REIT types

Equity REITs own and invest in property. They might 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 some property and finance other property.

Most REITs are equity REITs and they must follow these rules:

• Invest most of their assets (75%) in real estate or cash equivalents. They cannot produce goods or provide services with their assets.
• Receive at least 75% of their income from those real estate assets in the form of rent, interest on mortgages, or sales of properties.
• Pay a minimum of 90% of their taxable income as dividends (also called distributions) to shareholders. Therefore, the classic earnings per share (EPS) and dividend payout ratios metrics aren’t well-suited to gauge the health of a REIT.

Sector strengths

REITs are unique in that they exist to pay generous distributions, making them a favorite for retirees! It’s easy to understand how most of them offer relatively high dividend income. This is one of the rare sectors where you can find “relatively safe” stocks paying 5%, 6% even 7%+. We must not get too greedy, though. Several REITs cut their distributions due to poor management or economic downturns.

Along with higher yields, REITs usually bring stability to a portfolio. It’s a great sector to start with if you’re looking for additional income. Real estate brings great diversification to your portfolio.

Finally, most REITs have built-in protection for their income in their leases. Many use escalator contracts that include yearly rent increases to ensure rental income matches inflation. This makes REITs a good protection against inflation for investors. Some REITs also operate a Triple-Net model where tenants are responsible for insurance, taxes, and maintenance costs. This not only reduces the REIT’s expenses but also its risk of unexpected charges!

Learn about our top-3 favorite Canadian REITs.

Sector weaknesses

One way REITs finance new projects is by issuing more units (shares). If a REIT purchases a property generating income of $20M/year, but issues more units to finance the purchase, you must consider the net outcome for unitholders. With REITs, the amount of profit per share is measured using the Funds From Operations (FFO) per share/unit metric.

Despite the new real estate, its $20M of income, and some new profit, the FFO per unit could drop because of the additional units that were issued to buy it. This isn’t necessarily good for investors as it affects the REIT’s ability to raise its dividend later on. Financing with new units can be difficult in a down market because investors will want to pay a lower price for the units.

The other way REITs finance projects is with debt. Some REITs are highly leveraged which won’t end well with the current state of interest rates. High interest rates also hurt tenants. REITs can increase the rent, but only if tenants can pay. In a recession, some tenants might encounter difficulties and eventually fail to pay rent. That has an immediate impact on the REIT’s FFO.

Another downside of REITs is rigidity. We’ve seen several REITs try to shift from one industry to another. In most cases (H&R, RioCan, Boardwalk, and Cominar come to mind), the shift comes with a dividend cut and a loss in unit value. Wanting to get rid of shopping malls to buy industrial properties probably means selling at a price lower than what you’ll pay for the more appealing assets. RioCan seems poised to get back on track, yet still pays a very low distribution compared to 2019.

Finally, don’t be fooled into thinking that real estate investing through REITs is safer than other sectors. REITs face challenges while benefiting from tailwinds. While it’s true that an apartment building can’t go anywhere, having one hundred empty apartments due to an oversupply in a neighborhood means your investment can’t go anywhere either.

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Getting the best of the sector

While REITs are on the short list of sectors that are perfect for retirees or other income-seeking investors, it’s important to understand you cannot analyze them using the same metrics as other sectors.

The Funds from Operations (FFO) and Adjusted Funds from Operations (AFFO) are the most useful metrics to analyze a REIT’s financial performance. They replace the earnings and adjusted earnings for a regular stock.

We can find those metrics in REITs’ quarterly reports and related press releases. It’s important to also follow the FFO/AFFO per unit (share) of a REIT. This is akin to EPS and Adjusted EPS for stocks in other sectors.

FFO = Earnings + Depreciation (Amortization) – Proceeds from Property Sales

AFFO = Earnings + Depreciation (Amortization) – Proceeds from Property Sales – Capital Expenditures

The loan-to-value ratio (LTV) is useful to analyze a REIT’s ability to raise low-cost capital. You can calculate the LTV using these two pieces of data from the financial statements:

LTV = Mortgage Amount / FMV (fair market value) of properties

A REIT showing a high LTV might have its credit rating at risk, making future debt pricier, and leaving less money for dividends.

Another metric to follow for a REIT is Net Asset Value (NAV). The NAV (usually shown by units) is analogous to the Price-to-Book ratio.

NAV = Total Property Fair Market Value – Liabilities

Use the metrics to compare a few REITs against one another and to find those with the best results. A lower-than-industry average NAV is either a riskier play or a value play. The AFFO and LTV will tell you which one it is.

Should you invest in REITs?

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.

Some of my favorites:

• U.S.: Stag Industrial (STAG), Essex Properties (ESS), Equinix (EQIX), American Tower (AMT), Realty Income (O).
• Canada: Granite (GRT.UN.TO), CT REIT (CRT.UN.TO), InterRent (IIP.UN.TO), Canadian Apartment Properties REIT (CAR.UN.TO)

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