What you need to know about REITs - MoneySense

What you need to know about REITs

Learn what a real estate investment trust is, how to invest in one, the pros and cons, what kind of performance to expect, and more.

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Image by Sebastian Wagner from Pixabay

I crouched down to see the ants crawling along the baseboard, coming together in a living insect puddle near the side door. I assured my tenant I would handle it, and called the pest management company to take care of the problem, giving them my credit card number and a few hundred dollars in the process. 

Every few months something like this crops up in the investment property I own, whether it’s weeds taking over the backyard, a stove malfunctioning or a faucet leaking. And in every instance I have to take time away from work, assess the situation and more often than not, pay for it to be fixed. 

I’m lucky that the monthly rental income covers maintenance issues like this, along with my other carrying costs. Still, this kind of real estate investing comes with its fair share of headaches and has required continual injections of my time and money.

It stands in sharp contrast to my experience investing in Real Estate Investment Trusts, or REITs, where I simply purchase shares, take a nap and collect juicy dividends.  

What is a REIT, and how long have REITs been widely available to individual investors?

Real estate investment companies were structured as closed-end mutual funds until 1993, when governments allowed them to restructure as trusts and trade on open markets. 

This change transformed the industry and the number of REITs on the TSX jumped from around five to 35.  In the last 10 years alone, their market cap (or dollar value) grew an incredible 215% to just over $74 billion. 

Canadians can purchase trust units (essentially shares) the same way they would buy any other stock. This provides REITs with the money to buy and manage real estate. They can hold any kind of property, from apartment towers, to retail centres, to industrial buildings. Although some exclusively operate inside Canada, many also have international holdings.

The REIT collects rental income, pays its expenses and then distributes almost all its remaining income—usually 85% to 95%—to unit holders.  

They do this to avoid paying tax inside the trust. Instead, unit holders are taxed upon receiving the distribution. 

This makes REITs an incredibly simple way for the average investor to ride the coattails of the Canadian real estate industry, which has benefitted from massive appreciation over the last few decades. 

As of December 2016, national housing prices rose by 109%, up from January 2005. In urban centres the gains are even more pronounced.  In 2000, a Toronto detached house close to transit and jobs, for example, cost $515,322 in today’s dollars. Now it costs an incredible $2,091,768—an increase of 306%. 

Of course, the past does not represent the future and real estate prices have dipped before, most notably in the early 1990s when property prices sank and took over a decade to regain their former value. In other words, whether you invest in real estate directly, or via REITs, there’s no guarantee you’ll get a positive return.

What “landlord problems” can you avoid by investing in a REIT?

By far the biggest advantage to REITs is you can be a landlord from afar; that means no late-night calls when the plumbing backs up—and no need to book an exterminator. Here are some of the other issues you can sidestep by choosing to invest in a REIT:

Low barrier to entry

Most Canadians can’t afford to wade into real estate investing—a 20% down payment on an average Canadian home is just over $100,000, and that’s not including land transfer tax or lawyer fees. Flipping a home costs even more, and it requires extensive construction or project management experience. Plus, you’re required to report all the money you’ve made to the CRA and may be on the hook for capital gains tax.

Compare that to REITs, where you can purchase a unit for under $10. 

Liquidity

You can sell as many shares as you want in a REIT, but you cannot sell a single brick in a house. If you need cash in a hurry, you must generally sell your entire property, and there’s no telling how long that will take. You may also have to pay a real estate agent’s commission, home staging costs, capital gains tax and other fees. But it only costs around $5 to $10 to sell a REIT at a DIY online brokerage, you can sell as many or as few shares as you want, and you can get your cash immediately.

Accounting and taxes

Being a landlord is like running a small business, and it’s annoying as well as time-consuming to track income and expenses.

With a REIT, as long as you’re holding the units inside a registered account, you don’t have to worry about taxes at all. If you hold units outside of a registered account, it does get a little more complicated, as distributions from a single REIT can come from multiple sources, such as capital gains and income, and you must pay tax on those different types of income accordingly. REITs also pass along tax advantages to unit holders, such as expenses and depreciation. All of this will be broken out on your annual T3 form for tax-reporting and payment purposes. 

Diversification of real estate properties

REITs allow you to invest in multiple properties so that it doesn’t matter too much when one doesn’t work out. 

Diversification of real estate sectors

As a landlord you are likely renting only to tenants, or perhaps to a small business. But REITs have the capacity to rent to various industries, including huge retail and business clients.

What are the potential cons to investing in a REIT?

Limited use of leverage

Leverage is the biggest advantage that landlords have in building wealth. Using a minimum of your own cash and having someone else cover the debt cost magnifies returns (but also losses). Banks simply do not lend investors the same amount of capital at the same low rates that they do to landlords. You can still use leverage when purchasing REITs, either through an investment loan or a line of credit (and write off the interest the same as you would a mortgage, but it will likely be on a smaller scale.

Payouts taxed at full marginal rates outside of registered accounts

You must pay your full marginal tax rate on any income distributions provided you receive them in a non-registered account. That’s because, unlike dividends from blue-chip Canadian corporations, the payouts have not yet been taxed—they’ve simply flowed through the trust into your hands. 

What are 3 to 5 good “starter REITs” to consider?

Sean Pugliese, portfolio manager and director at  Wickham Investment Counsel in Hamilton, says a good way to start out in REITs is to buy an exchange traded fund that holds multiple REITs. This is to further diversify your portfolio and reduce your risk, while still enjoying the sector’s healthy returns. Otherwise, beginner investors should look for REITs with a market capitalization of $1-billion or more as large companies tend to be more stable and liquid.

Here are a few of his picks:

Ticker ZRE RIT GRT.UN REI.UN
Yield* 4.008% 4.197% 4.079% 5.306%
Sector Broad: retail, residential, office etc., Broad: retail, residential, office etc., Industrial, across Canadian, Austrian, and U.S properties.  Retail, mostly in Canada
Notes Holds both Granite and RioCan. Management fee of 0.55% Holds RioCan. Management fee of 0.75% Largest tenant is Magna International, the auto company founded by Frank Stronach Largest tenant is Loblaws

*Yield as of December 1, 2019

What kind of investor might consider a REIT? 

Any investor who is prepared to take on a medium-risk investment and values passive income is a good fit for a REIT. Investors who have a very low tolerance for risk and need the money within three to five years should perhaps consider staying out of the stock market.

As for me, I definitely plan on investing further in Canadian real estate through REITs, mostly because it’s just so darned simple. Like all stocks, the price bounces up and down on a daily basis, but I have confidence that property and land values will continue to rise over the very long term (around 30 to 50 years).  

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