What is a REIT?
A real estate investment trust (REIT) is a company that finances, operates, or owns income-generating real estate.1 It allows self-directed investors a way to enter the real estate market without having to own any physical property. REITs invest in different types of real estate, such as apartment buildings, cell towers, data centers, hotels, medical facilities, offices, shopping centers, and warehouses.2
Most REITs are considered, alternative investments and, unlike physical real estate, they are highly liquid because shares in this type of investment are typically publicly traded.2 They typically offer a steady source of distributions2.
Private REITS also exist but usually require a more significant financial commitment. They are also harder to sell because they typically come with a minimum holding period – forcing an investor to keep them for a fixed period before they can be sold off.
How to identify a REIT?
When investors look up a quote or use a stock screening tool, most REITs will have the word 'REIT' in the company name. Another common indicator is that the stock symbol will end with the letters '.UN'. The majority of REITs will pay out a monthly distribution versus quarterly payment for most dividend paying securities.
What are the different types of REITs?
In addition to the distinction between public and private REITs, several other different types of REITs are available on the market. They are distinguished by the way they hold their assets and by the types of assets they hold. Some REITs will only hold one type of real estate asset, while others will hold a portfolio of different real estate types under a single umbrella.
Types of Real Estate Assets
- Multi-unit REITs are different types of rental residential housing, such as apartment buildings or individual houses.
- Commercial REITs are office buildings.
- Retail REITs could be part of an office building or a dedicated space for retail, such as a shopping or strip mall with various anchor and smaller stores.
- Industrial REITs consist of real estate holdings such as factories or warehouses.
- Healthcare REITs in Canada are typically linked to property rented out to companies that run retirement homes or independent living facilities for the elderly.
- Hotel REITs are buildings rented out to management companies to run hotels and the array of services that accompany them.
Equity and Mortgage REITS
- Mortgage REITs are securities where the company doesn't own the underlying property and instead owns the debt securities that are backed by the property.2 In other words, they own the debt linked to the property, in the same way that a bank owns the debt on a mortgaged house.
- Hybrid REITs are a combination of Equity and Mortgage REITs.
How do REITs work?
Though REITs have existed in the US since the 1960s, they have only been available in Canada since 1993. Most REITs work on a straightforward equity model. By leasing space and collecting rents, the company generates income from its real estate holdings. That income is then paid out to shareholders as distributions.3 One important characteristic of REITs is that they generally have a payout ratio that is higher than dividend paying stocks. This is due to a legal obligation when REITs were first created to pay out at least 90% of their annual taxable income.
Since REITs pay out so much of their earnings in the form of distributions, they cannot rely on retained earnings to grow. They will issue units or use debt by borrowing money to purchase new buildings. This reliance on mortgage debt to finance growth enables a REIT to be significantly impacted by an increase in the interest rates and the costs associated with borrowing money.
What are the tax implications of holding REITs?
The tax implication and structure of REITs are not as straightforward as that of other types of securities. REITS pay distributions, which can be a combination of interest, dividends and return of capital. Accounting for distributions can require adjustments to the asset’s book value, making taxation more complicated.
Because of their unique tax structure, REITs are better suited to be held in tax-exempt accounts, such as TFSAs, RRSPs, or a First Home Savings Account (FHSA). Note that using a dividend reinvestment plan (DRIP) for a REIT in a non-registered account can get very cumbersome.
Advantages of investing in a REIT?
A REIT is an excellent way for self-directed investors to diversify their portfolio beyond publicly traded company stocks.1 They add another class of assets with a lower correlation compared to other traditional types of assets to an investor's holdings.
- They are a good option for investors looking for regular, passive income. They usually generate higher yields than most dividend paying stocks, and often pay out monthly.
- They tend to be less volatile than regular securities.
- They are easy to buy and sell since they are publicly traded.
Disadvantages of REITs
Though REITs are good for portfolio diversification, there are some disadvantages:
- They offer little in terms of capital appreciation.
- They are more influenced by shifting interest rates than other kinds of market movements and volatility since REITs finance real estate acquisitions with mortgage loans.
- They can have high management and transaction fees.2
How to start investing in REITs?
Self-directed investors who want access to REITs can purchase investment funds or exchange traded funds (ETFs) that hold securities in this sector. These ETFs can be passively or actively managed and Canada, US or globally focused. For those who prefer individual REIT securities, here are some important points to consider before jumping in.
Although REITs are very similar to dividend paying stocks, the same financial ratios do not apply because of their unique tax structure.
- Adjusted Funds from Operations (AFFO): REITs have a lot of non-cash deductions, such as depreciation and amortization. As a result, their EPS is not a good indicator to see how the REIT is doing. A stable or increasing AFFO is a positive thing.
- For dividend paying securities, investors will usually look at the dividend yield and then the payout ratio, but for REITs, an investor should consult the AFFO payout ratio.
- Occupancy rate: As with any rental property, empty units will not generate income, so the higher the occupancy rate, the better. Look out for rates that are improving over time.
- Another ratio that investors can consult is the Debt\EBITDA ratio which can be used to determine a company's financial health. It basically shows how much available income there is to pay down. A lower or decreasing ratio is preferred to a higher or increasing ratio.
- If the above-mentioned ratio isn't available, a company's credit rating can be used as an alternative measure. Look out for a stable or improving credit rating.
REITs are an excellent way for self-directed investors to diversify their holdings and play the real estate market without the commitment or outlay required to purchase. Compared to owning property, REITs are a very liquid asset that can be an excellent source of regular, passive income over the long term. However, it is important to remember that, like all investments, there are risks. Do your research, have an investment strategy, and make your money grow.
1. Voigt, K. Best-Performing REITS: How to Invest in
Real Estate Investment Trusts. www.nerdwallet.com. June 6,
2. Chen, J. Real Estate Investment Trust (REIT): How They Work and How to Invest. www.investopedia.com. May 24, 2023.
3. Nareit. What's a REIT (Real Estate Investment Trust)? www.reit.com