Real estate investment trusts should be an integral part of every income investor's portfolio. They offer steady income, relative safety, and tax advantages if held outside a registered plan.
The question is, how should you hold them? There are three possibilities: build your own REIT portfolio, use mutual funds, or choose a REIT ETF. Let's look at each.
Invest directly. The important thing here is diversification. Select four or five REITs that focus on different segments of the real estate market: residential, office buildings, retail, industrial, and retirement homes. Also, aim for geographic diversification. Don't put all your REIT assets in Canada; have some U.S. and international exposure as well.
A good combination right now would be Northview Apartment REIT (NVU.UN-T), Chartwell Retirement Residences REIT (CSH.UN-T), Dream Global REIT (DRG.UN-T), Allied Properties REIT (AP.UN-T), and Pure Industrial REIT (AAR.UN-T). Each focuses on a different type of property and the Dream REIT offers European exposure.
Mutual funds. There are a number of real estate mutual funds available, but most are unimpressive. Returns for the most part are low and expense ratios are high. Moreover, only a few invest primarily in REITs, which is what we are looking for here. The majority focuses on global real estate companies like Brookfield Property Partners, Simon Property Group, etc.
Of the few mutual funds that invest mainly (but not exclusively) in REITs, one has outperformed by a wide margin. It is the First Asset REIT Income Class, which generated a three-year average annual compound rate of return of 11 per cent to June 30 (A units). It currently pays a monthly distribution of $0.0667 ($0.80 a year) to yield 4.4 per cent. However, it has a high management expense ratio (MER) of 2.5 per cent. For that reason, I prefer its ETF stable mate, which is reviewed below.
ETFs. There are four exchange-traded funds that specialize in REITs. They are the BMO Equal Weight REITs Index ETF (ZRE-T), First Asset Canadian REIT ETF (RIT-T), iShares S&P/TSX Capped REIT Index ETF (XRE-T), and Vanguard Canadian Capped REIT Index ETF (VRE-T). Despite the fact they all focus on a relatively small sector of the economy, they have very different performance numbers, risk levels, and costs. See the following table. Results are to June 30.
A couple of key points immediately stand out. For starters, the First Asset ETF has the highest management expense ratio, yet it has outperformed its competitors by a wide margin. It also has the lowest Beta (a measure of volatility). The iShares ETF, which is by far the largest of the group with $1.3-billion in assets under management, is the worst performer. The Vanguard entry, which has a great advantage in cost structure, has a decent three-year record but has struggled recently.
All this raises several questions. For example, why has the iShares REIT ETF done so badly? For the answer, look at the portfolio composition. It is more diversified than it used to be, with 15 REITs in the mix. But it is still top-heavy, with 41 per cent of the assets tied up in three positions: RioCan REIT (17.68 per cent), H&R REIT (13.95 per cent), and Canadian Apartment Properties REIT (9.83 per cent).
RioCan's units have been in a downtrend for the past year. We advised selling it in June 2016 at $28.88 and the price is now down to the $24 range. Canadian Apartment Properties is off about $5 from a year ago while H&R is down about $1.50. With those three ETFs forming such a large percentage of the portfolio, it's no wonder the one-year return is in negative territory.
The Vanguard ETF shows a similar pattern to the iShares entry, although its results are better. Here again, RioCan, H&R, and Canadian Apartment Properties dominate. But there is a little less concentration on the top three, with 35.27 per cent of the assets. And even though this is a REIT ETF, it also contains some non-REIT real estate companies such as First Capital Realty and Extendicare, the latter of which has been performing well.
The BMO ETF shows a much better balance. It holds 18 REITs in its portfolio, all of which have roughly the same weighting. The top security, Northview Apartment REIT, comprises 6 per cent of total assets. Cominar REIT is at the bottom, at 5.1 per cent. RioCan sits at 5.6 per cent.
So what sets the First Asset ETF apart from the rest in performance terms? To begin with, it is actively managed (which accounts for the higher MER). The other funds are passively managed, which means they simply track the index on which they are based.
As well, the First Asset fund is much more diversified – the portfolio holds 39 positions, more than double its competitors. This enables it to invest in small- and mid-cap REITs, which are more likely to be subject to catalyst events such as mergers and takeovers. The fund may also hold up to 30 per cent of its assets in non-REIT real estate companies and service firms, adding to the diversification.
In the past couple of years this fund has also benefitted from being overweight apartments (which have done well) and underweight offices (which have been weak, in part due to the Alberta recession). Investors also benefitted from the weakness in the loonie as the ETF holds some companies with properties in the U.S., although they trade in Canadian dollars. Industry takeovers have also boosted returns, most notably the purchase of Amica by BayBridge Seniors Housing, which produced a profit of more than 100 per cent for the fund.
The monthly distribution is $0.0675 ($0.81 per year) for a yield of 5.2 per cent based on a recent price of $15.70.
Despite its high MER, the performance of the First Asset fund has earned it close look. This is no flash-in-the-pan. It has been around since November 2004 and shows an average annual compound rate of return of 10.5 per cent since inception.
Two caveats. Although the three-year Beta is the lowest in the group, the fund has shown it can be highly vulnerable in tough times. During the 2008 stock market crash, it lost over 40 per cent in a 12-month period. I'm not expecting a repeat of that but cautious investors should be aware of the risk.
Also, keep in mind that REITs are interest sensitive. That means prices are likely to come under pressure if rates continue to rise. In these circumstances, it is a good idea to build positions over time. Ask your financial advisor if it is suitable for you.
Disclosure: I do not hold a position in this ETF.
Gordon Pape is Editor and Publisher of the Internet Wealth Builder and Income Investor newsletters. For more information and details on how to subscribe, go to www.buildingwealth.ca.
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