Question: What do you think of real estate investment trusts? The yields look enticing, but are REITs safe?
Before we address the safety question, let's brush up on the REIT basics.
What's a REIT?
REITs are trusts that invest in a wide range of real estate assets – shopping centres, office buildings, industrial properties and apartments, for example. Some REITs focus on a particular type of real estate, while others diversify across several property classes.
Some of the largest REITs in Canada include RioCan REIT and Calloway REIT (shopping centres), Canadian REIT and H&R REIT (office, industrial and retail) and Boardwalk REIT (apartments).
If you like the idea of owning investment real estate, but don't want the hassle of dealing with problem tenants or broken toilets, REITs have several advantages: They provide diversification and professional management, and they can be bought and sold quickly on a stock exchange, making them much more liquid than an investment property.
Tax efficiency
One of the main attractions of REITs is that they provide a steady flow of income, with yields that are often higher than those available from dividend stocks. REITs are generally not required to pay income tax as long as they distribute 90 per cent of their profit to unitholders.
The above-mentioned REITs, for example, yield anywhere from 3.6 per cent (Boardwalk) to 6.2 per cent (Calloway).
Although REIT distributions don't qualify for the dividend tax credit, a portion of the distribution is usually classified as return of capital (ROC). This benefits investors because ROC is not taxed in the current year. Instead, it is deducted from the adjusted cost base of the units, giving rise to a larger capital gain (or smaller capital loss) when the units are ultimately sold.
What's an appropriate weighting of REITs?
Dennis Mitchell, who manages the Sentry REIT Fund – Canada's largest real estate mutual fund – said the largest pension funds in Canada have, on average, about 9 per cent of their assets in real estate. This is a "reasonable" allocation for individual investors, excluding their principal residence, he said.
What REITs are his favourites? Based on current valuations, he likes Chartwell Seniors Housing REIT and Dundee REIT. He's also a big fan of Canadian REIT, which he called "the best REIT in the country. The reason I say that is that they have a great management team, a tremendous portfolio, they have almost the lowest leverage in the space and one of the lowest payout ratios."
Generally, the lower the payout ratio – the proportion of cash flow paid to unitholders – the safer the distribution. Canadian REIT also has a long track record of raising its distribution annually. (Full disclosure: I own units of Canadian REIT.)
What are the risks?
Many people believe that a potential increase in interest rates is the biggest threat to REITs. It's not, Mr. Mitchell said.
"The biggest risk to REITs right now is the economy as a whole," he said.
During the financial crisis of 2008 and 2009, the prices of some REITs fell by more than 50 per cent as investors worried that tenants would go bankrupt and REITs would be unable to roll over their debts. Prices have since rebounded sharply.
Many REITs are insulated to an extent from the impact of rising interest rates, because they have locked in the current low rates for long periods. "So if rates rise next year by 200 basis points [two percentage points] if I've already termed out all of my mortgages until 2020, I don't care," he said.
That's not to say higher rates won't hurt REITs. They will. But all interest-sensitive stocks – banks, pipelines and utilities – would be affected.
The outlook
In a recent report, CIBC World Markets analysts laid out a bullish case for REITs.
The "low-interest-rate environment … could continue for an extended period of time, perhaps several years," said the report by Alex Avery, Brad Sturges, Troy MacLean and Chris Girard.
At the same time, "new property development remains very limited for office, industrial, residential, retirement and hotel property, and with long lead times for development, new supply appears unlikely to have any effect on property markets for the next few years."
Those factors together could support "double-digit total returns" for REITs over the next two to three years, the report said.
Being prudent
Forecasts don't always come true, of course. It's also possible to imagine a scenario where the economy tanks and REIT prices tumble.
So, if you're going to invest in REITs, make sure your asset allocation fits your goals and risk tolerance, and be sure to diversify your exposure to REITs as part of a well-balanced portfolio. You can get instant diversification through a mutual fund or exchange-traded fund such as the iShares S&P/TSX Capped REIT Index Fund or the BMO Equal Weight REITs Index ETF.
Just remember that, although you won't have to fix a leaky toilet in the middle of the night, you will have to live with market volatility and the possibility that, should things get really bad, some REITs could cut their distributions.
Read more of Globe Investor's 29 Ways in 29 Days to be a better investor
John Heinzl