REITs are awesome. They give you all the benefit of owning real estate without the associated work.

Think about buying a rental property. You’ve got to go out and show the thing, which is pretty much like dating. You make awkward small talk for juuuuuuust long enough to consummate the relationship. And then it’s awkward.

The work isn’t done once you rent the place, either. Your tenant wants things like a working stove and walls without holes in them. You’ve also got to harass them if the rent is late and make sure they actually clean the place when they leave. They never do.

Plus, there’s no return anymore, especially if you live in Toronto or Vancouver. Don’t believe me? Check this out. That house is going to return about as much as an investment in Nortel in 1999.

I’ve also shown you kids how to leverage REITs, which takes away another reason to buy physical property.

There’s just one problem. People don’t know how to invest in REITs. They’re are far different asset class than regular stocks with a bunch of different quirks.

Here’s how I invest in REITs.

Kinds of REITs

Let’s start broad. Here are the different kinds of REITs in Canada:

  • Retail REITs (shopping malls, stand-alone stores, etc.)
  • Office REITs (office towers, usually located in the downtown core)
  • Industrial REITs (warehouses, manufacturing facilities, etc.)
  • Self storage REITs (these don’t exist in Canada, unfortunately)
  • Apartment REITs (they may also own townhouses)
  • Health Care REITs (hospitals, medical offices, retirement homes)
  • Diversified (own a little of many different asset classes)

There are approximately 35 different publicly-traded REITs in Canada and more than 100 in the United States.

The important terms

Before we get into how to invest in REITs, let’s talk a little about how a REIT is different than a plain ol’ corporation.

REITs get special tax status from the feds in exchange for paying out almost all their earnings as distributions to shareholders. As long as they pay 90% of earnings back to shareholders, the REIT itself doesn’t have to pay any taxes.

Canadian REITs are forced to either write-up or write-down the value of their assets each quarter. Most of the time the value of the buildings stay the same, but sometimes they’ll fluctuate. REITs with a lot of Alberta exposure have been writing down assets lately, while those with exposure to Ontario are saying their buildings went up in value.

These adjustments impact earnings. If a REIT earned $10 million after expenses and then wrote down the value of assets by $10 million, it officially earned nothing. But the $10 million loss is just a paper loss; it doesn’t affect cash flow.

REIT investors don’t really pay much attention to earnings. They look at the following terms:

  • Net operating income, which are earnings after all operating expenses have been paid
  • Funds from operations, which is essentially a REIT’s net income
  • Adjusted funds from operations, which equates roughly to a REIT’s free cash flow

Some companies will use a term called normalized funds from operations, which is the same as normalized earnings. It’s income but without all the weird adjustments. The problem with that is normalized funds from operations may exclude stuff that actually impacts the bottom line. Tricky accounting is tricky.

The balance sheet

I normally like to avoid companies with a whole bunch of debt on the balance sheet. That’s not possible in the world of REITs. They will always have debt, and often several different kinds of debt.

Most of the debt will be in the form of mortgages against properties. This is ideal, since a REIT can usually get a mortgage for well under 3%. It’s the cheapest kind of debt.

Other forms of debt may include debentures (those are like bonds but without the pledge of specific collateral), or preferred shares. These will cost anywhere from 5% to about 7%, depending on the REIT’s overall indebtedness. Debentures are preferred because they pay interest (which is an expense) versus dividends (which are paid out of post-earnings cash).

I mostly care about the debt-to-total assets ratio. Most REITs maintain about a 50% debt-to-assets level. but the ratio can go higher. Apartment REITs are the most likely culprits, although I’ve seen REITs in just about every asset class that have too much debt.

The easy way to get the debt-to-assets ratio down is to issue more shares. The problem with that is a debenture might cost a company 5% and the common stock costs 7%.

Dividends

REITs don’t actually issue dividends. They pay distributions instead. The difference becomes pretty important come tax time.

Each distribution is split up into a different number of categories. Some of the payout might be return of capital. Some might be straight investment income. If the REIT has sold a building lately, some might be in the form of capital gains. And so on.

Here’s what you need to know about REIT distributions:

  1. If you want the whole payout, hold it in your TFSA or RRSP
  2. If you hold a REIT in a taxable account, it won’t be taxed as well as a dividend

In terms of a payout ratio, I tend to look at the payout versus adjusted funds from operations. As long as that number is 90% or under, I’m cool. So if a REIT pays out $1.00 per share and earns $1.20, this is good. An 83% payout ratio is pretty normal when investing in REITs.

High yields are common. REIT yields are anywhere from under 4% all the way to above 10%. The general rule of thumb is a higher yield is riskier. Keep that in mind if you’re enticed by a big distribution.

Invest in REITs

When I’m looking to put money in a REIT, I focus on a few different things.

The first is book value. I want discounted assets when I invest in REITs. Most REITs won’t trade above book value because investors know the value of the portfolio is constantly adjusted. I usually don’t get very interested in a REIT unless it trades at 20% under book value.

Morguard REIT (which I wrote about on Monday) trades at 58% of book value.

Next is the payout ratio. Anything above 95% of adjusted funds from operations is at risk of getting cut. One thing to look for is whether the REIT offers a dividend reinvestment plan. If it does and a lot of investors are taking advantage of it, it can lower the cash payout ratio to 80% or even 70%. Cominar REIT is a good example of this.

I also like a management team that owns at least some of the company. Sometimes a REIT will hire a third-party company to manage the assets. This can create issues, especially when it comes to negotiating fees. Internally managed REITs are thought to be the better choice. Most REITs in Canada are internally managed.

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