As of 2017, more than 66% of Canadians owned their own home. And according to a 2021 survey from Royal LePage, over 10% owned two homes or more. Many of us know the benefits of real estate investing through homeownership or purchasing an investment property. But did you know it is possible to invest in the sector without owning physical property? One of the best ways for any investor to gain exposure to the real estate asset class is through a real estate investment trust, or REIT for short.
The following is an in-depth guide that reviews this investment type, the benefits associated with it, and how to invest in a REIT in Canada.
Table of contents
What is a real estate investment trust (REIT)?
A real estate investment trust (REIT) is an entity that owns a pool of properties and provides unitholders with exposure to the real estate market. The Income Tax Act of 1986 paved the way for the REIT market in Canada, though the concept first appeared in the United States in the 1960s. The Canadian market remains smaller than the American market to this day.
A REIT falls into the alternative asset class, a category of investments that includes all non-traditional assets. Traditional investments are cash, fixed income, and equities that trade publicly. A real estate investment trust is not one of these conventional assets, so it falls into the alternative investment class as a sub-type of real assets. That being said, REITs are closer to an income-producing exchange-traded fund investment than some of the other alternative assets like private debt or private equity.
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How do REITs work?
Real estate investment trusts have different structures and legal rules depending on where they are located. In Canada, they must take on a mutual fund trust structure. By contrast, a REIT in the United States is a corporation.
To be classified as a REIT, the entity must pay out a certain percentage of its taxable income to unitholders. In Canada, all taxable income must flow through the entity for it to maintain its REIT status. In the US, however, the entity must distribute at least 90% of its income — though often companies will distribute more than the required amount. Regardless of the country, the payment regularly made to shareholders is classified as a dividend.
To understand how real estate investment trusts make money, we must consider the category where they fall. In the case of an Equity REIT, the entity will own multiple properties, collecting income from those who lease space in the buildings. For a Mortgage REIT, the entity provides financing for real estate and earns income from the interest. A Hybrid REIT acquires revenue from a combination of rental income and interest paid.
Types of REITs
There are many types of real estate investment trusts, which are categorized based on the underlying properties that they own. A few of the major types in Canada are as follows:
- Retail REITs (eg. shopping centres)
- Residential REITs (eg. multi-family rental apartment buildings)
- Healthcare REITs (eg. hospitals, medical centers, nursing facilities, and retirement homes)
- Office REITs (eg. office buildings)
- Hotel REITs (including resorts)
- Industrial REITs (eg. warehouses and distribution centers)
- Diversified REITs (eg. two or more property types)
Are REITs a good investment?
There are pros and cons to owning a real estate investment trust, as there are with any asset. They can make for a good investment provided that the unitholder understands the specific characteristics of the REIT and property type.
Buying into a REIT also allows the investor an opportunity for diversification. As an alternative asset, the investment has a risk and return profile uncorrelated with conventional assets. This helps to lower the risk of the overall portfolio.
Pros and cons of owning a real estate investment trust
Owning a REIT provides an investor with benefits similar to owning real estate directly. For example, real estate can provide an income stream when renters occupy the property.
It has also traditionally performed as a hedge against rising consumer prices. During periods of rising inflation, property owners can pass along the increase in costs to those leasing. As we are currently in an inflationary environment, this can be a significant benefit and aid investors with maintaining and growing their purchasing power.
Diversification
Buying into a REIT also allows the investor an opportunity for diversification. As an alternative asset, the investment has a risk and return profile uncorrelated with conventional assets. This helps to lower the risk of the overall portfolio.
Owning a REIT instead of directly owning a property allows for diversification amongst real estate holdings as well. Direct ownership provides the investor exposure to just a few real estate properties. On the other hand, a trust exposes the investor to a basket of properties. Not only does this decrease the risk associated with a single unit, but it provides for a less volatile income stream.
Liquidity
Additionally, REITs have the significant advantage of being a liquid investment. At any time, the investor can sell their ownership stake in the trust and receive cash for the sale within days.
The same is not true when it comes to selling property directly. It can take months, sometimes years, for a seller to divest their real estate holdings. Even when they do, there can be sizable costs associated with the sale, including realtor fees, closing costs, etc. For someone simply looking to gain exposure to the real estate sector, the lack of liquidity and additional selling costs can turn direct ownership into a headache.
Risks
Along with all the benefits of owning a REIT, investors must consider the downsides.
One of these is that the investment is subject to market risk. Prices can change drastically, regardless of the constant income stream that they provide. The owner of an investment property does not usually see their property value fluctuate day-to-day. That is not the case with REITs, as they trade on an open exchange and tend to underperform during periods of economic recession.
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Tax implications of owning a REIT
One key consideration is the tax implications associated with the investment type. As Canadian REITs must pay out all their income, the entity does not pay taxes on its earnings. Instead, they have a tax flow-through structure. In some cases, the investor takes on the tax burden, treating those distributions as income. Declaring distributions annually as taxable income can be a drawback for some investors.
If an investor holds the REIT in a registered or tax-sheltered account, they will not need to pay taxes on any distributions. This can be a significant advantage as they can gain exposure to the real estate market without the tax consequences.
One unique aspect of the REIT tax structure is return of capital (ROC). REITs can sometimes make a distribution to the investor for an amount that is above its net income. This excess payment is due to non-cash items, including depreciation. When this occurs, the extra amount is classified as a ROC payment. The ROC distribution is not taxable annually but upon the sale of the investment.
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How to invest in REITs in Canada
Since 1993, real estate investment trusts in Canada have traded on the Toronto Stock Exchange (TSX). Units are purchased through a stock exchange, mainly the TSX, and held in any trading account. These account types include a non-registered investment account, a Registered Retirement Savings Plan (RRSP), or a Tax-Free Savings Account (TFSA). (More on investment accounts here and here.)
While a REIT may trade on the stock exchange, it is quite distinct from a publicly traded equity. As outlined above, the tax structure and the mutual fund trust setup differs from a corporation with its stock listed on a public exchange.
What to look for in a REIT
Not all REITs are created equal, and it is essential to know how to pick the best investment for your portfolio. Some of the key considerations are as follows:
- Occupancy rate: Consider purchasing a REIT with a higher occupancy rate. A higher rate suggests a more significant percentage of units occupied, with a smaller percentage vacant.
- Debt-to-equity ratio: REITs tend to rely heavily on debt financing, significantly impacting both positive and negative returns. When evaluating a purchase, consider a REIT with a lower debt-to-equity ratio.
- Price to AFFO: The price to adjusted funds from operations (AFFO) is a valuation metric. A lower ratio tends to indicate a better investment.
- Management team: Management’s track record and guidance can often provide valuable insight into a specific REIT and how it may perform in the future.
What percentage of my portfolio should be in REITs?
There is no single rule for how much of your portfolio to invest in either real estate or REITs. Your allocation will instead depend on your personal risk tolerance characterized by your willingness and ability to take risks, and investment objectives like saving for retirement or funding post-secondary education for your kids.
Due to the flow-through nature, investors searching for steady income tend to prefer REITs. How stable is this income, though? According to data generated from YCharts, the iShares S&P/TSX Capped REIT ETF shows an annual total return of 8% on average over the past ten years. From January 1, 2012, to December 31, 2021, this equates to a total return of over 116%.
An investor focused on income generation may find the appropriate allocation for REITs to be up to 20% of their portfolio. Alternatively, a growth investor with a higher risk tolerance may choose to allocate only 5-10% of their portfolio to a real estate investment trust, as they forgo dividend-paying investments for high-growth assets.
As always, we recommend performing due diligence on all investments, including REITs, and turning to a professional wealth manager for additional support. They will have training and experience working with different types of assets and can help you determine the proper allocation for REITs in your portfolio. For more information on finding a trusted wealth manager in Canada, refer to our guide.
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How to form a REIT in Canada
Forming a REIT in Canada is a lot more complicated than investing in one. The process can be complex, and it is best to involve professionals in setting up the trust.
The entity must be a publicly traded trust and, to qualify as a REIT, it must pass the test found in the Income Tax Act. The trust must also reside in Canada and have a flow-through income structure. A declaration of trust is mandatory as the governing document. Trustees will be required to maintain legal ownership and management of the trust.
Takeaway
Investing in a real estate investment trust can be an excellent way for any investor to gain exposure to the real estate market. The asset type can provide a steady income stream and hedge against inflation. It can also provide increased liquidity and decrease property-specific risk, especially when compared with direct real estate ownership.
As an investor, consider allocating a portion of your portfolio to REITs to aid in diversification and boost income. As always, consult with a qualified professional and do your due diligence before entering into any investment.
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