Real estate appeals to many investors because it is perceived as being safe in a world fraught with uncertainty. Fortunately, today there are a wide range of alternatives for investors looking to park capital in real estate and collect the rent. For those not interested in the workload of direct property ownership (clean-ups, repairs, and even derelict tenants) a Real Estate Investment Trust (REIT) can provide a much more passive stream of income.
A REIT is a company that owns income-producing real estate and redistributes a high percentage of net cash flow back to its investors. REITs can be publicly traded on a stock exchange and be bought and sold by anyone like a regular stock. Currently, the Canadian market is home to about 52 publicly-traded REITs which invest in all types of income-generating property like apartment buildings, office towers, industrial and warehousing facilities, shopping malls and retail stores, and the list goes on. In today’s market, these REITs offer their investors income yields ranging from 3 per cent to more than10 per cent.
Now, yields upwards of 10 per cent may look pretty attractive to a less-than-discerning income investor – but buyers beware. Things are not always as they appear in the stock market and REITs are no exception. There is a wide range in the quality of the companies occupying this space, with some REITs boasting multibillion-dollar diversified portfolios of high-quality properties in major centers, while others may have only a single property valued at a few million. It’s important to know what you’re buying, and there are a few key factors to think about to be an informed investor.
Payout Ratio:This is the percentage of a company’s net cash flow paid back to investors. REIT distributions are not guaranteed and can be reduced at any time. Payout ratios near or above 100 per cent put the distribution at risk. Most of the more established REITs tend to maintain payout ratios in the 80 per cent to 90 per cent range, or even lower.
Debt Leverage:Debt is an essential tool for maximizing returns in real estate, but too much debt can be disastrous. The right balance between debt and equity is critical. One important metric for measuring this leverage is the debt-to-gross book value ratio. Higher-quality REITs generally maintain a ratio in the 45 per cent to 55 per cent range or lower.
Asset Quality: Assets are the lifeblood of any business. Low quality assets can result in deferred maintenance costs and stagnant rents down the road. High quality assets allow the REIT to attract the best tenants and charge premium rents. Location, age and class of buildings, occupancy levels, and rent and same property net operating income growth all fall into this category.
Most of these metrics are readily available to investors in a company’s financial documentation. However, if sifting through dozens of financial statements while calculating and comparing ratios doesn’t sound like an exciting adventure to you, then congratulations, you are like 99.9 per cent of the population (and surely much more fun at parties than I am). Researching individual REITs is time-consuming and technical. Investors looking for a less active investment strategy might want to consider an exchange-traded fund (ETF) that is indexed to the REIT sector. Indexed ETFs trade like stocks and can pay an income yield, but their objective is to hold a basket of companies that replicate the performance of a particular index (in this case the S&P TSX REIT Index). The draw of this vehicle is its easy management and low fee structure. The trade-off is that there is no potential to outperform the respective index. In Canada, there are several established ETFs available to investors. One example is the iShares S&P TSX Capped REIT Index ETF (XRE: TSX) which currently yields around 5.5 per cent
For investors trying to outperform the average, individual REIT selection is likely the best option. In this endeavour you can either go it alone or you can utilize the services of a qualified, independent advisor who specializes in picking individual stock, KeyStone Financial will soon release its 2016 REIT sector report, which will provide commentary, analysis and actionable advice to investors about the 52 REIT stocks in this sector.
- Aaron Dunn is asenior analyst at Vancouver-based KeyStone Financial, one of Canada’s only independent stock market research advisor firms. Dunn is considered an expert at uncovering Canadian dividend growth stocks and serves as head analyst for KeyStone’s income stock research service. Dunn can be reached through www.keystocks.com