What Is a REIT? Understanding How REITs Work in Canada
Many Canadians have had success with real estate investing over the years, but there are downsides to having to purchase and maintain an investment property. If you don’t have the capital upfront to purchase physical real estate, or you’re looking for a more passive investment opportunity, you may want to consider a real estate investment trust (REIT).
But what is a REIT, how does it work, and how can you invest in a REIT in Canada? In this article, I’ll cover the basics of REIT investing in Canada.
What Is a Real Estate Investment Trust (REIT)?
A REIT is a type of trust that manages, owns, or finances income-producing real estate properties. Investors can buy shares in REITs, representing ownership in the underlying properties. Many REITs are traded on major stock exchanges, making them easily accessible to regular investors. REITs are designed to provide a steady income stream and offer several benefits.
Types of REITs
There are two main types of REITs: Equity and Mortgage REITs. Here’s a closer look at each type:
Equity REITs primarily own and manage income-producing real estate properties, such as apartment buildings, office spaces, shopping centers, and other commercial real estate properties. Investors in Equity REITs earn dividends from the rental income generated by these properties.
Mortgage REITs finance income-producing real estate through mortgages and mortgage-backed securities. Instead of receiving distributions on rental income, investors earn dividends from the interest paid on the loans held by the REIT.
Besides those main types, some hybrid REITs combine both approaches – owning properties and investing in mortgages. Additionally, we can classify REITs based on their sectors, such as:
- Retail: overseeing shopping centres, malls, and outlets
- Industrial: managing warehouses, distribution centres, and manufacturing facilities
- Residential: apartment buildings, single-family homes, and student housing
You can also choose between publicly traded REITs listed on stock exchanges and non-traded or private REITs, which don’t trade openly and typically require a higher initial investment. Private REITs can be less transparent and more challenging to liquidate, so they might not be the right choice for every investor.
Benefits of Investing in REITs
REITs offer several advantages you can’t get from owning a single-family rental property. Here is a list of REIT benefits to consider:
They Generate Passive Income
Since REITs distribute a significant portion of their income as REIT dividends, investors can enjoy a steady stream of passive income. REIT investors don’t have to worry about late-night calls to deal with a clogged drain or flooded basement.
They Offer Diversification
REITs provide investors with an easy way to diversify a portfolio comprised mainly of stocks and bonds. And because a single REIT will be involved in several real estate properties across different markets, a single REIT is well-diversified within the real estate asset class.
The Offer Liquidity
Many REITs are listed on major stock exchanges, such as the Toronto Stock Exchange. This allows you to buy and sell shares easily. This makes REITs a much more liquid investment than directly owning a physical rental property.
Low Minimum Investment Requirement
Purchasing publicly-traded equity REITs on the stock market is similar to buying individual shares of stock or units of a mutual fund. For example, at the time of writing, Granite REIT (GRT.UN) trades at $69.50 per share, and Canadian Apartment Properties REIT (CAR.UN) trades at just over $45. In other words, you can begin to add real estate to your portfolio for under $100. That’s a huge advantage compared to the high upfront and ongoing costs required to own a physical real estate property.
Canadian vs. U.S. REITs
Canadian REITs are very similar to U.S. REITs in how they are governed, but there are some differences. For example, according to an industry report from Edward Jones, U.S. REITs must pay at least 90% of their taxable income as distributions to investors. In Canada, it’s 100%. In Canada, REITs are structured as mutual fund trusts, whereas in the U.S., they are corporations. And in most cases, Canadian REITs pay a monthly dividend. In the U.S., dividends are typically paid quarterly.
Pros and Cons of REITs
REITs can be an excellent addition to your portfolio, particularly because they allow you to gain real estate exposure without directly owning property. However, like any investment, there are pros and cons worth considering.
- Diversification: REITs provide diversification in the real estate sector by investing in various properties, such as apartments, office buildings, warehouses, shopping centres, hotels, and more. Adding REITs to a stock portfolio can help reduce its overall risk since real estate typically doesn’t correlate directly with stock market performance.
- Liquidity: Unlike direct investments in real estate, which can be challenging to sell quickly, REITs are traded like stocks and can be easily bought or sold on the market.
- Income Potential: REITs are legally required to distribute income to shareholders through dividends. This feature makes them an attractive option for income-focused investors.
- Professional Management: When you invest in a REIT, you benefit from professional management, much like a mutual fund. This means experts with experience and knowledge of the real estate market handle property acquisitions, maintenance, and tenant leases.
- Lack of Control: Although you benefit from professional REIT management, you also sacrifice control over the properties. Unlike individual real estate investments, you won’t be able to make decisions about property selection, improvements, or management strategies.
- Interest Rate Sensitivity: REITs are often sensitive to interest rate fluctuations. When interest rates rise, REITs tend to decrease in value due to higher real estate borrowing costs.
- Management Fees: Like mutual funds, REITs often charge management fees, which can affect the overall return on your investment.
What Is a REIT ETF?
A REIT ETF is an investment vehicle that allows you to gain exposure to the real estate market through a diversified portfolio of real estate investment trusts (REITs). It can be an excellent way to invest in the property sector without owning or managing any properties yourself directly. The fund is passively managed, which means it seeks to replicate the performance of an underlying index of publicly traded real estate companies.
How to Invest in REITs in Canada
There are a few ways to build your own REIT portfolio in Canada. The most direct way is by purchasing units of an individual REIT through an online brokerage account, the same way you would buy stocks, ETFs, or mutual funds.
Another option is to purchase a REIT mutual fund, which is a mutual fund that invests primarily in REITs or other real estate companies. One example of a Canadian REIT mutual fund is CIBC’s Canadian Real Estate Fund. The downside to REIT mutual funds is their high management fees, which can impact overall returns. For example, the CIBC fund has an MER of over 2.3%.
You may also consider purchasing a REIT ETF. ETFs are similar to mutual funds, except they trade like stocks on the stock market. They are highly liquid investments that you can buy and sell anytime during the trading day. Generally, REIT ETFs also have lower MERs than REIT mutual funds. For example, BMO’s Equal Weight REITs Index ETF has a MER of only 0.61%
As always, take some time to research and analyze the available options before making an investment decision, and I also highly recommend consulting with a professional investment advisor.
Final Thoughts on REITs
You can make a lot of money owning physical real estate, but there are also risks. Individual real estate is not a diversified investment, it requires a lot of upfront capital to get started, and it’s not as passive an investment as some make it out to be. You need to deal with renters and keep the property well-maintained. And it can be a headache when it comes time to sell the property.
REITs are a great alternative for investors who understand the importance of having exposure to alternative investments, without the capital requirements and poor liquidity of physical real estate.
How do REITs generate income?
REITs generate income by owning, operating, or financing income-producing real estate properties. As the properties produce rental income, the revenue is collected by the REIT and distributed to investors in the form of dividends. This regular income stream is one of the primary benefits of investing in a REIT.
Are there any risks associated with REIT investments?
Like any investment, REITs come with their own set of risks. Some common risks associated with REIT investments include market, interest rate, and property-specific risks. Market risk refers to the potential for fluctuations in property values and rental income, which could impact the performance of a REIT.
Interest rate risk relates to changes in interest rates, which can affect the financing costs for REITs and their ability to acquire new properties or refinance existing debt. Property-specific risks can include factors such as location, tenant mix, and property management, which can influence the overall performance of a REIT’s assets. Always carefully assess the performance and portfolio of a REIT before you make an investment decision.
What factors should I consider when choosing a REIT?
When choosing a REIT for your investment portfolio, you should consider several factors. First, look at the type of properties within the REIT’s portfolio. REITs can invest in various types of properties, such as retail, industrial, office, residential, and healthcare facilities. Each property type has its own set of opportunities and risks, so it’s important to understand the specific market for each type.
Another factor to consider is the REIT’s management team and track record in managing income-producing properties. Strong management is crucial for a REIT’s success, as they’ll make key decisions related to property acquisitions, dispositions, and tenant management.
Finally, consider the REIT’s financial metrics, such as dividend yield, funds from operations (FFO), and price-to-FFO ratio. These metrics can help you gauge the financial health and overall value of a REIT relative to its peers, allowing you to make a more informed investment decision.