Imagine being able to look out to the vast Toronto skyline and point out to the numerous skyscrapers and say “I own that”. Walk into the local Walmart to talk to the manager and say “pay me my rent”. Or even get your boss at work to pay you rent for the office, but don’t have to answer his calls when the door to his office falls off its hinges. How does it sound to own hundreds of rental units with many tenants to collect rent from rather than one? All this may seem far fetched, but it isn’t. I could do all of these things right now.
Real estate is a great investment, but owning the actual property and maintaining it may not be for everyone. Some of us don’t even know how to paint let alone fix a leaky faucet. Having to deal with dead beat renters is even worse when they refuse to vacate the premise and end up squatting in your house for free. Taking the time to manage all these things is a lot of work. We want to spend our free time with our family or our friends, not having to worry about someone else’s problems.
Lucky for us, there is a way where we can make our investments in real estate without ever having to walk into an open house and going through a tedious bidding process. The vehicle for this investments are called Real Estate Investment Trusts. More commonly referred to as REITs as a short form. REITs are something you can buy on the stock market like any other company, only REITs invest directly into real estate. It is important to note, when buying REITs, if you are buying into an equity REIT or a mortgage REIT. Equity REITs own property, like houses, strip malls, apartments or office buildings. Mortgage REITs delve more into buying loans and mortgages from financial institutions and make their money off the difference in interest payments. If you only believe in bricks and mortar, stick to the equity REITs.
Owning equity REITs are almost like owning a house to rent, only you don’t have to worry about finding tenants or maintaining the home. All you are concerned about is collecting your portion of the rent every month. Since a REIT has much greater purchasing power than yourself, a REIT will be able to own more buildings, diversify into more expensive projects and collect rent from a greater number of sources. Even within equity REITs there will be some that deal strictly with apartments, some will only focus on commercial office buildings, while some do commercial retail buildings. If you work or live in any Toronto or Vancouver urban area, you’ll no doubt be familiar with the names like Allied Properties, Brookfield, Rio Can or perhaps Boardwalk. These are all publicly traded REITs that own and rent commercial or residential property.
What makes REITs so popular for investments are their high yields. Where your regular savings account will offer you a paltry 0.5-1.0% interest rate per year, REITs will normally range from 5-10% interest per year. Laws enacted by governments within North America mandate that REITs must distribute a significant, if not all, of its taxable income to shareholders of the company. In the United States 90% of income is distributed. In Canada it’s 100%. Taxable income is essentially the profit that the company makes after deducting mortgage expenses, taxes and maintenance. Therefore, by law, these companies are forced to give money back to you whenever they have excess. This is a good thing.
Another great thing about owning REITs, unlike companies that give dividends, is that REITs tend to have distributions every month. This means money in your pocket every month. Amazing! To further that, REITs in Canada will generally give your dividends in the form of capital returns. This means that the dividends that you receive from REITs is not taxable because it is considered a return of your capital. Wow, this is better! It seems almost too good to be true; no hands on work to do, high interest payments, laws that force the companies to pay out, and no taxes to pay! What’s not to like?
Despite the great positives of owning REITs, there are some downsides to buying them. Like any real estate investment, REITs are extremely sensitive to interest rate changes. An example for this year was that a simple 1% rise in long term mortgage rates resulted in Canadian REIT companies dropping close to 15%. That’s because higher interest rates means that it costs more for REITs to pay their mortgage resulting in less profit to distribute back to shareholders. Another decision to think about is how the dividends distributing back to you as capital returns impacts your taxes. It might be great that you are not paying taxes on your dividends, but what it is actually doing is lowering your initial cost of what you purchased you shares at. You will get taxed eventually, but in the form of a capital gains tax instead of a dividend tax. So how does this work?
- Imagine buying a REIT at $10
- After 1 year, you have received $1 in dividends but it was all a return on capital
- You pay no taxes, but now the government says that you bought your stocks at $9 instead of $10.
- If you sell your shares, you must report your purchase price as $9, not $10
It’s not unfathomable that when you sell your shares, if you have collected enough dividends, that you could have a negative purchase price! When you sell your shares, you must pay any capital gains taxes that would arise from the change in price of the share based on your new calculated purchase. It’s something to note if you decide to hold your shares for a very long time.
Like any other asset class that you decide to invest in, REITs are just another category. It’s important not to get overzealous and think that any one asset class is invincible to changes in the marketplace. That is why REITs should be a portion of a diversified fixed income portfolio. REITs are classified as fixed income because they provide a steady stream of income on a monthly basis. You should not be buying REITs if you are looking for capital gains. I repeat, you are not looking for capital gains when you buy REITs. You should be choosing to invest in REITs because you are happy with the interest payments that you are receiving, not because the price of the shares are increasing.
Contrary to the belief that you should flip real estate to make money, REITs are not speculative investments. People buy REITs because of their high yield. Remember these companies are required by law to return almost all their profits. REITs are these to generate a steady income flow so that they can meet their monthly dividend requirements. If REITs flipped and sold all their buildings all at once, there would no longer be any future dividends. The money would run out eventually.
So how do you get into REITs? A simple brokerage account will let you find REITs that trade on the marketplace. There are also many ETFs that bundle several REITs together, or perhaps find yourself a low cost mutual fund that might bundle the REITs together. Remember that diversification is important. One last great thing about REITs is the ability to put them into a dividend reinvestment plan (DRIP), where your dividends can be used to purchase more shares. This is a simple yet effective strategy used to do dollar cost averaging and compounding your gains all at the same time!
Adding REITs to your own investment portfolio is a great way to diversify your fixed income holdings. REITs add the dimension of real estate to the other forms of fixed income investing such as bonds, preferred shares and GICs. When deciding on what investments to make, give REITs a look and see if they make sense in your portfolio. Everyone’s investment portfolio will have different assets, so REITs may or may not be appropriate for you. It all depends on what your own goals are and how you want to go about achieving them.