We all love real estate as an investment. Who doesn’t? Prices go up and we make hundreds of thousands of dollars tax free. Everyone is making a ton of money on real estate, maybe everyone except for those in Alberta. But with prices for real estate reaching record highs in Canada and borrowing reaching its capacity can we still generate enough capital to invest in properties? This is where REITs come in. REITs are essentially corporations that invest in real estate, but can REITs replace investment properties? Are they effective at generating income?
What is a REIT?
REIT stands for Real Estate Investment Trust. A REIT is a company that invests in real estate for the purpose of generating income. There are various types of REITs that exists and they generally specialize within a certain type of real estate. It’s possible to find REITs that invest solely in residential properties, commercial properties or industrial properties. This means that each REIT is different than the other, however, they all share one goal in common and that is to generate monthly income.
- REITs try to distribute their income on a monthly basis to avoid paying corporate tax. The receiver of the income pays income tax rather than the corporation.
- REITs pay income on a monthly basis to the equivalent of 85-95% of the remaining income. This is money left over after expenses.
- Receiving dividends from Canadian REITs benefit from the dividend tax credit.
- Just like normal real estate, a REIT can gain in value through the appreciation of real estate prices.
Types Of REITs
When you buy a condo or a house as an investment property, you know exactly what you are getting. Four walls, a door, a couple of bedrooms, etc… This is a residential investment property. REITs, on the other hand, can fall into different investment categories.
Just like renting out an investment property, residential REITs focus on buying residential properties to rent out. One of the largest REITs in Canada, Canadian Apartment Propeties (CAP.UN), does exactly that. CAP REIT is an owner of over 30,000 apartment rentals across much of Canada with a larger focus on British Columbia and Ontario.
Ever visit a Walmart, or go to a Cineplex theater? More likely than not, RioCan (REI.UN) is probably the owner of the building. RioCan is an example of a commercial REIT. As Canada’s second largest REIT, Riocan owns almost 300 commercial properties across all of Canada.
Walk around downtown Toronto and you will see many plaques on buildings labelled with Allied Properties. This isn’t the builder, but it’s the REIT that owns the building. Allied Properties is one of the largest holders of Toronto office buildings, not Donald Trump or Chinese investors. If you walk into the Toronto Shopify office, then you just walked into an Applied Properties building.
With over 200 properties in the industrial space, Dream Industrial REIT represents one of the largest holders of industrial properties. This REIT operates across all of Canada supporting Canadian industries. If you wonder where trucks drive to on local highways, its final destination is probably a Dream building.
The advantage of using REITs as investments is the diversity. Unlike owning single properties, a REIT invests in many properties across many locations. This diversity helps lower risk in real estate investment. Just ask a condo owner in Calgary just how well they are doing?
REIT Exchange Traded Funds (ETFs)
The most confusing aspect of investing in REITs are the complications arising from having to choose a particular REIT to invest in. Thankfully, ETFs simplifies a lot of the complexities for us. There are a few ETFs available to Canadian investors. The most popular ones being the iShares Capped REIT Index (XRE) and the BMO Equal Weight REIT Index (ZRE).
Although both ETFs invest across the entire spectrum of REITs available, they do so in different ways. Let’s take a look at the top holdings for the two REITs indexes.
For the BMO Equal Weight REIT Index, here are the top five holdings:
For the iShares Capped REIT Index:
As you can see, the top five holdings vary greatly between the two ETFs. The BMO Equal Weight REIT Index does exactly what the name says. It holds many REITs, but each one is equally weighted at 5% of the funds total value. The iShares Capped REIT Index holds many REITs, but the percentages are based on the market value of the company. Essentially, if the company is worth more it holds more of it.
Which one is better? They both provide the same dividend yield at around 4.0% and both are very diversified in their holdings. Either ETF provides diversification for a REIT portfolio and provides less risk than purchasing a single REIT. That means both ETFs are effective at doing what an index fund should do.
Can REITs Be Better Than An Investment Property?
REITs can offer steady income just like an investment property, but can it be better than one? This is a hard question to answer. It really depends where the investment property is located and how much income it can generate. For instance, a recent article published by the Toronto Star and vehemently discussed on Reddit stated that many condo investors face being put into the red. What does this mean? It means condo owners cannot cover the mortgage and expenses with rent.
This is not true in all cases. If a condo owner bought many years ago then this wouldn’t be the case. However, if an investor wants to buy a new condo right now, in expensive cities like Toronto and Vancouver, then it’s highly likely that the rent alone will not cover the mortgage and monthly expenses.
A fairly new condo in downtown Toronto that is one bedroom sells for $785,000. Investment properties require 20% downpayment for a bank to provide a mortgage. This means an investor will need $151,600 in cash to start, which is quite a lot of money. The monthly mortgage payment is $2,835 assuming a 2.89% mortgage rate. After adding property taxes, maintenance fee and insurance (total $750), the monthly carrying cost to invest in a Toronto condo is around $3,585.
A typical one bedroom condo in Toronto would rent for $2,500. This means the condo investor would have to cover an additional $1,085 per month. Now, not all of the mortgage is throwaway, bit by bit the renter would be paying back the principal of the condo. So on average, over the first five years, the owner will pay $1,353 per month as interest, but the remaining $1,482 would go towards the principal.
Since the rent is $2,500 and the monthly expenses are only $2,100, the remaining $400 in profit from rent is also taxed at the marginal income tax rate. Assuming a middle tier tax bracket, that $400 in profit would incur a 30% income tax. This reduces the profit to $280.
After calculating all expenses, the remaining profit on a $151,600 investment is only $4,493.64 per year. This equates to a 2.94% annual return.
Investing in a REIT is quite simple. We don’t even need to pick a particular stock because there are two ETFs that are available. In our example let’s just use the BMO Equal Weight REIT Index.
The same investor that can buy an investment condo can elect to buy a REIT index instead. Using the $151,600 one could buy almost 5,900 shares Each share pays a monthly dividend of $0.10 per share based on the current ETF prospectus. Over the entire year, the 5,900 shares will produce $7,080 in income.
In addition to regular dividend income, the fund has consistently returned capital back to the shareholder. This is money in excess of income that distributes to a shareholder. This is similar to returning a bit of the $151,600 back to the investor every year. That capital actually reduces the average cost of the stock over time. This is important to note if the stock is ever sold. With the addition of an extra $0.70 per share (based on 2019 distributions) an additional $4,130 is returned back to the investor.
Dividends are subject to taxes by the government, however, dividends get taxed at a favourable rate to normal income. An investor in the middle tax brackets only pay 7.56% in taxes for dividends from Canadian companies. This means taxes for the $7,080 are only $535.25. The return of capital is not subject to any tax because it is the investor’s own money getting returned.
Given the same investment amount of $151,600, the return is $10,674.75 or 7.04%.
Capital Gains For REITs Versus Investment Properties
The subject of capital gains can be extremely difficult to compare. The performance of REITs is quite easy to compute because it is a stock. One only has to look at the trajectory of an ETF like ZRE to see how the performance of the stock has fared.
The BMO REIT index has tripled over the past 10 years. This follows closely to the performance of real estate across Canada. Not to say past performance equals the future, but an investor with $151,600 to invest could turn it into $454,800 over 10 years. Not too shabby. Also, that does not take into consideration the income that is earned.
For someone buying an investment condo, the calculation of gains is more difficult. Each region in Canada is different for real estate. If you invest in Alberta, you could be suffering losses. If you invest in Toronto or Vancouver there have been substantial gains.
There is one advantage to owning actual property and that’s leverage. As I have written before, buying property is the only way the bank is willing to lend an investor so much money. Leverage is what makes physical real estate worth investing. If the price of the investment property goes up 7.0% a year for the next five years, the investor that buys the $785,000 will be worth $1.1M. That would be a gain of over $300,000 in five years. That’s triple the money in 5 years versus tripling the money in 10 years. That’s the power of leverage.
When comparing capital gains for REITs and investment properties, it hard to say what is better. The only advantage that physical real estate gets is leverage. In a recession, it’s possible that both REITs and physical real estate can drop in value.
Monthly Cash Flow
This website is all about guiding the reader to financial independence. This means having enough cash on a monthly basis to sustain the standard of living that one desires. With the two examples which one is better for obtaining financial independence?
The investment condo is actually cash flow negative. Given that the mortgage is already $2,835 and the other expenses total another $750, the $2,500 in monthly rent is not nearly enough to cover all of it. This means owning the condo to rent out will not fulfill the need to become financially independent. The investment property might be a way to build wealth, but owning it will not provide food on the table, nor will it pay the cellphone bill.
This is why cash flow is so important in investments because it’s not always a guarantee way to provide financial freedom. Truthfully, it may take years of owning a condo to produce enough rental income such that it covers all the expenses.
Using REITs as investments in real estate does provide income regularly. For instance, investing $151,600 in a REIT index can generate $10,674.75 a year or $889.56 a month in passive income. This is quite the reversal between owning an investment property where the investor needs to pay an additional $1,085 a month.
Are REIT Investments For You?
Can REITs really replace investment properties for real estate investment? The answer really depends on what your personal financial goals are and in what location you plan to invest in properties. Each method of investing can bring someone closer to financial independence, but in different ways.
A good summary of how REITs can be beneficial are the following:
- Low cost of entry. Someone can start investing in REITs with little equity. You do not need a large amount of cash for a 20% downpayment.
- Monthly recurring revenue. REITs pay out on a monthly basis and the income is somewhat predictable.
- Better cash flow. For someone trying to reach financial independence, especially in expensive real estate markets like Toronto and Vancouver, REITs make much more sense to generate free cash flow.
- Tax advantages. Dividend income is treated kindly compared to rental income. Money returned as capital is completely tax free.
- No maintenance. There’s no need to deal with tenants or fix things in a rental unit. A REIT does everything for you
- Share in capital gains. If real estate appreciates, so too does the share price of a REIT. That’s what owning physical real estate is like as well.
Investing in REITs does have some disadvantages compared to physical real estate:
- Lack of leverage. As a wealth building tool, it will fall behind owning physical real estate because you cannot leverage as much as buying a house.
- Complex accounting. Return of capital is tax free but impacts the purchase price of the REIT for capital gains purposes. This can be hard to track especially when the REIT is sold.
Investing Correctly With REITs
If REITs seem like a viable investment to you, there are a few ways to ensure you invest correctly. First off, it’s a smart thing to invest in REITs inside your TFSA or RRSP. Why do you ask? Dividends and return of capital can be completely tax free. It will also eliminate the need to track the change in share price due to the return in capital. That’s because both the TFSA and RRSP allow you to invest tax free.
Second, it’s a smart idea to avoid choosing an individual REIT but rather investing in an index. Why is the index better? It’s much more diversified. It will hold all types of properties not just residential, industrial or commercial. The more properties you own, the lower your risk is. The term not “putting all your eggs in one basket” comes to mind.
Third. Owning real estate regardless if it’s physical or through REITs doesn’t come without risks. Higher interest rates will usually bring down the price of property. This can have a negative impact on REITs. Joblessness will also affect REITs are rental prices might have to come down or there is a greater amount of vacancies in the building. This could also affect the dividend or the share price. This means REITs should be a part of a balanced portfolio, but not the only investment type.
Fourth. REITs are like owning stocks. Don’t mistake real estate for being risk free. It is possible to lose money on REITs. The purpose for owning REITs should be for the income generation. This is why this investment class is so popular with retirees.
How much you invest into real estate is a personal choice. However, in a more balanced portfolio, REITs shouldn’t really be anything more than 10%. That’s already a lot. Real estate provides a lot of income, but what it won’t do is provide the growth needed to build wealth. That’s why always include equities and bonds into your portfolio. If you invest in REITs make it just another portion of a well balanced investment strategy.