No assembly required: how to become a landlord with REITs

Many of us would love to become landlords — that is, if it weren’t for those darn tenants. Every prospective landlord hears stories about deadbeat tenants who skip town without paying the rent. And even if you have good tenants, the life of a property entrepreneur isn’t easy. Nothing takes the shine off a potential investment faster than the thought of fielding complaints at two in the morning about clogged toilets or devoting part of your weekend to fixing the broken-down washing machine at your rental property. Fortunately, there is an easier way to become the next Donald Trump. Rather than buying rental units directly, why not invest in property through Real Estate Investment Trusts? REITs are professionally managed trusts that buy investment properties such as hotels, apartments, office towers and warehouses. They rent out these properties and generate cash for investors. In effect, you get to be a landlord without ever having to paint a kitchen or evict an ornery tenant. If rents go up, you benefit just as you would if you owned the property directly. And if times turn tough, REITs offer you the benefits of geographical diversification. Since most real estate trusts own dozens if not hundreds of properties scattered across the country, a downturn in one market isn’t as disastrous for them as it would be for a landlord with just a single property. Thanks to a healthy economy and a booming real estate market, REITs have produced sizzling returns over the past five years, with most achieving gains of more than 20% a year. Calloway REIT of Vaughan, Ont., which owns 1.7 million sq m of space in shopping centres across Canada, tops the pack with an amazing 81% annual return since 2002, but even the median performer among Canadian real estate trusts achieved a 25.5% total annual return over the last five years. Can REITs keep producing double-digit returns? The short answer is that it seems unlikely. The gradual decline in long-term interest rates over the last few years propelled many of the recent gains in real estate trusts and it’s difficult to see how rates can go much lower than current levels. Another factor that helped REITs in recent years was massive buying by large pension funds, which came around to the notion that real estate was a good long-term diversifier against the ups and downs of the stock market. That factor, too, appears to have largely run its course. REITs can still be attractive investments, but you should approach them with caution. Before buying, take a moment to add up the amount of real estate that you already hold. If you’re a homeowner, consider how exposed you want to be to the vicissitudes of the property market. In general, it’s not a great idea to have more than 33% of your total assets in real estate â€” if you own a home, you may be over that mark already. On the other hand, if you’re renting while you save up for a home, and you’re concerned that real estate prices will keep going higher, you can buy real estate trusts as a partial hedge against soaring property prices â€” if home prices go higher, so, too, should the value of your REITs. Right now, the REIT party is going strong and prices are high. So bide your time and wait, if need be, for the right buying opportunity. You may be glad you did. Some REITs are facing an uncertain future because of the federal government’s decision last fall to crack down on income trusts. The government initially announced that most REITs were to be exempted from the new rules â€” but since then many trusts (including Calloway, RioCan, and IPC U.S.) have discovered that they may be clipped by the changes after all, depending on how the final REIT exemption is worded. REITs that hold hotels, retirement homes, and non-Canadian properties face the greatest risk of being hit. Some may have to restructure, and a few could be hurt. Before you buy any REIT, make sure you know how it stacks up against its peers. You can assess a good cross-section of Canadian real estate trusts in Realty roll call below. In compiling the table, we stuck to trusts for which we had a large amount of information. Most investors’ eyes will immediately shoot to the column labelled “Distribution yield.” This is the percentage of your purchase price you’ll get back each year if the trust maintains its current distribution. A distribution yield of 10% on a trust that sells for $20 a unit implies you’ll get $2 a year in cash payouts. Why is this so important? Because most investors buy REITs for a steady, dependable flow of income. Therefore REITs that pay higher distributions are more attractive. But you shouldn’t just buy the trust with the highest yield, because not all distributions are created equal. The trusts that pay the most are typically ones that the market views, for one reason or another, as less stable — perhaps because they’re smaller operations or because they hold properties with less dependable tenants. The higher yields are your compensation for taking on extra risk. Tax matters, too. A distribution may be made up of many types of cash — capital gains, return of capital, or operating profit. Since each of these sources of cash is taxed differently, two trusts with the same distribution before tax can wind up putting significantly different amounts in your pocket after tax depending on exactly what makes up the distribution. Before buying any REIT, you should figure out the true after-tax distribution in your own case. Don’t rely on generalizations. One of the most important questions you should ask about any REIT is whether its distribution is sustainable. A good clue is how much a REIT pays compared to the amount of cash it generates. To figure out how much cash a trust is producing, look at what’s known as Funds From Operations (FFO), which is roughly a trust’s net income with depreciation added back. FFO, which you can usually find in the trust’s financial statements, is based upon the idea that properties generally rise in value over time instead of depreciating at the rate used by accountants. While that may be true, FFO doesn’t include money needed for property maintenance and therefore generally overstates the cash generated by a trust. Despite its flaws, FFO is a standard measure for REITs. Just keep in mind that it can present a slightly rosy picture of a REIT’s true ability to throw off cash. You should compare how much a trust is paying out in distributions to how much cash it’s producing in FFO. This is known as the FFO payout ratio. (For the detail-oriented, the FFO payout ratio is equal to distributions divided by funds from operations generated over the last 12 months). Most real estate trusts pay out nearly all their FFO as distributions and there’s nothing wrong with that. But if a trust pays more than 100% of its FFO, you should be wary. It’s living on the edge since it’s paying out more cash than it’s producing and may have to trim its distribution. For most investors, the most attractive real estate trusts tend to be those that pay you a nice distribution, but that don’t pay out more cash than they’re generating. The REIT with the highest distribution yield, and a payout ratio of less than 100%, is Royal Host, which sports a yield of 9.4%. Just behind are InnVest, with a yield of 7.8%, and IPC U.S., which generates 6.5%. These same three trusts also shine when we look at price-to-FFO ratios. These ratios are similar to the price-to-earnings ratio you’ve probably seen for stocks. Both are ways of comparing the price you’re paying for a security to the value that it’s creating. Like conventional P/E ratios, a low P/FFO ratio tends to indicate a good bargain, but it may also point to modest expectations for growth. The low P/FFO leaders in today’s market are InnVest at 11, Royal Host at 12, and IPC U.S. at 14. Each of these three trusts boasts some attractive features, but none is a surefire moneymaker, and each is threatened by the federal government’s new trust tax. Royal Host, for instance, focuses on North American hotels. It owns 37 properties, manages others for third parties, and franchises 109 locations under the Travelodge and Thriftlodge banners. It’s been churning out money and has increased its distribution five times in the last two years. But hotel profits tend to go up and down with the economy. Also, Royal is a fairly small REIT, which makes it a little riskier than some of its larger peers. InnVest, another hotel REIT, is much larger than Royal Host. Its portfolio contains 125 Canadian hotels plus a 50% interest in the largest hotel franchisor in Canada. Because of its size, InnVest is perhaps the better option for more conservative investors; it is also less expensive on a P/FFO basis. IPC U.S. owns commercial properties in the U.S. and invests primarily in class-A office buildings. Several large deals in the U.S. have jazzed up that market in recent months and IPC wants to take advantage of the buyout binge (and avoid the new trust tax) by selling itself to the highest bidder. It put itself up for sale at the end of January. Of course, wanting to sell and finding a buyer willing to pay a premium price are different things. But in the meantime IPC is producing a distribution yield of 6.5%. Before buying any REIT, you should be sure to read the firm’s latest press releases and regulatory filings. Scan newspaper stories to make sure you’re up to speed on recent developments. A trust’s annual reports and investor presentations can give you a lot of information about the challenges and opportunities ahead. My advice? After years of strong gains by REITs, it’s hard to be wildly enthusiastic about most of these trusts at current prices. But even in a hot sector there are a few unloved laggards with low-P/FFO ratios that are worth a second look. And if you’re patient, my suspicion is that you’ll see several opportunities arise over the next couple of years as the red-hot real estate sector cools and bargains begin to emerge.

No assembly required: how to become a landlord with REITs

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