Many investors don’t know the first thing about Canadian real estate investment trusts (REITs).
Most new investors these days strictly focus on learning how to buy stocks. But real estate exposure is important as well, and a real estate investment trust is an excellent way to make that happen.
The real estate conundrum in North America
Real estate assets, particularly residential properties, are not easy to acquire. Most first time buyers get into apartments or townhouses because they're a little cheaper. But it still does require a down payment, something that many Canadians simply don't have.
And, in surging markets like British Columbia or Ontario, rising prices are making it impossible for Canadians to enter the market.
So, how do you avoid the need for a large down payment and expose yourself to the residential, commercial, office, and even industrial sector with potentially less than $10?
You can buy real estate investment trusts.
What is a real estate investment trust, and how does it expose you to the real estate markets?
A real estate investment trust, or REITs, are primarily modelled after a mutual fund. The business model is to pool investor capital together and manage anything from townhouse suites to industrial buildings for investors.
The low capital investment from investors allows them to gain exposure to a multitude of properties which in turn generates cash flow for investors, typically resulting in a high dividend yield.
These trusts offer high dividend yields primarily because of their business structure. They are required to pay out practically all of their income after expenses to investors. Typically you'll see a REIT pay out 85-95% of its income back to shareholders.
As a result, share prices and the annual growth rate of REITs are not prone to significant movement. If you just started investing in 2020, the spread of covid-19 wreaked havoc on the REIT sector, so there was certainly capital gains to be made in their recovery.
But now that share prices have recovered, it's important we don't think of these trusts as growth stocks, but instead reliable income payers that are known for consistent growth of their distributions. Because it is required to pay out most of its profits back to shareholders, it's hard for the company to drive strong capital growth.
What should you look for in a REIT?
First, let’s talk about earnings for Canadian REITs. Net income is pretty much meaningless in the REIT world. That’s because every quarter a REIT’s management must revalue the portfolio.
Every now and again the values of buildings change, which shows up in the net earnings number. That impacts the bottom line, but not the true picture of profitability.
Best valuation metric to use instead to find the best REIT
Instead, as valuation metrics for a Canadian real estate investment trust, investors should use:
- funds from operations (FFO)
- adjusted funds from operations (AFFO)
- capitalization rates (cap rates)
FFO is essentially a REIT’s earnings, while AFFO roughly translates into free cash flow.
Cap rate is a way of telling how much you are paying for the buildings the REIT owns. It is found by dividing a REIT’s net operating income (NOI, think of it as EBITDA) by its enterprise value (market cap plus net debt).
It's critical you don't use the dividend payout ratio with REITs
To judge the security of the distribution (REITs pay distributions, not dividends, again you can think of them as the same), an investor should look at the payout ratio based on AFFO, though FFO will work too.
Anything below 80% is considered ultra-safe, while anything above 95% is cause for concern.
Top REITs in Canada have a diverse tenant base
Much like having your own rental property, these real estate investment trusts have to collect rent from tenants.
As a result, you want not only a diverse tenant base, one that includes companies with a long-standing reputation of rent payments, but you also want high occupancy rates.
A REIT that can maintain flawless occupancy rates should be held to a higher standard, especially during a broader market pullback like we witnessed in 2020.
The best Canadian REITs have strong debt to asset ratios
Most Canadian REITs tend to hang out at a 50% debt-to-assets ratio. Many are lower, but that’s usually because the REIT plans to borrow to fund expansion plans. The ones that are higher are usually trying to pay down debt, something a REIT will usually do by selling non-core assets or issuing units.
Now that we’ve gotten that primer out of the way, let’s take a closer look at 6 of the best Canadian REITs, the kinds of companies that should provide a combination of solid distributions and some impressive capital gains as well.
The top REITs in Canada for 2021 and beyond
Morguard REIT (TSX:MRT.UN)
The pandemic was harsh for REITs and several are still dealing with the sting of the biggest crash in market history. One of those is Morguard REIT (TSE:MRT.UN) which is still trading at a 50%+ discount to pre-pandemic levels.
Before COVID-19 changed the world, Morguard was trading around $12.00 per share. Fast forward to today, and the company is still trading at depressed valuations. In fact, it is arguably the cheapest REIT in the country.
As of writing the company is trading at a 48% discount to historical averages and at a 67% discount to calculated NAV of $17.89 per share.
This is the largest discount among all TSX-listed REITs which have a market cap north of $100M.
So why is Morguard struggling? It bills itself as a diversified REIT with a portfolio of retail, office, and industrial properties across Canada. However, it generates the majority of revenue from its Retail and Office segments.
Through the first six-months of the year, its retail properties which include strip malls and enclosed regional centres saw revenue drop by 8% and 5% respectively. Combined they accounted for 53% of revenue. The office segment accounts for 46% of revenue while Industrial – which has been the best performing industry – accounts for less than one percent of revenue.
Morguard was also one of the first REITs that was forced to cut its distribution during the pandemic. In May of 2020, the company slashed the distribution by 50% and it was forced to do so again by 50% this past January. For income investors, this was devastating.
Therein lies the reason for its underperformance. It has been highly exposed, and the pandemic has led to higher than average mall tenant failures and restructured rent agreements.
That is the bad news. The good news is that contrarians may see an opportunity to pick up the company on the cheap. Despite its challenges, a rebound in economic activity and a return to some normalcy will certainly help the REIT.
Furthermore, while the distribution cuts were no doubt disappointing, the current distribution is well covered with a FFO payout ratio of only 73%.
While not the safest of REITs, it certainly provides an attractive risk-to-reward opportunity for those who have some flexibility and are willing to take on additional risk, and are willing to be patient with the company.
5 year comparison of Morguard REIT Vs TSX
Inovalis Real Estate Investment Trust (TSX:INO.UN)
Next, we are going look at a relatively unknown REIT – Inovalis REIT (TSE:INO.UN). Inovalis is an office REIT with a focus on corporate clients in urban areas. While it is listed on the TSX, the company’s properties are located in France and Germany and the majority of its revenue is generated from rental income in France.
While office REITs are still out of favour, Inovalis looks attractive on many fronts.
First, the company has a strong financial footing with the lowest debt-to-equity (D/E) and debt-to-asset (D/A) ratios in the industry at 0.42 and 0.23 respectively. Furthermore, it has the highest FFO-to-interest coverage ratio among its peers. At 9.21 times, it is near double its nearest competitor.
Despite a rocky year for office REITs, Inovalis has quietly managed to grow revenue YoY and now has a six-year revenue growth streak.
The company is still trading at a discount to its pre-pandemic highs and at a 12% discount to net asset value (NAV). This has led to an above average yield of 8.78% - one of the highest in the sector.
The main concern with Inovalis, is the fact that this high yield may not be sustainable. The company’s payout ratio against FFO and AFFO is ~130% - which is not sustainable over the long term.
The good news is that the company has introduced a strategy to reduce AFFO payout ratio to below 95% over the next 12 months and below 85% within 3 years.
Can it get there? Absolutely, the company certainly has the resources and a strong management team to execute. The company’s payout ratios were below these ranges pre-pandemic so there is no reason the company can’t reach said targets once again.
Also worth noting the company is targeting low, single-digit AFFO growth and to increase the distribution by a minimum of 10% annualized over a three-year period. This will be supported by distributing profits from their asset recycling program.
There is no question that this REIT is one of the riskiest of the bunch, but it is also compelling on a number of fronts. It remains undervalued and provides an attractive starting yield, one that is likely to be maintained (and even grow) assuming the company can meet its stated targets.
10 year comparison of Inovalis Vs TSX
Automotive Properties REIT (TSX:APR.UN)
When it comes to pure growth potential, Automotive Properties REIT (TSX:APR.UN) is the clear winner.
This small-cap specialty REIT has loads of potential.
Automotive Properties REIT buys car dealership real estate, and then rents these locations back out to operators.
The company locks tenants into long-term agreements of a decade or longer with rent escalators because the operators value stability.
It’s a lot harder to move a car dealership than it is a clothing store.
Since the company’s 2015 IPO, it has more than doubled the size of its portfolio to 66 dealerships and 2.5 million square feet of leasable space. The company has properties from Alberta all the way to Quebec, and is continually looking to expand its network.
There’s still ample growth potential too. Various dealer operators are using Automotive Properties to accelerate their own growth prospects, since they can expand much faster if they don’t have to buy the underlying real estate.
Dilawri Group, Canada’s largest group of car dealerships, gives the REIT first dibs at any dealerships it sells. Automotive Properties’ portfolio will expand as more dealerships get sold to these big operators, a trend that should continue over the next decade.
Yes, COVID-19 has slowed the expansion plans of the REIT. Some dealers might even try to negotiate reduced rents. But these are long-term businesses that value stability. They won't abandon these locations just because of a few lean months.
Over the last year Automotive Properties has improved its balance sheet. The company’s D/E ratio now stands at 0.922, down from a high of 1.91 back in 2019. The company’s payout ratio is also reasonable as the distribution accounts for only 69% of funds from operations.
Further increasing the company’s attractiveness, Automotive Properties is currently trading at a 13% discount to its stated NAV of 14.77 as of end of June, 2021.
5 year comparison of Automotive Properties Vs TSX
Dream Industrial REIT (TSE:DIR.UN)
Industrial real estate is the hot sector right now. E-commerce is taking the world by storm, so much so that even major retailers like Walmart and Loblaw are participating. It's fascinating to think that you don't even need to go into the grocery store anymore to purchase food. And, this is a trend that is only just beginning.
As a result, everyone wants to own industrial properties that can benefit from the growth in E-commerce. The more companies that adopt and grow their E-commerce platforms, the more distribution space will be needed.
Dream Industrial REIT (TSE:DIR.UN) stands out as one of the few REITs poised to grow the top line by double-digits.
The REIT started 2021 with 177 properties after selling some of its lower quality assets in 2019 and 2020. It used the proceeds from the sales of those assets to pay down debt, and as of end June, 2021 it had debt-to-assets of around 36% and an attractive D/E of 0.66.
With such a low amount of debt, Dream Industrial has the capacity to make a lot of acquisitions. And it has. At the end of December, it owned 177 assets.
Management has said they can make another $275 million of acquisitions while still keeping its debt-to-assets below 40%. Even after all of that growth, Dream Industrial is going to have one of the safest balance sheets among REITs.
Through the first six months of the year, their portfolio stood at 215 assets with gross leasable area of 38.5M square feet, up from 27.3M just six months ago.
Not only has it grown by acquisition, it is also growing by increasing its rents. In the latest quarter, Q2 of 2021, the company signed new leases with at a 22% spread over prior rents. While this is lower than some previous quarters, it is still a healthy spread.
To top things off, occupancy rates are rebounding after a pandemic-impacted year. Dream’s in-place occupancy rate jumped from 94.7% as of end of 2020 to 97.4% as of end of June, 2021.
During the pandemic, REITs saw their value significantly impacted. The good news is that they have all mostly recovered. The bad thing, is that these REITs weren’t as cheap as they once were. Nevertheless, Dream Industrial is arguably the cheapest REIT among its industrial REIT peers.
With over $650M in liquidity at their disposal, don’t be surprised if Dream adds to their $1.8B in acquisitions they’ve completed thus far in 2021.
It trades at the lowest premium to NAV of $13.69 (19%) and also has the lowest P/FFO ratio of ~25. While this may seem expensive as compared to some other REITs, investors are paying for growth which as mentioned, is hard to find among REITs.
5 year comparison of Dream Industrial REIT Vs TSX
Allied Properties REIT (TSE:AP.UN)
If you are a believer that office REITs are due to make a comeback, then Allied Properties (TSE:AP.UN) is likely at the top of your list. Allied has one of the strongest portfolios of assets with a significant presence in major urban centres.
In total, it has 194 rental properties valued at $8.1B with 13.9M square feet of gross leasable area. Of that, ~81% is located in either Toronto or Montreal. The remaining portfolio is located in large urban centers like Calgary, Edmonton, Ottawa, and Vancouver.
While the Office segment makes up the majority of Net Operating Income, it also has exposure to Urban Data Centres (UDC) which account for ~17% of NOI.
This segment is seeing some pretty significant growth as they are critical to Canada’s communication infrastructure. In our opinion, they will only increase in importance as the world becomes more digital.
The company is highly diversified and no tenant makes up more than 5% of revenue. Interestingly, its top tenant is an unidentified cloud service provider which accounts for 4.9% of revenue.
As of writing, Allied is still trading at a 16% discount to June 30, 2021 NAV of $49.07 per share. It has an attractive yield and the distribution is well covered with an FFO payout ratio of 71.90%. Further to this, Allied is one of only 8 REITs which have achieved Canadian Dividend Aristocrat status. At nine-years and counting, it owns the second-longest dividend-growth streak among all TSX-listed REITs.
To top things off, the company is arguably one of the best capitalized REITs in the industry. It has one of the lowest D/EDBITA, D/E, and D/A ratios among all Office REITs. The company’s interest coverage ratio of 5.33 is also second only to Inovalis REIT, which we spoke about earlier.
While Allied carries additional risk as an Office REIT, analysts are still expecting 13.45% average annualized revenue growth over the next couple of years. This is among the highest of all TSX-listed REITs. It has a strong portfolio of assets, an impressive commitment to the distribution, and a strong financial profile.
5 year comparison of Allied Properties REIT Vs TSX
Canadian Apartment Properties REIT (CAR.UN)
In this environment of uncertainty, there are two REIT industries that have stood out in terms of performance – industrial and residential. In the latter, there is none larger than Canadian Apartment REIT (TSE:CAR.UN).
With a market cap north of $10B, it is around 4 times larger than its closest competitor, and is the largest REIT in the country.
The company operates over 65,000 rental apartments and housing sites in Canada, Ireland, and the Netherlands.
Despite trading at a slight premium (5%) to NAV ($56.06 per share), Canadian Apartment REIT still provides excellent value and is poised to deliver sector-beating returns.
Analysts are expecting 14.5% average annual revenue growth over the next couple of years, which is among the best in the industry. Worth noting, CAP REIT has grown revenue YoY for 23 consecutive years, the longest such streak in the sector.
This Canadian Dividend Aristocrat has also established itself as one of the most reliable income stocks in the sector. At 9-years long, it is tied with Allied Properties for the second longest dividend growth streak in the country.
Finally, Canadian Apartment also has one of the strongest financial profiles among its peers. Of all residential REITs, it is among the leaders across all debt-related categories. It also has an industry leading FFO-to-interest coverage ratio (2.38).
Combine the company’s strong balance sheet with an above average growth rate and a reliable (and growing) distribution, you have a company that is poised to deliver for investors.
Before we leave you, it is also important to mention the impact of rising interest rates. While it could be a headwind for many, especially those with higher debt loads, REITs – Residential REITs in particular – tend to perform quite well during periods of rising rates.
The reason for this is because as rates rise, property values do as well. They can also pass along inflation costs on to the renters through annual rate increases.
So while borrowing costs increase which certainly impacts high-CAPEX industries such as REITs, the benefits outweigh the cons and investors should be comfortable holding through inflationary periods.