Many investors don’t know the first thing about Canadian real estate investment trusts (REITs).
What qualities are important?
Most new investors these days strictly focus on learning how to buy stocks. But real estate exposure is very important as well, and a real estate investment trust is an excellent way to make that happen.
Real estate investment trusts - What should you look for?
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.
Most of the time the values of buildings don’t change – because a real estate investment is boring – but every now and again they do, 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 for REITs
Instead, investors should use
- funds from operations (FFO)
- adjusted funds from operations (AFFO)
- capitalization rates (cap rates)
as valuation metrics for a Canadian real estate investment trust.
FFO is essentially a REIT’s earnings, while AFFO roughly translates into free cash flow.
Remember REITs issue units instead of shares, but units and shares are the same thing for all intents and purposes.
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).
Much of a REITs income will be paid back to unitholders
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 a little sketchy.
Next, the best Canadian real estate investment trusts are those that are growing.
The total top or bottom line isn’t nearly as important as per unit metrics. You want to make sure when a REIT issues units to make acquisitions (which is common in the sector because REITs pay out so much of their income) that the deal is accretive to shareholders.
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 7 of the best Canadian REITs, the kinds of companies that should provide a combination of solid distributions and some impressive capital gains as well.
What is the best REIT to invest in Canada?
SmartCentres REIT (TSE:SRU.UN)
SmartCentres REIT (TSE:SRU.UN) owns 168 properties, the majority of which are shopping centres with a Walmart on the property or right beside it.
The Chairman of SmartCentres, billionaire Mitch Goldhar, is actually the man who first brought Walmart to Canada, so SmartCentres and Walmart have a very close relationship.
While only 25% of rent comes from Walmart, the real benefit of having Walmart on your properties is all the traffic it brings to the other stores in the shopping centre.
Smaller retailers or service businesses can rent a space on a SmartCentres property and inevitably some customers who went to Walmart are going to visit their store as well.
If we look just at SmartCentres as it currently is, we can fairly conclude it is cheap.
In 2019 SmartCentres earned $2.07 in AFFO, so SmartCentres is trading at just 12x 2019 AFFO. Based on 2019’s NOI, SmartCentres is trading at a 5.8% cap rate.
With most of its properties in major cities, and with lots of development/growth potential, that is very cheap.
The valuation is great, but the development is what is most exciting.
SmartCentres has an incredible pipeline of development projects.
It has 256 developments planned or underway right now – plans to build offices, hotels, storage facilities, apartments, condos, and seniors’ living facilities on its land.
Management estimates these projects will create somewhere around $1.4 billion of value for the REIT, which is worth approximately $8 per unit.
Between the development projects and SmartCentres’ current net asset value (NAV) of $28, it would not be surprising to see SmartCentres trade at $36 in a few years.
Don’t forget the distribution though.
Right now SmartCentres yields 8.8%. Even without any capital gains that would be a pretty good return since interest rates are so low.
And the distribution is secure. Using 2019’s AFFO, the payout ratio was 89%.
Not only does SmartCentres have a healthy payout ratio, but it has a healthy balance sheet with $500 million in cash and debt-to-assets of just 45%.
5 year comparison of SmartCentres REIT Vs TSX
H&R REIT (TSX:HR.UN)
H&R REIT (TSX:HR.UN) has been beaten up because of a combination of poor short-term results, a little uncertainty surrounding a key asset, the impact of COVID-19 on the portfolio, and, of course, a recent distribution cut.
Let’s start with The Bow, H&R’s marquee asset. The downtown Calgary landmark is home to Ovintiv -- the energy company formerly known as Encana -- but that organization has announced plans to move its official head office to Denver.
Although Ovinitiv is still responsible for the lease – which lasts another 18 years – investors are worried it will soon pull out of Calgary completely.
H&R also came out with some disappointing results lately, which included a dip in operating income caused by some unexpected vacancies.
Remember, H&R owns a lot of regional mall real estate in Canada, a segment of the market that is getting hit especially hard by online retailers and COVID-19. Investors are nervous about these assets, and rightfully so.
The REIT plans to expand in the U.S. residential market. The two-pronged approach includes acquiring already-built properties in states like Texas and Florida, as well as developing new properties with partners.
The Canadian REIT recently completed a large project in Long Island, New York and has developments in various stages of completion in places like Miami, San Francisco, Seattle, and Austin.
Investors are being well compensated for this uncertainty. H&R is one of the cheapest REITs in Canada trading at 6.8x 2019’s FFO and a steep discount to book value. Net asset value is $21.80.
The current unit price is around $12. That's a terrific bargain for this REIT, assuming you believe net asset value is accurately stated. Some investors think aggressive write-downs are coming.
Even after the distribution cut, H&R REIT offers a 5.9% yield. The payout ratio is under 50% of 2019's FFO. It looks to be one of the safer distributions in the sector today.
5 year comparison of H&R REIT 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 61 dealerships and 2.3 million square feet of leasable space.
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 could slow these 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 both improved its balance sheet – reducing its debt-to-assets ratio from 53% to under 50% — as well as bringing its payout ratio from 90.5% to 84.8% of AFFO.
That’s a solid payout ratio for a REIT that yields 7.5%.
5 year comparison of Automotive Properties Vs TSX
Dream Industrial REIT (TSE:DIR.UN)
Industrial real estate is the hot sector right now. Everyone wants to own industrial properties that can benefit from the growth in E-commerce.
Dream Industrial REIT (TSE:DIR.UN) might be the best combination of value and growth in the sector.
The REIT started 2020 with 209 properties after selling some of its lower quality assets in 2019. It used the proceeds from the sales of those assets to pay down debt, and going into 2020 it had debt-to-assets of just 23.7%.
With such a low amount of debt, Dream Industrial had the capacity to make a lot of acquisitions. And it has.
At the end of September, it owned 266 properties.
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.
Not only has it grown by acquisition, it is also growing by increasing its rents. In the third quarter, the leases the REIT signed were 37% higher than the leases that expired.
Those rental spreads will probably continue (though maybe not at 37%!) and keep contributing to Dream Industrial’s growth.
Because it has grown so much this year, it is tough to tell what Dream Industrial’s financials will be next year.
Even if you just use 2019’s financials though, Dream Industrial looks inexpensive.
It is currently trading at just 16x 2019’s FFO. Since 2021’s FFO will be so much higher, the market isn’t realizing just how cheap the REIT is.
The final thing that will contribute to growth, that hasn’t been seen yet, is how cheaply Dream Industrial can borrow money. Some of the acquisitions this year were in Germany and the Netherlands, which both diversified the portfolio, but also means Dream Industrial can borrow money in Europe.
European interest rates are much lower than in North America. As an example, in the third quarter Dream Industrial borrowed $150 million at an interest rate of just 0.9%.
This compares to its average interest rate in 2019 of 3.59%. If its interest rate comes down 1%, it could boost FFO by almost 15%.
5 year comparison of Dream Industrial REIT Vs TSX
Plaza REIT (TSE:PLZ.UN)
Plaza Retail REIT (TSE:PLZ.UN) is in one of the best positioned among retail REITs to benefit from the COVID-19 pandemic.
Plaza predominantly owns shopping plazas and quick service restaurants, and the majority of them have grocery stores or pharmacies as anchor tenants.
Over 91% of Plaza’s rent comes from national tenants like Starbucks, Tim Hortons, Staples, Sport Check, Sobeys, Dollarama, Canadian Tire and many more, who have the strength to ride out the pandemic.
Investors are underestimating how resilient Plaza’s tenants are.
Not only are the REIT’s current properties strong, but Plaza is working on a number of developments, which will add to Plaza’s growth for a number of years.
Michael Zakuta, the CEO of Plaza, has said the REIT is more about developing properties.
Plaza takes underperforming properties and refreshes them. Some of its best deals are when it buys shopping centres with large stores that are vacant. It then renovates those stores into multiple, smaller spaces, and then leases those at higher rents.
If retailers start going out of business, it could give Plaza a lot of shopping centres to buy and fix up.
The price of the REIT doesn’t reflect all of that growth potential.
Plaza trades at just 8.5x 2019’s FFO. A REIT with Plaza’s growth – it grew 19% in 2019 and even in 2020 has grown 2.8% before lease buyout expenses – should trade at a much higher multiple.
The growth in FFO is going to make Plaza’s already very safe distribution even safer. In 2019 the distribution was just 71% of FFO. Management reinvests the excess cash flow in its developments as well as buying back its units when they are cheap.
The combination of distribution, buybacks, and reinvestment makes Plaza Retail REIT one of the best REITs for income and unit price gains.
5 year comparison of Plaza REIT Vs TSX
Artis REIT (TSX:AX.UN)
Artis REIT (TSE:AX.UN) has undergone a lot of change in the past few years, and that is likely to continue.
Like other Canadian REITs, Artis REIT was weighed down by a lot of exposure to the Calgary office market in 2015.
It also had too much debt and was paying out more than 100% of cash flow in distributions. The distribution was cut, non-core assets were sold, and Artis embarked on a new strategy, one that emphasized stability and its strong office and industrial assets.
As part of that strategy management announced this fall that it wanted to spin off its retail portfolio into a new REIT.
That prompted Sandpiper Group, a Canadian activist REIT investor, to object and start a proxy fight with management to get control of the REIT.
Sandpiper wants to sell the retail properties slowly, which it says will bring in a higher price for them. The activist also wants Artis to raise the distribution again, cut costs (management is VERY well paid), and continue the asset sales to focus on the high quality properties.
Both management and Sandpiper wants to focus on industrial properties. 35% of net operating income comes from industrial assets currently, and Artis has a lot of properties where it wants to develop new industrial buildings.
The REIT has a goal of getting to 50% industrial exposure, a goal Sandpiper hasn’t argued with.
The payout ratio is 55% of AFFO, which is one of the lowest in the whole REIT sector. It gives the REIT plenty of excess cash that can be spent on unit buybacks, acquiring new properties, debt paydown, or developing industrial properties.
Of course it also means Sandpiper can easily increase the distribution if they get control.
That's a nice position to be in today, especially as other REITs struggle with unaffordable payouts.
It’s easy to argue Artis units are undervalued, especially after being crushed by recent investor doubt.
Artis trades at just 7.3x 2019's FFO and around 67% of NAV. Whether the activist investor or management wins the proxy fight, Artis REIT has a lot of ways to return to its fair value.
5 year comparison of Artis REIT Vs TSX
Dream Office REIT (TSX:D.UN)
Most REITs offer diversification across different types of real estate and locations. Dream Office REIT (TSX:D.UN) tried that, and the strategy came back to haunt management when the Calgary office market slumped in 2015. The REIT is now focused on the Toronto office market.
After selling off non-core assets and cutting its distribution to a more reasonable level, Dream was left with a portfolio consisting of 5.5 million square feet of office space, mostly in Downtown Toronto.
85% of its total rents come from Downtown Toronto office towers, with 89% of rent coming from the Greater Toronto Area.
While COVID-19 has office vacancies in Toronto moving higher, they are still very low (less than 5%), and Dream Office continues to have a lot of success leasing space.
In the second quarter of 2020, when every company was thinking about permanently working from home, the REIT was still able to lease 250,000 square feet of space at rents 40% higher than the expiring leases.
More companies are going to utilize work from home employees, I'm confident the Downtown Toronto market will still be hot even if overall office demand goes down.
Dream has transformed its portfolio and has improved its balance sheet at the same time. It has a debt-to-assets ratio of under 40%, with just over $150 million worth of debt to refinance in the next year.
The low debt and the low payout ratio make Dream Office’s 4.9% yield very safe. Year to date in 2020 the FFO payout ratio was just 66%.
Despite the attractive fundamentals of the portfolio, Dream Office is trading at just 72% of its net asset value and ~13x FFO.
Management has used the attractive valuation to buy back over 8% of the units outstanding this year. They see that Dream Office is a bargain.
Finally, the REIT has an interesting hidden asset. It owns just under 20% of Dream Industrial REIT, mentioned above as another of Canada’s best REITs. That stake is worth a little under $340 million.
5 year comparison of Dream Office REIT Vs TSX
The bottom line
One of the fun things about Canada’s top REITs is they’re a diverse group of companies and you'll find a little bit of everything on the Toronto Stock Exchange.
Whether you're looking for a retail, industrial, office or residential REIT, it's got a bit of everything.
Some, like Artis and H&R, are cheap turnaround stories.
Others, like Automotive Properties and Dream Office REIT, are specialty plays with great long-term growth potential.
And others, like SmartCentres, Plaza Retail REIT, and Dream Industrial, are just excellent operators that do everything right.
Canadian REITs have been traditionally known as yield plays. But these top picks go to show that significant capital gains are also possible if you choose the best.