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 REIT, is primarily modeled 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 rates 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 were 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 as 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 for 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 as 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.
Of note, these REITs are in no particular order.
The top REITs in Canada for 2022 and beyond
CT REIT (TSE:CRT.UN) generates the vast majority of revenue from leasing its properties to Canadian Tire Corporation, which operates the Canadian Tire retail stores. The trust's portfolio primarily consists of properties anchored by a Canadian Tire retail store, in addition to retail properties not anchored by Canadian Tire, distribution centers, and mixed-use commercial property.
The pandemic hit this REIT hard price-wise. However, fears turned out to be unjustified as Canadian Tire had a pandemic boom that saw its e-commerce sales surge.
Occupancy rates were maintained, and this REIT was able to put up very strong numbers over the duration of the pandemic while many other retail REITs, particularly those focused on properties like shopping malls, struggled significantly.
The REIT has a market cap of around $4B at the time of writing and is certainly one of the larger REITs in Canada today. With it being more established, growth is likely to be slower, as analysts project the fund will grow revenue by around 5.2% annually over the next couple of years.
Although CT REIT certainly isn't flashy, we really don't need it to be. Instead, with this fund, you'll get rock solid coverage ratios, one of the best payout ratios in the industry, along with a growing and high-yielding distribution.
At the time of writing, CT REIT has a FFO to interest coverage ratio of 2.7, and one of the lowest debt to asset ratios of all REITS in Canada at 0.19. The company is paying out only 68% of trailing funds from operations towards the dividend, and it yields in the low 5% range.
It is a Canadian Dividend Aristocrat, having grown the dividend for 9 straight years. In terms of dividend growth, don't expect anything more than low single digits annually. However, this will be the case for most all REITs here in Canada.
Overall, if you're looking for a high-yielding, reliable REIT in the retail sector, CT REIT is one you'll want to look at.
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 72 dealerships and 2.7 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, and negative sentiment towards the automobile sector coming out of the pandemic may hold this one up. But these are long-term businesses that value stability. They are not abandoning these locations anytime soon.
Over the last year, Automotive Properties has improved its balance sheet. The company’s D/E ratio now stands at 0.90, down from a high of 1.91 back in 2019. The company’s payout ratio is also reasonable as the distribution accounts for only 83% of funds from operations.
Further increasing the company’s attractiveness, Automotive Properties is currently trading at just 1% premium to its current net asset value.
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 at the time of writing, it has a debt to equity ratio of only 0.58, debt to assets of only 0.38, and an interest coverage ratio of 7.48. With such a low amount of debt, Dream Industrial has the capacity to make a lot of acquisitions.
Through the first six months of the year, their portfolio stood at 257 assets with gross leasable area of 46M square feet. Not only has it grown by acquisition, but it is also growing by increasing its rents. Over the last year, the company has grown rent prices in the low single digits.
To top things off, occupancy rates are rebounding after a pandemic-impacted few years. The fund's occupancy rate dipped into the low 90% range during the peak of the pandemic but now sits at 99.1%.
Trading at a price to FFO of only 14.6 at the time of writing, the company is cheaper than major peers like Granite Real Estate (TSE:GRT.UN). It is also trading at a 25% discount to its net asset value, as the near-year-long correction of real estate investment trusts is leaving some attractive options on the table.
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.
The company has total assets in excess of $11.5B, which is a compound annual growth rate of 26.4% since its 2003 IPO. Of those assets, ~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 low double digits in terms of net operating income. 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 a large portion of revenue.
As of writing, Allied is still trading at a 36% discount to its NAV. It has an attractive yield and the distribution is well covered with an FFO payout ratio of 72%. Further to this, Allied is one of only 8 REITs which have achieved Canadian Dividend Aristocrat status. At 10 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 3.56 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 16.5% 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.
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 $8B, it is around 4 times larger than its closest competitor, and is the largest REIT in the country.
The company operates over 67,000 rental apartments and housing sites in Canada, Ireland, and the Netherlands.
Analysts are expecting 7.45% average annual revenue growth over the next couple of years, which is among the best in the industry. Worth noting, that 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 10 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 one of the best interest coverage ratios out of all residential REITs at 2.28, trailing only Killam Apartment REIT (TSE:KMP.UN).
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 that 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.