For income investors, REITs have proven to be perennial favourites.
Offering high distributions, steady income streams, and potentially high
capital gains, they’re one of the few ways to invest in real estate without
borrowing money. Not only that, but historically, North American REITs have
outperformed direct real estate investments, with a 9% annual return for REITs
compared to 8% for homes (according to data from Forbes). Factoring in the fact that most home
buyers have to take out mortgages and pay
interest, the REIT advantage becomes even more substantial.
But all this comes with a catch: compared to other stocks,
REITs do not necessarily shine. Since 2006, REITs as a class have returned just
14%, compared to 28% for the TSX. Granted, there have been some exceptions: in
2018, REITs solidly outperformed the benchmark, for example. But over a
long-term time frame, REITs are not the biggest growth sector around.
On the whole, REITs are a diverse sector with both good and bad
features. First, let’s take a look at the good.
The most obvious thing REITs have
going for them is high income. Canadian REITs offer above-average yields that
can reach as high as 14%, while 5-6% is the
norm for the sector. Many REITs also pay monthly distributions instead of
conventional quarterly dividends, so the payout frequency can be higher than
average. However, REIT payout ratios tend to be higher than in other sectors,
so earnings misses can easily drive yields lower. If you’re looking for safe
income, it’s better to go for a REIT like RioCan REIT (TSX:REI.UN), which yields a “low”
(by REIT standards) 5.82% but has a steady payout history.
The main disadvantage of REITs is
that their returns tend to lag relative to other classes of stocks.
Interestingly, this has not been the case for Canadian REITs over the past 12
months: the iShares Capped REIT
ETF has beaten the TSX over that time frame, with a positive return of
about 8%. But over a very long-term time frame, the reverse is the case, with
the TSX having solidly beaten REITs over 12 years. With that said, the slight
disadvantage REITs have in terms of returns is more than made up for by
dividend yields, which, in this sector, can easily approach double digits.
thing REIT investors should be aware of is that valuation is more important for
this sector than others. Because REITs don’t offer frothy growth, they’re
especially hard to justify at huge price/earnings multiples. Warren Buffett once
said in a speech to a group of MBAs that he preferred direct commercial real
estate investments to REITs, with the only exception being if a REIT can be
found for an extraordinarily cheap price. This makes sense given that REITs
have overhead costs (payroll costs, etc) that direct property investments
don’t. So, if you’re going to invest in REITs, it pays to buy them cheap. This,
incidentally, is another argument in favour of RioCan, which currently trades
at just 11.5 times earnings and 0.99 times book value.
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