A large portion of Canadians’ wealth is invested in our homes – 68% of Canadians own their home and the national average value for a Canadian home is $373,000 (BC average being the highest at around $600,000 and PEI being the lowest at $160,000).

That stake in your home may provide enough of an allocation of your overall wealth being invested in real estate. Overweighting real estate relative to your other assets can expose you to greater downside risk in your net worth – for example, a significant increase in mortgage interest rates or a downturn in the local market’s economy where the property is situated – can quickly dampen real estate values. Once again, diversification is the key to a successful long term strategy of preserving wealth and that includes holding different forms of assets.

A great incentive to invest in a principal residence is the fact that you do not pay tax on its appreciation when you sell. However, investing in an individual rental property can involve major disadvantages if it constitutes a significant source of retirement cash flow. The cash yield tends not to be high. Maintaining the property and securing good, long term tenants are ongoing challenges. Also, if you need one-off access to retirement cash flow, eg for a new car or a new roof or a vacation, the rental property is not divisible to fulfill your need, ie you must sell the entire property—you can’t sell the bathroom! Also, there is a time delay factor in listing and closing on the sale and large commissions and possibly large capital gains tax.

One way to avoid these difficulties is to have a ‘passive’ stake in quality real estate properties by way of shares in Real Estate Investment Trusts (REITs). These are specialized trusts that hold real estate, which may include residential or commercial or industrial properties, such as apartment complexes, office towers, shopping centers, warehouses and hotels. Listed REIT units trade over the stock exchanges and are a much more liquid, and divisible, alternative to holding individual real estate properties. They can provide an immediate diversified mix of types of properties, along with a variety of locations and tenants, that would be hard to assemble on your own.

As trusts, they are structured to be “flow-through” entities which pay little or no tax. Consequently, the trust unitholders who receive the cash flows are passed the responsibity for paying the tax (and if paid into a registered plan or a pension plan there are no immediate taxes triggered). The cash distributions paid out to unitholders are primarily generated by the REITs’ net rental earnings—the average “payout ratio” is around 80% for Canadian REITs. In the US, REITs are legally required to pay out 90% of their taxable income annually. For conservative investors, REITs should have a history of steady payouts that are expected to be sustainable over time. Potential returns generated by REITs also include capital gains realized by the appreciation in the REIT’s unit price when sold. Most REITs in Canada presently are not bargains, after rallying from their bottoms in 2009. However, they are considered to be in better shape now than before because many have refinanced their borrowings at lower rates and for longer terms, so the risk they could face from rising interest rates has been reduced.

Yet another way to invest in REITs is to own an exchange-traded fund (ETF) that itself holds a number of REITs. While there is an embedded annual management fee (MER) for the ETF, it is relatively low. For example, the S&P/TSX REIT Index Fund has an MER of 0.55% and holds 13 Canadian REITs. There are also a large number of US-based REITs and accompanying ETFs that trade over American exchanges. Some of these ETF-REITs hold properties exclusively outside of North America – a large percentage of their holdings are in Asia (including Hong Kong, Japan and Singapore). Below are examples of some of the larger Canadian and US traded REITs.

REITs

Canadian Real Estate Investment Trust (CREIT) is the oldest REIT in Canada. Its 15-year annual compound total return (that includes distributions plus change in share price) has been 20.3%. Below is the history of CREIT’s annual total returns:

CREITs

While Canadian REITs, such as CREIT, have provided solid returns, many investors recently have been drawn to the US real estate market due to its current depressed prices. In the coming years, all North American REITs will face increasing competition as investors seek opportunities in emerging markets across the globe. Regardless, inclusion of some form of REIT in your portfolio can contribute diversification along with providing a source of both regular and one-off cash flows.

 

Article posted: 27-Jun-11