Look for Canadian REITs that focus on investment inputs as well as investment outputs. They should also meet these 9 key criteria.
Top-quality Canadian REITs are among the most stable and highest-yielding real estate investments. That’s because many REITs hold high-quality, non-depleting assets, and took advantage of low interest rates to lock in financing costs for long terms. The best of the REITs have good management and balance sheets strong enough to weather long economic downturns. They also have high-quality tenants and carefully match their debt with their leases.
All in all, Canadian REIT investing is a good option for investors looking to invest in real estate.
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On January 1, 2011, Ottawa imposed a tax on distributions of income trusts. The new tax put income trusts on an equal tax footing with regular corporations.
Virtually all Canadian income trusts then converted into conventional corporations. But some are still out there—mostly real estate investment trusts (REITs).
What are Canadian REIT taxes?
All in all, Ottawa felt the income-trust business structure is appropriate for real estate investment trusts, or REITs, so it has exempted REITs from the income-trust tax.
Meanwhile, Canada offers special tax treatment for Canadian REITs. When they flow their income through to their unitholders, they don’t pay much if any corporate tax. Investors pay tax on most of the distributions as ordinary income (although some distributions qualify as a tax-free return of capital).
Real estate investment trusts resemble former Canadian income trusts, but with a key difference: REITs invest in income-producing real estate, such as office buildings, shopping centres and hotels. (We cover a number of carefully selected real estate investment trusts in our Canadian Wealth Advisor newsletter.)
Meanwhile, the basic tests we use to ferret out good investments and reject bad ones still apply, not only to Canadian REITs, but to other types of investments, as well.
How should you judge a Canadian REIT?
In evaluating investments, many investors focus on what we’d call “investment outputs,” such as earnings, dividends, cash flow, return on equity, sales growth and so on. These are all important, of course, but you shouldn’t focus on them to the exclusion of what you might call “investment inputs.”
Investment inputs are harder to work with than investment outputs, since it takes a judgment call to determine their risk or value. To give you a better idea of what we mean, here are 9 keys to picking the best Canadian real estate investment trusts. We look at each before recommending any REIT:
- Do you have any doubts about the integrity of the insiders? If so, stay out.
- Did the Canadian REIT buy its assets in the midst of a recent boom, or has it owned them for some time? Bidding for assets in the midst of a boom tends to be risky, since it can lead to unpleasant investment surprises.
- How much debt is the Canadian REIT carrying? You need to gauge the debt in relation to all assets, including hidden assets and those that appear on the balance sheet. Too much debt in relation to assets can lead to a steeper downturn in distributions when the business hits a snag. Meantime, you’ll want to see if a REIT has taken advantage of today’s low interest rates to refinance their debt?
- Is the business dominant or at least prominent in its industry? If the answer is no, risk is higher.
- How much of its cash flow is it paying out? Paying too much leaves it vulnerable to a cut in distributions. This can have a devastating effect on the unit price.
- Has its cash flow and profitability shown acceptable performance in relation to the rest of its industry? If it can’t make money when business is good, when can it make money?
- Are there any special factors worth considering? With REITs, you need to look at the quality of tenants, length of leases and the possibility of improving the use or expanding the occupancy of existing properties.
- Is the Canadian REIT the subject of a lot of favourable broker and media attention? If so, investor expectations may be excessively high, and that leaves the trust vulnerable to a steep downturn on any hint of bad news.
- Is the current and prospective yield high enough to justify the risk?
Should you invest in private Canadian REITs?
A private REIT is real estate investment trust that is not publicly traded on a stock exchange, unlike a conventional REIT. That means that private REITs calculate the value of their own units, and needn’t reveal all the information that’s available with publicly traded investments.
A private real estate investment trust typically portrays this feature as a benefit—since it avoids what it sees as the volatility and speculation of public markets.
But at the same time, private REITs lack the scrutiny from nosy outsiders and analysts who will find out about, and draw attention to, hidden risks and problems that the REIT happens to suffer from.
How interested are you in real estate investment trusts? Share your opinions in the comments.
This article was originally published in 2010 and is regularly updated.