Real Estate Investment Trusts – Five Critical Keys To Consider When Investing In A Canadian REIT

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Investing in Canadian REITs has again become the darling for investors looking for regular monthly dividends.

We asked expert REIT investor, Adam Cutler of REITinvestor.ca, – Canada´s only independent REIT ranking and rating service, what an investor should look for when considering a REIT investment. Here are Mr. Cutler´s five critical keys to consider before making an investment.

1. The Payout Ratio & Cash Flow Stability/Growth

REIT investors are attracted to REITs for the distributions that flow monthly into unitholders´ bank accounts. The distribution is the excess cash flow from operations that the REIT pays out to unitholders. The Payout Ratio is simply the amount of cash flow distributed to unitholders divided by total cash flow, or distributable income.

The Payout Ratio should trend below 100% of distributable income. When a REIT´s distributable income per unit is stable and the REIT´s distribution trends well below 100% of its cash flow, unitholders can feel assured of the current distribution continuing. A REIT whose cash flows are unstable will need to assure unitholders that it has plans to stabilize performance and achieve growth targets, or the units´ market price will likely fall.

2. The Liquidity Ratio & Near-term Funding Needs

Liquidity is the total of cash on the balance sheet plus any undrawn lines of credit. A simple Liquidity Ratio is given by dividing the total of cash and undrawn credit by the REIT´s total debt.

A REIT with poor or declining liquidity exposes its unitholders to a rising risk of it cutting its distribution. This reflects the clear fact that any REIT needs to meet its near-term obligations before distributing cash to its unitholders. If, for instance, the Liquidity Ratio declines to less than 3%-4%, cutting the distribution is a high-risk outcome. REIT´s with Liquidity Ratios of more than 10% have favourable odds of maintaining the distribution.

In all cases, investors need to consider the Liquidity Ratio in relation to near-term funding needs, both those that support existing operations and any growth plans. A REIT may have large needs pending for which it has not prepared or in all probability cannot fund internally, such as financing a construction project or covering a maturing debt. External financing, such as drawing down credit lines, refinancing debt, or issuing new units or debt will affect the Liquidity Ratio.

3. Leverage & the Lender-Defined Model

Leverage refers to the ability to borrow against an asset. In the REIT sector, as in all real estate ownership, understanding leverage is critical to determining asset values. This understanding requires knowledge of lender-defined models for each type of real estate, be it hospitality, commercial, institutional or industrial, or residential.

In short, each REIT is constrained by lender-defined models that determine its ability to borrow against its assets. It is the lender who determines the maximum leverage available for any particular asset type.

Despite lender-based metrics, REITs typically focus on debt as a ratio of the price paid for a property, its Gross Book Value. However, as this has little relevance to a lender, it should be largely ignored by the investor.

Investors do need to know the lender-defined model prevailing for each property type. For example, a non-residential, revenue-generating property, such as a retail center or office building, will attract lenders to a maximum of 65%-70% of appraised economic value. Economic value is based on factors including occupancy, rental rates and re-sale value, and is only loosely related to the Gross Book Value.

If a REIT property or portfolio appears levered over the expected maximum loan-to-value of a reasonable lender, the investor should dig deeper to determine if the REIT is heading for a fall. An over-levered REIT potentially faces forced de-leveraging by its lender(s), which could spell serious trouble for its unitholders.

4. Asset Types

Each REIT typically specializes in an asset type, such as retail, office, industrial, hospitality, seniors´ living or residential apartments. The investor needs to understand recent trends for each type, including rental rates, vacancies, lender appetite and other important details such as geographic concentration and demographics. Whether the REIT is diversified or more narrowly focused, investors need to understand the important trends and health of its asset type(s).

5. Management Quality & Insiders´ Alignment with Public Unitholders

Although REITs are typically viewed as investments in real estate, the REIT´s management makes the operational, acquisition and disposition decisions. As in any business, there are REITs that are well managed and a few badly managed. The well-managed REIT keeps the unitholders´ interests in focus. Bad management views the REIT as its private business, ignoring what is best for the public unitholders. In extreme cases, a bad manager will permit conflicts of interest that favour insiders to the detriment of the market investors. Both management´s interests and the Board of Trustees´ need to be always aligned with unitholders´ interests, and any indication that they are not should be viewed as reason not to invest.

REITinvestor.ca uses its proprietary quantitative rating and ranking model to build in all the above critical keys and many others that together enable subscribers to determine the quality of each of the 23 TSX listed REITs its covers. To learn more about REIT investing visit www.REITinvestor.ca