What to look
for when investing
in Real Estate
Investment Trusts

What to look for when investing in Real Estate Investment Trusts

by Tom Dicker, Vice President & Portfolio Manager, 1832 Asset Management L.P.

As a manager of a number of real estate portfolios, I am often asked questions about individual REITs (Real Estate Investment Trust). The questions skew heavily towards REITs with high distribution yields. While a high current yield on a REIT can be tempting, we prefer a total return approach to REIT investing. As a result, our portfolios tend to own companies with yields lower than the S&P/TSX Capped REIT Index but with higher potential for dividend and net asset value growth.

A low yield is not the goal itself. What we look for in a REIT is a low payout ratio, which often results in a lower distribution yield. A decade ago, Canadian REITs notoriously had high yields and high payout ratios. Many REITs have chosen to lower their payout ratios and retain more cash flow to reinvest in their businesses, which we applaud.

There are a few problems with a REIT having a high payout ratio. First, when a REIT pays out all of its cash flows as dividends, it doesn’t leave itself a lot of flexibility should interest rates start to rise, increasing its interest expense. Additionally, should a REIT experience prolonged vacancies, resulting in lower income and often unexpectedly high capital expenditures to renovate empty space, having a high payout can put upward pressure on leverage ratios. Given that we are both late in the business cycle and in a rising interest rate environment, these issues could affect REITs over the next few years.

The other major concern for REITs with high payout ratios is that their growth is heavily dependent on outside sources of capital, which are expensive and not always available. Real estate is a capital intensive business. Capital is a commodity. The winner in a commodity business is the low cost provider. For a REIT, the lowest cost dollar of capital is a dollar the REIT produces from its own operating earnings (because it costs nothing extra). Raising equity or debt from the capital markets can cost over 6% in some cases.

Companies with low payout ratios, for example below 50% of AFFO (Adjusted Funds From Operations), have a much lower cost of capital and can pursue more opportunities for growth because funding that growth is less expensive. In addition, because these REITs are at a lower risk of defaulting on their debts due to the additional cash flow coverage of their dividends, their debt is often seen as less risky and often bears a lower interest rate than peers with higher payouts. As a result, a low payout ratio often gives a company more opportunities for growth and a lower cost of capital.

Lastly, a low payout REIT can often reinvest in its business at a much higher rate of return than the dividend that is being paid to unitholders. This is how REITs with 3% or lower yields can and often produce higher total returns and often have higher rates of dividend growth. Great management teams with a low cost of capital can allocate that capital to high returning projects and compound the cash flows from existing assets at very attractive rates, sometimes well into double digit rates of return. These projects could include renovating or redeveloping their own buildings, acquiring newly built buildings from other developers, or developing a new property themselves. These higher returning projects are often not available to high payout companies because the additional cost of raising the capital required to do the project or buy the asset would make the returns dilutive.

We believe in the low payout ratio model for REITs, and expect to see more Canadian REITs evolve toward it over time, as their U.S. peers have done since the financial crisis.

Tom co-manages the Dynamic Global Real Estate Fund, which invests in high quality REITs around the globe.

About Tom Dicker

Tom Dicker joined Dynamic in 2011 as a portfolio manager and member of the Equity Income team. He is co-manager of several funds and covers a number of areas, including U.S. equities, small cap equities and real estate securities.

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Disclaimer:

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