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Don’t Bother With Investment Properties; Buy These REITs Instead

It’s slim pickings for real estate investors in Canada’s big cities these days.

In most of our largest cities, investors have rushed in and bought condos en masse, driving up prices. This has driven down returns to the point where it’s common to see investors having to subsidize units that don’t collect enough in rent to cover the interest on the mortgage, condo fees, and property taxes. These investors are hoping for one thing — price appreciation.

Things are so overvalued that Boardwalk (TSX: BEI.UN), Canada’s largest apartment real estate income trust, came out with some interesting news. It would like to buy more units and expand its operations, but it can’t find apartment buildings that make sense. Valuations are just too high.

Let that sink in for a moment. There are tens of thousands of apartment blocks across the country — yet Boardwalk can’t find any to buy without paying too much. Am I the only one who finds this crazy?

For many real estate investors, the end of Canada’s housing boom is going to be a painful experience. Imagine buying a $400,000 condo with a $20,000 down payment. After a year, values have fallen 5%. Just this small decline wipes out the entire down payment. Suddenly, this investor is stuck subsidizing a property that’s not only going down in value, but also isn’t spinning off enough cash to pay for expenses. How long would you hold an investment like that?

If Canada’s real estate market sells off in a huge way, there’s no doubt REIT shares will suffer. In that type of situation, it’s very obvious that the REIT’s underlying properties are worth less than before.

How bad will it get? Most REITs are relatively conservative with their balance sheets, and have average loan-to-value ratios nowhere close to that of many individual investors. Most REITs give investors yields in the 6%-8% range, and should get gobbled up by income-hungry investors if yields get much higher. As Canadians fall out of love with real estate as an asset class, more folks should rent, increasing demand for rental property.

It’s obvious that REITs are the place to be during a real estate downturn.

REITs also give an investor one other huge advantage over someone who owns one or two physical units: diversification. If there’s a flood in the only condo someone owns, it could potentially be a disaster. In contrast, if a store closes down in a facility owned by RioCan (TSX: REI.UN), that’s 10,000-20,000 out of more than 80 million square feet of retail space. It’s such a minor issue that the company wouldn’t even bother disclosing it to investors.

RioCan is a terrific choice for investors looking for alternative real estate exposure. The company owns some of the finest retail space in the country, leasing to the heavyweights of the retail world. Even if Canada’s entire economy slows down significantly, huge numbers of stores aren’t about to shut down, especially in RioCan’s facilities, which are usually located in prime locations. The stock currently yields 5.1%.

Another terrific stock for real estate investors is Dream Office REIT (TSX: D.UN), the country’s largest owner of office space. The company owns 185 different office buildings, with more than 28 million square feet in space. Its top tenants are among the finest in the country, including Bank of Nova Scotia, Telus, and various levels of government.

Plus, investors are getting the shares cheap. The company is trading at just 10% above its 52-week low, and currently yields more than 7.6%. The reason the company is beaten up is because its current occupancy rate is a little disappointing, at 94%. Once the company gets it up above 95%, look for the shares to recover.

At this point, things are bound to end badly for investors who buy individual rental properties. Valuations have just gotten out of hand over the last few years. Investors should stick to REITs instead. Over the next few years, they’re bound to outperform any rental bought at the top of the market.

Five more stocks that will crush residential real estate

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Fool contributor Nelson Smith has no position in any stock mentioned in this article. 

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