Before we invest in anything, we should have a goal in mind. The goal needs to be realistic, so that it’s attainable and measurable. For dividend investors, the safety of the dividend, the dividend yield, and the growth of that yield are all essential information.
Here, I will use real estate investment trusts (REITs) as examples to show how to set realistic expectations for different kinds of REITs.
A high-quality REIT
Canadian REIT (TSX:REF.UN) is a conservatively run REIT. The business buys high-quality property assets that help it maintain high occupancy levels and high rental rates. Further, it maintains a conservative payout ratio (about 60%) to ensure it can continue increasing the annual payout every year.
In fact, for 13 years it has increased its distribution, and I dare say Canadian REIT pays the safest REIT yield in Canada.
The last distribution hike was in June, and it increased 2.9% year over year. With funds from operations expected to grow north of 2%, its distribution is also likely to grow around that rate if the REIT doesn’t expand the payout ratio.
So, investors can expect an investment today with a yield of 4.3% to grow by at least 2-3% in the foreseeable future. That implies a total return of 6.3-7.3%.
In this case, shareholders would be foregoing some income growth and returns by sticking to a high-quality REIT.
A high-yielding REIT
Dream Global REIT (TSX:DRG.UN) owns and rents out commercial properties in Germany. Germany is the Eurozone’s largest economy and has a low unemployment rate. So, the real estate market there is one of the most stable in the Eurozone.
Over the past three years Dream Global is among the top three acquirers of office properties in Germany. Now, the REIT owns properties in seven of Germany’s major office markets: Hamburg, Berlin, Munich, Frankfurt, Cologne, Stuttgart, and Dusseldorf.
Since its initial public offering in 2011, it hasn’t increased its distribution, but Dream Global has maintained it. At the current price of $9.7 per unit, it yields 8.3%. So, what Dream Global lacks in distribution growth, it makes up for it with a high yield.
A moderate yielder with growth
With Allied Properties REIT (TSX:AP.UN) you have both a decent yield to start and a growing income. Allied Properties REIT owns and manages a portfolio of primarily Class I office properties in the urban areas of Ville de Quebec, Montreal, Ottawa, Toronto, Kitchener, Winnipeg, Calgary, Edmonton, Vancouver, and Victoria.
For the past couple of years, it has grown funds from operations at a rate of 8%, which is pretty high growth for a REIT. Because Allied Properties REIT’s management incorporates growth into the business model, the REIT was able to increase distributions by almost 25% from 2004 to 2014. In other words, if you had invested in Allied Properties at the start of 2004, you would have seen your income increase by 25% by now.
What Allied Properties lacks in yield compared with Dream Global, for example, it makes up for it with business growth, translating into income growth for shareholders.
Tax on the income
REITs pay out distributions that can consist of other income, capital gains, foreign non-business income, and return of capital. Other income and foreign non-business income is taxed at your marginal tax rate, while capital gains are taxed at half your marginal tax rate.
To avoid any headaches when reporting taxes, buy REIT units in a TFSA or RRSP. However, the return of capital portion of the distribution is tax-deferred. So, it may be worth the hassle to hold REITs with a high return of capital in a non-registered account.
Each investor will need to look at their own situation. If you have room in your TFSA, it doesn’t make sense to hold investments in a non-registered account to be exposed to taxation.
It’s essential to set realistic expectations for your investments, whether it be for income or growth. It’s all right if the numbers don’t come out exactly as you expect. We are talking about the future here.
When we set expectations, we focus on the measurements that are most important to us. And we can look at those measurements later on to see if we’re on the right track. If not, then adjustments need to be made in your investment process.
Fool contributor Kay Ng owns shares of CDN REAL ESTATE UN.