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Income Investors: 3 Important Reasons You Might Want to Avoid REITs

I’m a firm believer that Canada’s REITs should be a part of most portfolios.

These companies are a fantastic way for investors to generate substantial passive income without taking on the stress of managing a rental property. They also offer diversification across both geography and different kinds of real estate as well as certain economies of scale. A REIT can manage an extra few units a lot more efficiently than someone with a full-time job.

But at the same time, I firmly believe owning REITs might not be for everyone. In fact, there are thousands of Canadian investors who have overexposed themselves to the sector and are facing a potential disaster if it turns negative.

Here’s why you may want to think about at least minimizing your exposure to REITs.

The dividends aren’t as good as they seem

On the surface, a stock like RioCan (TSX:REI.UN) looks to be a rock-solid dividend payer. It sports a yield of 5.9% and a plan to convert dozens of existing strip malls to exciting mixed-use developments. This should lead to substantial income growth over time.

Compare this to Shaw Communications  (TSX:SJR.B)(NYSE:SJR), which pays out a 4.9% yield. The company is spending every spare nickel expanding its wireless network, which means investors aren’t likely to see a dividend increase for a number of years.

It would appear RioCan’s dividend is 1% more than Shaw’s, which translates into about 20% more income, assuming equal investments in the two. But if you hold both investments in a taxable account, Shaw’s payout might end up netting you more after taxes.

In 2017, RioCan paid out $1.41 per share in distributions and 27.5% of the payout was taxed as capital gains. But 72.5% was taxed as other income, which is fully taxable at your marginal rate. For retirees without much active income, this isn’t a big deal. But for investors with good full-time jobs today, a REIT’s payout isn’t tax efficient.

Shaw’s payout is an eligible dividend, which means it comes with a low tax rate. This makes it attractive for taxable accounts. Other top dividend stocks will see their payouts taxed the same, while a REIT’s distribution isn’t.

Over exposure to real estate

Many Canadians — especially those who live in our largest cities — already have a big chunk of their portfolio exposed to real estate in the form of their principal residence.

Say you own a house in Toronto worth $1 million and you have a $2 million net worth. You’d already have 50% of your net worth tied up in real estate. That’s a lot, even for an asset class that has performed as well as Canadian houses. I’d argue the prudent move would be to put every spare dollar to work in other sectors.

High payout ratios

Many of Canada’s top REITs have payout ratios close to 100% of their net operating income. This means they’re more likely to cut their distributions during tough times. That might be the prudent thing to do from a company’s perspective, but it’s devastating for an investor who’s counting on that income stream.

There are a couple of ways investors can guard against this. They can diversify across a number of REITs, which minimizes the risk of a cut from one company. And they can do a little analysis and avoid REITs that may be a little shaky.

One REIT that may be in danger of cutting its distribution is Artis (TSX:AX.UN). In its most recent quarter, it posted a payout ratio above 100% of funds from operations, which is something investors never want to see. It also has a large exposure to the Calgary office market, which is still reeling from the energy sector’s weakness.

The bottom line

REITs should be part of a well-balanced portfolio. They’re a great asset class to own over the long term. But perhaps they shouldn’t be a big part of your assets at this point.

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Fool contributor Nelson Smith has no position in the companies mentioned.

 

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