Real estate investment trust

A real estate investment trust (REIT) is an income-producing security that enjoy tax advantages, including return of capital. In Canada, a REIT is a "publicly listed closed or open-ended trust ... that holds primarily income producing real estate assets". REITs invest in a variety of properties, including apartments, hotels, industrial parks, office buildings, retirement residences and shopping malls. As trusts, they are required to distribute most of their earnings to unitholders, i.e., the investors.

Some investors invest a small percentage of their for portfolio in Canadian or foreign REITs for diversification or current income purposes, for example in various complex portfolios. The diversification argument is based on the limited correlation between REITs and other asset classes. There is already a component of REITs and other real estate businesses in major Canadian, US and international stock indices. So a decision to add a stand-alone REIT allocation to a portfolio is often a decision to overweight this particular sector.

This article briefly introduces the history of REITs, then lists the pros and cons of overweight REITs in one's portfolio. Historical returns, standard deviations and correlations are then examined. The article goes on to review the percentage of REITs in various Canadian and US model portfolios, and the particular tax characteristics of REITs. Finally some index ETFs that invest exclusively or mostly in REITs are mentioned.

History
Following U.S. tax changes in 1986 that constrained the pass-through of losses to investors in limited partnerships (LPs), REITs found a level playing field. While publicly traded LPs were almost invisible in Canada REITs gained a footing after the Olympia and York collapse in the early 1990s commercial real estate bust (which also took down Confederation Life).

From three REITs in the early 1990s, the market has expanded to 48 REITs on the Toronto Stock Exchange at the end of 2015 with a market capitalization of $53 billion.

Pros and cons of REITs
Many model portfolios aimed at Canadians do not include REITs, but some do (see a compilation below), and REITs are regularly discussed on the Financial Wisdom Forum.

Arguments for

 * An easy, affordable, liquid way to invest in income-producing real estate without single property risk
 * Professional management of real estate
 * They have offered relatively high yields thanks in part to the tax characterization of their distributions
 * Regular (typically monthly) distributions
 * Part of the monthly distribution is return of capital, not regular income (favorable tax treatment; see below)
 * Portfolio diversification due to low correlation with most other asset classes (see below)

Arguments against

 * REITs may not be a separate asset class, but can instead be seen as only a sector of the Canadian stock market (or foreign equivalents)
 * The volatility of REIT indices is higher than that of broad stock market indices (see below)
 * Extreme market movements of REITs and broad stock markets indices are synchronized, especially during crashes
 * The idiosyncratic risk of the real estate sector remains: investing in REITs is a sector bet
 * For investors who don't need high current income, REITs may not be tax-efficient, as most of the distribution is taxed as regular income (as opposed to dividends or capital gains on stocks)
 * If the investor is using ETFs, those covering Canadian REITs have high management fees and only about 20 holdings each (see below)

Annualized returns
Over the period 2003-2016, the S&P/TSX Capped REIT Index had an annualized return of 10.7%, versus 9.0% for the S&P/TSX Composite (Canadian equities), 7.9% for the S&P500 (US equities), and 6.3% for the MSCI EAFE (International equities), all expressed in Canadian dollars. These high REIT returns may not persist in the future, but at least this shows that REITs can have returns comparable to those of broader equity indices.

Risk
Standard deviation of annual returns is one possible measure of risk. Higher standard deviation mean greater volatility. Over the period 2003-2016, the S&P/TSX Capped REIT Index had a standard deviation of 21.6%, compared to 17.3% for the S&P/TSX Composite, 15.2% for the S&P500 and 15.8% for the MSCI EAFE. So Canadian REITs are typically more volatile than broader equity indices. In 2008, REITs lost 38.3%, which is worse than the other three indices, which lost between 23 and 33% when expressed in Canadian dollars.

Correlations
The correlation coefficient measures the degree to which two variables are related. This coefficient can range from -1 (perfect negative correlation) to +1 (perfect positive correlation), while zero means that there is no relationship. The following table shows the correlation between Canadian REITs and other asset classes over the period 2003-2016:

While Canadian REITs indeed have a moderate, low or even negative correlation with many asset classes, the correlation with Canadian equities is quite high, so portfolios very heavy in Canadian equities may not get as much diversification benefit they had hoped for.

Percentage in model portfolios
Model portfolios for "balanced" investors (about 60% equities, 40 fixed income) typically include between 0% and 10% REITs. The following table compiles recommendations from specific sources aimed at Canadian investors:

A number of US sources (aimed at US investors) recommend higher REIT percentages, in the 5-15% range, for balanced portfolios. The following table shows four examples:

There is nothing special about the 6% number that pops up in the tables above: it can be arrived at by arbitrarily assigning 10% of equities to REITs, and for a 60% equity-40% fixed income portfolio, that means 6% REITs.

Tax characteristics
As with any publicly traded company formed as a trust, a REIT distributes its taxable income to its trustholders. Otherwise, its earnings would be taxed at the trust's corporate income tax rate, rather than the trustholder's top marginal tax rate.

What adds to the attractiveness of REIT distribution is that, depending on the trust indenture, much of the Capital Cost Allowance (CCA) is flowed through to investors. CCA is depreciation; as it is flowed through, it reduces the unitholder's adjusted cost base (ACB). When the ACB reaches zero, any divestment is calculated as a pure capital gain.

Apart from that, income earned by the REIT can be recharacterized. It may flow through as earned income, dividends, or capital gains (as well as return of capital). From Deloitte:
 * The income from a REIT is generally characterized as other income from trust property for income tax purposes. For example, if a REIT's taxable income is $11 million, of which $10 million is derived from rental income and $1 million is interest income, a 0.1% investor, for tax purposes, does not receive an allocation of $10,000 of rental income and $1,000 of interest income on the T3 supplementary form. Instead, that investor would simply receive $11,000 of income classified as other income.


 * Rental income is generally included in the definition of earned income for Registered Retirement Savings Plan (RRSP) purposes, but the rental income earned by a REIT is not rental income in the hands of the unitholder. Therefore, taxable income received by an individual REIT holder does not qualify as "earned income" for the purpose of calculating the investor's RRSP contribution limit for the following year.


 * Fortunately, the Income Tax Act does contain rules that permit a REIT to designate certain types of income to essentially retain its character upon distribution to the unitholder. For example, a REIT may designate a taxable capital gain distributed to the unitholders to be a taxable capital gain to such unitholders. As a result, an investor will pay income tax on only one-half of the share of the capital gain realized and distributed by the REIT. A REIT may also designate a dividend received from a taxable Canadian corporation and distributed to the unitholders to be a dividend received by the unitholder. An individual investor could then benefit from the dividend tax credit.


 * Provided the REIT has allocated its taxable income to its unitholders, each investor in the REIT will receive a T3 Supplementary slip either directly from the REIT or indirectly through the brokerage house with whom the units are held on behalf of the investor. The unitholder will then be able to determine what portion of the distributions represents capital gains, dividends from Canadian corporations (usually flowing from the REIT's corporate subsidiaries) and other income. These amounts are then reported on the investor's personal income tax return.


 * The return of capital distributed by the REIT, i.e. the amount of the distribution paid by the REIT in excess of the taxable income (which includes, if applicable, capital gains), is generally not taxable immediately to the unitholder. However, the unitholder's adjusted cost base (ACB) of the units will be reduced by such amount, as discussed below. A return of capital distribution is attractive to the unitholder as it essentially represents tax-deferred cash flow from the REIT.

Exchange traded funds (ETFs)
An investor may choose to invest in Real Estate Investment Trusts using exchange-traded funds (ETFs) for this sector.

The oldest REIT ETF, which commenced on October 17, 2002, is the iShares S&P/TSX Capped REIT Index ETF (tsx: XRE), which tracks the performance of the S&P®/TSX® Capped REIT Index. The stated management fee is 0.55% and the ETF contains 21 holdings.

On May 19, 2010, BMO Financial Group launched the BMO Equal Weight REITs Index ETF (tsx: ZRE), tracks the which Solactive Equal Weight Canada REIT Index. Note that equal weight means that each constituent makes up the same proportion in the index, as opposed to being represented in the index as a function of its market capitalization. The stated management fee is 0.55% and the ETF contains 24 holdings.

The newest entrant, launched November 1, 2012, is Vanguard Canada's FTSE Canadian Capped REIT Index ETF (tsx: VRE) with tracks the performance of the FTSE Canada All Cap Real Estate Capped 25% Index (or any successor thereto). Note that the index on which VRE is based includes companies which are not REITs, but in early 2017, the top five holdings are the same as in XRE. Formerly, the inclusion of Brookfield Office Properties in VRE's top five holdings meant that yearly returns could differ significantly. The stated management fee is 0.35% and the ETF contains 16 holdings.