How I Invest in REITs

Real estate will always hold a special place in my heart.

My dad has been a real estate investor pretty much my entire life. He worked hard, saved his money, and eventually built up a pretty damn impressive real estate portfolio. He took a simple idea, took it seriously, and accomplished something really significant.

Plus, managing his real estate gives him something to do every day, the perfect semi-retirement job for a guy who just can’t envision completely hanging up the proverbial skates.

My very first investments were made in real estate, shamelessly copying what worked for him. I bought an older property that wasn’t in great shape, but it delivered loads of predictable cash flow — just like my dad suggested. And it worked.

So then I did it again.

And again.

Soon I was putting every spare nickel from my grocery store job towards paying off debt, yearning for the day I would own those properties outright. It took a few years, but I made pretty quick work of those mortgages, embracing a debt-free lifestyle I still value today.

I would’ve bought more, but, alas, the market moved. House values shot higher, meaning the same properties that previously offered 15%+ cap rates compressed to 6-7% cap rates. So I moved onto other things.

I held those properties for 20 years, and they were excellent performers. Sure, I had to replace the roof and the hot water tank occasionally, but I also had great long-term tenants who appreciated a cheap place to live.

Without those investments, I wouldn’t be in the position I’m in today. Those rent cheques (plus other savings, obviously) were reinvested in the stock market, eventually growing to the point where I currently live off my passive income.

I haven’t forgotten about real estate, either. Although I’ve since sold those properties, approximately 15-20% of my assets are invested in REITs today. Their big yields are helping me enjoy an early retirement — giving me the freedom to do things like hit the links on a random Thursday afternoon.

I’ve owned Canadian REITs for at least a decade, and I’ve analyzed many of them pretty deeply for the paid version of this newsletter. Combine that with the more than two decades worth of experience I have investing in physical real estate, and I think I’ve learned a thing or two about the sector.

Let’s take a closer look at how I invest in real estate today, including what I look for, how my thinking has changed, and a few examples of REITs I own for the long-term.

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My previous approach

I used to be a hardcore REIT value investor.

I would patiently follow the sector, wait until some REIT ran into issues, and then crunch the numbers. I was looking to buy the largest amount of net operating income, for the smallest cash outlay possible.

Essentially, I was looking to replicate the real estate strategy that worked so well for me when I was buying physical houses.

It worked, too. The first big REIT position I acquired was Dream Office REIT in 2016 after its then-Calgary-focused office portfolio ran into issues. I got in around $15, sold a little over a year later at around $21, and pocketed the distribution while I waited.

It was a great outcome.

I then doubled down on the strategy, buying shares of depressed REITs based pretty much entirely on their implied cap rates. I was thrilled to buy a distressed REIT for a 6.5% cap rate rather than buying a better one at a 5% cap rate. Besides, the distressed REIT almost always had a better distribution yield, and I enjoyed getting my cash out as quickly as possible.

I didn’t care about the balance sheet, the quality of the assets, or the REIT’s management team. I cared about the payout ratio, but I was happy to stomach a > 100% payout ratio if I thought the assets were undervalued enough.

Overall the strategy yielded okay results. I did well on Dream Office and made money on Cominar REIT, but had much worse outcomes with Slate Office REIT and American Hotel Income Properties. I collected very generous distributions from those REITs for a while until both eventually cut their payouts. I ended up losing patience with both, selling at losses.

Then 2020 happened, and it really changed everything.

Why COVID was a turning point

I worked in retail for most of my career, eventually rising up to running the grocery division for a regional grocer in Canada.

My line of work was a massive benefit when COVID first started rearing its ugly head in March, 2020. I watched perfectly reasonable people freak out and fill shopping carts with food they could barely afford and didn’t need because the supply chain would soon be disrupted.

Grocery stores were absolutely packed, yet grocery-anchored REITs were crashing. It didn’t make any sense to me.

Meanwhile, I was lucky enough to be sitting on a pretty significant cash pile in my portfolio. I’d like to take credit for my excellent prognostication skillz, but the cash pile was from a big private investment paying out and a REIT I owned being taken private. It was mostly just a coincidence I had so much cash at that point.

Anyway, I watched as REITs I previously thought were too expensive fell by 20%… 40%… even as much as 60% in just a few weeks:

• Crombie REIT fell from $16 to $10 (a 38% drop)

• RioCan REIT fell from $27.50 to $14 (a 49% drop)

• SmartCentres REIT fell from $32 to $16 (a 50% drop)

• Slate Grocery REIT fell from $13.50 to $6 (a 58% drop)

These were considerably higher quality than the REITs I had previously purchased, and they were suddenly available at pretty damn attractive prices. So I bought. And I bought some more. Soon I was sitting on a pretty substantial position (I’ll guess > 10% of my portfolio) in retail REITs.

It turned out to be a great entry point. These REITs rallied nicely off their lows, flirting again with pre-COVID highs about 18 months later. I took some gains, but I mostly stayed put.

It turned out I really liked owning higher quality REITs. I felt comfortable tucking these REITs away for the long-term. I didn’t need to stress their balance sheets or the safety of their distributions or their ability to grow earnings over the long-term. I slept well at night knowing I owned good assets that I had paid a very fair price for.

Emboldened by this realization, I started stressing the quality of a REIT before buying. I wanted to buy forever assets at reasonable prices that I could tuck away for a very long time.

Then 2023 happened, with higher interest rates hitting the Canadian REIT sector pretty hard. Suddenly the entire sector was on sale, allowing me to purchase some of the best REITs I could identify at multi-year lows.

I bought Canadian Net REIT, a small-cap owner of triple-net retail properties in Ontario, Quebec, and Atlantic Canada. Canadian Net has a demonstrated history of growing both earnings and distributions on a per share basis, high insider ownership, huge growth potential, and well-regarded management. I really think it resembles Realty Income from about thirty years ago.

I bought more Primaris, a shopping mall REIT with a fantastic balance sheet, an attractive valuation, and one of the lowest payout ratios in the entire REIT universe. Primaris is also trading at a 40% discount to its net asset value, meaning I get to buy what I think is a high quality REIT at a value price.

I gobbled up some Canadian Tire REIT shares, a conservatively-managed REIT with a solid balance sheet, a history of growing the bottom line, 10 consecutive years of hiking the distribution, a good payout ratio, and a management team I truly believe is one of the best in the sector.

I bought Morguard Residential REIT, which offers an excellent balance sheet, a low payout ratio, a diverse portfolio of apartments spanning North America, a fantastic valuation, and is one of the rare REITs that’s willing to repurchase what it thinks are undervalued shares.

And finally, I continued buying Choice Properties, which owns a portfolio of mostly Loblaw-anchored properties across Canada. Choice has all the qualities I like to see in a REIT — a history of growing earnings, a very affordable distribution, a conservative balance sheet, and good management — but it also has substantial development potential it can slowly seize over time. This, combined with rent increases to current tenants, should translate into solid earnings growth over the long-term.

The REITs I purchased gave me an average yield in the 6% range, a nice balance between income today and some wiggle room for the underlying REITs to grow distributions, make acquisitions, or pay down debt. If I was looking to maximize income, I would’ve gone down a different path.

My journey from value to quality real estate wasn’t without a few bumps, however. I slipped up and bought Artis REIT and went back to Dream Office REIT as well, emboldened by their cheap prices and promised turnaround plans. I’ve since sold out of both, using the proceeds to add to what I view as higher quality REITs.

The bottom line

In short, I’ve gone from trying to find the best value in real estate to buying what I view are excellent assets, REITs I can buy, hold, and not have to worry about.

These high-quality REITs have the following characteristics in common:

• Good balance sheets

• Prudent management

• Sustainable payout ratios

• A history of growing net asset value and earnings over time

• Are focused on one type of asset

By focusing on these qualities, I’m able to ignore the whims that hit the REIT sector. Strong balance sheets make it easy to ignore increased interest rates. Low payout ratios mean I don’t have to worry about distribution cuts. Solid management and prudent balance sheets mean I don’t have to closely follow every earnings release. And REITs that grow over time will add some capital gains to my distribution income — allowing me to defer taxes.

A value approach worked moderately well back in the day for me, but ultimately I’m much happier focusing on quality. It’s that simple.

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