U.S. REITs For The Canadian Investor

I’ve been following both U.S. and Canadian REITs for years now, and I’ve come to a conclusion.

U.S. REITs typically get way more attention than their Canadian counterparts, they tend to perform better, and they usually trade for higher valuations.

This can be especially frustrating for those of us who hold a lot of Canadian REITs.

I believe this phenomenon exists for a few different reasons, including:

• U.S. REITs tend to have stronger balance sheets, higher earnings growth, better growth prospects, and quality managers. In other words, they’re higher quality than Canadian REITs, and deserve to trade for a higher valuation

• There are millions of U.S. investors who love the idea of owning REITs. They analyze, discuss, and create buzz around the sector. More investor demand = more scrutiny, and ultimately better results

• The Seeking Alpha Effect. The site has created a community of REIT investors, which in turn attracts authors who write about REITs. There’s somewhere regular retail investors can go to get solid analysis and top picks, so they don’t have to do the research

As the owner of an investing website for Canadian investors, I know that there are a lot of my fellow countrymen who just don’t invest in Canada. Thousands and thousands of Canadians are pouring money into U.S. indexes, large tech stocks or the most speculative of plays, depending on how frisky they might feel.

Many are chasing returns. The U.S. has put up the best returns over the last decade, so they invest there.

Others have been told it’s foolish to have a home country bias, and so they move most of their investments outside of Canada.

Some are convinced Canada is doomed, so they move their money into some other country’s market. These folks have considered leaving the country, but for whatever reason, they don’t.

And finally, some of these folks are a little bit like me. I like turning over rocks and analyzing stocks in different markets. Certain markets will have more bargains, and will naturally be better hunting grounds. Besides, dividends in different currencies can further add to a portfolio’s diversification.

I know some of you are interested in U.S. REITs, so let’s take a closer look at that asset class. We’ll talk about the differences between Canadian and U.S. REITs, how U.S. REITs are taxed, and a few interesting REIT investment ideas south of the 49th parallel.

Let’s start with the difference between REITs on each side of the border.

What Canadians need to know about U.S. REITs

First, the good news. REITs are functionally pretty much identical on both sides of the border. No matter what part of North America you’re looking at, REITs offer the following characteristics:

• They pay zero corporate taxes; income is taxed in the hands of unitholders

• REITs will pay out a large portion of earnings out to unitholders

• Rather than looking at earnings, the best metric for judging a REIT’s bottom line is funds from operations (FFO)

• Adjusted funds from operations (AFFO) is essentially a REIT’s free cash flow. It’ll be the best metric to use if you’re determining a REIT’s distribution sustainability

• Most REITs own either residential, retail, office, or industrial property, or some combination of each. No matter what side of the border you’re on

Okay, now what about the differences?

The first one I’ll talk about is the breadth of the market. There are more than 200 publicly-traded REITs in the United States, and the country is big enough that there are all sorts of specialty REITs out there. Canada, meanwhile, only has about 40 REITs that trade on the TSX, and a few of them strictly own U.S. assets. In short, our REIT market offers way less choice than the U.S. market, and our specialty REIT sector is puny compared to south of the border.

For instance, a small sprinkling of specialty REITs offered in the U.S. include:

• Postal Realty Trust (NYSE:PSTL), which owns mostly post office properties occupied by the USPS

• Weyerhaeuser (NYSE:WY) owns more than 24M acres of forest land between Canada and the United States

• Gladstone Land (NYSE:LAND) owns approximately 103,000 acres of farmland across 15 states and more than 55,000 acre-feet of water assets in California

• Digital Realty Trust (NYSE:DLR) is the owner of more than 300 data centers worldwide, growing to become the 4th-largest publicly traded U.S. REIT

There are scores more, but you get the picture.

The other big difference between U.S. and Canadian REITs has to do with growth and payout ratios. In Canada, REITs mostly look to pay high distributions. It’s what retired Canadian investors want, and so these companies deliver.

Compare that to the U.S., where REITs typically have better growth potential. They feature lower payout ratios, freeing up capital that is put towards buying new properties. This translates into better dividend growth. The most famous U.S. REIT, Realty Income (NYSE:O), has hiked its dividend each year for more than 30 years, and calls itself The Monthly Dividend Company. That impressive record isn’t tops among U.S. REITs, either. There are some that have consecutively hiked dividends for even longer.

There isn’t a single Canadian REIT that has even been publicly-traded for 30 years, and the best dividend growth streaks in the sector belong to Canadian Tire REIT (TSX:CRT.un) and Granite REIT (TSX:GRT.un), which have raised distributions by 12 and 14 consecutive years, respectfully. InterRent (TSX:IIP.un) can also boast a 13-year distribution growth streak, but it’s about to be acquired. So it doesn’t really count.

Now that we’ve established the main differences between REITs on each side of the border, let’s talk distributions and taxes. But first…

REIT taxes on both sides of the border

This newsletter needs more Simpsons memes.

As those of you who own Canadian REITs in their taxable accounts can attest, Canadian REIT taxation can get complicated. Basically, REITs north of the 49th pay distributions that are a combination of:

• Return of capital

• Capital gains

• Rental income (which is taxed at ordinary income rates)

They are generally more tax-efficient for Canadian investors, since a portion of the payout is often return of capital. Canadian REITs will specifically recycle their parts of their portfolio (which is a fancy finance term for selling stuff, essentially) to be able to get that return on capital designation. But on the negative side, that return on capital lowers your cost base over time. So when the REIT is sold, the capital gain becomes larger than it would first appear.

I’ve done the work on a couple of REITs I’ve owned, and it’s not that hard. But still, it’s annoying. So I tend to tell folks to own REITs in RRSPs or TFSAs instead. You don’t need to worry about the tax consequences of the income.

U.S. REITs, meanwhile, don’t do any of that. Their dividends are taxed at ordinary income, just like if the payout was coming from a physical property. Canadian investors would first be charged a 15% withholding tax, and then any taxes levied by the Canadian government on top of that. That would depend on your tax bracket.

The way to get around the withholding tax is to hold U.S. REITs inside your RRSP. The U.S. recognizes RRSPs as a tax-deferred account, and so doesn’t charge the withholding tax on anything in the account. The tax is charged on TFSAs, and quite obviously it’ll be charged on any income from your taxable account.

So the solution here is simple. Put U.S. REITs in your RRSP and call it a day. Easy.

Related: Where to Invest What, my quick and easy guide to what investments belong in what accounts

A few U.S. REIT ideas

Now that you’re all up to speed on the difference between U.S. and Canadian REITs, here are a few ideas for your RRSP.

The first one is Americold Realty Trust (NYSE:COLD), which is North America’s largest owner of refrigerated and frozen storage space.

Besides having an excellent ticker, COLD offers its lowest valuation since the 2018 IPO, its highest dividend yield in its history (more than 7% as I type this), and the company plays an important role in our food distribution system. Without cold storage, your grocer’s freezer would be pretty barren.

Rather than renting a warehouse to one frozen food producer, COLD’s warehouses have product for multiple different customers. Space is rented by the pallet spot, meaning rents are charged on a 3D basis — rather than most other real estate, which is rented based on square footage.

This also creates operating leverage as more spaces are rented. Unlike other REITs that move slowly and are locked into long-term leases, COLD’s customers are more fickle. The economy slows a little — as it’s doing today — and fewer pallet spaces are rented. But on the positive side, this can change in a hurry, and that creates upside.

The stock has gotten decimated lately, falling more than 50% in the last year. Results haven’t been great as CPG companies continue to struggle. They’re renting less space, which is hitting the stock straight in the bottom line. Still, it trades at about 10x AFFO, and earnings should tick up nicely as customers get back to normal.

Next I’ll feature VICI Properties (NYSE:VICI), which is another one of those specialty REITs I was talking about earlier. VICI owns casino properties across the United States and even into Canada, including big chunks of the Las Vegas Strip. These are irreplaceable properties secured by long-term leases from operators who don’t want to give up hard-fought space.

VICI shares haven’t done much of anything over the last year as investors remain concerned about the future of Las Vegas. Traffic is down to the iconic tourist destination, with many feeling that the weakness is permanent. After all, why go to Vegas when you can gamble to your heart’s content on your phone?

I’m not super concerned. Vegas has struggled before, and it always comes roaring back. Besides, VICI is more than just Vegas; it owns properties scattered across North America.

VICI also offers a solid balance sheet, a 5%+ dividend yield, a reasonable payout ratio in the 75% of AFFO range, and it has raised the dividend each year since its 2018 IPO — including a 4% raise just last month. Dividend growth has averaged about 6% per year since the IPO.

And finally, the valuation is reasonable. Shares trade at about 12x FFO, which is pretty attractive versus the historical valuation. That’s been closer to 15x FFO.

Finally, I’ll mention W.P. Carey (NYSE:WPC). W.P. Carey is one of the U.S’s largest owners of triple net real estate. This is real estate where the tenant takes care of all the maintenance, taxes, and even insurance, leaving the landlord with both a mostly hands-off investment and one that offers better margins. This is the very same business model that Realty Income has used successfully for decades, too.

WPC is diversified across North America and even into Europe, owning some 1,600 properties. It’s also diversified among asset classes, but industrial space dominates the portfolio with about 65% of assets invested in industrial/warehouses. I like the industrial space over the long-term.

One reason why I mention W.P. Carey today is I think the stock is misunderstood. Many data services say the company recently cut its distribution, but the “cut” was really caused by the company getting rid of its troubled office portfolio. This move raised a bunch of cash the company has put to work acquiring properties, a move that should increase the bottom line by about 20% next year. It also strengthened the balance sheet.

As I type this, the stock offers a 5.3% distribution yield and trades for between 14 and 15x forward FFO. Not bad. I’d expect continued distribution increases, too.

One more thing

Just a quick note before we go.

Your author is on vacation next week. Our next regularly scheduled Sunday newsletter will be on October 19th. Enjoy your long weekend!