Last Updated on December 2, 2024
Overview
Chances are there’s a certain building (or buildings) you pass by on a regular basis. Maybe you see them on your daily commute, or perhaps there are roads you routinely use and you happen to see certain buildings every time you go on them.
Have you also noticed that many of those buildings have changed their occupants through the years?
Not all companies own the buildings they operate in: after all, purchasing property can be a big expense, not to mention the added expenses that come with maintaining one. Instead, many companies choose to lease the property they wish to work out of.
If many companies don’t own the properties they work out of, then who does? In most cases, Real Estate Investment Trusts (REITs) do.
For many people, REITs are invisible entities that largely operate behind the scenes, and for the most part, that’s what they do. REITs don’t micromanage the properties they own (they don’t get involved with the day-to-day operations of tenants), and some properties make no indication whatsoever as to whether or not it’s managed by a REIT. It’s safe to say that most people may not even know what a REIT is.
Investors, however, are much more likely to know what a REIT is. Perhaps they’ve seen it mentioned in real estate investing discussions, or are thinking of analyzing one they wish to add to their portfolio.
Though not known for being “exciting” investments, REITs still find themselves in the portfolios of many investors. This article will look at what REITs are, and why they are appealing in the eyes of certain investors.
Avenues of Real Estate Investing
Real estate investing is widely talked about and heralded in many investing circles. There’s no shortage of stories of people who have experienced (or at least claimed to have experienced) great success with it. Despite the supposed glamour that real estate investing offers, let’s take a step back and understand how exactly to get involved with it.
Some investors choose to buy properties themselves for investment purposes. For example, some investors may choose to buy houses, others may choose to buy apartments/condos, and some may even choose to buy industrial spaces (e.g., a large warehouse or office building).
Investors can usually make money from these properties in one of two ways: by selling them at a price higher than what they bought them for (i.e., making money via capital gains) or by generating cash flow from them (e.g., leasing the property out to tenants).
This all sounds great in theory, but obviously, not every investor has the means to purchase property that easily. Unless they have an abundance of cash lying around, a prospective real estate investor’s next best option is to take out a mortgage – an additional financial burden that some investors may not be willing to shoulder.
Not only that, but some real estate investors choose to be very hands-on with the properties they do own, with some going so far as to do the necessary renovations and touchups themselves, or for those with the financial means, hiring contractors to do this work.
While this may be appealing for some investors, it may not be the case for others. If so, then what’s a prospective real estate investor’s next best option?
The other choice is to own property indirectly.
This is usually done by selling marketable securities to the investing public, whereby an investor will have some fractional ownership over a portfolio of properties. In exchange for their capital, investors will receive the returns generated from a portfolio of properties.
Some examples of indirect property ownership include mortgage-backed securities (MBS) and Real Estate Investment Trusts (REITs). Because the focus of this article is REITs, let’s dive a bit deeper into how they work.
Demystifying the World of REITs
In the introduction, we talked briefly about how many of the properties you regularly come across aren’t owned by their tenants but rather by a Real Estate Investment Trust (REIT) instead.
A REIT is a type of company that owns (and in many cases, operates) a portfolio of income-generating properties. In other words, REITs don’t earn money by selling property in hopes of netting capital gains, but rather by leasing their properties out to tenants: the rent that tenants pay is the income that REITs collect.
Many countries have laws that dictate the operation of REITs, and in particular, how they’re taxed (this document details REIT tax treatment in the U.S.). REITs are usually set up in such a way as to avail of favourable taxation, usually on the condition that they distribute the bulk of their taxable income to unitholders in the form of dividends.
The larger-than-average dividends that many REITs offer are their primary selling point, and because of this many investors include them in their portfolios as a source of reliable, consistent cash flow.
Just like a corporation, REITs can choose to operate either privately or publicly. REITs that allow public investors are known as equity REITs, and instead of offering shares, investors are instead offered “units”. Therefore, investors in REITs aren’t known as shareholders, but rather as “unitholders”.
Different REITs own different types of properties. Some have a residential portfolio comprised of apartments, some may own office space situated in a city centre/downtown, while others may be more niched and own properties whose tenants are exclusively medical professionals (dentists, physicians, private surgeons, etc).
Key Investment Factors Pertaining to REITs
Regardless of what type of property a given REIT specializes in, they all share some commonalities, which makes things a bit easier when investors want to analyze them. This isn’t to say that every REIT is exactly the same, but rather that there’s a lot of overlap between them.
Arguably, the unifying factor that connects all REITs is that they aren’t known for experiencing superb capital appreciation – very few investors, if any, purchase REITs with the hope of making money from them via capital gains. Rather, their appeal lies in the robust cash flows they offer via their larger-than-average dividends (relative to other equities).
Because of this, REITs don’t stress that much over their day-to-day unit price (this isn’t to say that they don’t care about it at all, it’s just that it isn’t their top priority). Rather, their focus is on making sure they receive a constant stream of funds from their properties. If something were to impede this cash flow, then problems may start to arise.
With this in mind, we can look at some potential investment factors to keep an eye on when analyzing a REIT.
Vacancy Rates
One of the fastest ways to assess a REITs’ health is to check its vacancy rates. Now, there’s no standardized method of reporting vacancy rates, and different REITs will choose to report these rates differently based on their specific operations.
For example, a REIT that operates in one country but across several cities may choose to break down the vacancy rate per city, whereas a REIT that operates in different countries may report the rates for each country instead.
Regardless of how it’s reported, what ultimately matters is that vacancy rates are as low as possible. Low vacancy rates mean properties are filled with as many tenants as possible, which means these properties are operating near or at their full potential when it comes to generating rental income.
Although low vacancy rates are desirable, it’s important to understand the context behind the numbers.
REITs that own apartment buildings near a university may see seasonal swings in their vacancy rates which correspond with the start and end of a school year. REITs that build or acquire new property in a short period of time may report a sudden increase in vacancy rates, not because tenants are leaving, but because they now have more leasable space which has not yet been occupied.
Additionally, it’s important to know what qualifies as a “low” vacancy rate. 15% vacancy may be astronomically high for some REITs, whereas for others that may be more typical. It’s important for investors to find out what a typical vacancy rate is for a given REIT to ensure they don’t form incorrect conclusions.
How Leases Are Structured
REITs are sought after by some investors because of the steady cash flow they offer; however, this stability is contingent on having tenants on hand to collect rent from. If a property is “transient”, that is, there are no long-term tenants that occupy it, then how can any sort of income stability be expected if tenants are always coming and going? If certain tenants leave, then who knows how long it will take before they can be replaced.
To help ensure this stability, a relatively easy solution is to structure leases in such a way that tenants will need to commit for the long term. For example, many Commercial REITs make their tenants, usually large or mid-sized corporations, sign multi-year leases, with some even spanning decades (such as Ovintiv’s lease in Calgary downtown’s “The Bow”).
Other REITs may not have the ability to make tenants sign such long leases. For example, Residential REITs usually don’t offer their tenants decades-long leases on their properties. If a tenant expects to live at a property for the foreseeable future, then a multi-year lease may be possible, but for other tenants such as students or temporary workers, a contract that only spans months is more likely.
Regardless of how specific leases are structured, what matters in the eyes of investors is that the leases a REIT offers lead to some sort of stability. Even if a tenant agrees to occupy a property for just one year, one year of stability is better than nothing at all.
Just like vacancy rates, what classifies as “long-term” may vary across specific REITs. What seems like a long-term lease for a Residential REIT may appear to be a blink of an eye to a Commercial one. Ultimately, the goal is to ensure that properties are occupied for as long as possible, which means income will steadily be flowing for as long as possible too.
Attracting and Retaining High-Quality Tenants
Having low vacancies and securing tenants for the long term are both very important factors investors will want to carefully assess – both of these ensure that a given property is generating the most income it possibly can.
While the preceding factors we’ve discussed are certainly important, there’s an implicit assumption being made: the tenants that occupy these properties have the ability to pay their rent on time and in full, for the entire duration of their lease. In other words, these properties are assumed to be occupied by high-quality tenants.
If a property is occupied by low-quality tenants, then it doesn’t matter how low the vacancy rate is or how long the leases are. If these tenants repeatedly struggle to pay their rent on time, then it’s likely that they won’t be able to honour the terms of their lease, and will soon be forced to leave the property. It’s no exaggeration to say that REITs live and die by the sort of tenants they choose to take on.
When it comes to tenants, REITs are usually more concerned with quality over quantity. A handful of tenants who have never missed their rent and can easily honour their lease obligations are worth more than dozens of lacklustre tenants who consistently struggle to cough up enough money on time.
Because of this, many REITs go to great lengths to ensure they attract and retain high-quality tenants.
For example, apartments that are managed by a REIT usually impose strict application requirements for prospective tenants such as providing proof of income, showing an excellent credit score, and even getting reference letters from previous landlords.
Meanwhile, Commercial REITs do their best to find “anchor tenants”. These are tenants that usually occupy the most space in a given property, and sign very long-term leases; usually, they are large corporations. Anchor tenants may even attract other, smaller tenants such as coffee shops, convenience stores, and even daycares, which means even more rental income that a REIT can stand to collect. Because of all these things, it’s not surprising that anchor tenants are highly sought after.
It would be wise for an investor to understand what sort of tenants a REIT is taking on (or the sorts of tenants they’ve taken on in the past), and to assess whether they can honour their leases or not.
Having High-Quality Properties and Amenities
Up to this point, our discussion has been focused exclusively on the tenants. A REIT that offers strong investment merit is one whose properties are highly occupied (low vacancy rates), have tenants who are locked in for the long term (properly structured leases), and are able to honour their lease obligations until it expires (having high-quality tenants).
Although tenants greatly influence the future success of a REIT, it’s easy to forget that the relationship between a REIT and its tenant goes both ways. REITs lease their properties out with the expectation of receiving routine payments, but the tenants who occupy these spaces come with their own expectations as well.
When businesses or institutions are on the market for new office space, there are several criteria they have in mind: offers enough space to suit their needs, has robust security at all times, has state-of-the-art architecture/design, offers plenty of parking space, and has a fully-equipped fitness center.
Similarly, when people look for a place to rent, they will also have similar criteria. Perhaps they want to live in a place that has new appliances, has recently been renovated, has excellent security, and offers other private amenities exclusively for tenant use.
The onus rests on REITs to ensure that the properties they have will satisfy a tenant’s needs, otherwise, tenants won’t hesitate to look elsewhere. If a REIT wants to attract high-quality tenants, then they better make sure that the properties they’re offering are also high-quality. Expecting to attract high-quality tenants while giving nothing in return is wishful thinking.
Any REIT that wants to stay competitive will do their best to ensure that the properties they have offers enough incentives such that tenants will be more than willing to sign long-term leases with them. Certain incentives may be costly upfront, but those costs will repay themselves several times over if it means high-quality tenants are willing to lease out a given property.
Risk Factors and Challenges Faced by REITs
We know that REITs focus primarily on generating as much cash flow as they possibly can, and that day-to-day unit price isn’t really their primary concern. Therefore, when looking at potential investment factors, the focus is on making sure that those factors will ultimately lead to an increase or maintenance of cash flow.
Conversely, this also means that when looking at potential risks and challenges, the focus should be on things that have the potential to adversely impact a REITs’ cash-generating ability. Again, this isn’t to say that unit price doesn’t matter at all, but rather capital appreciation isn’t why investors choose to purchase REITs in the first place.
Let’s take a look at what some of those risks and challenges are.
Tenants Are Affected by Adverse Economic Conditions
Whether it’s a family living in an apartment or a large corporation occupying a prominent office building, a tenant’s ability to pay their rent on time and in full ultimately hinges on their economic well-being. If economic conditions take a turn for the worse, then certain tenants may find themselves unable to honour their lease obligations, and REITs may see their cash flows take a hit.
An example is how Calgary’s downtown real estate market was significantly impacted following the 2014 oil price crash, and how the effects of that single event still linger several years later.
Calgary’s downtown had long been dominated by oil and gas companies, both domestic and foreign. However, in 2014, global oil prices crashed, and many oil companies found themselves struggling just to stay afloat.
In the years that followed the oil price crash, the oil and gas companies that once dominated the Calgary city centre either reduced the office space they leased, shut down satellite offices, or moved their headquarters elsewhere. This exodus of tenants meant the REITs who owned those offices witnessed a large bulk of their rental income suddenly vanish.
At the end of 2022, downtown Calgary had an office vacancy rate of 27.2%, a gaping hole that still persists partly because of all the oil and gas companies that left or downsized ever since 2014.
Now, this may sound like something that only concerns REITs who have business tenants, but that isn’t necessarily the case.
If a Residential REITs’ properties are occupied by tenants who are predominantly employed by a single industry, and if that industry were to suddenly experience challenging times, then the people who work in it may find themselves working reduced hours, or even being laid off, meaning they may have a harder time paying their rents on time, let alone in full.
Even the biggest corporations or most financially stable individuals can fall victim to the vicissitudes of the economy, and it’s important for REITs, as well as their investors, not to forget this risk.
Future Mass Lockdowns
Before the COVID pandemic struck, virtually everyone took day-to-day human presence for granted.
Busy malls, packed public transit, sitting shoulder-to-shoulder on flights, and going to concerts with countless other attendees were all ordinary aspects of life, but one day all of that disappeared.
Similarly, REITs also operated with the implicit assumption that people would always be out and about in their daily lives. However, when lockdowns were implemented in response to the pandemic, all of a sudden people weren’t going to work at the office, hotels weren’t welcoming large numbers of guests, and once bustling malls quickly shut their doors.
Following the lockdowns, some REITs saw an immediate loss of revenue due to uncollected rents, either from businesses that were forced to shut down and could no longer generate any revenue, or from the newly unemployed people that these shuttered businesses inadvertently created.
With the worst of the pandemic now largely behind us and with virtually all businesses with physical storefronts now open again, the lockdowns and their aftermath now seem like a distant memory.
However, it would be wise for REITs not to forget what happened so easily. That’s because the lockdowns showed just how vulnerable they were, and if human presence disappears en masse ever again, then they’re in for a very big shock.
Frustratingly, there isn’t much REITs can do to reduce or control this risk. That’s because REITs fundamentally rely on people to physically occupy their properties – without anybody occupying their spaces, their business model essentially falls apart.
Of course, one way would be to diversify the types of tenants they take on, but most REITs specialize in one category of property, so diversifying beyond their scope of expertise and capabilities may end up being an even bigger risk.
Tenants Are Hesitant to Commit to the Long-Term
Earlier, we discussed how in order for REITs to ensure some form of stability in their cash flows, they get tenants to sign long-term leases with them. After all, it’s difficult to promise investors stable dividends if REITs are always scrambling to find new tenants to occupy their spaces.
Although long-term leases are beneficial in the eyes of REITs and their investors, prospective (or even current) tenants may not share the same sentiment.
There are countless reasons why tenants may not see themselves staying at a given property for the long haul. Based on the type of REIT in question, those reasons can vary significantly.
For example, a commercial tenant who has recently begun operations in a new city may first want to get a feel for their new environment, so they don’t want to stay at an office for too long in case their business plans don’t pan out as expected. Certain residential tenants such as university students may only need to find housing for the duration of the academic year, and after that, they will leave the city.
These reasons are well beyond the control of a REIT, and the best they can do is to try and accommodate these tenants within reason.
However, if there are tenants on the market looking for a long-term lease, and they choose not to sign with a certain REIT that offers them one, then they’ll need to stop and assess why.
Earlier we discussed how the relationship between REITs and tenants is a two-way street. REITs want to attract certain kinds of tenants to occupy their properties, while tenants have certain things in mind they want to see offered at a given property. REITs can only attract high-quality tenants if they offer high-quality properties.
If prospective tenants feel that they aren’t getting the value they seek from a given property offering because of a lack of incentives, then REITs face an uphill battle trying to convince them to sign a long-term deal.
Again, REITs can’t control every factor when it comes to a prospective tenant’s willingness to sign a lease with them. However, that doesn’t mean they’re completely blameless, and if they neglect factors which they do have control over, such as the quality of their properties and the incentives they offer, then they shouldn’t be surprised when prospects overlook them.
Properties Find Themselves in Undesirable Locations
In the world of real estate, there’s a saying that goes “Location, Location, Location”. Although it comes off as a bit hyperbolic, there is a lot of truth to it – properties derive a large portion, if not most, of their value based on where they’re situated. Sometimes, the difference between a property worth $100 million and $10 million may be determined by just a few kilometres.
Any REIT will want to make sure that the properties in their portfolio abide by this principle, and for the most part, they successfully do. No Commercial REIT would want to own office buildings near the outskirts of a city, nor would a Residential REIT fight to get their hands on an apartment complex in the middle of a crime-ridden neighbourhood.
Although REITs can decide what sort of properties they’ll acquire, as well as how they plan to run and maintain them, they exercise very little control over their surroundings.
A REIT can own a portfolio of world-class properties, but if those properties find themselves located in gradually-declining surroundings, then they may soon find it very difficult to attract and retain tenants. Perhaps a once-safe neighbourhood has seen a steady uptick in crime, a once-vibrant commercial area has seen many businesses leave in recent years, or public transit access to the area has slowly been neglected.
Just like anybody else, REITs can’t predict the future, so their decisions to acquire properties in certain locations are based on the best information they currently have, not the results of clairvoyance.
One way to defend against this risk would be to leave a location before things go from bad to worse. Fortunately, REITs can rely on certain numerical metrics to help make that decision a bit easier such as crime rates, population growth/decline, and the number of businesses that operate in a given area, to name a few.
In the end, deciding whether to leave a location to try and cut their losses is something that hinges on a REIT’s judgement and past experience, which is much easier said than done.
Other Considerations to Keep In Mind
At the onset of the COVID pandemic, many people still needed to go to work, but couldn’t physically go to their workplace due to widespread lockdowns. As a result, remote work quickly became the norm.
As the pandemic gradually died down, many businesses have since re-opened their physical locations, and many workers have returned to the traditional on-site work environment. However, remote work left a lasting impression on some people and wanted to keep it as a permanent fixture, with workers going so far as to choose termination rather than head back to the office.
Because of the rising popularity of remote work, along with a continued (albeit reduced) need for physical presence, a certain work model has enjoyed a sudden resurgence: hybrid work. A growing number of companies are starting to adopt a hybrid work model, and have even begun using it as a way to attract talent, touting the flexibility it offers to workers as one of the many benefits they offer.
If the hybrid work model continues to gain popularity, this may prove to be a watershed moment for REITs, specifically ones that take on business tenants.
First, it’s important to understand that there will always be a demand for physical office space. Just because many businesses are adopting a hybrid model doesn’t mean all of them are. Additionally, businesses that have a hybrid work model still need a physical location, the catch is that going to the office regularly isn’t required, meaning not everyone will be under the same roof all at once.
Second, just as there are benefits to remote work, so too are there valid benefits for in-person work as well. A hybrid model aims to make the most of both remote and in-person work which, again, means physical office space isn’t being eradicated anytime soon.
So, with these things in mind, what exactly do REITs (and by extension, their investors) need to keep an eye on?
If hybrid work does continue to be the new norm, then this means some businesses will need less space than they did in the past. REITs that charge rent based on the amount of area a tenant occupies (e.g., $/square foot) could see a steady decline in revenue if their tenants adopt hybrid models and choose to downsize their physical presence.
To compensate for this potential loss of revenue, REITs could focus on targeting prospective tenants that will occupy lots of space, or fit more, smaller tenants into a single property, both of which sound great in theory but could be hard to implement in practice.
If tenants are demanding less space, then this means REITs may subsequently spend less time and money acquiring and/or developing new properties. Again, demand will still exist, just not to the same extent as before. If the hybrid work model continues to gain more steam, then REITs will want to practice extra caution when expanding their real estate portfolio. Acquire too much space too fast, and a REIT may be stuck with a surplus of unproductive (i.e., non-income producing) properties.
Nobody knows for sure how the hybrid work model will evolve in the years to come, but it certainly is something that REITs, along with their investors, cannot afford to ignore or disregard as a mere fad.
Wrapping Up
Many investors want to expand into the realm of real estate investing, and one way to accomplish that is by adding a REIT to their portfolio.
Just as equities grant investors fractional ownership of a public business and are entitled to a portion of the earnings, REITs grant investors fractional ownership of a portfolio of properties and qualify them to receive a portion of the earnings they generate.
REITs are known for the robust, consistent cash flows they provide, so because of that, potential investment factors look at how that cash flow can be improved or maintained, whereas risks deal with how that can be impeded.
Following the COVID pandemic, the decades-long status quo of always needing to work at a physical location was quickly called into question, which led to a resurgence in the hybrid work model. If more businesses continue to adopt the hybrid model, then this is definitely something REITs and their investors will want to keep a close eye on.
