Canadian commercial real-estate has been a cornerstone in investment portfolios for many years. It offers stability, income potential and inflation protection. Investors are now faced with a decision as the market changes: whether they should invest in Real Estate Investment Trusts or direct property investments.
Recently, I discussed the state of Canadian commercial property. Now I would like to look at this information in the context of REITs and direct property investments. Office vacancy rates are around 10%, due to the remote working trend. Retail REITs can adapt to the challenges of e-commerce. Industrial REITs gain from an increased demand for logistics. Residential REITs enjoy stable returns despite population growth. These same market conditions are also faced by direct property investors, but they have different risk profiles and management styles. Direct investments and REITs are both affected by changing trends, such as the integration of technology, sustainability initiatives and new work models. Both investment types can benefit from the rise of mixed-use developments and transit-oriented properties as well as e-commerce driven demand for industrial property. Direct property investments offer greater control and are more flexible than REITs. However, REITs have the advantage of being able to quickly adopt new technologies, spread risk over a variety of portfolios, and rapidly adapting to market changes. Both strategies must adapt to regulatory changes and market shifts. The choice between direct property investments and REITs will be determined by factors like capital availability, risk tolerance, and desired level of involvement in the evolving Canadian commercial real-estate landscape.
Real Estate Investment Trusts (REITs)
What are REITs?
Real Estate Investment Trusts (REITs) are companies that own or operate income-generating properties in various property sectors. REITs in Canada are structured as trusts, and they are required to pay a large portion of their income tax to unitholders.
Types of REITs in Canada
Canadian REITs are available in a number of forms. Equity REITs are real estate companies that own and manage income-producing properties, while mortgage REITs finance real estate through mortgages or mortgage-backed securities. Hybrid REITs combine strategies from both equity and mortgage-backed REITs.
Canadian REITs are often specialized in certain property types. REITs are often focused on specific property types, such as residential rentals like apartments or single-family homes, office buildings, retail space, industrial properties and healthcare facilities. This allows investors to concentrate on specific sectors of the real estate market that fit their investment philosophy.
The Canadian REIT Landscape
The Canadian REIT market has experienced significant growth since its inception in the early 1990s. As of 2024, the Toronto Stock Exchange (TSX) hosts over 40 publicly traded REITs, representing a diverse range of property types and investment strategies. This robust marketplace offers investors ample opportunity to gain exposure to various segments of the Canadian real estate market.
Direct property investment and REITs are both viable ways to invest in commercial real estate. Investors seeking passive income and liquidity will find REITs a convenient, professional option that is diversified, accessible, and offers a professional management. While direct property investments require more capital and time, they offer greater returns and control through active management. These investment strategies, or a combination thereof, will depend on the investor’s goals, financial status, level of risk tolerance and involvement. Some sophisticated investors include both approaches in their portfolios to take advantage of the benefits and minimize their drawbacks. To determine the best real estate strategy, you should conduct thorough research and due diligence and consult with real estate and financial professionals. As with all markets of investment, the real estate sector is also subject to fluctuations and cycles. Follow me to stay informed of market trends, regulatory changes, and economic indicators. A well-thought out real estate strategy, whether through REITs or direct property ownership (or a combination), can play an important role in building wealth and conserving it over time.
Pros of REITs
1. Liquidity
Liquidity is one of the biggest advantages REITs have. REITs are easily traded on the major stock exchanges as they are publicly-traded securities. Investors can quickly exit or enter positions. They can also adjust their exposure to real estate in response to changing market conditions. And they have access to their capital, without having to sell physical properties. This liquidity is a key factor for investors that prioritize flexibility and may require quick access to funds.
2. Diversification
REITs provide instant diversification, across multiple sectors and properties. They can even cover geographical regions. Diversification reduces localized economic recessions, mitigates risk related to individual properties and provides exposure to different real estate sectors. A single REIT could own office properties in Toronto, industrial buildings in Vancouver and retail space in Montreal. This would provide a balance of exposure to various markets and types of property. The built-in risk diversification is particularly useful for investors whose capital may not be sufficient for direct investments.
3. Professional Management
Investors in REITs benefit from professional management teams’ expertise. They are in charge of scouting for profitable investments, negotiating rents, managing tenants, maintaining and improving properties, as well as navigating the complex regulatory environment. The professional management of REITs is an appealing option for anyone looking for passive exposure to real estate. Real estate investment requires a deep understanding of the market, proper property management, and financial optimization.
4. Lower Initial Investment
REITs offer investors a way to get exposure to commercial property with much lower initial investments. The accessibility of REITs allows smaller investors to take part in larger-scale projects. It also provides more flexibility when allocating capital and allows for gradual growth in a property position. This lower entry barrier can make a big difference for many investors. Especially those who are just starting to accumulate wealth.
5. Regular Income
Canadian REITs are required to distribute a large portion of their taxable income to unitholders. This structure often results in attractive dividend yields, typically higher than many other dividend-paying stocks. Investors can benefit from consistent income streams and the potential for dividend growth as the REIT’s portfolio expands or becomes more profitable. These regular payments can appeal to retirees and investors who are looking for a steady stream of cash.
6. Transparency
Publicly traded REITs must adhere to high reporting standards. Investors benefit from this transparency by receiving detailed financial statements, performance metrics, updates about major leasing and acquisition activities as well as insight into the management strategy and market outlook. Investors can make more informed decisions, and monitor their investment closely. This transparency is not often available when investing in direct properties.
Cons of REITs
1. Market Volatility
Although REITs are a form of real estate ownership, the stock price can also be affected by market sentiment. It can cause price changes that do not always reflect real estate values, short-term loss potential due to corrections in the market and correlation with overall stock markets, which could reduce diversification. Investors should be aware of this volatility, and that the short-term movements in price may not reflect the real estate asset’s performance.
2. Lack of Control
Investors in REITs have very little or no influence on the selection of properties and their acquisition, as well as how they are managed day to day. They also do not get to decide when a property is sold or refinanced. Investors who like to be hands-on in their real estate investments may find this lack of control frustrating. This limitation can be frustrating for those investors who feel they can create value by actively managing properties or having specific opinions on the selection of property.
3. Complex Tax Implications
Taxation of REIT distributions can be complicated in Canada. The investor is usually taxed on the income portion at his marginal rate. Tax implications may also differ depending on whether REITs are held in a registered (like an RRSP, TFSA or a taxable savings account) or non-registered accounts. A tax expert can help investors understand their particular situation.
4. Potential for Higher Fees
The REITs have a variety of operational and management expenses, which may impact the investor’s return. Management fees, acquisition and disposal costs of property, administrative costs and marketing and lease costs are all included. These fees, which are usually reflected on the REIT’s financial statements can reduce overall returns. The fees associated with REIT ownership should be compared with those associated with direct property ownership when evaluating REITs.
Direct Property Investment
Direct investment in commercial property involves buying the assets directly, whether individually or through a partnership.
Pros of Direct Property Investment
1. Full Control
Investing in direct property gives investors control over all aspects of their investment. The control includes the selection of the property and its acquisition, tenant negotiations and selection, renovations and improvements to properties, as well as timing for property sales and refinancing. Investors can implement their strategies through this control and maximize return on investment. This level of control is a great advantage for those who have expertise in the real estate market or other specific areas.
2. Potential for Higher Returns
Direct ownership can yield considerable profits through a variety of channels. Rent income provides a steady cash flow. Property appreciation can also lead to substantial capital gains. Renovations and repositioning of a property can increase its value dramatically. Depreciation, along with other tax deductions, can also increase overall returns. Investors who are able to identify properties that are undervalued or can improve the performance of their property may be able to achieve higher returns than REITs.
3. Tax Benefits
Investors can reduce their taxable income by deducting expenses such as property taxes and mortgage interest. Investors can may claim Capital Cost Allowance on depreciable portions of property. This allows them to defer tax until they sell the property. Capital gains on sale are taxed, however the tax rate is dependent upon the income bracket. Canada, unlike the United States does not offer a similar provision to 1031 exchanges, which allow for capital gains tax deferral through reinvesting in properties of like kind. Since capital gains cannot be deferred in Canada, investors must pay capital gains tax upon the sale of a property.
4. Leverage
Real estate investors can use borrowed funds to amplify their returns, a strategy known as leverage. Mortgages allow for the purchase of properties with a relatively small down payment, potentially magnifying gains on the invested equity. Positive leverage occurs when the property’s return exceeds the cost of borrowing, further enhancing overall returns. However, it’s important to note that while leverage can amplify gains, it can also magnify losses, increasing the risk profile of the investment.
5. Tangible Asset
Owning physical property provides a sense of security and stability that many investors find appealing. Unlike stocks or bonds, real estate is a tangible asset that can be physically inspected and evaluated. This tangibility also presents opportunities to add value through physical improvements. Real estate is often viewed as a hard asset that typically appreciates over time, providing a hedge against inflation and economic uncertainty.
6. Inflation Hedge
Inflation has been a major concern for real estate investors in the past. Rents and property values tend to rise with inflation. Fixed-rate mortgage payments also become cheaper in inflationary environments. Real estate, for example, often performs better than financial assets in inflationary times. This makes them an important component of a portfolio diversified to preserve long-term wealth.
Cons of Direct Property Investment
1. Large Capital Requirement
Purchasing commercial properties typically requires a substantial amount of capital. This includes a significant down payment, often 25-35% of the purchase price, funds for closing costs including legal fees and land transfer taxes, and reserves for property improvements and unexpected expenses. This high capital requirement can be a significant barrier to entry for many investors, limiting their ability to diversify across multiple properties or markets.
2. Illiquidity
Unlike REITs, direct property investments are not easily convertible to cash. Selling a property can take months or even years, depending on market conditions and property-specific factors. Forced sales due to urgent cash needs may result in suboptimal pricing, potentially leading to losses. Market conditions can significantly impact the ability to sell quickly, leaving investors potentially stuck with a property longer than they intended. Investors should be prepared to hold their properties for extended periods and have other sources of liquidity to meet unexpected financial needs.
3. Management Responsibilities
Direct ownership comes with significant management duties that can be time-consuming and potentially stressful. These responsibilities include finding and screening tenants, collecting rent and handling tenant issues, coordinating property maintenance and repairs, and ensuring compliance with local regulations and zoning laws. While these tasks can be outsourced to professional property managers, doing so incurs additional costs that can impact overall returns. The time and expertise required for effective property management should not be underestimated.
4. Concentration Risk
Investing in a single property or market increases vulnerability to various risks. These include local economic downturns, changes in neighborhood demographics or desirability, shifts in local supply and demand dynamics, and property-specific issues such as environmental concerns or major repairs. Diversification in direct property investment typically requires substantial capital to acquire multiple properties across different markets or property types, a luxury not available to all investors.
5. Transaction Costs
Buying and selling properties involve significant expenses that can eat into overall returns, especially for shorter-term investments. These costs include real estate agent commissions (typically 3-6% of the sale price), legal fees for purchase and sale agreements, land transfer taxes and registration fees, and potential mortgage prepayment penalties when selling. These transaction costs can significantly impact the profitability of an investment, particularly for properties held for shorter periods.
6. Ongoing Expenses
Property ownership comes with regular costs that can impact cash flow and need to be carefully managed. These include property taxes, insurance premiums, utilities (for vacant spaces or common areas), maintenance and repair costs, and property management fees if using a third-party manager. Investors must carefully project these expenses and ensure sufficient cash flow to cover them, even during periods of vacancy or economic downturns.
Considerations for Canadian Investors
Canadian investors need to consider several things when deciding whether or not they want to invest in REITs or direct properties. Your investment goals are important – do you want to accumulate wealth over the long term or short-term? Are you primarily focused on capital growth or income generation? What is your preferred level of investment involvement?
Another important factor is risk tolerance. Are you comfortable with the market volatility of REITs as compared to property-specific risk in direct investments? Are you able to withstand periods of market decline or vacancy? Will you take on direct investment debt?
Considerations such as time and experience are important. Are you able to manage your properties actively? Are you familiar with local trends and markets? Are you able to rely on a team of experts, such as real estate agents and lawyers, in order to make the most out of your investment?
For direct investment in property, market knowledge is a must. Are you familiar with certain property types and geographic regions? Are you familiar with local demographic and economic trends? Are you able to identify properties that are undervalued or have value-add potential?
Diversification of your portfolio is advisable. How much real estate do you own? How much real estate do you want to include in your investment portfolio overall? What role does real estate play in your overall diversification strategy
The attractiveness of various real estate investments can be affected by your tax situation. Take into account your income tax bracket at present and what you expect in the future. Do you invest through registered (RRSPs, TFSAs) or unregistered accounts? Can you take advantage of real estate tax breaks?
Direct property investments are a good example of where financing options can be useful. Have you access to mortgage finance? How much are interest rates currently? What impact will your debt-service ratio have on your ability to obtain commercial mortgages? Take into consideration the effect of adding additional debt to your financial situation.
Market cycles and timing should also be considered. In your market, what is the phase of the cycle? What are your expectations regarding future interest rates? Your investment decision can be influenced by understanding the dynamics of supply and demand in certain property sectors.
Hybrid Approaches
Some investors choose to combine REITs and direct property investments to leverage the advantages of both approaches. A core-satellite strategy involves using REITs as a core holding for broad market exposure while selectively adding direct properties for enhanced returns or specific market exposure. Sector diversification can be achieved by investing directly in a preferred property type while using REITs to gain exposure to other sectors. Geographic expansion is possible by owning properties directly in familiar local markets while using REITs to invest in distant or international markets. Liquidity management can be achieved by maintaining a portion of real estate allocation in REITs for liquidity while pursuing longer-term direct property investments.
