How to Analyze REITs

The following article will walk you through why investing in real estate investment trusts are advantageous, the different types of REITs, pros and cons of this investment vehicle and finally how to analyze each trust to ensure it’s a good fit for you and your investment goals. 

Key Points

  • Real Estate Investment Trusts are the lowest-maintenance way to dip your toe into real estate investing. Modelled after mutual funds, REITs are trusts that allow you to passively hold interest in real estate. 
  • REITs allow investors, such as yourself, to participate in owning income-producing properties that otherwise may have been inaccessible to the average Joe.
  • To get into the nitty-gritty, at least 75% of the trust’s revenue must come from rent or mortgage interest from Canadian properties, as well as capital gains from the sale of such properties. 

Not too long ago, I opened a new so-called High-Interest Savings Account that’s earning me 0.010% on my hard-earned cash. 

Now don’t get me wrong, the name has a very poetic ring to it, but sheesh – you know it’s not great when you have to go down to four decimal places to learn how the bank plans to grow your money!

Like so many Canadians, I knew that while this account would bring me 100% security, it wouldn’t get me very far in terms of financial growth and my long-term plans. And so, my personal financial horizons had to expand to include stocks, bonds, mutual funds, real estate, GICs, EFTs and whatever other combinations of the alphabet the financial sector could throw at me.

At Fundscraper, we firmly believe that as an intelligent investor (which we know you are because you’re doing your homework right now), diversification is key. And part of a well-diversified portfolio includes investing in real estate.

While there are an amplitude of ways to invest in the real estate market (you can read an overview here), one of the most popular among Canadian investors are Real Estate Investment Trusts, also known as REITs (another acronym for you to file away in your memory). 

Here’s Why You Should be Investing in Real Estate Investment Trusts

Real Estate Investment Trusts are the lowest-maintenance way to dip your toe into real estate investing. Modelled after mutual funds, REITs are trusts that allow you to passively hold interest in real estate. They allow investors, such as yourself, to participate in owning income-producing properties that otherwise may have been inaccessible to the average Joe.

REITs come in many shapes and sizes and often hold interest in specific forms of property, whether it be apartment complexes, office buildings, shopping malls or industrial spaces – spreading your investment over multiple properties and across many regions. Simply put, they aggregate capital from investors, which they then use to acquire, build, operate and/or update these properties. 

To get into the nitty-gritty, at least 75% of the trust’s revenue must come from rent or mortgage interest from Canadian properties, as well as capital gains from the sale of such properties. 

When you invest in a REIT, the Trustees of the REIT hold the legal title to manage the trust on behalf of the unitholders (you), so no decision making is required on your part. These Trustees have a fiduciary duty and the income that is earned by the trust is passed onto the unitholders. 

REITs pay out almost all of their taxable income to shareholders, which makes their dividends attractive. The average Canadian return on a REIT is around 4% – that’s 400x higher than that “high interest savings account” we talked about earlier.

Bottom Line: REITs work in a similar fashion to how an investment property (such as owning and renting out a single-family home) earns rental income. However, unlike owning a rental property, REITs help you avoid the headache of property management, and best of all they trade on the stock exchange, making them more liquid than traditional real estate.

Types of REITs

Now that you know how REITs work, let’s explore the different types of REITs that you can invest in. 

Equity REITs

When most people talk about REITs, they’re talking about equity REITs.

Equity REITs derive most of their revenue from rent collection and from the sale of the properties they own. These REITs tend to specialize in owning certain types of buildings such as apartments, malls and/or resorts. Because a majority of their revenue is generated through rent collection, it’s fairly straightforward to calculate their payouts, providing relatively stable income to their unitholders.

Equity REITs, however, tend to be more sensitive to recessions and booms, often following the cyclical nature of the stock market. Like most markets, they are susceptible to swings in supply and demand, where too much supply can lead to lower rental income, in turn lower payouts for investors. 

Mortgage REITs

Just to make things confusing, mortgage REITs are also sometimes called mREITs or debt REITs. However, regardless of the naming convention, they offer their own set of benefits.

Unlike equity REITs, mortgage REITs make loans secured by real estate, but do not own or operate the properties themselves. By providing financing for these income-producing properties, mortgage REITs earn interest off these investments, which they then pay out to their unitholders. 

Like equity REITs, individuals can buy shares in these REITs via the stock exchange, just like would for any other stock. 

Of interesting note, mortgage REITs tend to perform better than equity REITs when interest rates are rising. However, changes in interest rates may also affect the probability that some borrowers will refinance or repay their mortgages – there’s two sides to every coin. 

Pros and Cons: What You Need to Know

Pros

  • No Property Management – We often consider real estate a passive form of investing. However if you buy a property and rent it out to a negligent tenant, it can be a huge time suck. REITs help you avoid being a property manager altogether.
  • Liquidity – Many REITs are traded on the public stock exchange. That means that unlike owning traditional real estate, you can sell your share with a quick phone call. 
  • Portfolio Diversification – REITs invest your money in multiple properties, in multiple different areas. This helps to diversify your portfolio and ensure that all your eggs aren’t in one basket.
  • Access to Commercial Properties – REITs open up investors to a whole host of properties that most real estate investors wouldn’t typically have access to. It’s not everyday that the average investor could go out and buy a multi-million dollar apartment complex.
  • Avoid Double Taxation – Unlike many investment vehicles, REITs pay out their distributions before they pay tax. This means that you avoid double taxation – helping you build wealth.

Cons

  • Lack of Control – Unlike when you buy a home and rent it out, as a unitholder you have no say in what properties you want to invest in or where they are located. While you don’t get to scope out the property first, you have to trust that the Trustees have done their due diligence – rest assured, they earned the name “TRUSTee” for a reason.
  • Property Specific Risks – As mentioned, REITs tend to specialize in a specific type of property, such as an office building REIT. It’s important to note that each type of property has risks associated with it and are susceptible to different economic conditions. This can be seen in the transition to work from home, in the case of office buildings. 
  • Investment Time – Like most real estate, REITs are best suited for longer term investments. It is recommended for investors looking to invest their money for 5+ years.
  • Slow Growth – In Canada, a REIT is required to distribute 90% of its profits to investors. Unlike penny stocks which don’t typically offer dividends and instead re-invest those earnings, REITs only have the remaining 10% of profits to grow the company by investing in additional properties. This means that you most likely won’t see your investment take off within a year or two.

How to Analyze REITs

Since REITs are dividend-paying stocks, they can be analyzed in a similar way that you would analyze other stocks, with a few minor differences. Before crunching the numbers, it’s important that you first look at the following factors:

  • The REITs’ Tenants – Are any of the tenants having major financial issues? This will likely affect their ability to repay their loan or pay their rent.
  • Acquisitions and Dispositions – Is the REIT growing their portfolio? Are they shrinking? Neither one of these is inherently good or bad, but it’s important to make note of and understand why they took those actions.

…now to crunching the numbers. Once a REIT looks like a solid investment opportunity, you need to make sure you’re paying a fair price for the stock.

Funds from Operations (FFO)

Following the General Accepted Accounting Principles (GAAP) , REITs must charge depreciation against their assets. However, as you likely know, many real estate properties generally appreciate in value over time, not depreciate. The depreciation expense can have a substantial impact on their reported net income and make a dividend payout ratio appear higher than it truly is. 

Additionally, we must account for the capital gains or losses from the sale of property. While these gains and losses are real, they’re not indicative of how much cash flow you can expect the REIT to generate in the future, so it’s important that we exclude these values to get a better understanding of the REITs performance. 

That’s where Funds From Operation (FFO) comes in. This quick calculation gives investors a clearer picture of the REITs true earnings. It is calculated using the following equation:

FFO = Net income + depreciation expense – gains on asset sales + losses on asset sales

Adjusted Funds from Operations (AFFO)

It’s important to note that each company calculates AFFO slightly differently. However, AFFO provides further adjustments to the REITs FFO to provides and even more accurate measure of the REITs performance. In the standard FFO calculation, we do not account for capital expenditures (CAPEX). Using AFFO, we deduct any capital expenditures to give a more accurate valuation. 

But utilizing these calculations, you’ll be able to get a better understanding of the REITs performance and if the REIT is undervalued or overvalued in comparison to other REITs.

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How Real Estate Investments Earn Money

Investing in real estate is one of the smartest moves you can make, no matter what age or stage of life you are in.

Real estate investments can add diversification to your portfolio – and getting into the market can be as easy as buying a mutual fund.

If you’ve ever had a landlord, you probably don’t dream of being one: Fielding calls about oversize bugs and overflowing toilets doesn’t seem like the most glamorous job.
But done right, real estate investing can be lucrative, if not flashy. It can help diversify your existing investment portfolio and be an additional income stream. And many of the best real estate investments don’t require showing up at a tenant’s every beck and call.

In this article, we take a look at how real estate investments on our marketplace earn money.

Key Points

  • Real estate investments break down into two broad categories: debt and equity.
  • The main ways to make money are from asset appreciation and dividends from rents/interest payments.
  • There are several ways to invest in real estate equity investments, including direct investment, mutual funds, REITs, and investment platforms.

Debt vs. Equity

Real estate investments break down into two broad categories: debt and equity. Let’s first look at the differences between these two types of investments to begin to understand how returns are structured in the form of income or appreciation.

DebtEquity

Under a real estate loan, an investor lends money to a borrower (typically a buyer or real estate developer). 

The investor earns income for the duration of the loan usually at a fixed rate following a schedule of regular interest payments on the loan principal. 

A debt investment is typically less risky than an equity investment, but there are several factors that impact how risky each individual investment can be, as discussed below.

See Example Debt Opportunity Listing

An equity investment gives an investor ownership of a physical property. An equity investment entitles the investor to a claim on money earned from any appreciation earned by the asset when it’s sold. 

Appreciation returns are usually realized in a one-time payment, in the form of capital gains. An equity investment also gives an investor the ability to earn regular income from rental payments for the lifetime of the investment typically on a monthly basis. While equity investments enable investors to earn both income and appreciation, they’re often riskier than debt investments as we discuss below.

The main ways to make money are from asset appreciation and dividends from rents/interest payments.

How Real Estate Investments Earn Income

Is your primary investment objective Current Income? Both debt and equity investments can earn you consistent income. Let’s take a look at how.

Loan Interest Payments

A real estate loan investment is an arrangement in which an investor lends money to a buyer or developer who then pays interest on the principal lent. An investor earns a return in the form of income from the interest payment while the loan is repaid. Payments are often made on a monthly basis making them an appealing investment option for those seeking “passive” or “residual” income.

Debt investments can only earn income, but they offer the advantage of lower risk than equity investments do thanks to their senior position within the capital stack. This means debt investors receive their principal plus interest before an equity investor can realize any returns (apart from rental income potential).

Within the debt tranche of the capital stack, there’s a further division of seniority among the types of debt which determines loan repayment priority. Senior debt is unsurprisingly the most senior and therefore has the highest repayment priority. It’s followed by junior debt and mezzanine debt, and then the equity portion of the capital stack.

In addition to seniority, debt real estate investments can be secured or unsecured. An investor with a secured debt investment has the right to foreclose on a property in the event of loan default to recoup the value of their loan. Senior debt investments are typically secured positions, and other debt investments may be secured, but the terms can vary by investment.

Rental Payments

Equity investments can also generate their own income stream using rental payments. Traditional, or common, equity ownership gives investors the right to lease the property to tenants to earn income through rental payments.

Unlike a debt investment, which generally has a fixed rate of return over a defined lifetime, an equity investment generates rental income that can change over time, growing or shrinking in relation to market demand. Income potential is also based on occupancy rates, which can also vary for any given property. This means that equity investors may incur more risk to earn income, but they also have the potential to earn a higher rate of return.

Also, common equity investments don’t usually have pre-defined periods of ownership and can last indefinitely, giving an investor the ability to earn income until the property is sold. Real estate is a long-term investment, especially for equity investments, which gives investors the ability to earn significant income over time on a monthly basis.

Common equity ownership offers rental income potential, while preferred equity investments offer cash flow in a way that’s more similar to debt investments. Like a loan interest payment, preferred equity investments offer a fixed rate of return commonly referred to as “preferred return.” Due to its middle position in the capital stack, preferred equity investments receive payments until they’ve reached the agreed rate of preferred return after all debt investments have been repaid and before common equity investors receive their return.

How Real Estate Investments Earn Appreciation

There are several ways to invest in real estate equity investments, including direct investment, mutual funds, REITs, and investment platforms. The investment vehicle used to invest in an equity investment impacts how an investor receives their return as well as how and when it is taxed.

For example, an investor with a direct investment can collect their capital gains directly from the sale of an investment. On the other hand, an investor with an investment through a fund may realize appreciation from the sale of a property through a fund distribution or through an increase in the value of the shares that they own. Each option brings its own advantages and disadvantages, which can make each option more or less preferable for an investor, depending on their financial goals and resources.

Regardless of how you invest in real estate, at some point, a rigorous underwriting process, which evaluates the aspects of a potential investment property, is key. If you’re investing independently, the onus for that underwriting process will fall on your shoulders, whereas, if you’re investing through a fund or platform like Fundscraper, a team of experienced real estate professionals will handle the evaluation on your behalf.

No matter who performs the underwriting, this due diligence process plays a vital role in determining whether an investment opportunity is financially sound.

Evaluating Your Options

Common equity investments are easier to access than debt investments. Individual investors can buy an investment property and manage it on their own. However, due to the high sums of money, knowledge, and time commitment required for direct investment, individual investors are often limited in the number and types of properties that they can buy — and manage — on their own.

As with debt investments, pooled-fund investment options, such as mutual funds, REITs, and investment platforms, offer a way to invest small sums of money across several assets and asset types. Private equity funds are also available to accredited investors. While it’s more feasible for an individual investor to invest in a single-family home or duplex, a fund can give an investor access to investments across a wide range of commercial real estate in multiple locations at a fraction of the dollar investment size.

For instance, with Fundscraper, you can invest in opportunities with a target diversification level that matches your goals containing a mixture of assets across different geographies.

Fundscraper allows investors with small amounts of capital to get in on private real estate deals. Whether you are looking for cash flow now or let your money sit and grow over the long term, Fundscraper offers a wide range of opportunities including Real Estate Investment Trusts, Private Equity, Mortgage Investment Corporations and Mutual Fund Trusts with shorter and longer term horizons.

We welcome you to create a free profile and browse our marketplace. If you’d like to discuss your financial goals and your options with one of our licensed dealing representatives, fill out this short questionnaire and book your call today.

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The Role of the Credit Committee of an Exempt Market Dealer

The Credit Committee, sometimes called the Investment Committee, is a panel of individuals ubiquitously found in financial institutions, pension and endowment funds, credit unions, banks, insurance companies, and the like. Here, we’ll focus on the role and inner workings of the Credit Committee of an Exempt Market Dealer offering real estate products to the public.

Key Points

  • An EMD is a firm that has been licensed to distribute investment securities that are exempt from the rigours of a prospectus normally required by the Canadian Provinces in which it is registered to carry on business
  • The Board of Directors of an EMD normally establishes the Credit Committee comprised of senior management individuals with authority and relevant skill and experience. They meet regularly to consider new investments and approve, amend or turn away investment opportunities being brought forward under the auspices of the EMD
  • The credit committee serves as a natural buffer or safeguard against an overly enthusiastic promoter. An essential part of its mission is to protect the ultimate consumer of products offered to the public under the umbrella of an EMD

What is an exempt market dealer (EMD)?

An EMD is a firm that has been licensed to distribute investment securities that are exempt from the rigours of a prospectus normally required by the Canadian Provinces in which it is registered to carry on business.

EMDs may act as dealers for prospectus exempt securities sold to qualified clients. Typically, an EMD offers products covered by an Offering Memorandum (OM) which need not be pre-cleared by a Securities Commission. An OM is an issuer-prepared document purporting to describe its business. OMs assist prospective purchasers in their decisions of whether to invest in the securities being offered by the Issuer.

The Credit Committee does much of the “heavy lifting” for investors in evaluating the underlying merit of any investment opportunity.

What is a credit committee and what does it do?

The Board of Directors of an EMD normally establishes the Credit Committee comprised of senior management individuals with authority and relevant skill and experience. They meet regularly to consider new investments and approve, amend or turn away investment opportunities being brought forward under the auspices of the EMD.

The Credit Committee has a broad range of duties and responsibilities, including the obligations to:

  • Ensure regulatory compliance for each investment
  • Review regularly investment policies and recommend to the Board of Directors changes in policies, procedures, internal controls and underwriting guidelines
  • Promote wise investment and credit management
  • Rule on investment opportunities, taking into account credit, market, operational and legal risks
  • Ensure any investment is consonant with the EMD’s published investment criteria and policies

What is a loan officer?

The Loan Officer assigned to any proposed transaction is an experienced underwriter charged with presenting the investment opportunity to the Credit Committee, including all the supporting research. An underwriter’s main task is to assess the quality of an investment, its sponsors, and its inherent risks. Oftentimes, the Loan Officer’s presentation to the Credit Committee will have been previously vetted and endorsed by the Loan Officer’s supervising manager.

Why is it called underwriting? The term comes from the historical practice of Lloyd’s of London Insurance of requiring each risk taker (often for a sea voyage with risks of shipwreck) to put their “written” signature “under” the total monetary risk they were willing to assume in return for a fee. Hence the term “underwriting.”

It’s the credit committee’s job to approve, amend, or disapprove of an investment application.

How does a credit committee evaluate an investment opportunity?

Over and above its general obligations, on a daily basis, the Credit Committee is charged with evaluating potential investment opportunities falling within the EMD’s jurisdictional orbit. The review begins with the Loan Officer’s discussion paper, which includes a profile of the people behind the deal, its proposed terms, detailed analyses, and recommendations.

After deliberating over the Loan Officer’s underwriting report and completing any follow up interviews, the Credit Committee can approve, amend, or disapprove of the investment application at hand.

If the application is turned down absolutely or with amendments, the Loan Officer will advise the applicant accordingly. If it’s approved, a letter of intent will be sent. Upon acceptance by the applicant, a term sheet and commitment letter prepared by the Loan Officer and approved by the Credit Committee is forwarded to the applicant for signature and acceptance. The Loan Officer then will confirm that all due diligence and funding requirements are in order and that arrangements are put in place to fund the transaction. The EMD’s Legal Counsel will be retained to prepare and register the mortgage and/or any other security documents and ensure all conditions have been satisfied before funds are released. Barring the need for an extension down the line, the work of the Credit Committee is now done.

At this juncture, the EMD moves on to fulfill its regulatory obligations and attends to matters related to qualification of investors, suitability, conflicts of interest, disclosure, and more. It’s a complex process; the full treatment of these tasks is beyond the scope of this paper!

The credit committee serves as a natural buffer or safeguard against an overly enthusiastic promoter. An essential part of its mission is to protect the ultimate consumer of products offered to the public under the umbrella of an EMD.

What is due diligence?

Due Diligence, as applicable, covers many things, including:

  • The credentials of an Issuer or Sponsor
    The financial details of the proposed deal, including principal amount, yield, duration, and other salient features and conditions
  • Creditworthiness of the borrowers and/or guarantors, including credit checks, financial statements, personal references, and net worth statements
  • Third party reports such as valuation appraisals, architectural certificates, environmental reports, building condition assessments, geotechnical appraisals, and quantity surveyor reports
  • Leases, rent rolls, and estoppel certificates
  • Development budgets and construction schedules
  • Ability of the originator to fund budget shortfalls and need for a Deficiency and Cost Over Run Agreement
  • Zoning and building permits
  • Details of prior and subsequent encumbrances and availability of lender consents, if necessary
  • Assessment of loan to value ratios and other compliance with the EMD’s investment criteria
  • Evaluation of current competing market conditions for similar deals, including prevalent offerings by competitors
  • Timing of advances to the borrowers
  • Availability of collateral security
  • Builder’s risk and liability insurance
  • Validity of repayment schedules, as well as feasibility of exit route through refinancing or sale of underlying property
  • Evaluation of originator’s track record and project’s progress to ensure continued sustainability in case an extended term is needed
  • Location of the property, including marketability, condition, and value
  • Contemporaneous assessment of general economic and societal forces, including state of financial markets, existing and proposed government policies, local issues, and force majeure conditions
  • Review of commitment administrative and all incidental expenses and fees
  • Legal structure and supporting documentation

Meet the Fundscraper credit committee

Our team has over 125 years of experience in real estate development, finance, private equity, law, and technology. We’re proud leaders in our fields! Meet the Fundscraper credit committee here.

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