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Potential for high dividends and tax benefits: Individual REIT stocks can provide higher yields (if selected correctly) and more favorable tax treatment on dividends than REIT ETFs.
Volatility risk: Individual REITs can be more volatile, but this can be mitigated by building a diverse portfolio.
Balanced approach: A diversified portfolio of REITs offers reduced volatility while maintaining higher income and tax benefits.

Being Selective with REITs vs. REIT ETFs: Choosing the Best Approach

When it comes to real estate investment trusts (REITs), investors often face a common question: should you invest in individual REIT stocks or opt for a REIT ETF that offers broad exposure to the sector? While REIT ETFs provide diversification and convenience, building a portfolio of carefully selected individual REITs has its own unique advantages. In this post, we'll explore why being selective with individual REITs can be a smart strategy and how to balance the pros and cons.

Advantages of Investing in Individual REIT Stocks

Higher Dividend Yields
Individual REITs often offer higher dividend yields than REIT ETFs. By selecting individual REIT stocks with strong cash flows, investors can focus on maximizing income. This is especially beneficial for income-focused investors seeking stable, regular payouts from their investments.
Tax Benefits on Dividends
In many cases, dividends from individual REITs may come with favorable tax treatment, especially if they include return of capital or capital gains. Unlike REIT ETFs, which pool dividends and distribute them, investing directly in individual REITs allows investors to better leverage these tax advantages.
Selective Choice of Quality Management and Solid Fundamentals
One of the greatest advantages of investing in individual REITs is the ability to selectively choose those with strong management teams and solid fundamentals. Not all REITs are created equal, and being selective allows investors to focus on REITs with high-quality assets, efficient operations, and strategies that align with long-term growth. This selectivity can help mitigate the risk of poor performance that may come with weaker REITs typically included in ETFs.

The Downside: Volatility in Individual REITs

While the advantages are clear, picking individual REIT stocks also has its drawbacks. The primary concern is volatility. Unlike REIT ETFs, which spread risk across multiple REITs and sectors, individual REITs can be affected by specific circumstances in their industry. For example, a REIT focused on retail may face challenges due to changing consumer habits, while a REIT with significant office properties could be impacted by remote work trends.

Managing the Volatility: Building a Balanced Portfolio

The good news is that the volatility of individual REIT stocks can be managed by diversifying across multiple REITs. By carefully selecting REITs across various sectors—such as residential, industrial, office, diversified—investors can create a well-balanced portfolio that mitigates the risk of any one REIT dragging down overall performance. With this approach, you can enjoy the best of both worlds: reduced portfolio volatility while maximizing the benefits of high dividends and tax advantages from individual REIT stocks.

Example Portfolio and How I Built It

I built a portfolio of Canadian REITs using several key factors:

High dividend yields
Good fundamentals (e.g. stable cash flow, modest growth, stable payout ratio)
Diversification across sub-sectors to evenly distribute risk

Here's the breakdown of the portfolio by sector and REIT allocation:

Office (30%)
- Allied Properties (AP.UN-TO): 19%
- BTB REIT (BTB.UN-TO): 11%
Retail (22%)
- Slate Grocery REIT (SGR.UN-TO): 6%
- Firm Capital Realty Trust (FCD.UN-TO): 6%
- Primaris REIT (PMZ.UN-TO): 5%
- CT REIT (CRT.UN-TO): 5%
Diversified (11%)
- NET REIT (NET.UN-TO): 7%
- HR REIT (HR.UN-TO): 5%
Industrial (37%)
- Nexus REIT (NXR.UN-TO): 16%
- Pro REIT (PRV.UN-TO): 13%
- Granite REIT (GRT.UN-TO): 8%

This diversified approach helps balance risk and ensures that no one sector dominates the portfolio, while collecting 7.4% dividend per annum. That would equate to about $1235 per month if the overall portfolio size was $200,000. If you compare this to the real world scenario, imagine buying a condo for $200,000 as a rental property (which doesn't exist anymore in Canada), which would collect $1235 net monthly without doing any work. That sounds like a good deal to me.

It also allows me to benefit from the stability of multiple sectors while capturing attractive dividends from individual REITs. Let's compare its normalized overall stock price in comparison to ZRE.TO, BMO Equal Weight REIT ETF:

As seen in the 5 year chart, the stock price moves pretty similar to the ZRE.TO. The recent slight underperformance can be attributed to either a relatively heavy focus on office sector (which was shot down due to the work from home narrative), or a heavy focus on relatively small sized REITs that tends to give out higher dividend yield for their underperformance in stock price. However, if you consider the overall dividend yield of 7.4% vs. 4.5% (ZRE.TO) at the time of writing, the collection of dividend and their tax advantage easily outweigh this small discrepancy in the price variation.

Conclusion: REIT ETFs or Selective REIT Portfolio?

Investing in REIT ETFs offers simplicity and broad diversification, making them a great option for investors who prefer a hands-off approach. However, for those willing to invest the time in research, building a selective portfolio of individual REITs can provide greater control, higher yields, and tax advantages. By carefully choosing REITs with strong fundamentals and diversifying across sectors, investors can strike a balance between income, tax efficiency, and reduced volatility—allowing them to enjoy the benefits of both individual REIT investing and REIT ETFs.