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Some of the smartest buys investors can make with $500 today are stocks that have upside potential and pay you to wait. Two factors can drive higher stock prices: earnings or cash flow growth and valuation expansion. Ideally, you would want to consider stocks with underlying businesses that have both above-average growth and depressed stock prices. These are rare, though.
REITs as smart dividend stocks to buy now
The stocks of real estate investment trusts (REITs) have generally been weak since 2022 from higher interest rates, leading to higher interest expense, which has, in turn, weighed on near-term funds from operations (FFO) growth — the equivalent of cash flow growth in REITs.
As a result, investors can buy units of Canadian REITs at relatively cheap valuations compared to, say, late 2021. Importantly, REITs pay out decent cash distributions that are like dividends. The distributions are essentially income for investors but are taxed differently from dividends depending on what they’re composed of. More about this later. First, here are some Canadian REIT ideas!
RioCan REIT
In late 2021, RioCan REIT (TSX:REI.UN) traded at about 14 times FFO. While the retail REIT’s FFO per unit has climbed over 10% from 2021, the value stock has declined more than 20%! At $17.52 per unit at writing, RioCan REIT trades at about 9.9 times FFO, which represents a discount of about 29% from its normal valuation. Of course, it could take three to five years for the stock to arrive at that level.
At least in the meantime, investors can pocket a generous cash distribution yield of 6.3% — income that’s 18% more than the highest Guaranteed Investment Certificate (GIC) rate of 5.35% at writing.
RioCan just raised its cash distribution in February. In addition, it has an investment-grade balance sheet and a sustainable payout ratio that should keep its cash distribution safe. Notably, FFO per unit growth could be about 2-3% per year until a new interest rate-cutting cycle begins.
Remaining in the REIT space, for higher growth, investors can explore Granite REIT (TSX:GRT.UN).
Granite REIT
The industrial REIT commands a premium valuation to RioCan REIT as it is expected to have higher growth potential. Its balance sheet has lower leverage, allowing it to fare better in a higher interest rate environment. Over the next few years, it could experience FFO per unit growth that doubles that of RioCan.
In late 2021, Granite REIT traded at about 27 times FFO. While the industrial REIT’s FFO per unit has climbed over 22% from 2021, the stock has declined about 29%! At $72.26 per unit at writing, analysts believe it trades at a discount of almost 19%. Furthermore, it offers a cash distribution yield of almost 4.6%, which is not bad.
Income tax on Canadian REIT distributions
Canadian REITs pay out cash distributions that are like dividends but are taxed differently. In non-registered accounts, the return of capital portion of the distribution reduces the cost base. The return of capital is tax deferred until unitholders sell or their adjusted cost base turns negative. REIT distributions can also contain other income, capital gains, and foreign non-business income.
Other income and foreign non-business income are taxed at your marginal tax rate, as are 50% of the distributions that are marked as capital gains. If you hold Canadian REITs inside tax-advantaged accounts like a Tax-Free Savings Account, Registered Retirement Savings Plan, Registered Disability Savings Plan, Registered Education Savings Plan, or First Home Savings Account, you won’t need to worry about the source of income other than foreign income which may have foreign withholding tax. When unsure of where best to hold REIT units, seek advice from a tax professional.
