The sun sets behind Berlin's Brandenburg Gate as a EU flag flies. By purchasing 1.5 million square feet of office space for $568-million in Frankfurt, Hamburg, Munich, Cologne and Dusseldorf, Dundee has not only added to its portfolio, but also proven it is not constrained by a real estate market in Canada that has become fully valuedJOHN MACDOUGALL
Canadian REITs have turned out to be some of the most lucrative investments over the past few years, providing competitive yields and significant price appreciation. For 2012, The BMO Equal Weight REITs Index ETF returned 18.1 per cent (on a total returns basis), while the iShares S&P/TSX Capped REIT Index produced a total return of 16.2 per cent.
Market returns have been aided considerably by the correction experienced in November 2008, when the U.S. housing crisis caused the S&P/TSX Capped REIT Index to drop by more than 60 per cent from its all-time highs. Launched in May 2010, ZRE entered the ETF space as REIT prices were in the midst of their recovery. Since the financial crisis, XRE has steadily gained, but as XRE closes in on its highs, posted in February 2007, its price momentum has slowed down, as the ability for the underlying REITs to continue to deliver compelling returns has become more constrained.
In 2012, U.S. REIT ETFs posted comparable total returns to those in the Canadian market. The average of 13 ETFs focused on the American market was 15.8 per cent. Their trajectory post-housing crisis has been very similar to XRE's.
In contrast, the REIT ETFs with an international focus that are available in the U.S. market outperformed the Canadian REITs by an almost two-to-one margin. The average total return of eight global REIT ETFs in 2012 was 30.8 per cent. Relative to XRE and ZRE, these funds have not rebounded as quickly and are currently trading well-below their all-time highs, by an average of 29.1 per cent, suggesting there is still further room for these ETFs to appreciate.
Consistent with this trend, Dundee REIT has expanded its growth potential by sourcing an international acquisition opportunity in Germany that closed earlier this month. By purchasing 1.5 million square feet of office space for $568-million in Frankfurt, Hamburg, Munich, Cologne and Dusseldorf, Dundee has not only added to its portfolio, but also proven it is not constrained by a real estate market in Canada that has become fully valued and now offers limited opportunities for REITs to make new acquisitions at cost-efficient prices.
Moving forward, the ability to add profitable properties in foreign markets could be the key driver of growth for Canadian REITs. While some of the trusts have already diversified their assets beyond the domestic market, others have failed to exhibit any international expertise.
Amongst the ETFs that focus on Canadian REITs, the level of foreign exposure is mainly limited to the U.S. market:
iShares S&P/TSX Capped REIT Index Fund
With $1.4-billion in assets under management, this fund has been in the market for over 10 years. The portfolio consists of 15 holdings, with RioCan REIT accounting for 19.2 per cent of the total, followed by H&R REIT (10.7 per cent) and Dundee REIT (8.8 per cent). RioCan has made continued expansion into the U.S. market a priority, announcing the opening of a new regional office this year and indicating a willingness to partner with a pension fund to bolster their American acquisition strategy. H&R REIT has been active in the American market, acquiring the Hess Tower in Houston for $442.5-million and Two Gotham Center in Long Island City for $415.5-million.
BMO Equal Weight REITs Index ETF
With net assets of $378.5-million, ZRE has 20 REITs in its portfolio, ranging from 4.9 per cent to 5.6 per cent of the total. Dundee REIT (5.3 per cent), RioCan REIT (5.1 per cent) and H&R REIT (4.9 per cent), feature in this fund, but their relative weighting is considerably less (38.7 per cent versus 15.3 per cent) as a result of ZRE's equal-weighting methodology (rebalanced semi-annually). Many of the other prominent holdings – including Pure Industrial REIT, InnVest REIT, Allied Properties REIT and Morguard REIT – are exclusively focused on Canada.
Vanguard FTSE Canadian Capped REIT Index ETF
Launched in January 2012, VRE has $5.1-million in net assets. RioCan is the largest holding (16.3 per cent), followed by Brookfield Office Properties (12.7 per cent), H&R (9.35 per cent) and Dundee (7.2 per cent). The portfolio consists of nineteen holdings, a list that is very similar in composition to XRE, with the exception of Brookfield. With properties across the U.S., as well as the United Kingdom and Australia, Brookfield has significant international scale and capabilities.
An alternative approach to gaining access to foreign markets is to buy a real estate ETF with a global focus. There is currently one Canadian ETF on the market that offers considerable international exposure.
Global Real Estate Index Fund
The majority of the underlying exposure is in the United States (45.2 per cent). The other countries represented in the portfolio include Hong Kong (11.9 per cent), Japan (10.4 per cent), Australia (8.7 per cent) and Singapore (3.9 per cent). The fund has significant diversity, comprised of seventy-five holdings, with no single company accounting for more than 4.1 per cent of the total. Launched in August 2008, this ETF has $36.4-million in assets under management and represents retail (33 per cent), office (25 per cent) and residential (18 per cent) assets. The portfolio is focused on companies with dominant positions in their local markets. CGR offers investors a trailing yield of 2.0 per cent and delivered a 25.4 per cent return in 2012.
While it seems unlikely that Canadian REITs will be able to post double-digit returns consistent with their recent four-year run, the primary allure of these vehicles has always been yield. In this regard, ETFs like XRE, ZRE and VRE, should continue to fill a void created by a low interest rate environment that has reduced the appetite for fixed income assets. The steady flow of REIT distributions provides some assurance that investors will maintain their positions in both the ETFs and the underlying trusts, creating unit price stability, even if growth rates are curtailing. For investors searching for more upside, ETFs like CGR can potentially overcome the limits presented by a fully valued real estate market in Canada.
ETFinsight is a website dedicated to helping Canadians connect with relevant ETF solutions. Read more at www.etfinsight.ca, follow us on Twitter@etfinsight and Josh Erhlich can be contacted at: josh@etfinsight.ca