Real estate investment trusts seem to have it all: capital appreciation in a booming real estate market and generous payouts for income-thirsty investors in a decade-long interest rate drought.
But as central banks inch up their benchmark interest rates, REITs are coming under pressure.
"The moment you see more volatility on interest rates, or sentiment shifting on interest rates, REITs will automatically be affected. That's for sure," says Frederic Blondeau, director of real estate research at Eight Capital.
REITs are publicly traded companies that own or finance income-producing real estate. Some REITs focus on real estate subsectors such as residential, commercial or industrial. Others are more diversified.
REIT prices fluctuate, but income investors are rewarded with steady dividend payouts far superior than anything the bond market can offer. But recent interest-rate hikes by the U.S. Federal Reserve and the Bank of Canada – and the promise of more increases to come – could narrow the payout gap between REITs and bonds.
"I don't think that rates will go up dramatically or rapidly," says Mr. Blondeau. But as they do, he expects REITs with the highest debt levels to be most vulnerable. "Within the commercial space, the guys that are using more leverage will be most affected."
The real estate sector relies heavily on leverage. Higher borrowing costs cut into profitability and ultimately the rate of return for investors. On the other hand, Mr. Blondeau points out that higher interest rates are also a response to economic growth, which normally boosts real estate prices.
"The sector partially benefits from cash-flow growth due to an increase in demand for space and higher inflation, assuming the rise in rates is due to inflation," he says.
Mr. Blondeau has been calling for caution in the REIT space since the start of 2017. His area of concern is what he calls "the faltering Trump trade" – signals out of Washington that the pro-growth administration of U.S. President Donald Trump is falling flat, and could stoke volatility on the interest rate front.
"This kind of political irrationality makes me think we should really focus on risk management," he says.
His advice is to invest in REITs with less exposure to debt and REITs that benefit from higher interest rates such as multi-family rental units. Higher borrowing rates lead to higher mortgage rates, which keeps prospective home buyers in the rental market.
"In a rising interest-rate environment, demand for single-family residential products should be impaired, favoring demand for rental units," he says. "Multi-family residential is probably one of the best inflation hedges and also one of the best hedges against rising interest rates."
Two REITs on Eight Capital's "buy" list are InterRent REIT and Killam Apartment REIT, which both hold multi-unit residential properties across Canada. InterRent currently pays a dividend yield of just over 3 per cent and Killam pays out 4.7 per cent.
So far this year, InterRent has gained in value by 7 per cent and Killam, 10.4 per cent. Both are outperformers considering the broader TSX Capped REIT Index is trading flat in 2017 after more than doubling since 2009.
"There's not a great opportunity in the space. If you can get your yield, you should be happy," says Paul Gardner, partner and portfolio manager at Avenue Investment Management. As a former bond fund manager, his primary job is to generate income wherever he can.
Mr. Gardner also doesn't expect interest rates to rise quickly and says 6-per-cent REIT yields should be attainable for the time being.
"It's going to be hard for the Bank of Canada to raise rates. There's still overcapacity. There's still deflation in the system, and you have a Canadian dollar that is very strong. That's going to cause deflation," he says.
Like Mr. Blondeau, Mr. Gardner favours apartment REITs such as Killam and Canadian Apartment Properties REIT.
He also likes FirstService Corp., which is technically a stock and not a REIT. The United States- based real estate company has stakes in home improvement brands including Paul Davis Restoration Inc. and California Closet Company Inc. Its biggest holdings are in home maintenance.
"Their main business is to manage properties in the U.S. condominium market. They cut the lawns, they do the painting and all that," Mr. Gardner says.
Mr. Gardner also likes BTB REIT, which holds commercial, office and industrial properties concentrated in Quebec. "Its focus is on industrial retail in Quebec, and Quebec has a good hot economy," he says. BTB pays an 8.8-per-cent annual dividend yield.
One real-estate subsector Mr. Gardner avoids is bricks-and-mortar retail, found in RioCan REIT, SmartREIT and others, as traditional brands such as Toys "R" Us and Sears Canada fall victim to online retailers.
"Retail is getting hit hard by online, and it's just the beginning," he says.
In any case, he says REITs are better suited now for investors looking for yield ahead of capital gains, at least until interest rates start matching REIT yields.
"It's a competitive market. If rates go up, REITs become less desirable on a risk-free basis."