It's a little bit surprising that the investing world's bubble police haven't yet pounced on real estate investment trusts.
After being massacred in the 2008-09 market crash, REITs have been outstandingly good investments. The S&P/TSX Capped REIT Index is up 54 per cent on a cumulative basis over the past three years, roughly three times more than the broader market. In these risk-averse times, that's the kind of performance that leads to bubble talk.
REITs have been largely immune from such chatter, which is appropriate because they're positioned to thrive in today's low-rate, low-growth world. "This sector has a lot of strong fundamental levers going forward," said Michael Missaghie, co-manager of the Sentry REIT Fund. "They're firing on all cylinders right now and we don't see anything on the horizon that is going to derail this."
REITs hold portfolios of malls, industrial properties, offices, apartments, hotels or retirement homes. They typically pay out quarterly income to investors, with a significant portion coming from a return of capital. Income received as a return of capital isn't taxed in the year it's received, but it does reduce the adjusted cost base for an investment. This, in turn, may give you a larger capital gain when you sell.
Mr. Missaghie describes REITs as being somewhere between average and peak valuation levels, which means the opportunity for serious price appreciation has passed. Even after a small recent pullback, the REIT index has gained 16 per cent in the past 12 months. What's left, in his view, is an opportunity to generate income yielding about 5 per cent and additional share price gains of 4 to 6 per cent based on strong fundamentals for commercial real estate.
There are key differences between that segment and residential real estate, which appears to have peaked in Canada. The question being asked by those who don't sell houses for a living is whether residential prices will merely dip or plunge in the months ahead. By comparison, commercial real estate is in good shape. Even with the economy growing slowly, REITs have been able to consistently increase their cash flow.
Acquisitions, new developments and redevelopments of existing properties have helped boost cash flow, as have rising occupancy rates and rents. Mark Newman, a vice-president at bond rater DBRS, said mall REITs are benefiting from the arrival of U.S. retailers such as Target and Nordstrom, industrial REITs are recovering from a hit to their tenants caused by the rising Canadian dollar (which makes our exports less competitive) and office REITs are doing well because of a limited supply of office space. "We are starting to see some new projects come online – that may be a concern in four or five years," he said.
DBRS is interested strictly in the bonds issued by REITs, not their shares. But the firm's analysis is worth considering because it speaks to the underlying health of the sector. In a recent review, DBRS said the trend was stable for six of the REITs it covers and positive for one.
The big risk to the sector from DBRS's vantage point is rising interest rates, although there's no sense of urgency to the concerns. "We don't expect rates to go up any time soon," Mr. Newman said. "It could be one to three years."
The sharp declines in rates that came with the global financial crisis have been a huge help to REITs. The trusts have been able to borrow at historically cheap levels and refinance existing higher-cost debt. Low rates also help their interest coverage ratios, which is a measure of how easily a company can repay its debts.
Rising rates would increase financing costs for REITs, but Mr. Newman said the larger REITs his firm covers have done a good job of staggering the maturity of their bonds so they don't face a massive refinancing in the next three years.
The sharp run-up in prices has made REITs less attractive, a point that was highlighted when analyst Alex Avery of CIBC World Markets downgraded the sector late last month to "market weight" from "overweight." The move, he explained in a note to clients, was simply a reflection of an average 19-per-cent year-to-date total return for TSX-listed REITs, compared to 5 per cent for the S&P/TSX composite index.
Still, Mr. Avery expects average total returns of 10 to 15 per cent over the next 12 to 18 months. He favours large REITs such as Artis, Calloway, H&R and RioCan.
Implied in forecasts like Mr. Avery's is that roughly half the gains from REITs will come from their cash distributions. The yield for a stock or bond declines as its price rises, but the S&P/TSX Capped REIT Index still yields about 5 per cent these days. Even after fees charged by a REIT-focused mutual fund or exchange-traded fund, investors are still way ahead of the 1.3-per-cent yield on a five-year Government of Canada bond. Within the index, yields range from 6.8 per cent for Artis to 3 per cent for Boardwalk REIT.
Sentry's Mr. Missaghie says he believes that the fundamental health of the commercial real estate market means REIT distributions are safe from being cut or suspended. Of course, that assumes there are no global economic blowups along the lines of what we saw five years ago.
When the market crashed back then, REITs were among the most conspicuous casualties. From late 2007 to through early 2009, the S&P/TSX REIT index lost more than half of its value. Distributions were kept intact for the most part, with H&R REIT being one notable exception. Known for its conservative approach, H&R had to cut its payout to preserve funds for its development of The Bow, a major office tower in Calgary.
Since plunging 38 per cent in 2008, the S&P/TSX Capped REIT Index has notched five four years of double-digit total returns if you include year-to-date 2012. Big gains in this sector are history, but the outlook is stable. The bubble police can stand down.