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What's Next for REITs and A New REIT Pick

July 13, 2014 | About:

Gordon Pape

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When the year began, the outlook for real estate investment trusts (REITs) was not very promising. The sector had just endured a miserable 2013, sparked by fears of rising interest rates. The S&P/TSX Capped REIT Index was trading at close to 180 in spring 2013 but then dropped sharply to below 150 after then Federal Reserve Board chairman Ben Bernanke mused publicly about winding down the quantitative easing (QE) program. The index is still well below its 2013 high, closing Friday at 161.37.

It was expected the tough times would continue into 2014, based on the expectation of higher interest rates. (REITs are interest-sensitive securities, tending to move inversely to rate changes). Instead, we have experienced a modest rally in the sector, with a year-to-date gain of 6.3%. That's well below the performance of the S&P/TSX Composite Index but it's a pleasant surprise for investors.

REITs are portfolio mainstays for many income-oriented Canadians. They offer good yields (generally above 5%, a few higher than 6%) and, in most cases, monthly cash flow. When held outside a registered plan, they receive modest tax breaks. In 2013, about 30% of the $1.41 per unit distributed by RioCan (our only REIT recommendation) was treated as a capital gain, of which only half is taxable.

The downside is that REITs can be volatile, sometimes unnervingly so. During the credit crunch, the Capped REIT Index plunged from a high of about 179 in early 2007 to around the 70 level in February 2009. That loss of 60% unnerved investors. Many sold for big losses, vowing never to trust REITs again. Those memories still remain.

It's unlikely we'll see another such bust any time in the near future. But the fact REITs are lagging well behind the performance of the overall TSX Composite shows that investors are reluctant to pay premium prices for them. That helps to explain why the yields continue to be high.

The nervousness is understandable. With the economy gradually gaining momentum and inflation rising to over 2%, the day when the Bank of Canada finally starts pushing rates higher is drawing closer. When that happens, perhaps as early as later this year, REIT prices will come under pressure.

However, the market reaction to future interest rate hikes may be more muted than investors expect. Last year's sharp drop in the REIT Index (and in a wide range of other interest-sensitive securities as well) was due in large part to the surprise at Mr. Bernanke's remarks and the timing. In fact, the Fed did not begin implementing its tapering program until the beginning of this year, more than seven months after the former chairman's comments.

That surprise element is gone. The Fed confirmed last week that the quantitative easing program would end later this year. Interest rates are forecast to rise by no later than mid-2015. Those expectations have been built into REIT pricing.

A recent in-depth analysis of the sector by RBC Capital Markets concluded that, on a yield basis, REITs and real estate operating companies (REOCs) offer better value today than they did at the beginning of the year when compared to bond yields and credit spreads.

RBC is not expecting to see any growth on a net asset value (NAV) basis for the rest of the year, which means we are unlikely to experience any significant price escalation across the sector. But stable prices combined with a good yield would be just fine for income-oriented investors.

The bottom line is that REITs aren't positioned to offer any meaningful capital gains in the second half of 2014 but neither do they show signs of crashing. If cash flow is your number one priority, you should seriously consider adding one or two to your portfolio.

Our companion Income Investor newsletter offers a wide range of REIT recommendations. However, we have only one on the IWB list, RioCan REIT (TSX: REI.UN, OTC: RIOCF), which I added way back in 1998 and which was updated in the issue of June 23.

RioCan owns and operates shopping malls, which some analysts believe is a dying breed due to the rise of e-commerce. I think those predictions are at least premature and probably even wrong - people will always prefer to try on clothes rather than buying jackets and dresses on-line. And nothing beats personalized service when you're shopping for a gift for someone who has everything.

That said, we need to diversify our REIT list. To that end, I recommend the purchase of Canadian Apartment Properties REIT (TSX: CAR.UN) (OTC: CDPYF), known more familiarly as CAP REIT. Here are the details.

The company: This REIT is one of Canada's largest residential landlords, with interests in over 41,500 residential units including apartments, townhouses, and manufactured homes. Its main focus is in the Toronto area, however it has properties in major urban centres from coast-to-coast as well as in Dublin, Ireland.

The security: I recommend the purchase of CAP REIT units, which trade on the Toronto Stock Exchange. They are also listed on the over-the-counter Pink Sheets in the U.S. although volume there is very light (less than 8,000 units a day on average).

Why we like it: Residential properties tend to be more stable than office or retail holdings in difficult economic times. In the case of this REIT, net operating income (NOI), a key measure of a real estate trust's financial health, has increased every year since 2006, including during the recession of 2008-09. The NOI in 2013 was 76% higher than in 2006.

Distributions, which were flat for many years, have been raised four times since the middle of 2012, the latest being a 2.6% hike in June. This is another positive financial sign.

Financial highlights: The company reported a very strong first quarter, unaffected by the harsh winter. NOI was up 12.4% to about $71.4 million. Normalized funds from operations (NFFO) came in at $0.395 per unit, a record for the REIT and up 9.1% from the same period in 2013. The payout ratio based on NFFO improved from 79.3% last year to 74.7% this year. CEO Thomas Schwartz described it as "one of the strongest first quarters" in the REIT's 18-year history.

Risks: All REITs are interest-rate sensitive. A sudden, sharp rise in rates (which is not likely) would have an immediate downward effect on the share price. A gradual increase in rates (more likely) may have some negative impact but that could be offset if the REIT continues its recent policy of distribution increases.

Distributions: CAP REIT currently pays $0.0983 per unit monthly ($1.18 per year). At the current price the units yield 5.2 %.

Who it's for: This REIT is suitable for conservative investors who are looking for above average yield. This does not mean it is without risk but CAP should fare better than most other REITs if the market turns sour.

Summing up: This is a quality REIT with a good track record in a stable business.

Action now: Buy. The shares closed on Friday at C$22.90, US$21.32. - G.P.

About the author:

Gordon Pape
GuruFocus - Stock Picks and Market Insight of Gurus

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