Special Feature

Diversify with real estate

This three-part series outlines opportunities available to clients investing in real estate, an asset class that is not correlated to traditional stocks and bonds. In part one, we examine the outlook for real estate mutual funds; on Thursday, the outlook for real estate investment trusts. The final article on Friday will highlight investing in mortgage investment corporations.
 

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The market does not believe a big interest rate increase is in the cards, which spells good news for REITs

By Dwarka Lakhan |

Prices for real estate investment trusts [REITs] in Canada and the U.S. have lost ground so far this year, but some portfolio managers are optimistic that the sector is poised for a rebound. 

"Since January [to the end of September], U.S. REITs [prices] are down 12% while Canadian REITs are down 11%," says Ben Cheng, president and chief investment officer with Aston Hill Financial Inc. in Toronto. However, he assumes "a 10% bounce in REIT valuations, which could result in a 10%-15% pick up in prices by June 2016."

As a result of the decline, REITs "are currently trading at significant discounts to the net asset values of their properties and are relatively cheap," says Derek Warren, assistant vice president and portfolio manager with Lincluden Investment Management Ltd. in Mississauga, Ont. At the same time, their yields have picked up appreciably, with spreads widening significantly to 5.5%-9%, he adds.

A major reason for the recent price decline has been the prospect of the U.S. Federal Reserve Board increasing interest rates, which has been on the table for most of this year. An increase in interest rates in the U.S. would boost the debt servicing costs of REITs, says Warren, while Cheng notes that the current value of their income stream would also decrease.

However, the market now believes that potential increase in short-term rates will not be as great as first anticipated, Cheng says. That suggests the threat of higher costs will disappear, leading to a pick-up in REIT prices.

Over the long term, Cheng expects REITs to "provide returns in the high single digits or around 8% to 9%, which is very compelling."

In addition to providing potential capital appreciation, REITs are also an income vehicle. Cheng says the average distribution yield of REITs is around 5%, Cheng says. (About 10%-20% of REITs provide no distributions.) However, "the average investor can put together a portfolio in the 6%-7% yield range, without making sacrifices in quality," Warren says. In comparison, bonds are yielding between 3% and 4%, he says.

The performance of REITs is also tied to the health of the economy and the outlook for rents, says Warren: "If the economy is good, then rents will be stable."

Cheng notes that the weakest real estate market in Canada is in Alberta because of low oil prices, which have been a drag on the provincial economy. On the other hand, his long-term outlook for occupancy and rental income properties in Ontario and Quebec is positive.

From a subsector standpoint, REITs that invest in industrial real estate are still attractive, Cheng says, although it would seem unlikely given the cyclical nature of the sector, which is usually tied to overall economic conditions. Meanwhile, office space REITS are "most desired by institutional investors and in high demand," making these REITs attractive.

Cheng is worried about long-term prospects of retail real estate REITs. "As online shopping accelerates, retail malls are struggling to attract shoppers." However, within this sector, he believes malls and shopping centres that are anchored by grocery stores will remain steady.

The residential REIT market for apartments is also attractive and is probably the next area of interest for pension funds, says Cheng. Warren notes that large Canadian and U.S. pension funds have been accumulating properties in this sector. Warren also sees potential in the retirement home sector, which has experienced significant merger and acquisition activity.

This is the second article in a three-part series on real estate investing.

Next: Investing in mortgage investment corporations