Real Estate Investment Trusts (REITs) have been richly rewarding for investors in recent years, but some fund managers wonder whether it’s time to look for greener pastures.

“It’s a crowded [place], and looking expensive,” says Alex Sasso, CEO and portfolio manager with Calgary-based Hesperian Capital Management Ltd. in Toronto.

The financial meltdown led to a precipitous drop of 38% for REITs in 2008, but they have been on a tear since, fuelled by a strong Canadian real estate market and low interest rates. The S&P/TSX capped REIT index showed a three-year average annual return of 23% as of Sept. 30; and for the nine months ending on that same date, REITs gained 16%, based on regular distributions and strong share price increases.

“There has always been a component of REITs in our income funds, but the convergence of positive circumstances that have helped REITs could change,” says Les Stelmach, vice president of Bissett Investment Management Ltd. in Calgary and co-manager of Bissett Strategic Income Fund and Bissett Canadian High Dividend Fund, sponsored by Toronto-based Franklin Templeton Investments Corp. “We’ve been harvesting some gains and are at the ebb of our REIT exposure. It’s a reflection of the good performance of REITs and a desire to reallocate and to take advantage of opportunities elsewhere.”

Tom Dicker, portfolio manager with GCIC Ltd. in Toronto and co-manager of both Dynamic Global Real Estate and Dynamic Real Estate Infrastructure funds, sponsored by Toronto-based Bank of Nova Scotia‘s wealth-management division, says valuations are no longer cheap: “By almost every metric, REITs are close peak or through the peak of the last cycle.” But, he adds, the spread between the juicy 5%-6% average yields on REITs and the 1.7% yield on a 10-year Government of Canada bond is higher than historical averages, which makes REITs still enticing.

“Many baby boomers and retirees,” says Dicker, “have based their retirement lifestyle on higher return expectations than they can get in fixed-income securities like bonds today, and they are having to look elsewhere.”

REITs offer steady income based on stable cash flow from rents, hotel room fees and leases. The fact that REITs own physical assets such as apartment buildings, office towers, seniors homes, hotels, industrial complexes and shopping malls also is comforting at a time when governments are adding to the money supply and setting the stage for future inflation. REITs have the ability to pass along any inflation in their costs to their tenants in the form of higher rents, and REITs have been benefiting from high occupancy rates in strong Canadian markets in which income-producing real estate is not in oversupply.

The vulnerability of REITs lies in their sensitivity to a rising interest rate. Although most fund managers don’t predict an imminent or substantial increase in the interest rate, the next move is likely to be upward. A higher rate could eat into the cash flows on properties and hurt REIT distributions. In addition, as the yields become more attractive on competing securities in the fixed-income arena that are not subject to the same business fluctuations and vacancy risks as REITs, investors looking for safety and income could shift back into bonds as those interest streams improve.

“REITs are heavy consumers of debt capital,” says Scott Lysakowski, vice president of RBC Phillips Hager & North Investment Counsel Inc. and lead manager of PH&N Canadian Income Fund. “And any change in interest rates affects their financing costs.”

On average, he says, Canadian REITs are trading at 18 times free cash flow – richer than the historical average of 15 times and also exceeding the S&P/TSX composite index’s price/earnings ratio of 13 times, which is a comparable measurement. Meanwhile, Canada’s big banks, which also offer a healthy income with an average dividend yield around 4%, are trading at only 10 times earnings.

“We maintain a core holding in REITs due to their attractive yields and stable characteristics,” says Lysakowski. “But, given their valuations, we have been deploying some assets to Canadian banks, where the valuations are more reasonable.”

Lysakowski has been “high-grading” the PH&N fund’s REIT portfolio, moving toward higher-quality REITs with strong balance sheets and sustainable distribution payouts: “We want management teams that exude a certain level of conservatism. In a period in which low borrowing costs have led to elevated property valuations, we want to see a disciplined management team that is careful in the way it deploys capital and assesses future acquisitions.”

Among the REITs Lysakowski favours are Boardwalk REIT, which specializes in residential apartments, and Brookfield Office Properties Canada REIT, which focuses on office property and Canadian REIT, which focuses on retail and office properties.

Other risks facing REITs are a material slowdown in the economy or a broad recovery in stock markets that leads to greater confidence and a willingness to venture from the safe havens of conservative, steady-income securities and into more growth-oriented stocks.

“REITs have been viewed as a safe haven,” says Lee Goldman, senior vice president and portfolio manager with Toronto-based First Asset Investment Management Inc., which sponsors two closed-end funds and a mutual fund specializing in REITs. “But in a ‘risk on’ environment, they could experience some weakness as investors focus on growth rather than on yield.”

Several fund managers are seeking REITs that have staggered debt-maturity schedules spread out over the next decade, so that if the interest rate rises, these REITs will not be forced to renew all their debt at the same time.

Stelmach favours a number of niche REITs, including: Cominar REIT, which focuses on office, commercial and industrial properties primarily in Quebec; and Northern Property REIT, which focuses on multi-family housing in northern Alberta, British Columbia and the Northwest Territories.

© 2012 Investment Executive. All rights reserved.