Canadian real estate investors have done very well since 2009. The real estate market did not tumble as far as the U.S., as Canadians were not as highly leveraged and did not have many or large MBS (Mortgage Backed Securities) issues. In fact, for personal mortgages, the Canadian banks were not as exposed to highly-leveraged mortgages, as the federal government - via a government-owned entity: The Canada Mortgage and Housing Corporation (or CMHC) - assumes the risk, and insures highly-leveraged mortgages.
The non-residential property classes suffered, but not as extremely as real estate in most of the other developed countries - the Canadian government, banking and resources sectors rescued the economy, and this provided a floor for property prices. One of the government's contributions was to reduce the Canadian Prime Rate to 1%.
The impact was a boom in Canadian real estate prices, and share prices for REITs (Real Estate Investment Trusts). iShares S&P/TSX Capped REIT Index ETF (XRE:TSX) tracks the S&P/TSX Canadian REIT Index. As you can see from the 5-year chart, Canadian REITs have done extremely well from spring 2009 to May 2013.
The Bank of Canada governs Canadian interest rates, and has been warning of impending interest rate increases. A recent example:
As Mark Carney makes his final announcement as the Governor of the Bank of Canada, the central bank continues to warn investors that its next move on interest rates will be higher.
Since then, the "smart money" (professional investment managers and funds) has been exiting many of the interest-rate-sensitive securities. One can see this in the volume spike during the decline. That said, there is a huge local demand for REITs, as identified in this article on Canadian Initial Public Offerings (IPOs) in 2013:
REITs have dominated the IPO market over the last year because unit holders use the steady income they generate as shelter against overall market volatility amid an uneven global economic recovery. Of the 13 new issues in the latest period, four were REITs, PwC's survey shows.
Despite investor interest, the threat of increasing interest rates has impacted the REIT sector - there has been a 15% drop in prices, with a corresponding 15% increase in yield. The 6-month chart "says it all":
The question for high-yield oriented investors is: Is this an opportunity to "buy on dips" or a time to exit? In other words, is there a disconnect between the current price of REIT units and the potential gains?
First, let's consider the Canadian REIT market:
The old adage that opportunity arises from adversity seems apt for the evolution of real estate investment trusts (REITs) in Canada. Marking a 20-year milestone this month, the collective real estate ownership investments have evolved into a market with about 37 TSX-listed trusts, a market capitalization worth at least $72-billion, and assets worth more than $100-billion. Despite a recent dramatic pullback, portents of the demise of this roaring sector are premature...
There's little doubt that interest rates will eventually rise to the point when investors will inevitably commence comparison shopping. But now is not the time to question the wisdom of investing in, or bailing on REITS. Consider that only 10% of Canadian real estate is publicly securitized, which means compared to the U.S., the REIT sector in this country is still in its infancy. Furthermore, industry players predict most commercial real estate in Canada will eventually be converted into a real estate trust. Sure, REITs have come down from their heady heights and are currently trading at a discount of 5% to 7% to net asset value, but many industry analysts still expect total returns from the sector to be in the 10% to 12% range. By any measure, those numbers are worth celebrating.
Not everyone is optimistic, but the yields improve with lower prices and provide investors with a solid return.
Paul Gardner, partner and portfolio manager at Avenue Investment Management, is a little more pessimistic.
"You won't see much price appreciation from this sector," he says. While he expects REIT units to continue trading around their current levels, he still thinks the sector has solid fundamentals.
"[Building] vacancies are at an all-time low, there's been very little overbuilding of commercial and office properties, pension plans are aggressively buying in the sector. And even if the trading price of the REIT units doesn't go up, the yield being paid is still competitive."
Next, let's examine the business model of a REIT. At a big-picture level, it is: Buy properties; finance them; manage operational costs; and, rent/lease them out for more than the total costs. The largest cost is typically depreciation, which is a non-cash expense, so can be returned to the shareholder as a distribution.
Many Canadian REITs have leveraged the opportunity of low interest rates to refinance existing mortgages, issue preferred shares, convertible debt, and long-term debt, and, expand their portfolios by buying more Canadian and U.S. properties. The various forms of financing tend to be for long terms, and at low rates.
The impact of a future rate increase on RioCan's (OTC:RIOCF) operations will be limited, at least in the short term. Only 6.3% of the total debt is at a floating rate, which means the vast majority of the debt will be isolated against the impending long-term rise in interest rates.
RioCan's website specifically describes the long-term, low-rate, debt financing strategy:
As at March 31, 2013, RioCan had eight series of Debentures outstanding totaling $1.4 billion (December 31, 2012 - eight series totaling $1.3 billion). During the First Quarter, RioCan issued $250 million of five year senior unsecured debentures at interest rate of 2.87%. Subsequent to the quarter end RioCan has filed a Redemption Notice for the $150 million Series M debentures that carry a 5.65% coupon and issued $200 million Series T ten year senior unsecured debentures at an interest rate of 3.725%;
In other words, RioCan (and other) REITs have locked-in low costs for a long period of time. Investors in real estate expect this - REITs are often low-growth, and typically delivering the most of their returns in the form of higher yields. The long-term, low-rate financing, should enable RioCan (and many other Canadian REITs) to generate a stream of high income and distributions, regardless of whether the Bank of Canada increases interest rates by 0.25%.
The table is a list of many Canadian real estate companies and REITs (REITS are bold) - the ones that I have found that trade in the U.S. The data is courtesy of Barchart.com, except for the yields, which are from CIBC Investors Edge (a Canadian discount brokerage, which provided me better yield information on Canadian securities). It demonstrates that even a 2.5% increase in rates - one magnitude more than the next anticipated rate increase - will permit investors to continue to earn a superior yield. I have sorted the securities by the current price/high price - this is a quick way to see the percentage price decline. I like to buy-in when they have dropped at least 20%. There are many real estate companies which meet this criterion and have attractive yields.
Regent Pacific Grp
Royal Host Inc
Partners Real Estate
Canadian Apt Pptys
Dundee Real Est TR
Cominar Real Estate Investment Trust
Killam Pptys Inc
Interrent Real Estat
Inn Vest Rl Est Inv
Brookfield Residential Propert
H&R Real Estate Investment T
Calloway Real Estate Investment Trust
Artis Real Est In TR
Chartwell Seniors Housing Real E
Riocan Real Estate I
Northern Ppty TR Ut
Retrocom Midmkt REIT
Crombie Real Estate
Morguard Real Est Ut
Canadian Real Estate
Amica Mature Lifesty
Boardwalk Real Estat
Allied Pptys R E Inv
First Capital Realty
Mcan Mtg Corp
Brookfield Properties Corp.
Btb Real Estate Invt
Whistler Blackcomb H
Brookfield Real Est
Lanesborogh Real Est
Firm Cap Mtg
Genesis Land Dev Cor
Medical Facs Corp
Pure Indl Real Estat
Lakeview Hotel Real
Melcor Development L
Cineplex Galaxy Inc
Additionally, as the U.S. economy recovers, and positions the rest of the global economy for growth, The Canadian (and many other countries') real estate markets should benefit. In other words, these investments will provide you high yield during the low market and better valuations plus high yield in more robust economic times. There will be volatility, but the long-term scenario appears good.
No investment is risk free, but many Canadian real estate companies are yielding "north" of 6% in a 1% risk-free (Canadian bonds) environment. As identified in a previous article, Canadian REITs can provide investors opportunities for higher yields with a degree of risk mitigation. Severable of these listed real estate companies - including Extendicare, RioCan, Brookfield Properties, and Morguard - have substantial U.S. holdings. A comprehensive list, with descriptions, is in this series of articles.
I am adding to my positions on dips (on down days, these securities trade within a few percent of their 52-week lows). If you plan to buy-in, be patient - there have been many days that the market for interest rate sensitive stocks, such as Canadian REITs, has fallen. For those who are building new positions in their portfolios, I would purchase iteratively; perhaps build your positions 25% at a time, over the next few months. You may also prefer to wait to see what happens to the U.S. and Canadian fiscal and monetary policies in September before acquiring a large position.
This is not to propose that buying Canadian real estate is following the investment herd - this is clearly a contrarian strategy: "In finance, a contrarian is one who attempts to profit by investing in a manner that differs from the conventional wisdom, when the consensus opinion appears to be wrong." My belief is that the rise in interest rates will not devalue real estate yield securities below the current level, and that the next few months provide investors an opportunity to lock-in at a high yield.
My largest industry holding is Canadian real estate, as you may have concluded from the disclosure of my positions. I like the asset class for many reasons - they are long-term, high-yielding, tax-deferred and with the exception of the 2009 financial crisis impact, assets that have tended to appreciate in value over the long-term. As a yield-oriented investor, the steady and high distributions from "assets that I can touch," is what I find most attractive.