Since the Fed announcement in May, this year has not been kind to REIT investors. With the fears of rising interest rates, the premiums at which REITs trade over guaranteed premium investments are forced to rise, putting downward pressure on the price of REIT investments. Accordingly, the broad Canadian REIT market pulled back nearly 21% from the end of April and trades at a loss year to date around 17.5% on the Dow Jones Canadian REIT Index.
A Brief Summary of the Pullback and the Current Bear Market
In May of this year, the U.S. Federal Reserve announced that it expects to reduce its bond-buying program during the year. This signaled to markets the upcoming end of the low-interest environment, and sparked the end of the REIT Bull Market as REITs in Canada and the US started to pullback.
The rising interest rates have a major impact on the long-term financing of the REITs as many of them are well-leveraged to pursue their operations and acquire new properties. This effect is significantly more long term for REITs such as Riocan (OTCPK:RIOCF) which use fixed-rate debt, but will nevertheless affect refinancing in the future.
A more significant aftershock of this is the short-term impact on the stock valuations. REITs are more risky than a guaranteed principal investment such as a treasury bond or a Guaranteed Investment Certificate. As a result, REITs have to offer their investors a stronger yield or value proposition than guaranteed investments. As the rates achieved on guaranteed investments rise, the required yields on REITs have no choice but to follow suit.
For more information on the market condition change and U.S. REITs, I would recommend the following piece by a fellow Seeking Alpha contributor.
The Investment Proposition
The low interest environment since 2008 created a growth story in REITs as they were able to complete acquisitions and refinance under lower rates and accordingly improve operating results. This resulted in a significant bull market in REITs as investors looking for both yields and growth were lured to these investments.
Since the announcement in May, however, the story has changed. The decline in REITs is not a temporary pullback, but rather a change in underlying market conditions and by the looks of things is not about to change in the near future. As a result, investors looking to buy a share in any of these REITs should not count on a recovery and capital gain, but rather look at the income proposition of these REITs. The three REITs identified below continue to offer excellent value to investors based on their strong operating results and healthy yield:
With a market cap of $7.41 B and a massive chain of acquisitions in the pipeline, this is the largest Canadian REIT. It has outperformed its peer group slightly during the pullback and now sits near $24 with a yield of 5.73%.
As of the third quarter of 2013, Riocan had a portfolio of 54M square feet of net leaseable area, almost exclusively in Retail Space. These properties were primarily located in Canada, however, Riocan has been consistently expanding into the U.S., with American properties representing 17% of the total square footage. Average net rent per square foot was of $16.53 in Canada and $14.08 in the U.S. and the REIT had an occupancy rate of 97%. Riocan's FFO per unit stood at $0.40 for the quarter and $1.16 YTD, for a price-to-FFO ratio of 15.4.
Calloway trades at a market cap of $3.3 B and owns a portfolio of 133 properties comprising a total of 27 M square feet of gross leaseable area all located in Canada. The REIT trades with a dividend yield of 6.28%.
The trust has been heavily involved in acquisitions and works with the Smart Centres company to create exceptional and highly sought after rental properties. This is clearly evidenced through its higher occupancy rate of 99% and strong rental rate per square foot of $14.66. Calloway's shares generated an FFO of $0.469 in Q3 2013 and currently trades at a price to FFO ratio of 13.1.
With a market cap of $5.74 B, H&R is Canada's largest diversified REIT and offers a dividend yield of 6.34%. H&R has made the news recently with several major acquisition. Chief among these was H&R's acquisition along with KingSett Capital Inc. of competitor Primaris in a $3 B deal for a total of 8.7 M square feet of retail properties. The REIT also completed a 1/3rd acquisition of Echo Realty L.P., a grocery anchored retail REIT operating in the U.S.
Amid these transactions, H&R has become Canada's largest diversified REIT, owning a total of 53 M square feet between Office properties (26.1%), Industrial Properties (41.3%) and Retail properties (32.6%). The REIT achieved 98.2% occupancy across its portfolio of properties and a net lease rate of $14.56 per square foot. H&R reported an FFO per unit of $0.45 for the third quarter and $1.35 YTD, resulting in a price-to-FFO ratio of 11.8.
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YTD Price % Change
iShares TSX Capped REIT
REITs to avoid
During a bear market, it is important to avoid companies that are under-performing their peer group. Not only are these companies affected by the changing industry conditions, the underperformance is usually indicative of internal weaknesses and could result in even worse than market performance.
Of the 15 REITs covered by the Canadian REIT ETF - XRE - the following three are trailing their peer group:
As one of the hardest hit, with a year-to-date decline of -25.11%, Dundee is a more risky investment proposition. The REIT owns 24.5 M square feet of office properties. Its occupancy rate lags the peer group at 9.46%, although the net rent per square foot is relatively strong at $17.74. The trust generated $0.73 in the third quarter, and trades at a price-to-FFO ratio of only 9.6. The REIT's market cap is of $2.9 B and it offers an 8% yield for those brave enough to hold it.
This REIT owns a portfolio of 38,000 suites of residential apartment properties located primarily in Ontario and throughout Canada. Occupancy was relatively strong at 98.5%, and the REIT achieved an average rent of $1,003 per suite throughout the year. It generated an FFO of $0.426 per unit and currently trades at a price-to-FFO ratio of 12.2. This REIT yields 5.6% and saw a 17.67% decline since the start of the year.
The REIT's lack of diversification coupled with negative market pressure from residential properties is a significant risk for the future performance. For example, Toronto which represents 41% of its total properties is on the tail end of a condominium boom which saw 28K units sold at its peak in 2011, with a similar story in progress in Ottawa and Montreal. The strong condo development figures have resulted in a very saturated market and accordingly in pricing pressure and lower demand as prices for new condominiums remain attractive.
Another one of the worst performing REITs, with a year-to-date decline of 20.8% is the diversified REIT Cominar. Based out of Quebec, Cominar owns a portfolio of 36 M square feet of leaseable area, and trades at a market cap of 2.28B with an 8% yield. Cominar generated a net income of $0.46 per unit in the third quarter, and trades at 9.82 times earnings.
75% of the REIT's portfolio of properties are located in Quebec, which poses a significant diversification problem. Quebec has been in a slightly worse economic condition than the country as a whole, with an unemployment rate of 7.5% (6.9% National Average) and average weekly earnings of $840 ($918 National Average).
The REIT lags its peer group significantly in terms of occupancy with a 93.3% rate, and in terms of net lease per square foot with $10.19 across the portfolio.
Additional disclosure: I am also long through Canadian REIT ETFs ZRE and XRE.