In troubled times, many real estate investment trusts, or REITs, still offer high income, moderate growth and low risks.
Canadian Real Estate Investment Trusts have outperformed the Toronto Stock Exchange 300 index in 2001.
REITs generated unweighted total returns averaging nine percent while the TSE 300 had a -26 percent performance as of Sept. 28, 2001.
As well as providing high current yields, most REIT unit prices except for hotels have been firm in 2001 as a result of declining interest rates, higher cash flow or funds from operations per unit. And, in a weakening economic environment, they appeal to investors because of their contractual revenue streams.
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REITs’ superior returns have been achieved with low price volatility and low price correlations with the TSE 300.
In other words, REIT price movement hasn’t necessarily moved in tandem with the Canadian index.
REIT fundamentals remain healthy for Canadian office, retail and industrial space with positive prospects for growth in cash flow, or funds from operations, in 2001, 2002 and beyond.
Because of relatively dormant construction in recent years and low interest rates, the sector enjoys high occupancies and firm rents.
In the near term, the strongest income trends are expected for apartment REITs, due to a tight supply of apartments and falling energy costs, and for REITs with the financial capacity to buy more property.
Near-term income weakness is expected for hotel REITs, owing to reductions in business and personal travel in the aftermath of the attack on the World Trade Center, and to a slowing economy.
In our view, variations in prospects among REIT property-type sectors are already reflected in the relative pricing of REIT units.
However, because of the unpredictability of travel industry trends in the near-term, risk-sensitive investors may want to limit their exposure to hotel REITs.
REITS, excluding hotels, are trading at 7.9 to 11.5 times estimated 2001 cash flow per unit and have yields of 7.4 percent to 11.9 percent.
Also, in our estimation, they are trading within 10 percent of their net asset values – value of total assets less total liabilities of the REIT – in almost all cases.
High current yields, estimated cash flow growth averaging two percent in 2001 and six percent in 2002, and firm price-cash flow multiples should generate attractive risk-adjusted returns.
Most Canadian REITs distribute less than their cash flow after appropriate reserves for maintenance-type capital expenditures.
Almost all of the others should achieve this objective by 2003.
REITs, with the exception of hotels, should continue to provide combinations of high income, moderate growth, and strong financial positions that are appealing on a risk-adjusted basis.
In the near-term, we believe that their units will likely continue to receive boosts from falling interest rates and capital flows diverted from other market sectors experiencing cuts to earnings estimates and stock valuations.
Investors considering a REIT may want to ask if there is a clear property-type focus, such as offices and retirement homes, and good quality underlying assets; strong management, preferably internal; favourable past and anticipated cash flow growth; access to capital; sustainable cash distributions; and reasonable pricing.
A commitment by management to create or realize shareholders value doesn’t hurt either.
On this basis, we consider as attractive the Rican REIT the largest Canadian REIT focused on shopping centres; O&Y REIT, a high-quality Canadian office REIT; and the Retirement Residences REIT.
For the longer term, we believe REITs will attract a greater share of investors’ capital as the bulk of investors age.
Ian Morrison is a financial consultant with Wood Gundy Private Client Investments in Calgary. His views do not necessarily reflect those of CIBC World Markets Inc. This article is for information only. Morrison can be reached at 800-332-1407 or by e-mail at ian.morrison@cibc.ca.
