Why Are REITs Losing Momentum?

After posting big gains in the first half of the year, real estate investment trusts (REITs) appear to be running out of steam. Here, Gordon Pape investigates.

As of the close of trading on Sept. 12, the S&P/TSX Capped REIT Index was down three per cent for the month. That followed breaking a drop in August that broke a winning streak that began at the end of February. Still, the index was ahead 12 per cent for the year at that point, so investors can’t be all that unhappy.

The upsurge in REITs earlier this year has been fuelled by investor demand for yield. With interest rates at their lowest levels in living memory, any security that provides decent cash flow has been a magnet for new money. REITs distribute almost all their cash flow to unitholders and virtually all have yields in excess of 4 per cent. Compare that with yields of around 1.6 per cent on five-year GICs and you can see why investors have been piling in.

The pullback this month appears to have been caused by growing investor awareness that the sector has become modestly overpriced plus concern that the U.S. Federal Reserve Board may move to raise its key interest rate at its September meeting.

Despite the recent retreat, many REITs are still outperforming their peer group, some by a wide margin. Here are a few of the big winners this year from the Recommended List of my Income Investor newsletter. Prices are as of the morning of Aug. 30 and do not include distributions.

Allied Properties REIT (TSX: AP.UN). Opened 2016 at $31.57. Current price: $37.50. Gain: 18.8 per cent.

Canadian Real Estate Investment Trust (TSX: REF.UN). Opened 2016 at $42.06. Current price: $49.29. Gain: 17.2 per cent.

Chartwell Retirement Residences (TSX: CSH.UN). Opened 2016 at $12.33. Current price: $15.65. Gain: 26.9 per cent.

However, not all REITs have benefitted from this cash inflow. For example, Boardwalk REIT (TSX: BEI.UN) is up only 6.4 per cent from its 2015 close of $47.25 and has lost more than $9 per unit in the past six weeks. The main reason is its heavy concentration (about 60 per cent of total assets) in economically troubled Alberta.

There are a lot of REITs on the market these days with more coming on stream all the time. So if you’re shopping for one for your portfolio, what should you look for? Here are some guidelines.

Increasing cash flow. In REIT terms, this is described as funds from operations (FFO) and it is one of the most important indicators of financial health. Any REIT that has a history of steady FFO growth is worth a look.

Distributions. Some REITs increase their payouts on a regular basis. Others do so only rarely and with apparent reluctance. Stagnant payouts may make the share price more vulnerable when interest rates rise.

Geographic diversification. REITs that concentrate their assets in one region are likely to run into trouble if a local economic downturn hits. Boardwalk REIT is a prime example. Choose a REIT that has broad national diversification.

Tax treatment: Some REITs structure their payments so as to provide tax advantages to investors with non-registered accounts. Others are less tax-friendly. Check the REIT’s website for details on how the distributions from previous years were taxed.