Bullish on REITs

It looks as though the bull market for REITs is not over yet. An analysis published by RBC Capital Markets in January predicted earnings growth of around 5 per cent for Canadian real estate investment trusts this year with distribution increases from about half of them.

REITs have been on a terrific run since their meltdown during the 2008-09 credit crisis. The S&P/TSX Capped REIT Index finished 2012 with a gain of 11.1 per cent, eclipsing the Composite Index which advanced only 4 per cent. Over the three years to Dec. 31, the REIT index added 47.1 per cent. The gain for the Composite Index was a puny 5.9 per cent.

So far in 2013, the REIT sector has been quiet with a year-to-date advance of only 0.3 per cent (to Jan. 30). But it’s early days and if RBC is right we should expect the REIT Index to be ahead by between 5 per cent and 7 per cent by year-end. So it’s not time to abandon the sector — in fact, you may want to consider adding to your positions.

However, it’s important to be selective. Not all REITs are created equal. The RBC team has identified six qualities they look for in recommending REITs for clients. They are:

  • Institutional quality property portfolios.
  • Longer-term track records.
  • A well-defined investment strategy.
  • An operating model with value-added potential.
  • Lower financial leverage and payout ratios.
  • Internalized/aligned structures.

REITs are attractive to income-oriented investors for several reasons. For starters, they offer above-average returns – most REITs yield 4.5% or higher with a few in the 6% range.

Second, they come with tax advantages. Part of the income is received as tax-deferred return of capital; the amount will vary between REITs.

Third, they offer inflation protection. That is not a major concern now but it will be at some point in the future. Inflation drives up the price of real estate thereby increasing the market value of a REIT’s portfolio. It also enables REITs to charge higher rents.

Here’s how the REITs on the Recommended List of my Income Investor newsletter fared over the 12 months to Jan. 18 (excluding Dundee International REIT which added in late November). Figures are supplied by Morningstar.ca and Globeinvestor.com.

Gordon-Pape-REIT-Chart-1302

As you can see, returns varied widely. The best performer was Allied Properties REIT which generated a profit of more than 37 per cent. Primaris (TSX: PMZ.UN) added almost 31 per cent with most of the gain coming after it became a takeover target. The latest news on that front is a friendly bid from H&R REIT at $28 a share, which has been accepted by the Primaris board. At the time of writing, the shares were trading around $27, a discount of 3.6 per cent to the H&R offer.

Speaking of H&R, it had the lowest one-year return of any of our picks at just under 4 per cent. That was largely due to a pull-back in the share price, which touched a 52-week high of $26.29 in August. At the current level, H&R offers one of the most attractive yields on our list at 5.8 per cent. Plus, if the Primaris bid succeeds it will become the largest REIT in Canada, supplanting RioCan.

If you are thinking about adding REITs to your portfolio, be sure to consult with a financial advisor first.

Gordon Pape’s new books, Tax-Free Savings Accounts and Money Savvy Kids, are now available for purchase at 28% off the suggested retail price at http://astore.amazon.ca/buildicaquizm-20. For information on a three-month trial subscription to Gordon Pape’s Income Investor newsletter go here.