What to look for in a REIT

For the general characteristics of REITs and how to tell if they’re right for you, read this article.

Michael Missaghie, Senior Portfolio Manager, Sentry Investments

Investmentstrategy

When it comes to REITS, we focus on companies rather than sectors. We seek consistent cash flow that grows over time, sustainable capital structures, and management teams that effectively deploy capital. I’d suggest Boardwalk and Allied Properties REITs.

Boardwalk is an apartment REIT with a well-aligned management team. It has a history of delivering strong free cash flow growth.

Allied Properties operates in the office asset class but eschews larger urban or suburban buildings. Instead, it operates industrial buildings retrofitted to act as office buildings in Canada’s major urban markets.

Internationally, we’ve allocated capital to opportunities in the U.S., Europe, Australia and Asia. The U.S. has the world’s largest public REIT market, with REITs trading at attractive valuations and poised to deliver free cash flow growth buoyed by an economic recovery.

The U.S. also has unique asset classes unavailable in most other geographies — student housing, data centers and cell towers.

In Europe, we’ve identified REITs that can provide above-average free cash flow growth in an economy on the mend.

Selectionprocess

We focus on factors that we remember using MAPLe — management, assets, payout ratio and leverage.

Management:

We seek management teams that align with investors, which usually means they’re large shareholders of their own companies.

Assets:

We look for REITs with assets of enduring value. A compelling example is Toronto’s privately owned Eaton Centre. Shoppers continue to flock to the asset despite the bankruptcy of the namesake tenant and ever-changing tenant mix, thus drawing retailers and ensuring continued cash flow.

Payout ratio:

REITs with sustainable distribution payout ratios and growing free cash flow are good candidates. CREIT (Canadian Real Estate Investment Trust), for example, has a strong history of operating at a sustainable payout ratio, thus increasing distribution over the last decade, despite a financial crisis.

Leverage:

We look for REITs with no more than 10% to 15% debt maturing in a particular year.

Futureprospects

The REIT sector has experienced some volatility in recent months as investors contemplate the impact of rising rates. But compared to historical norms, we are still in a low-growth, low-interest-rate environment where REITs’ stability, yield and cash flow continue to look attractive.

Fundamentals (occupancy and rent) remain sound across all asset classes while commercial real estate supply in Canada remains below average.

New office supply is coming to key markets like Toronto, Vancouver and Calgary. While the majority of these assets have some pre-leasing, we’ll need to monitor the effect the new space has on existing assets, and weigh whether there’s continued demand from tenants.

Finally, we expect larger retail REITs to perform well because of stable consumer and tenant demand, especially from U.S. retailers. The Canadian retail REITs have already done a good job selling their lower quality assets over the last few years, and recycling capital into urban and high-quality suburban assets. REITs like RioCan and First Capital are now involved in mixed-use (retail, office and residential) real estate projects in downtown cores that should be a strong driver of value.

Catherine Ann Marshall, CFA, Vice-Chair, Toronto CFA alternative assets committee, former research director, CPP investment board

Multiple choices

If you’ve decided against physical assets, then stocks and real estate products are other viable choices.

Equity funds:

REITs move in sync with the overall stock market and should be seriously considered if you’re indifferent to the general variability of the price and concerned only with a monthly distribution. But REITs can easily oscillate between a premium and discount to net asset value, and these valuations can change quickly.

Still, once you get past the volatility, REITs have their virtues. Since they’re secured by real estate, they produce stronger income than bonds. You’re protected against any single property or tenant having a serious impact on the investment’s performance. Professional management also protects you by managing potentially problematic events.

For instance, when the Bay wanted to sell Zellers to Target, most negotiated successful transitions to Target as a new tenant. But when Target didn’t assume the Zellers lease, REIT managers had to negotiate to protect their organizations from the financial hardship of losing an anchor tenant in their shopping centres.

Private funds:

Another choice for sophisticated investors is private funds. Gradually growing in popularity, they represent a conservative, low-volatility investment as long as they’re well diversified and don’t engage in risky development activities. They range from funds offered by large investment management companies, such as life insurers, to specialized investment companies with private wealth divisions, like Fiera Capital or Connor, Clark & Lunn.

Investments are typically made via a collective investment scheme that pools capital from investors into open-ended funds. The negative aspect is that these investments are illiquid, compared to REITs. You can only sell shares back to the fund and must follow the fund’s rules around how and when you can sell the units back.

Funds are sold through the broker-dealer network and typically have a 10-year life span consisting of a two-to-three-year investment period during which properties are acquired, and a holding period during which active asset management is carried out and the properties sold.

A big drawback of these investments is they’re not liquid until the properties are sold. With the help of your financial advisor, review marketing material for the fund’s investment strategy and policy, and look for key words like diversification, low risk and steady income.

Real estate mutual funds:

This option, designed for average investors, invests in securities of Canadian companies involved in the ownership and management of real estate assets.

Outlook

Commercial real estate is anticipated to have a steady outlook, with little capital appreciation and a lot of income production. Residential real estate is a big question mark, though. During the low-rate environment of the last few years, many investors ventured into real estate and found it sounder than your typical stocks or bonds. Today’s rising interest rate environment, however, seems to suggest there might be downward pressure on prices.