Take advantage of REIT ETFs

What is the appropriate weight for REITs in a portfolio? The capital value of REITs has been about as volatile as stocks, but REIT distributions are expected to remain within a stable range — 4.5% to 7%.

Long-term balanced portfolio

An average RRSP account has 60% equities, 40% bonds and a time horizon of more than 15 years. It will often include real estate the same way some pension funds do (for a list of the policy real estate weights for the largest funds, see “Canada: Largest,” this page).

Most institutions are at or slightly over their policy weights. The current interest rate environment, viewed by most as artificially low because of central bank intervention, may force institutions to consider alternatives to long bond positions. Real estate is a logical choice, so allocations may rise.

Most institutions get real estate exposure through direct property holdings, not REITs. Direct property has different risk characteristics than their public-market cousins, including lower volatility and restricted liquidity.

“Commercial real estate in Canada” (table, this page) shows the difference between actual commercial real estate distribution and the sector exposures of the three REIT ETFs that trade here.

The underweight to multi-residential is good news for Canadian REIT ETF investors. Overvaluation talk is primarily associated with the residential sector. However, multi-residential rental cash flow is considered stable compared to other sectors. As a result, it has a current capitalization ratio — the ratio of operating income to property value — of about only 5.2%.

Senior care is another source of stable income and also underweight among ETFs. Both of these sectors involve higher leverage, partly because of government subsidies either in financing, operating expenses, or both.

The debt-to-total-capitalization ratio is 45% for multi-residential and 56% for senior care. This compares with 34% and 33%, respectively, for comparable REIT sectors in the U.S.

The overweight to retail and office real estate is also evident, so Canadian REIT ETF holders need to be particularly aware of the outlook for those sectors.

Income portfolios

Including REIT ETFs in an income portfolio makes sense because they provide stability. Given the myriad risks involved, the diversification is also a boon. We looked at the dividend growth for REITs and the S&P/TSX Composite and found them to be virtually identical.

A J.P. Morgan study of U.S. REITs established they behave like common stock in the short term and real estate in the long term. This suggests income seekers willing to overlook short-term market fluctuations should reap the diversification benefits real estate offers.

Traders

Advisors with shorter-term orientations should know higher interest rates may make financing future acquisitions more expensive and access to capital more difficult, given already-leveraged balance sheets.

Canadian REITs have smaller capitalizations and higher debt-to-capitalization ratios than their American counterparts. And here at home, retail investors primarily own REITs, unlike institutional investors in the U.S. Since capitalization ratios are near historical lows, we should expect more volatility here.

The outperformance of Canadian real estate recently, compared with the U.S., is largely due to appreciation of relative property values. This is more likely to favour the U.S. over the next few years.

After any big run, investors want to know if there is room left to benefit. So, just be sure you use these instruments for what they can do in the future, not what they have done in the past.

Canada: Largest Pension Fund Policy Real Estate Weights

¹ March 31, 2011

² March 31, 2012

Source: Bentall Kennedy

Mark Yamada

Investments

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.