How to weight 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 as of April 2013, REIT distributions are expected to remain within a stable range — 4.5% to 7%.

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.

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,” which is current as of April 2013, 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.