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Dundee Reit - Entrust Tower in Ottawa. (Handout)
Dundee Reit - Entrust Tower in Ottawa. (Handout)

Funds

REITs open world of commercial real estate Add to ...

Like the idea of being a landlord but don’t relish the thought of evicting problem tenants or calling a plumber at 4 a.m.? With real estate investment trusts (REITs), you can get all the joys of property ownership without the hassles.

One of the easiest ways to indulge your inner Donald Trump is through an exchange-traded fund (ETF) that holds a basket of REITs. With a single purchase, REIT ETFs give you low-cost, broad exposure to a collection of companies that invest in office buildings, shopping centres, industrial real estate, apartments and retirement homes.

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But while these ETFs provide portfolio diversification and a steady flow of cash to supplement the anemic yields of bonds and GICs, investors should be careful not to overdo it. Prices of many REITs have risen sharply and could pull back if the economy slows, interest rates rise or the commercial property market cools.

“People are attracted to the yields that REITs pay right now,” said Kevin Gopaul, vice-president and chief investment officer at BMO Asset Management. Its BMO Equal Weight REITs Index ETF has grown to about $170-million in assets since it was launched in May, 2010.

ZRE holds 20 REITs of various sizes, but – as the name implies – each is weighted equally in the portfolio. For example, shopping centre owner RioCan is by far the largest Canadian-based REIT, with more than 300 properties in Canada and the United States. Yet RioCan accounts for just 5 per cent of ZRE’s holdings – roughly the same as Crombie REIT, which is a fraction of RioCan’s size.

Mr. Gopaul said equal weighting has several advantages.

First, because the portfolio is rebalanced semi-annually to bring the constituents back to equal weights, the fund effectively has to sell REITs that may be overvalued and buy those that may be undervalued. Second, by limiting the influence that any one REIT has on the portfolio, the ETF reduces “single-stock risk.”

Finally, by giving equal weighting to some smaller but higher-yielding REITs, the overall yield of the fund is higher than it otherwise would be.

ZRE currently has a “portfolio yield” of about 5.87 per cent, which refers to the yield of the REITs in the fund. To calculate the yield an investor would actually receive, one would subtract the ETF’s management expense ratio (MER) of about 0.62 per cent, for a net yield of 5.25 per cent. That’s substantially higher than the yield from GICs or most bonds. But in exchange for that additional yield, investors are taking on extra risk.

“REITs do not guarantee the level of distributions to unit holders. Their payouts can fluctuate, or disappear, but they rarely vanish in totality,” said Adrian Mastracci, portfolio manager with KCM Wealth Management in Vancouver. “REITs are generally subject to the financial health of their tenants. Tenant bankruptcies, prevailing business conditions and the direction of interest rates can all have an effect on vacancy rates.”

As a rule of thumb, he recommends that investors allocate no more than 12 per cent of their portfolio to REITs.

The largest REIT ETF in Canada is the iShares S&P/TSX Capped REIT Index Fund . It uses the more traditional market capitalization methodology, which gives a bigger weighting to larger companies. RioCan is its largest holding, with a weighting of about 24 per cent – more than 10 times that of the smallest constituent.

XRE has the same management fee as ZRE, but fewer holdings, at 13, and a slightly lower net yield of about 4.78 per cent. With about $1.35-billion in assets, however, XRE is nearly eight times as big as its competitor from BMO. And it’s still growing fast: Investors have poured nearly $500-million into XRE in the past three years.

“We’re in an environment where returns have been low and hard to achieve, so something like this is attractive to investors,” said Mary Anne Wiley, head of iShares Canada.

Another thing REITs have provided, in addition to income, is capital appreciation. XRE posted a total return, including dividends, of 20.8 per cent in 2011. ZRE gained 13.9 per cent.

Ms. Wiley disputes the notion that equal weighting is a superior methodology. With equal-weighted portfolios there are more trading costs because the fund manager has to trim certain positions and raise others each time the ETF is rebalanced, she said. Also, some of the smaller REITs are less liquid.

As for diversification, she said market cap weighting is preferable. A large REIT such as RioCan deserves to have a substantial weighting, because the scope of its real estate holdings provides more diversification than a REIT that is much smaller in size, she said.

Mr. Mastracci of KCM Wealth Management said investors can obtain further diversification by investing in real estate outside Canada. One option is the Claymore Global Real Estate ETF , which has about 84 per cent of its holdings in the United States and Asia.

This ETF has had a rockier ride, however, falling about 4.5 per cent, including dividends, since inception on Aug. 26, 2008 – a reminder that real estate doesn’t always go up.

Follow on Twitter: @johnheinzl

 
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