Recently, I used some of the “cash” that had accumulated in my Strategy Lab model dividend portfolio to purchase additional units of the iShares S&P/TSX Capped REIT Index Fund (XRE).
Today, as promised, I’ll elaborate on my reasons for doing so. So let’s dive right in.
Reason No. 1: The price has tumbled
XRE, an exchange-traded fund that holds a diversified basket of 15 real estate investment trusts, peaked at $17.99 on April 30 – right about the time bond yields started marching higher. When I pulled the trigger on my Sept. 3 purchase, XRE’s price had fallen to $14.84 – a hefty drop of 17.5 per cent, excluding distributions.
Some investors might look at the sharp selloff in REIT-land and think the sector is way too risky right now. I see it differently: Prices have already fallen hard, so fears of rising interest rates are already baked into REIT prices.
To my mind, REITs are actually less risky now than they were when everything seemed hunky-dory a few months ago. As the late fund manager Sir John Templeton once said: “The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.”
Reason No. 2: Yields are rising
Will REIT prices fall further? I don’t know. They’ve actually rebounded a little since I added to my position. As a long-term dividend investor, my goal is to build a portfolio of solid companies that will pay me a growing stream of cash for the rest of my life. If I can add to my positions when prices are down, I get more income for every dollar I invest.
In the case of XRE, the yield has risen to 5.2 per cent from about 4 per cent in April, reflecting the lower unit price and an increase in the fund’s monthly distribution.
Many of the REITs that the fund holds have raised their payouts in the past year – some, such as Canadian REIT, have raised it more than once – and I expect this trend to continue.
Reason No. 3: Rates are still very low
Even after a roughly one-percentage-point jump in 10-year government bond yields, REITs are still able to refinance their maturing debt at attractive rates. According to CIBC World Markets analyst Alex Avery, average interest rates for commercial REIT mortgages expiring in 2013 and 2014 are 5.5 per cent and 5.3 per cent, respectively – significantly higher than the 10-year mortgage rate of about 4.6 per cent available today.
“This suggests a high probability that most REITs continue to enjoy the benefits of refinancing at lower interest rates well into 2014,” Mr. Avery said in a recent note.
Reason No. 4: Rising rates aren’t all bad
Rising interest rates signal an improving economy, which is good for REITs that own office, industrial, retail and other types of property. In addition to enjoying solid occupancy levels, many REITs will be able to renew expiring leases at higher rates, providing a boost to cash flow and, ultimately, distributions to unitholders. This will help to offset any interest rate-related pressure on unit prices.
Reason No. 5: Yield spreads are favourable
From 2002 to 2007, the spread between REIT distribution yields and Government of Canada 10-year bond yields averaged 332 basis points (a basis point is one one-hundredth of a percentage point). The spread has since widened to 412 basis points, according to Mr. Avery’s Sept. 5 report. This indicates that REITs are already pricing in higher government bond yields.
All that said, REITs aren’t risk-free. If bond yields rise sharply, REIT unit prices will likely come under pressure. What’s more, individual REITs face specific risks with respect to financing, occupancy levels and rental rates depending on the type of real estate they own and the geographic markets they serve.
Owning a diversified collection of REITs through an exchange-traded fund such as XRE is one way to minimize company-specific risk. (Disclosure: I also own XRE personally.) Another ETF worth considering is the BMO Equal Weight REITs Index ETF (ticker: ZRE). To further control risk, in my own portfolio I keep my REIT exposure to less than 10 per cent.
Real estate is hard to beat as a long-term investment. Businesses will always need office buildings, warehouses and industrial space, and consumers will need apartments and retail stores. While real estate values – and REIT prices – will fluctuate, these bricks and mortar investments will likely provide growing distributions for years to come.