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Some smaller REITs are well-positioned to be taken over. (Alexei Popkov/Getty Images/iStockphoto)
Some smaller REITs are well-positioned to be taken over. (Alexei Popkov/Getty Images/iStockphoto)

REAL ESTATE

3 top picks for small-cap REITs Add to ...

Investors who bet on the big boys of Canadian real estate investment trusts have made good money in recent years, but it might be time to look further down the REIT food chain for tomorrow’s best deals.

The iShares S&P/TSX Capped REIT index, which is dominated by the country’s biggest REITs, has gained about 83 per cent, including reinvested distributions, over five years as it recovered from the 2008 financial crisis, but this year the benchmark has been flat, suggesting that many investors regard it as fully valued.

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By looking beyond the index, investors can find opportunities that are below the radar among smaller players that may “give a nice yield advantage and provide some good returns,” says Derek Warren, a portfolio manager with Morguard Financial Corp. “You can benefit from capital appreciation if the business grows over time.”

Smaller REITs are still able to make acquisitions that can substantially increase their earnings per share, while larger players are having a tough time finding takeover opportunities big enough to have a significant effect on their results, he said.

In addition, smaller REITs offer a degree of protection if market winds begin to shift and money managers decide to dump their real estate holdings to invest in another hot sector. In that scenario, most of the selling pressure would be directed at the biggest, most easily traded names, rather than smaller firms.

Some smaller REITs and real estate operating companies are also well positioned to be swallowed up by larger players, which could produce big takeover premiums.

Cominar REIT acquired Canmarc REIT last year at a 24-per-cent premium to the price that Canmarc was trading at before the takeover bid was launched. On Tuesday, shares of C2C Industrial Properties Inc. surged 26 per cent after Dundee Industrial REIT announced a takeover bid for the company.

Still, smaller REITs can come with higher risks because they may not always be able to get financing for acquisitions that will add value and sustain their yield, Mr. Warren warned.

“Be very cautious when it comes just buying small companies with high yield. It is much better to invest in a company that has a slightly lower yield, but with good growth prospects … somewhere in the 7-per-cent range, but not 8, 9 or 10 per cent.”

Here are three top picks among smaller-cap REITs from real estate equity fund managers.

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Derek Warren, portfolio manager, Morguard Financial Corp., CIBC Canadian Real Estate Fund

Pure Industrial REIT

Annual distribution: 0.312 cents a unit for yield of 6 per cent

Last close: $5.20

The REIT, which owns industrial properties across Canada, has an average lease of about nine years on its properties, which means its cash flow and yield over that period are highly predictable. “This is a very safe dividend payout,” Mr. Warren said. Unlike many large-cap peers that have payout ratios exceeding 90 per cent, the comparable figure for Pure Industrial is only 82 per cent. Pure Industrial REIT trades at roughly 13.5 times its estimated adjusted funds from operations (AFFO) for 2014 – a reasonable valuation, he said. He has a one-year target of $5.75 a unit.

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Jeffrey Olin, manager, Vision Capital Corp., Vision Opportunity funds

InterRent REIT

Annual distribution: 16 cents a unit for a yield of 2.5 per cent

Last close: $6.39

Mr. Olin says that InterRent, which operates apartments mainly in Southern Ontario, has an experienced management team that typically looks to acquire properties where the REIT can add value. “They don’t buy coupon-clipping assets.” Besides raising rents, it will increase revenue by adding new suites in existing buildings or reduce costs by installing submeters for hydro consumption that will be paid by tenants, he said. The REIT, which could climb to the $7.50-to-$8 range in one to two years, is expected to raise its payout this year, he added.

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Lee Goldman, co-manager, First Asset Investment Management Inc., First Asset REIT Income Fund

Morguard North American Residential REIT

Annual distribution: 60 cents a unit for a yield of 5.4 per cent;

Last close: $11.22

The apartment operator has 55 per cent of its properties in the United States and the rest in Canada. “We expect most of the growth to come from the U.S.,” partly owing to an improving real estate market and higher-quality properties, Mr. Goldman said. The REIT, which could raise its payout next year, trades at a discount to peers, and to an estimated net asset value (NAV) of $12.75 a unit, he added. Morguard Corp., a long-term shareholder, owns 49 per cent of the REIT so there won’t be takeover premium priced into it, but “the discount is pretty extreme right now,” he said.

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