The driving force behind the soaring prices of Canadian real estate investment trusts has been talked about so much that it’s almost cliché. Post-income trusts, investors hungry for yield need to park their money somewhere, and distribution friendly REITs just so happen to be one of the likeliest spots.
However, that argument is starting to draw its critics. Just look at how much REITs have already outperformed, they say. The S&P/TSX REIT index was up 22 per cent in 2011, beating the S&P/TSX Composite Index and its 9 per cent annual loss by a long shot. Something this good can’t last forever.
Forever, definitely not. But possibly for one more year? Alex Avery and the real estate research team at CIBC World Market think so, and they’ve outlined their reasoning in a new report.
No doubt, they mention the quest for yield as a driving factor, but even ruling that out, there are a number of other drivers behind the Canadian REIT market right now.
For starters, don’t conflate an overheated condo market with the REIT market. Though the heads of Royal Bank of Canada and Bank of Montreal are now warning about a bubble in Vancouver's and Toronto’s condo markets, these don’t directly relate to REITs. There are apartment REITs, sure, but these rely on rental income, while their peers focus on commercial and industrial buildings.
For these sectors, CIBC notes that their vacancy rates continue to fall, market rents are higher than the rents the REITS have locked in and there is very limited new construction. Tight supply should drive up prices.
Low interest rates are another key driver. REITs must continually re-finance their mortgages, and now’s the perfect time to do so. “Current 10-year commercial mortgage rates of [around]4 per cent and five-year mortgage rates of [about]3 per cent should provide considerable interest cost savings on REIT refinancing,” CIBC noted. Plus, cheap borrowing costs gives more incentive for the REITS to buy new properties and increase their cash flows.
Moreover, cheaper mortgages and more acquisitions should help to boost distributions. CIBC expects a return to “more normal, periodic distribution increases in 2012” after a three-year period in which they were very rare. Names most likely to increase include: RioCan , H&R and Chartwell .
CIBC also points out that property should start appealing to more pension funds and life insurance companies. For the most part these institutions target average annual returns of 7 to 8 per cent, and they aren’t going to get that from government securities this year. Real estate could be a safe place for them to park some more money, and any activity on this front should keep the sector hot.