Will REIT cap rates ever reach a bottom?

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For a brief moment in time, it looked like Canadian real estate investment trusts might just plateau. After a big run up over the past few years, there was a chance that investors were content with their real estate exposure and would consider piling into other sectors.

That didn't last very long. Over the past few months, REITs have taken off again, and the sector is up about 10 per cent in 2012 on an unweighted basis.

Given this heavy appetite, REITs have been able to fund acquisitions quite easily, and that continues to drive down capitalization rates – or the income generated from a property divided by its value.

(If a $1-million property generates $100,000 in income, its cap rate is 10 per cent. If that building's value jumps to $2-million, the rate falls to 5 per cent.)

Just when it seems like cap rates can't get any lower, new quarter-end numbers will come out and the market gets yet another shock. According to CB Richard Ellis, cap rates for office properties in Montreal, Ottawa, Calgary and Edmonton fell by 75 basis points in the first quarter; cap rates for apartment properties in Calgary fell by 25 basis points; industrial property cap rates fell by 25 basis points in Montreal and Ottawa; and hotel property cap rates compressed by up to 100 basis points in Calgary and Ottawa.

Driving this: strong demand for stable income-producing investments, easy access to low-cost debt (or ease of raising equity), and a scarcity of good-quality properties on the market, according to analyst Alex Avery at CIBC World Markets.

Because those fundamentals don't have much reason to change, at least not this year, Mr. Avery has predicted even lower cap rates by the end of 2012. For commercial properties, whose rates currently range from 5.75 per cent to 7.5 per cent, he wouldn't be surprised by another 50 basis point compression.

The big threat to this? Obviously, higher mortgage rates. For just a few weeks, it looked like this could become an issue when five-year and 10-year yields ran up. But they quickly reversed course.