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Defying expectations, real estate investment trusts delivered some of the best market returns in Canada this year, driven by heavy demand for owners of industrial properties and apartment buildings.

Since Jan. 1, the S&P/TSX Capped REIT Index has returned 5.6 per cent, including distributions, while the total return of the broader S&P/TSX Composite Index is down 10 per cent over the same period. REITs have also delivered the second-best return of any TSX subsector this year, surpassed only by technology stocks.

The positive performance during such a brutal year for Canadian stocks is impressive enough, but it is particularly surprising because interest rates are rising.

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For close to a decade, rate hikes were widely expected to trigger a sell-off for publicly traded real estate investment vehicles. Lately, though, investors and analysts have come to see the sector in a completely different light. Rather than focus on underlying interest rates, they now put more stock in economic fundamentals.

“We believe that economic growth and supply demand levels are more important drivers of REIT performance than interest-rate changes, so long as the interest-rate changes are gradual and not unexpected," RBC Dominion Securities analyst Michael Smith wrote in an e-mail.

The paradigm shift marks a significant development. REITs started sprouting in the 1990s, offering retail investors a chance to invest in portfolios of commercial real estate, ranging from apartment buildings to office towers to industrial warehouses, but they caught fire in the wake of the 2008 global financial crisis. As interest rates and bond yields plummeted to record lows, Canadian investors went searching for stable securities that paid high dividends or distributions.

REITs pay most of their revenue out to investors in the form of monthly distributions − much like the income trusts that were essentially banned in 2006 − and they are also known for buying income-producing properties. Because they collect rent, they often earn stable and predictable cash flows suitable for monthly distributions. Low interest rates also reduced their mortgage costs.

Coming out of the financial crisis, Canadian REITs went on a stellar four-year run. But by 2013, the U.S. Federal Reserve was expected to start hiking interest rates, and doing so would send bond yields higher. Suddenly, the 5-per-cent or 6-per-cent annual yields that many REITs paid did not seem as attractive, and the sector went into a tailspin, with the S&P/TSX Capped REIT Index dropping 18 per cent in four months.

Ultimately, the fears of rampant rate hikes proved to be over the top and REITS found their footing again, but the experience left an indelible mark. Once rates really did rise, the sector was expected to sell off.

Five years later, this theory has been turned on its head. Both the Fed and the Bank of Canada have hiked their respective rates multiple times in 2018 − four times for the Fed and three times for the Bank of Canada − yet REITs have delivered one of the best sector returns.

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The gain is largely driven by companies that own apartment buildings − known as ‘multiresidential’ properties − and industrial warehouses. “Both sectors are benefiting from favourable demand/supply dynamics and a supportive economic growth backdrop, even though interest rates have been increasing all year," Mr. Smith wrote.

In many major urban markets, rental units are almost impossible to find, with the rental vacancy rates falling to 1 per cent in both Toronto and Vancouver, according to Canada Mortgage and Housing Corp. Since the start of the year, Canadian Apartment Properties REIT, one of Canada’s largest multiresidential property owners, is up 17 per cent before distributions, and Minto Apartment REIT is one of the few Canadian companies to have a successful initial public offering this year, with its stock up 27 per cent since the June IPO.

In the industrial property market, private-equity giant Blackstone acquired Pure Industrial REIT in February for $2.5-billion, signalling global interest in companies that own warehouse space to house distribution centres.

While REITs have defied conventional wisdom this year, analysts at CIBC World Markets have argued that it should not be all that shocking. After studying the sector’s movements in past rate-hike periods, they noticed that higher rates do not necessarily spell trouble for REITs.

One reason why: REIT returns are most often compared with the 10-year Government of Canada bond yield, and as the CIBC analysts said, ''central banks generally have limited influence on longer-term interest rates."

Reflecting on REIT returns recently, the analysts noted that “the current spate (year to date) of Canadian REIT outperformance versus the broader market is, on balance, supported by history and not just a one-off anomaly."

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The unknown heading into the New Year is whether this strength will persist. While the Canadian economy is still expected to expand, it isn’t clear if apartment and industrial properties will draw even more investors, helping to mask the woes of retail property owners struggling with a shift to the digital economy.

Retail accounts for 48 per cent of Canadian REIT assets, according to CIBC, and “absent any such outsized returns from these smaller sub-sectors [apartment and industrial] in 2018/2019, the direction and magnitude of retail performance could have a larger impact on the sector over the next 12 to 18 months,” the analysts wrote.

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