Challenging times may be ahead for all types of real estate, not just housing.
Real Estate Investment Trusts, most of which hold commercial properties, have been a stalwart in the portfolio of income-seeking investors for years now. But with speculation of a rate increase in December by the U.S. Federal Reserve, REITs have been volatile. The S&P/TSX Capped REIT Index was off almost 8 per cent from its 52-week high as of Oct. 17 and has underperformed the broader S&P/TSX composite index in the past few months.
Real estate is synonymous in this country with investing success, both in the commercial and residential sectors. But we're entering a period of uncertainty for the sector. The federal government has introduced several measures to cool the residential market, and now commercial real estate is facing headwinds. Real estate remains a core long term financial asset, but it's time for all investors to re-visit their holdings to see if they're overly exposed.
In a recent column, I suggested people with a lot of their net worth tied up in their house to be careful about investments in securities that hold residential mortgages. Now, it's time for caution about commercial real estate as well. Beware over exposure to REITs.
The S&P/TSX composite index has a 3.1 per cent weighting to real estate, which means that any broad based Canadian equity fund or ETF pretty much automatically has some REITs in it. You could probably add some additional REIT exposure without being reckless. But there's a limit. If 10 per cent or more of your overall portfolio is exposed to the sector, you should consider your tolerance for seeing share price declines ahead.
Rising rates do increase the cost of borrowing for REITs, but they also improve occupancy rates in commercial properties. All in all, the improving economic outlook indicated by rising rates implies a neutral or even positive outlook for REITs. But REITs are also seen as an income play, and this type of investment tends to fall in price when rates rise. Utilities, pipelines, telecom and consumer staple stocks are similar.
If you're laser-focused on income and unconcerned about share price declines, then REITs may not present any worries. But investors do get unnerved by price drops in income investments. This is a key lesson of the plunge in preferred price shares that we saw over the past few years.
We've had great results from both commercial and residential real estate in recent years, but that won't always be the case. Prepare your portfolio now for the challenges ahead.