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A buying opportunity is emerging in real estate investment trusts, but read the fine print before you jump in. It says REITs are becoming an attractive buy for income-seeking investors willing to risk more price declines in the near term. Those looking for the kind of growth we saw in the past few years should take a pass.

"This summer is the time to buy in [to REITs] and increase the yield of your portfolio," said Derek Warren of Morguard Financial Corp. "Just be prepared for increasing volatility, and don't expect REITs to go straight up to new highs. That's over."

After a thrashing in the bear market of 2008-09, REITs became one of the happiest stories in the Canadian stock market. The S&P/TSX Capped REIT Index produced total returns (monthly cash distributions plus share price changes) of 19.7 per cent annually over the three years to Dec. 31.

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REITs hit the wall in May when U.S. Federal Reserve chairman Ben Bernanke began talking about reducing the central bank's massive government bond-buying program later this year. Buying bonds helped the Fed keep interest rates low. Now, investors are looking ahead to higher rates and they're selling bonds and stocks they see as vulnerable. Utilities and pipelines are in this group, and so are REITs.

The concern with REITs is that they will become less profitable as rising rates increase the cost of financing their acquisitions. This is the primary reason the REIT index has plunged 8.5 per cent on a total return basis for the year through July 30. "The fundamental environment for REITs – from occupancy to rental rates – is very good," said Alex Avery of CIBC World Markets. "But the narrative is broken for the sexy story of why you should own REITs instead of something else."

At the portfolio management firm PUR Investing, the managers took the weighting in some client portfolios down to 5 per cent from 10 per cent in May as a result of rising volatility. PUR president Mark Yamada said Canadian REITs tend to have higher debt levels than their U.S. counterparts. "Even a whiff of an interest rate hike could impact them a little bit more." He's also feeling cautious about REITs as a result of data showing that the number of commercial and residential highrise buildings under construction in Toronto last year was roughly twice the level of other major North American cities. Rising supply suggests lower occupancy rates and less ability to raise rents.

Analysts at bond rating agencies like DBRS watch the impact of a changing rate environment on REITs because their ability to manage debt and pay interest on the bonds they've issued can be affected. If bond raters ever start to worry about a REIT, so should shareholders who count on the cash distributions these securities pay out each month. Bond yields have in fact risen significantly over the summer, but no alarms have been triggered at DBRS. "With every REIT that we rate, the trend is stable," said Anil Passi, a managing director at the firm. "We're not looking to move any of our ratings in the next little while."

Morguard's Mr. Warren characterizes the REIT rout this summer as an exodus of investors who gravitated to REITs because they were a growth story. He argues that the best argument for holding REITs is to generate income. On that basis, REITs are much more attractive than they were three months ago because their yields have risen.

When prices for REITs and dividend stocks fall, yields rise. For example, as RioCan's price has fallen 21 per cent from its April 30 peak, the REIT giant's yield has increased to 6 per cent from 4.8 per cent. "Sophisticated investors will see through the recent [price] volatility and realize that this is just an opportunity – a gift – to be able to pick up quality real estate at higher yields," Mr. Warren said.

He thinks this is a good time to start buying RioCan (REI.UN), although he warns it's especially susceptible to big price swings during uncertain times like these for REITs because it's a dominant name in the sector.

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All of the 14 names in the capped REIT index were down for the year through midweek, but the magnitude of the declines varies a lot. At the low end are quality REITs such as Canadian Real Estate Investment Trust (REF.UN) and Allied Properties REIT (AP.UN), both down less than 7 per cent.

Among the harder hit REITs is Cominar (CUF.UN), which was off 14.5 per cent and now has a yield around 7.5 per cent. Mr. Warren describes Cominar as a very stable, multibillion-dollar organization that has been lowering its debt level.

Another hard-hit name he likes is Dundee Industrial REIT (DIR.UN), a newcomer to the REIT sector that focuses on industrial real estate.

Down almost 23 per cent this year, Dundee Industrial's yield has exceeded 8 per cent. "If you believe the U.S. economy is going to recover in the next 12 to 18 months, then now is a fine time to get in. The Canadian industrial market's biggest client is the United States."

CIBC's Mr. Avery said his top picks are REITs that can increase their cash flow from operations fast enough to offset rising interest rates. Boosting occupancy rates is one way to do this, but many big REITs already have little unoccupied space.

Among the REITs with the potential to boost occupancy is Chartwell Retirement Residence (CSH.UN), which had a yield of 5.9 per cent this week after a year-to-date price decline of 15.5 per cent. Another option is Regal Lifestyle Communities (RLC), with a year-to-date decline of 23 per cent and a yield of 9.9 per cent. One more name highlighted by Mr. Avery is Brookfield Office Properties (BPO), which is down just 0.9 per cent this year and yields 3.4 per cent.

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In a rising rate world, REITs will disappoint investors who expect the kind of capital gains we saw in the past three years. But income-seekers can buy with confidence.

"We don't see, among the mainstream REITs, any cause for concern about the sustainability of dividends," Mr. Avery said. "It's going to continue to be a very good experience for income investors."

Read more from Portfolio Strategy.

For more personal finance coverage, follow Rob Carrick on Twitter (@rcarrick) and Facebook (robcarrickfinance).

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Personal Finance Columnist

Rob Carrick has been writing about personal finance, business and economics for close to 20 years. He joined The Globe and Mail in late 1996 as an investment reporter and has been personal finance columnist since November 1998. Rob's personal finance columns appear in The Globe on Tuesday and Thursday, and his Portfolio Strategy column for investors appears on Saturday. More


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