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Park Meadows mall in Lone Tree, Colo. The more competitive U.S. market results in much thinner margins than in Canada.

Matthew Staver/Bloomberg

For income-minded investors, real estate investment trusts have long been a staple of the portfolio.

REITs are a way for investors to participate in real estate without actually owning any real estate. That's because the trusts own and manage the buildings, and its investors own units that can be traded in the market, providing the liquidity that you can't get as a landlord.

But with the economic recovery uncertain, it's important to understand how the companies work and how to pick the winners from the losers, said Dennis Mitchell, vice-president and senior portfolio manager at Sentry Investments, where he manages the $400-million Sentry REIT Fund.

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The fund has gained 33 per cent in the last year, compared to the REIT group average of 22 per cent (the S&P/TSX capped real estate index returned 38 per cent). It has an average annual return of 5.2 per cent since its inception.

Here Mr. Mitchell fields questions on the state of today's REIT market.

What sort of investors should be looking at real estate investment trusts?

The No. 1 thing REITs provide is very tax-efficient, monthly income. For accounting purposes, much of the cash flow is classified as return of capital, which is generally not taxed when the investor receives it. It's accounting return of capital, not economic return of capital - you're not actually receiving your own money back.

Why does that matter?

Generally, return of capital isn't taxed when the investor receives it. It reduces the investor's cost base and when they sell the unit, it gets taxed as a capital gain. Since capital gains taxes are lower than earned-income tax rates, the distributions from a REIT tend to be more tax efficient than interest income from a bond. They are also provide more consistent income than bonds since most bonds pay semi-annual coupons while REITs pay monthly distributions.

I always liken REITs to the three-man in basketball - somebody who can hit the outside shot and also drive to the hole and finish. With REITs, you get consistent stable income but also growth potential as well. Now that growth potential means that you're exposed to a downside as well, but everything exposes you to a downside in some way, even bonds.

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What is the downside?

REITs do poorly in deflationary environments, when demand for commercial real estate is shrinking because the companies themselves are downsizing or going bankrupt. REITs tend to under perform, because occupancy and cash flows both decline and distributions come under pressure. In addition, the actual value of their assets decline as well.

You also have to worry about spikes in long-term interest rates. I'm not really talking about benchmark rates like the overnight rate in Canada. Generally, if the overnight rate is going up, then the economy is doing well and inflation is a concern. REITs tend to outperform during these time periods as the demand for commercial real estate increases.

What we are concerned with are spikes that are driven by macro shocks. If Greece defaults on its sovereign debt, or the U.K. restructures its sovereign debt, it would drive a huge risk premium into everything, especially long rates. The long end of the yield curve ratchets up because people perceive more risk in sovereign debt and demand more return for putting their capital at risk, especially over longer periods of time. That raises the cost of capital for everyone, but real estate and utilities tend to be relatively highly levered so they are exposed more than other sectors.

What are main differences between REITs in Canada and in the U.S.?

The valuations - REITs are generally valued based on AFFO [adjusted funds from operations]multiples. There's usually a two-multiple gap between U.S. and Canadian REITs, with U.S. REITs getting a premium for growth. Canadian REITs are trading around 14 times AFFO, which is historically where we've traded over the last 12 years. In the U.S., REITs are at 21 times AFFO, which is much higher than where they usually trade and a big premium to Canadian REITs.

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Why so high?

Good question. There's nothing fundamental going on that would justify that kind of spread. When I talked to my colleagues in the U.S., one guy said they were looking through the trough to 2012. Another guy said it's all a leap of faith. Either way, it spells overvaluation and we sold our U.S. REIT positions in May. U.S. REIT multiples need to decline to 16 times before they are fairly valued, which means U.S. REIT share prices have to fall by another 5 [to]10 per cent before I'm all that interested again.

Are the market fundamentals really so different?

Definitely, our financing model has survived because we didn't rely so much on commercial securitization to fund real estate mortgages (residential or commercial). We used it a little here, but it wasn't the main source of capital, like it was in the U.S. In the U.S., it was the dominant source of debt financing and few financial institutions retained any of these mortgages on their own balance sheet. When the securitization market went away, U.S. REITs saw their cost of capital rise dramatically and at just the time they needed access to cheap capital. They were forced to forge new relationships with new lenders at a time when credit spreads were blowing out. Right to this day, there is very little lending going on in the U.S. right now. In the U.S., lending is now pretty much limited to government programs or entities, with little bank lending taking place. That is not the case here. We've always been balance sheet lenders and most REITs already have strong relationships with the group of lenders in this country.

The other fundamental difference is occupancy. The U.S. is much more competitive than Canada is and as a result, margins are much thinner. When a downturn like we are currently experiencing happens, there is less room for U.S. companies to manoeuvre and as a result, there are many more bankruptcies. In Canada, we have one national grocer and several regional players, making competition in that sector relatively benign. Compare that to U.S. grocers where there are several large regional competitors in each market and you see the potential for bankruptcies and reduced occupancy.

Are things that much better in Canada?

We're not an island, but absolutely, things are better. People ask me all the time, what happens when vacancy falls to 60 per cent? Are you kidding me? Look at the tenants and you tell me which ones are going out of business. If occupancy at RioCan falls to 50 per cent, you'll have a tough time finding fresh produce and a hell of a time filling out your prescriptions because that means Loblaws and Shoppers Drug Mart are out of business. Good luck getting coffee too, cause that means Tim Hortons must be gone too.

What numbers should investors pay attention to when trying to pick a REIT?

When we're trying to gauge the riskiness of an investment we look at the cash flow stream - I don't care about stock price volatility, real risk is the risk of permanent loss of capital. We value REITs based on their free cash flow as measured by AFFO so we measure their risk as a function of the riskiness of their AFFO.

We measure this riskiness as a function of the quality, duration and stability of the cash flow we're getting. Stability is best represented by occupancy and how volatile it is over a business cycle. Quality refers to the tenants that underlie that occupancy. If you have a whole bunch of mom and pop companies in your property that's generally poor-quality cash flow. Large, national tenants and/or government tenants are generally better-quality cash flow. Finally, duration is a function of the term of the leases. Longer-term leases are generally preferred since that provides greater visibility on cash flow over a longer time period.

Most investors don't have the time to do that type of analysis, so the easiest thing to look at is AFFO or FFO (funds from operations) and payout ratios based on AFFO and FFO. All REITs report FFO, and it is generally the standardized calculation defined by RealPAC, whereas not everyone reports AFFO.

What's been happening with distributions?

Historically, everyone has distributed as close to 100 per cent as they could. Most will tell you that they're "targeting an 85-95 per cent AFFO payout ratio," but most are distributing close to 100 per cent. Now at times like this, when we are emerging out of a sharp recession, some REITs end up distributing more than 100 per cent of their AFFO.

Does the payout ratio really matter?

Yes, it does. You want to see something below 100 but also have to keep in mind that if someone is over distributing, that doesn't necessarily mean they'll cut. Instead, they may deprive you of distribution growth for next two years while they grow into their distribution. But in that case, you need to see a credible plan to grow free cash flow. If you're paying out 120 per cent of AFFO and your properties are 99 per cent occupied, how are you going to generate any incremental free cash flow? You're left with a problem: Pray for recovery or cut the distribution.

Mitchell's picks

Brookfield Properties

"They have triple-A trophy assets in markets like Toronto, Ottawa and Manhattan. Their assets are second to none, they have a great management team and a very low payout ratio. Low leverage, too. We think it's worth $18, and it's trading at $14.09."


"This is a cost of capital trade. They can acquire properties at 8 to 13 per cent cap rates and they can finance them with CMHC insured debt at 4 per cent-plus right now. That is a huge spread. I think it's worth $8.25 and it's trading at $7.30 right now."

Dundee REIT

"It has a huge exposure to Calgary and that's a bit of an overhang, but their buildings are still 95 per cent occupied. They also actively diversified out of Calgary by buying offices in Toronto and Ottawa as well as some industrial. We think it is worth $27, and it's trading at $24.57."

A REIT primer

Why invest in a real estate investment trust?

REITs buy and sell properties, giving investors a passive way to own real estate. They also pay cash distributions.

Net asset value (NAV)

Values of all assets, minus the debt.

Funds from operations (FFO)

Comparable to earnings per share for stocks, this measures a REIT's profitability. Or lack thereof.

Adjusted funds from operations (AFFO)

A more precise measure of profitability that strips out one-time capital expenditures.

Payout ratio

The amount of money a REIT pays its unit-holders, relative to how much it earns. A lower ratio means it is hanging on to its cash; ratios close to 100 per cent could mean the distribution is in peril of being reduced.

Steve Ladurantaye

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