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real estate

Pedestrians head for work among the highrise buildings at Spadina Avenue and Bremner Boulevard in Toronto. Investors can tap into the growth of commercial real estate – retail, office and rental properties – through REITs, real estate investment trusts.Fred Lum/The Globe and Mail

Most Canadians don't need to be told the country's real estate market has been a big money-maker over the past several years.

But of course there's more to real estate than houses and condos. Retail, office and rental properties are also a huge part of the real estate scene – and these sectors have also been enjoying nearly a decade of strong growth. Not many individuals manage to participate directly in the sector – but investors have been able to tap into its growth through REITs – real estate investment trusts.

These investment vehicles own commercial real estate properties and are required by law to pay out a fixed portion of their taxable income to shareholders. They trade like individual stocks and typically pay a yield of 5 to10 per cent to their investors.

For the past few years REITs have been one of the best-performing investment classes in Canada. The number of firms on the S&P TSX REIT Index has more than tripled in the past four years – and that doesn't take into account the income payouts the REIT holders have enjoyed.

However there have been signs the sector has lost momentum. The REIT index peaked last summer and has yet to return to that level.

So the question is: Is it too late to make money in REITS? The consensus seems to be that returns will be reduced – but the sector is still attractive.

"I think Canadian investors must brace themselves for lower returns in this asset class for the next two years," says Ben Cheng, president and chief investment officer at Aston Hill Financial in Toronto.

The firm manages portfolios for institutional investors, provides advisory services and offers a suite of mutual funds. Mr. Cheng is also lead manager of two income funds for IA Clarington.

While he sees returns dipping, Mr. Cheng remains a fan of the sector.

"Real estate still represents an attractive class with real diversification benefits. However it is subject to downturns just like any other asset class – but we do not see that happening in 2013."

Paul Gardner, partner and portfolio manager at Avenue Investment Management, is a little more pessimistic.

"You won't see much price appreciation from this sector," he says. While he expects REIT units to continue trading around their current levels, he still thinks the sector has solid fundamentals.

"[Building] vacancies are at an all-time low, there's been very little overbuilding of commercial and office properties, pension plans are aggressively buying in the sector. And even if the trading price of the REIT units doesn't go up, the yield being paid is still competitive."

Even the manager of the country's largest REIT mutual fund acknowledges the days of runaway gains in the sector are over for now. But that doesn't mean Dennis Mitchell thinks the sector should be avoided.

"For any investor looking for tax-efficient income, REITS make sense. Even now," says Mr. Mitchell, chief investment officer at Sentry Investments, as well as the lead manager of the Sentry REIT fund. The $1.4-billion fund is larger than all of its competitors combined. REITs held by the fund raised their distributions 27 times last year.

He sees two threats for REITs: rising interest rates, and a slowing economy.

"If interest rates rise you'll see the sector correct. Market multiples for REITs will come down. But I would see that as a buying opportunity for most investors – especially because price drops would mean higher yields," Mr. Mitchell says.

He says if economic growth retreated into recession it would be a "big concern" for the sector, since demand for commercial real estate would drop, and values would decline as well. But he feels it would have to be a "very deep, very long" recession to really upset REITs on an operational level, since their rental terms and rates are typically locked in for a period of several years, and tenants have no choice but to pay their rents before other expenses.

On the other hand there are also factors that may give the sector a boost, including merger and acquisition activity, such as the ongoing takeover battle for Primaris REIT. However, Mr. Mitchell doesn't see mergers spurring a meaningful jump in the trading prices of REITs.

Instead, he advises investors to stick with the fundamentals, and use his 'MAPL' criteria for choosing a quality REIT.

Management : Look for REITs that boast strong management teams with proven track records.

Assets: Only buy companies that own the best properties. The old saying is true – in real estate it's all about location, location, location.

Payout: Don't be fooled by high yields. The lower the payout ratio, the more secure the distribution. Don't buy REITS that are overdistributing.

Leverage: All real estate companies have a lot of debt on their balance sheets. Avoid companies that are excessively leveraged.

REIT top picks

Paul Gardner, Avenue Investment Management

Mainstreet Equity: "They own low-rise apartment buildings in Alberta and Surrey, B.C. Good assets and demographic trends, cheap asset acquisition costs, and it trades at a discount to its net asset value."

Dennis Mitchell, Sentry Investments

RioCan: "The largest REIT in Canada. It's relatively cheap right now – it's worth $5 to $10 a unit more than where it's currently trading. Add that to a yield of about 5 per cent, and the return for such a quality REIT is hard to beat."

Ben Cheng, Aston Hill Financial

Dundee Industrial, Allied Properties, Cominar.

Editor's note: An earlier version incorrectly stated that REITs are required by law to pay out 90 per cent of their taxable income to shareholders.