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Investors often assume rising interest rates are bad for real estate investment trusts (REITs), given they’re in the business of taking on debt to add to their property portfolios.

At first glance, that sentiment appears to be accurate, given the more than 20-per-cent drop in the S&P/TSX REIT index so far this year.

But there are alternative arguments for REITs in the current rising inflation and interest rate environment: Real estate trusts are in the business of managing rate risk, they can generally raise rents, and holding real assets when inflation is soaring might not be a bad thing.

In mid-June, CIBC REIT analyst Dean Wilkinson concluded in a report that REITs could produce a strong bounce-back for investors given their heavy discount.

The REIT sector is very diverse, with some sailing through the pandemic (industrial/warehouse and apartments), while office trusts and retail REITs stumbled as business went online and virtual.

“Some of the REITs are trading at such heavy discounts,” says Alfred Lee, a portfolio manager and ETF investment strategist with BMO Global Asset Management in Toronto.

He points to office REITs and mall operators, which are once again “packed” as pandemic restrictions have disappeared. “Some of the discount in those sectors is going to offset some of the impacts of rising interest rate risks,” he says

Mr. Lee manages the second-largest REIT ETF in Canada (by assets), the BMO Equal Weight REITs ETF (ZRE-T), with $618.5-million in assets and an MER of 0.61 per cent. It has dropped 17 per cent so far this year. (All data from Morningstar as of June 28.)

ZRE’s biggest holdings are retail REITs (29 per cent of total assets) with names such as CT REIT, Choice Properties REIT and Slate Grocery REIT. Its second-largest holding (23 per cent) is residential REITs.

The largest REIT ETF by assets is iShares S&P/TSX Capped REIT ETF (XRE-T), with about $1-billion in assets and an MER of 0.61 per cent. It has dropped by just over 18 per cent year to date.

While there is some worry that rising rates can crimp the acquisition ambitions of REITs because of higher debt costs, REITs typically handle inflationary periods because they can raise rents.

However, the “rising tides” viewpoint comes with a specific caveat, notes Brooke Thackray, a research analyst with Horizons ETFs (Canada) Inc. of Toronto. His firm sells the Horizons Equal Weight Canada REIT ETF (HCRE-T) with about $52.4-million in assets and an MER of 0.33 per cent. It has dropped 15.6 per cent so far this year.

Mr. Thackray is concerned a slowing economy is the wrong time to be buying into REITs.

“Rising rates this time around are not necessarily a factor of a strong economy, and therefore the impact is expected to be different,” he says.

For investors who want to participate in the REIT sector, Mr. Thackray advises looking at areas considered more defensive, such as health care. One name he likes is Northwest Healthcare Properties REIT, which owns medical office buildings and health care facilities across Canada, and has extensive international operations.

“I would never recommend buying just one REIT,” he adds. “I still think that the best exposure to REITs as a class is through some broad-based ETF, but if you are really trying to catch a business cycle trend, I think looking at some of the defensive cycle REITs is not a bad idea.”

Neena Mishra, director of ETF research with Zacks Investment Research in Chicago, says some investors may wish to focus on income-producing names as a strategy in the current market.

“We know that income is a major thing for investors this year because bonds have fallen so much,” she says. “So many investors who relied on coupon payments earlier – they are looking for alternatives.”

She currently likes two REIT ETFs which should be able to raise rents in an inflationary environment:

The first is the Nuveen Short-Term REIT ETF (NURE-BATS), which focuses on real estate trusts with shorter-term leases such as apartment buildings, hotels and self-storage facilities. NURE, with US$108.9-million in assets and an MER of 0.35 per cent, has fallen 19.42 per cent so far this year.

The other is the iShares Residential & Multisector Real Estate ETF (REZ-NYSE), with a 0.48 per cent MER and US$910.8-million in assets. It has decreased by about 17.7 per cent year to date.

“REZ also focuses on residential, health care, self-storage REITs,” she says. “So those are the two which I think will do well in a rising rate environment.”

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