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yield hog

Most investors buy REITs for their juicy yields and modest growth.

Apartment owner InterRent Real Estate Investment Trust (IIP.UN) flips the traditional REIT model on its head: It yields a ho-hum 2.7 per cent, but the units have posted a sizzling annualized total return, including reinvested distributions, of about 14 per cent over the past five years – nearly three times the return of the S&P/TSX Capped REIT Index.

InterRent’s secret? The REIT buys apartment buildings that have been neglected or managed poorly, invests heavily in suite upgrades, common-area improvements and cost-saving energy efficiency programs, then releases the suites at substantially higher rents.

The strategy, combined with the tailwinds of high housing prices and a tight rental market, has produced exceptionally strong results for InterRent, whose $1.66-billion property portfolio is located primarily in the Greater Toronto Area, Ottawa and Montreal.

Since 2010, InterRent’s total suite count has more than doubled to about 8,880, and the average monthly rent a suite has climbed to $1,110 from $805. This has driven steady annualized growth in the REIT’s funds from operations (FFO) a unit – a real estate cash flow measure – and fueled regular increases in the distribution, which – at 2.25 cents a month or 27 cents annually – is more than twice as high as it was in 2010.

No wonder analysts give the REIT so much love. InterRent “is one of our best ideas; it is a go-to name in the Canadian REIT space for investors who prioritize organic growth, in our view,” Desjardins Capital Markets analyst Michael Markidis said in a recent note. He’s one of nine analysts who rate InterRent a buy; there are two holds and no sells, according to Thomson Reuters.

Will InterRent continue to post such scorching returns? That could be a challenge, given that the units – which closed on Tuesday at $10.06 – have appreciated by about 30 per cent in the past year alone and are already within striking distance of analysts’ average 12-month price target of $10.64. The units (which I own personally) aren’t cheap; they trade at a multiple of about 21 times estimated 2018 FFO – higher than other residential REITs – reflecting InterRent’s above-average growth and strong operating track record.

Yet, there are reasons to believe that InterRent will deliver steady – if not spectacular – returns in the years ahead. It’s anyone’s guess what the unit price will do in the short run, but for long-term investors seeking a stable source of income that will almost certainly grow over time, this well-managed REIT is worth a closer look.

The fundamentals for apartment REITs have rarely been stronger. Population growth in urban centres, driven by rising immigration, is expected to keep demand for rental housing high, RBC Dominion Securities analyst Michael Smith said in a recent note. Tighter mortgage-qualifying rules should also support rental demand, while the supply of new apartments could be constrained by more stringent rent controls recently introduced in Ontario, he said.

“We believe the REIT’s portfolio and its management team are well positioned to benefit from operating in some of the country’s strongest multifamily rental markets, as 100 per cent of its [net operating income] is generated in central Canada,” Mr. Smith said.

In recent weeks, InterRent has taken steps to make itself even more appealing to investors. In February, the REIT brought its external property management function in-house by paying about $38-million to CLV Group, a company controlled by InterRent chief executive Mike McGahan. The internalization is expected to save InterRent about $8-million to $9-million in fees annually and also eliminates a potential conflict of interest.

In March, InterRent closed a $98-million equity offering, with proceeds used to repay debt and fund future acquisitions. InterRent said its leverage - the ratio of debt to the gross book value of its assets – would fall to about 45 per cent based on the expected use of the proceeds, down from 47.8 per cent at the end of the fourth quarter. InterRent’s leverage has come down steadily; in 2010 the ratio was more than 58 per cent.

Prudent financial management is one of InterRent’s strengths, and it applies to the REIT’s distribution policy as well. For 2017, InterRent’s payout ratio was 53.1 per cent of adjusted cash flow from operations. ACFO - which measures operating cash flow, minus items including maintenance capital spending – “can be a useful measure to evaluate the trust’s ability to fund distributions to unitholders,” InterRent said.

Given InterRent’s conservative payout ratio, growing cash flow and history of raising its distribution, I would expect to see more increases in the years ahead. That’s something to keep in mind when you look at this growth-oriented REIT’s modest yield.

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