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Real Estate Investment Trusts have been on a tear this year, but further gains may require a continued rally in government bonds. That could be a bet worth making.

The relationship between bonds and REITs – essentially companies that own office towers, malls or residential buildings and distribute about 90 per cent of their taxable income to investors – is remarkably close.

Investors generally hold REITs because the yields tend to be considerably larger than yields on safe government bonds, but the spread between the two yields can cause volatility. Just as rising bond yields in the fourth quarter of 2018 made REITs look less attractive, causing a REIT selloff, falling bond yields in 2019 have spurred a 25-per-cent rally by REITs.

Now, though, some observers are sounding cautious about what comes next.

Capital Economics expects that REITs will be caught in a broader equity downturn before the end of the year, as interest-rate cuts by central banks fail to improve the deteriorating global economy in any meaningful way.

Analysts at CIBC World Markets recently noted that rising valuations make REITs vulnerable to a setback. Based on estimated funds from operations (a measure of how much cash a REIT will generate over the next 12 months), REIT valuations have climbed sharply this year to a level that is now above the historical average.

An alternative measure of valuation: The S&P/TSX Composite Index Real Estate sector now yields 4.2 per cent – down from 5.1 per cent at the end of 2018, before the current rally kicked in. That marks the lowest yield in the three years since the sector was added to the broad index, and suggests that the best feature for REITs is no longer so compelling.

Here’s a standout example: Minto Apartment REIT, which had its debut in July, 2018, after an initial public offering with an indicated yield of 2.6 per cent, has seen its yield fall to just 1.9 per cent after an impressive rally in the unit price. That’s in line with yields on one-year GICs.

But a recent report from Colliers International, the global commercial real estate services organization, pointed out that any selloff in REITs in the near term should make a good long-term buying opportunity.

Why? Part of the argument is based on fundamentals. Craig Hennigar, Colliers’ director of market intelligence in Canada, argued that this country is facing an acute shortage of industrial and office premises in Toronto, Montreal, Vancouver and Ottawa. As well, Canada’s progressive immigration policy underscores the need for multifamily properties.

As investments, REITs cater to an aging population.

“Long term, there will be more demand for these types of cash-flowing opportunities, particularly with an aging demographic of baby boomers who are going to be moving into more fixed-income types of investments. Bonds are giving them so little yield, and the advantage of real estate is that it’s inflation indexed,” Mr. Hennigar said in a phone interview.

But there are more technical arguments in favour of REITs.

Declining bond yields could be part of a longer-term trend. The rising number of negative bond yields – currently valued at almost US$14.7-trillion, according to Bloomberg – has some observers wondering if that’s where North American bonds are ultimately headed. If that’s the case, even today’s modest yields on REITs will shine by comparison.

Yes, the flat yield curve – or relatively little difference between the yields on short-term government bonds and longer-term government bonds – implies that investors are pessimistic about where they see bond yields in the future.

But if this pessimism causes a selloff in REITs over the next year, Mr. Hennigar believes it would mark a buying opportunity for investors who are willing to bet on continuing demand for real estate.

“REITs pay a dividend, they are based on real estate that typically goes up in value, and what we are seeing is no shortage of demand for multi-family, industrial real estate and office, too,” Mr. Hennigar said.