REIT bonds not for the faint of heart

REIT bonds, a small niche of Canada’s corporate bond market, have been seen as orphans. Yet, they can be reasonable investments for clients who understand them.

A typical REIT bond — shopping centre operator First Capital Realty Inc.’s 5.25% issue, due Aug. 30, 2018 — was recently priced to yield 4.3% to maturity. That’s 185 basis points over the Government of Canada 4.25% issue due June 1, 2018, which was recently priced to yield 2.45% to maturity. In addition, First Capital’s bond yield was 38 bps more than the 3.92% yield to maturity of the subordinated issue of TD Capital Trust 7.243%, due Dec. 31, 2018.

The REIT segment of the bond market is small: about three dozen bonds from 30 issuers, most of them familiar names such as RioCan REIT, Calloway REIT, First Capital Realty, Brookfield Office Properties Inc. and H&R REIT. However, the average ratio of distributions to cash flow from operations in the REIT sector is in the 60% to 80% range. The good news is that the sector is stable. The big mall operators, such as RioCan REIT, have durable tenants on long-term leases.

The sector maintains what is generally a 60% to 70% ratio of debt to equities — conservative by most measures. Most of all, REITs, which by nature diversify their properties, are in no danger of having their reputations ruined in a day like leveraged investment banks, such as Lehman Brothers Holdings Inc., that lost the confidence of the market. Yet, almost all REIT bonds are in B-rated territory, with RioCan at the top with BBB (high) from DBRS Ltd. and most others as just straight BBBs.

Most REIT bonds are three-to seven-year issues and small (around $100 million), which suggests light trading and potential liquidity problems. However, the average payout ratio in the REIT sector is a conservative 60% to 70% of cash flow from operations. RioCan’s is almost 100%, but it gets money back from its dividend reinvestment program.

Those payout ratios are hostage to interest rates. Says Mark Newman, vice president for real estate with DBRS in Toronto: “Interest rates on REITs’ current debt are low. If they spike up in future, that could make defaults rise.”

There are other risks, Newman adds: consumer debt levels in Canada are near record highs and consumer spending is leveraged on those interest rates, too — especially when it comes time to pay off credit cards. Therefore, stores in REIT-owned shopping centres could have lower sales and some might not be able to pay their rents as a result.

There are also cross-border worries. Bond managers know that U.S. REITs have fallen into trouble. A major operator — General Growth Properties Inc., with 169 regional malls in 43 states — defaulted in 2008 as a result of the massive meltdown of the U.S. economy. An operator of prestigious, high-rent malls, it nevertheless missed a US$900-million interest payment and was petitioned into bankruptcy by its creditors.

Hard hit by the recession, the U.S. retail mall market suffered far more in the subprime mortgage crisis than did Canada’s mall lessors. Nevertheless, as Benoît Poliquin, lead portfolio manager with Exponent Investment Management Inc. in Ottawa, says: “The shadow of U.S. failures hangs over Canadian REITs.” Thus, the lesson of General Growth would appear to be that no REIT is too big to fail.

The core problem for REIT bonds is that they are unsecured debt that rank behind first mortgages secured by real estate. Bond buyers focus on covenants, says Chris Kresic, co-lead for fixed-income and a partner with Jarislowsky Fraser Ltd. in Toronto: “With REITs, you don’t have the security you would have with commercial mortgage-backed securities.”

There is also a problem of asset concentration. “Many REIT operators concentrate their investments in Ontario and British Columbia, both highly priced property markets vulnerable to a downturn,” says Beste Alpargun, a portfolio manager and corporate credit analyst with Seamark Asset Management Ltd. in Halifax. “The REIT bonds have illiquidity risk, vulnerability to rising interest rates, the risk that property prices could fall, and contagion risk from the financial services institutions from which they obtain mortgages.”

Those risks, plus the fact most REIT bonds offer little security other than the full faith and credit of issuers, account for their yield premiums. Explains Robert Follis, managing director for corporate bond research with Scotia Capital Inc. in Toronto: “Most corporate bonds rank as equals, while REIT bonds are not equals, with other REIT debt [such as secured mortgages].”

REIT bonds with weak backing could, in an insolvency, leave holders with the chaff of their companies’ balance sheets, such as goodwill and capitalized expenses.

REIT bondholders could even be forced into taking equity in the workout. With that in view, investors can elect to skip the bonds and buy REIT equity units directly, or buy REIT exchange-traded funds, such as the BMO Equal Weight REITs Index ETF that offers security through diversification and recently yielded 5.2%.

Clients who want to stick to safe, A-level credits should be excluded from taking a chance on REIT bonds. But for other investors who want diversification, REIT bonds are potentially attractive. Says Poliquin: “REIT bonds are one of the few ways to get diversification out of the usual niches of banks, telecommunications, utilities and pipelines. You could say that Canadian REITs, tarnished by the record of some U.S. REITs, are in bad company. But you can’t ignore them.”

In his view, they belong in a diversified Canadian bond portfolio; however, they should not take up more than their 3% weighting in the DEX universe all corporate bond index. IE