Is now the time to consider REITs?

The S&P/TSX capped REIT index dropped by 8.4% in the nine months ended Sept. 30, underperforming the 5.3% gain for the diversified S&P/TSX total return index after a dramatic outperformance during the previous three years.

“When the U.S. Federal Reserve {Board] hinted at tapering this past spring, income-paying assets such as REITs fell off a cliff with a sharp correction,” says Matt Skipp, chief investment officer of SW8 Strategy Fund, a long/short hedge fund sponsored by Toronto-based SW8 Asset Management Inc. “Prior to that, the REIT sector was overpriced and crowded. REITs are now looking attractive, providing we don’t see a significant move upward in interest rates that would cause everything to unravel.”

Skipp expects any future tapering by U.S. officials of the bond-purchasing program designed to stimulate economic growth will be approached cautiously, in view of the bond sell-off and the rise in interest rates that was triggered by the mere mention of tapering intentions this past spring.

The yield on the bellwether U.S. 10-year treasury bond rose to 3% after the taper talk as bonds plunged from 1.7%, but a partial market recovery has brought the yield back to about 2.5%. REITs and other income-producing securities also had corrected, but, due to the substantial drop in REIT unit prices, the valuations are looking more attractive relative to other income-paying securities, such as banks and utilities.

REITs have failed to recover to their highs of earlier this year, even though the fear of interest rate hikes has subsided, says Leslie Lundquist, portfolio co-manager of Bissett Canadian High Dividend Fund in Calgary, and senior vice president in the Bissett Investment Management division of Franklin Templeton Investments Corp. of Toronto. Thus, she says, REITs present a better buying opportunity than utilities, which didn’t drop by as much.

Lundquist has been adding to Cominar REIT, which has a yield of 7.6%, and focuses on office, commercial and industrial properties located primarily in Quebec.

A move to much higher interest rates would be bad for REITs as that would increase financing costs and cut into cash flows from properties, hurting REIT distributions. Rising rates also could cause yields to become more attractive on competing fixed-income securities that are not subject to the same business fluctuations and vacancy risks as REITs.

The price/free cash-flow multiple on REITs, currently 15 times, historically has been higher than the comparable price/earnings ratio of Canadian banks’ shares by a margin of 4.3, says Michael Missaghie, senior portfolio manager with Toronto-based Sentry Investments Inc. But REITs currently are trading at a lower multiple differential of 3.8, making them more attractive than usual. The REIT multiple now is 2.7 less than that for utilities, a greater discount than the historical difference of 1.9.

“The relative attractiveness of REITs has come about because of the recent pullback in the sector,” Missaghie says. “If you looked at these premiums and discounts prior to May, REITs screened as expensive relative to the other, most common yield options. This past summer was the most volatile time for the REIT sector since the financial crisis of 2008.

“REITs,” he adds, “have more levers to increase the value of their business and grow their free cash flow than some of the traditional yielding sectors, such as utilities. REITs are underpinned by long-term leases and, through rent increases, can grow their income to keep up with inflation. And they offer protection to investors in an environment in which inflation and interest rates might increase.”

Even if interest rates rise, Missaghie says, that is likely to happen because economic growth is picking up, and REITs are in a position to benefit. As more tenants demand more space, REIT properties can charge more rent in an improving economy.

Missaghie is focusing on REITs that can generate cash-flow growth through internal activity, such as development or improvement of existing properties, rather than REITs that need to refinance or borrow to grow through new acquisitions.

In particular, Missaghie likes Simon Property Group, a U.S.-based retail REIT that will benefit as consumers increase their spending and return to shopping malls. On the Canadian side of the border, he favours Boardwalk REIT, which focuses on apartment properties, primarily in Alberta.

Chris Couprie, portfolio analyst with Toronto-based First Asset Management Inc., which sponsors two closed-end funds and a mutual fund specializing in REITs, also likes Boardwalk.

Couprie says REITs specializing in multi-family residential units tend to reset their leases annually and can catch up more quickly with any interest-rate increases, while other types of properties are locked into longer-term leases. IE