Whether we realize it or not, real estate plays an important role in most of our lives. At some point, most of us will think about owning a home, which means thinking about mortgage rates, resale values, renovations, and many other things. My family is looking to move this summer, so I know how much time and analysis goes into shopping for a new home and getting an old one ready for sale.
I think about real estate at work, too, as MD invests across a number of real estate sectors in Canada and other markets. But when I’m at the office, I view real estate very differently. Our portfolios are primarily exposed to real estate investment trusts (REITs), which can be affected by some of the same factors as residential real estate, such as interest rates, but there’s more to consider, like land use, yields and occupancy rates.
The basics of REITs
Real estate can be a difficult asset class to invest in because of its illiquid nature. That’s where REITs come in. A REIT is a company that owns and operates income-producing real estate, giving investors exposure to real estate while providing benefits such as daily pricing, daily liquidity, corporate governance and no large minimum investment requirements. REITs span several sectors, including multi-family, industrial, retail, office tower, storage and hospitality.
They also receive special tax considerations and tend to have a higher distribution yield than traditional corporations. They offer diversification benefits, too, because real estate tends to have a lower correlation with traditional equities and bonds, meaning these asset classes don’t typically move in tandem.
Focus on yield
Like equity investments, REITs have the potential for capital appreciation, but historically, yield has been the primary driver of returns for the asset class.
At the end of the global financial crisis in 2008 – 2009, central banks around the world, including the Bank of Canada, began reducing interest rates to near zero. Although the Bank of Canada has begun to move interest rates back up, it is doing so cautiously, and rates are still very low relative to historical standards. Accordingly, bond returns are expected to be very muted for some time.
In comparison, the real estate sector offers relatively stable, generous yields. In Canada, the sector had a yield of 4.93% as of March 22, while 10-year government of Canada bonds yielded 2.17%. The highest-yielding real estate sector was the retail sector at 6.02%. The lowest was the office sector at 4.30%, which is still fairly high. The difference is that the retail sector yield is pricing in higher levels of risk relative to the office sector, which isn’t surprising since retail malls have come under pressure from online giants such as Amazon, which is reducing foot traffic at malls across Canada and other regions.
Of all our portfolios, MDPIM Dividend Pool currently has the highest allocation to real estate at 4.2%—compared to 2.9% for the S&P/TSX Composite Index—with a focus on retail and office REITs. Montrusco Bolton Investments Inc., sub-advisor to MDPIM Dividend Pool and MD Dividend Growth Fund, believes that positive Canadian retail sales are helping shopping centre-focused REITs achieve steady operating results. They’re also encouraged to see the final stages of rationalization of Canada’s department stores, with only three national chains left (Hudson’s Bay, Walmart and Costco) compared with 15 chains in the U.S.
A great example of this is shopping centre REIT SmartCentres, as its Walmart-anchored properties, with occupancy rates of approximately 98%, likely to provide stability. Additionally, Montrusco Bolton believes SmartCentres is well positioned to benefit fromshifting land use which provides another avenue for growth, low debt levels and one of the highest inside ownership rates among Canadian publicly-traded REITs at about 22%.
Allied Properties, an urban office REIT, is another holding of Montrusco Bolton. The sub-advisor appreciates that 80% of Allied Properties’ assets are in the strong Toronto and Montreal office markets, and believes its development pipeline and intensification projects provide visibility for growth over a multi-year period.
Interest rates remain a risk
Despite their attractive yields and upside potential, REITs face certain macroeconomic risks. Montrusco Bolton believes that, right now, the future path of interest rates poses the most significant risk to future returns. All else being equal, rising interest rates are generally negative for real estate. Higher interest rates mean that the income generated by REITs at the current stock price is worth less, so prices generally have to fall in order to increase the yield of REITs relative to other income-producing instruments.
The Bank of Canada has raised interest rates three times since July, and expectations are for another two rate increases in 2018. These increases have already had an impact on the real estate sector, as the sector returned 4.68%, underperforming the S&P/TSX Composite Index by about 0.65%.
I don’t believe that’s a reason to be discouraged about the sector, though. It just means that analyzing the benefits and potential challenges of each individual REIT is as important as ever, which is the approach we’ve always taken when it comes to investing in real estate.
When I leave the office this evening, I’ll continue thinking about interest rates and how they’ll affect my search for a new home. Will rising rates bring prices down to more affordable levels or stabilize prices and just make the cost of home ownership higher? Sometimes personal real estate decisions are not all that different from ones I have to make for our clients.