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REITs battered down to eye-catching levels

rcarrick@globeandmail.com

00:00 EST Saturday, December 06, 2008

Who knew REITs could go so wrong?

Long thought of as a conservative way to generate income, real estate investment trusts met the wrecking ball in 2008. The buildings they own are still standing, but their shares have been pounded.

The benchmark stock index for REITs was down 49 per cent for the year through Dec. 4, a fair bit worse than the 42-per-cent plunge by the broad S&P/TSX composite index. Established names in the sector like RioCan, Calloway and H&R are down by 40 to 70 per cent, and their yields have gone into double-digit territory.

REITs are income trusts that hold portfolios of offices, malls and big-box stores, hotels, apartments or seniors housing. REITs make regular cash distributions like other income trusts and, for much of the decade, they also rose steadily in price. REITs gained some added appeal when they were largely exempted from the new income trust tax that will take effect in 2011.

Today, REITs face challenges from both the slowing economy and the global financial crisis. But there's a sense that some have fallen to levels that make them attractive buys right now.

"Valuations are getting pretty close to a floor in my opinion," said Oscar Belaiche, manager of the Dynamic FocusPlus Real Estate Fund and a vice-president at Dynamic Funds. "I wouldn't be rushing to sell today. As a matter of fact, selectively, we're buying selected REITs. There are some good REITs that have been beaten down to levels that don't make sense to us."

Before you consider buying REITs, you have to understand the factors that drove them down in price and threaten to cause further problems looking into 2009. One of the most serious difficulties is that REITs are having trouble getting financing as a result of heightened caution among banks about lending. "It's like a boa constrictor squeezing the real estate sector," Mr. Belaiche said.

The financing problem for REITs is exemplified by what's happened recently at H&R REIT, which is developing a huge office tower project in Calgary called The Bow. EnCana Corp., Canada's largest energy company, has agreed to locate its head office in the project, and yet H&R has been having trouble securing construction loans.

H&R units are down by almost 70 per cent this year, and the yield is around 23 per cent. Investors are obviously expecting a significant drop in H&R's monthly cash distribution, although this isn't a certainty. Last month, CIBC World Markets issued a report playing up the possibility that H&R will arrange financing without having to cut its distribution.

A weak economy is another problem for REITs, and it's one with potential to get worse in a lingering recession. Retail store closings and bankruptcies are bad for retail REITs. Rising layoffs are bad for office REITs. Reduced consumer spending is bad for hotel and even seniors housing REITs.

Harry Levant, an independent income trusts analyst, said current REIT prices already seem to reflect these eventualities. "The market has really built in an ugly scenario," he said.

Part of this negative outlook is the expectation that REITs will have to cut their distributions. No income trust is immune from distribution cuts, but REITs have always been considered to be one of the safest of the various kinds of trusts.

"Right now, I don't see a big risk of distribution cuts," Mr. Belaiche said. "You'd have to see a lot more tenant bankruptcies. If that comes, then you're going to have pressure on rental income, and then on the payout ratio [the percentage of earnings paid out in distributions]."

Mr. Levant said current REIT prices in some cases reflect expected distribution cuts of as much as 50 or even 60 per cent. While he believes some REITs may have to trim their payouts, he sees the price plunge as being overdone.

The safest name in the REIT sector could well be Canadian Real Estate Investment Trust, which offers a high level of diversification through its portfolio of office, retail and industrial properties located across Canada. Canadian REIT's share price has fallen just 19 per cent this year and has a comparatively tiny yield of 5.8 per cent. "It's a heavyweight in the sector and the one you'd probably buy for the most reliable cash flow stream," Mr. Levant said.

Apartment REITs are considered to be an especially conservative type of REIT because demand for rental housing is more recession-resistant than other types of property. Of the two big TSX-listed apartment REITs, Canadian Apartment Properties and Boardwalk, Mr. Levant likes the former for its superior level of national diversification. Boardwalk has extensive properties in Alberta, where the economy is vulnerable to further declines in oil prices.

Two big retailing REITs, RioCan and Calloway, have been hit hard because of concerns about rising vacancy rates in a recession. But both get significant amounts of revenue from tenants that sell non-discretionary items like groceries and both health care and household products. Mr. Levant has rated both as being low risk on his website, IncomeTrustResearch.com.

There are roughly 26 REITs listed on the Toronto Stock Exchange, but Mr. Levant suggested investors stick to the most established ones, or at least members of the S&P/TSX capped REIT index.

"All the very best names are on sale, so why would you buy anything riskier?" he said.

Investors can buy the entire index through an exchange-traded fund called the iShares Cdn REIT Sector Index Fund, which is listed on the Toronto Stock Exchange under the symbol XRE. Other options can be found among mutual funds in the real estate equity category.

If you buy into the REIT sector now, you have to be prepared for further declines and you have to recognize that distributions could be cut. That said, the credit rating agency DBRS has a stable outlook on all of the nine REITs it analyzes but H&R (it's under review with a negative outlook).

Mr. Levant said a lot of potentially bad news has already been priced into REITs.

"They just look unbelievably cheap at this point."

*****

The REIT stuff

Real estate investment trusts have been absolutely savaged in the bear market. Now, some people see good value in the sector. Here are some ways to put REITs in your portfolio.

The largest TSX-listed REITs (as measured by market cap)

Year-to-date
NameTickerYieldPriceprice change
RioCanREI.UN10.6%$13.00-40.5%
CanadianREF.UN5.8%$23.50 - 19.0%
BoardwalkBEI.UN7.9%$22.70 - 49.2%
H&RHR.UN23.6%$6.10 - 69.3%
CallowayCWT.UN17.2%$9.00 - 63.3%
CAPCAR.UN8.8%$12.30 - 23.3%

An exchange-traded fund that tracks an index of Canadian REITs

iShares Cdn. REIT
Sector Index FundXRE12.0%$7.47 -47.6%

Real estate equity mutual funds with substantial Canadian REIT holdings

Year-to-date
NameMERprice change
Sentry Select REIT2.7%- 48.1%
Dynamic FocusPlus Real Estate2.6%- 38.0%
CIBC Canadian Real Estate2.8%- 45.4%

Note: all price data is to Dec. 4

DOUGLAS COULL/THE GLOBE AND MAIL; SOURCES: GLOBEFUND.COM AND GLOBEINVESTOR.COM

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