Performance is not quite so bad on a total return basis once distributions are added back to the above price chart but it is still negative. Why? What bad event has affected REITs and what can we as investors expect in future? Is there a buying opportunity?
The primary culprit - a rise in interest rates
REITs are investment vehicles mainly designed to provide steady and relatively high income. As such, they get compared to other income vehicles like bonds. Observe that the big slide downwards for XRE, ZRE and VRE occurred in the spring when interest rates took a leap upwards.
Does that mean if and/or when interest rates rise again REITs will get a further smack? It could be, according to the excellent October 2013 Canadian REITs Monthly report from CIBC (found posted on an Investor Village chat thread where various investors discuss implications - well worth a read). The sharper and faster interest rates rise, the worse the damage. The CIBC analysts estimate that a further 1% rise in the 10-year Government of Canada bond rate could entail an 11 to 12% further drop in REIT prices. That would certainly hurt but the report goes on to point out a lot of positive factors affecting REITs.
Business conditions and operating fundamentals are still favourable for REITs
- Demand and supply conditions in the various REIT segments (office, retail, industrial, hotel, apartment, retirement homes) remain positive; there are certainly no big negative changes apparent
- Debt refinancing costs at current interest rates are only a threat to increase for REIT's around 2017 and debt loads for most REITs are within prudent bounds
- Cash distribution levels look to be sustainable though for many REITs the future will likely see a lower rate of cash distribution increases
- REIT yield spreads versus bond alternatives are still high by historical standards and REIT unit share prices seem to be attractively priced; REIT prices appear to have priced-in an expected higher level of bond prices a year from now
Bottom line, it's unlikely there will be a big recovery in REIT prices. But REITs will continue churning out steady income as they were designed to do (and as we saw a few months ago when we compared XRE cash distribution to other sector ETF s and XIU for the past decade).
REIT income has attractive tax qualities
REITs distribute a lot of Return of Capital and Capital Gains. ROC is effectively deferred capital gains (for how this works, see our popular post Return of Capital: Separating the Good from the Bad) and capital gains itself is taxed at half the rate of the ordinary interest income paid by bonds. For holdings in a non-registered taxable account the lower tax rate is a big advantage, as we showed in this post comparing the tax efficiency of various ETFs, including XRE. CIBC's report lists the tax-type breakdown of distributions for individual REITs in 2012 in Exhibit 48, while the distributions tabs for XRE, ZRE and VRE shows the breakdown for every year of each ETF's existence. We can see, especially with XRE which launched in 2002, that ROC and capital gains make up the majority of the income year after year. Note that ROC in a taxable account must be used to reduce the Adjusted Cost Base of the holding and if ever the ACB turns negative, that becomes a capital gain that must be reported and taxed in that year (see a step by step illustration in Appendix 2 of Deloitte's classic 2004 REIT Guide). For an investor in the top marginal tax bracket who may lose half of the income from bond interest to tax, REIT cash distributions can leave significantly more in the pocket than bond cash distributions. The larger REITs are now paying out 4 to 8% cash yields while a bond ETF like iShares DEX Universe Bond ETF (XBB) pays out only 3.2% cash.
Investment options
The easiest and quickest way to buy into Canadian REITs is through the three ETFs we mentioned at the start. The limited universe of REITs in Canada ( for lists of REITs see appendices in the CIBC report, or check a summary by sector in Wikipedia) means there is a lot of overlap in the ETFs but there are appreciable differences in holdings and especially in weightings (see Couch Potato's comparison).
Alternatively, for an investor with enough capital, it is possible to assemble your own basket of REITs by simply buying a piece of each of the biggest ones, much like an ETF. Then again, one can try finding the best value REITs. Certainly the individual REITs have not all gone down this past year by the same amount. Amongst the major REITs, Dundee (D.UN) has fallen the most - a 24.5% one-year price fall and a negative 18.5% total return. Yet it is profitable and its financials look reasonable, except that CIBC expects no growth. A Stockchase thread summarizes what seem to be a mixed bag of analyst opinions on Dundee. Is it a buy? It's hard to tell and more research than we have done here would be required to develop a firmer opinion. Some have even risen in price, like Canadian REIT (REF.UN) up 1.2% in price with 5.0% total return. CIBC gives its ratings in the report but they may not be correct. This recent Globe Investor story suggests that company insiders think REIT are oversold. Opinions abound.
In any case, almost all recommended portfolio allocations beyond the simplest dual stock and bond combination include a 5-10% real estate holding. REITs' excellent diversification qualities by being uncorrelated with stocks (currently close to zero per page 22 of the CIBC report), except at extreme times of financial crisis, justifies that inclusion. Most investors can thus take a long term view, confident that REITs will be around a long time, despite swings of price and interest rates, and rebalance their portfolio when the REIT allocation rises, or in this case perhaps drops, beyond the target limit set by the investor's policy statement.
Disclosure: This blogger owns holdings in most of the major Canadian REITs, including D.UN and REF.UN and BMO's ZRE ETF.
Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.
Investment options
The easiest and quickest way to buy into Canadian REITs is through the three ETFs we mentioned at the start. The limited universe of REITs in Canada ( for lists of REITs see appendices in the CIBC report, or check a summary by sector in Wikipedia) means there is a lot of overlap in the ETFs but there are appreciable differences in holdings and especially in weightings (see Couch Potato's comparison).
Alternatively, for an investor with enough capital, it is possible to assemble your own basket of REITs by simply buying a piece of each of the biggest ones, much like an ETF. Then again, one can try finding the best value REITs. Certainly the individual REITs have not all gone down this past year by the same amount. Amongst the major REITs, Dundee (D.UN) has fallen the most - a 24.5% one-year price fall and a negative 18.5% total return. Yet it is profitable and its financials look reasonable, except that CIBC expects no growth. A Stockchase thread summarizes what seem to be a mixed bag of analyst opinions on Dundee. Is it a buy? It's hard to tell and more research than we have done here would be required to develop a firmer opinion. Some have even risen in price, like Canadian REIT (REF.UN) up 1.2% in price with 5.0% total return. CIBC gives its ratings in the report but they may not be correct. This recent Globe Investor story suggests that company insiders think REIT are oversold. Opinions abound.
In any case, almost all recommended portfolio allocations beyond the simplest dual stock and bond combination include a 5-10% real estate holding. REITs' excellent diversification qualities by being uncorrelated with stocks (currently close to zero per page 22 of the CIBC report), except at extreme times of financial crisis, justifies that inclusion. Most investors can thus take a long term view, confident that REITs will be around a long time, despite swings of price and interest rates, and rebalance their portfolio when the REIT allocation rises, or in this case perhaps drops, beyond the target limit set by the investor's policy statement.
Disclosure: This blogger owns holdings in most of the major Canadian REITs, including D.UN and REF.UN and BMO's ZRE ETF.
Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.
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