Friday, 17 October 2014

Canadian REITs - Which look good, which don't

Last week's post concluded by noting that the continued success of Canadian REIT ETFs from iShares and Vanguard depend a lot on two of their heavyweight holdings - RioCan and Boardwalk. This week, we'll drill down into these and other REITs, or similar real estate corporations, to see if they look attractive. We take the point of view of an investor looking for steady, high sustainable income and not, for instance, seeking under-valued turn-around candidates.

Safety first - Financial stability
The ability to keep paying distributions, especially higher rates, arises from a very solid financial foundation, notably:
  • Strong, consistent profitability - We looked at the net income performance of the last five years, favouring those REITs who always made money and downgrading the others. One REIT, Northwest Healthcare Properties REIT (TSX symbol: NWH.UN), did fine for four years up to 2013 but has faltered in recent months.
  • Track record aka proven management and size - A longer successful history means management and the internal processes of a REIT are more probably solid. One slightly worrying sign at RioCan is the resignation on October 2nd of the President and CEO Fredric Waks for the reason often given when it is not a happy departure - "... to pursue other interests". A larger portfolio of properties provides more internal diversification. We have thus eliminated REITs whose market cap is below $350 million (which excludes none of the REITs held by any of the three big ETFs). Also eliminated were a couple of REITs tied to one retailer - Canadian Tire for CT REIT (TSX:CRT.UN) and Loblaws for Choice Properties (TSX: CHP.UN).
  • Limited debt - The classic 2004 guide to REITs from Deloitte (still available as a free download from Investor Village) notes that 40 to 60% debt on the balance sheet is a desirable conservative range. We put aside those REITs above that range, shown as a Debt/Equity ratio above 1.5 in our table below (40% debt = D/E 0.67)
  • Business sector - REITs operate in various sectors, from hotels to office buildings. Some sectors are more vulnerable to economic swings, most particularly hotels. The most stable are apartments and seniors homes. In between are retail, office and industrial.
Sustainability of distributions
REITs should not pay out more cash than what is needed to maintain the assets and the business, as a minimum, or to undertake expansion that will grow distributions, as a more ambitious goal. The commonly used metric to gauge how much is Adjusted Funds From Operations (AFFO), which CREIT (TSX: REF.UN) describes as "... a measure of operating cash flow generated from the business, after providing for all operating capital requirements". Taking the actual distribution as a percentage of AFFO the maximum advisable rule of thumb (per the Deloitte Guide) is a 95% payout ratio. A couple of REITs, Pure Industrial (TSX: AAR.UN) at 101.1% and Crombie (CRR.UN) at 98.3%, exceed the target. RioCan is right on the line at 95.3%.

Growth in distributions, actual historical and potential future
A track record of growing distributions by a REIT is a good thing, the converse of no growth or reduced distributions being bad of course. The one-year and five-year growth records show what the REITs have delivered to investors. The better-performing REITs levitate towards the preferred upper part of the table.

Growing AFFO, low payout and low debt/equity show a greater capacity and potential for future distribution increases. The REITs in the top of the table show favourable combinations of these elements.

Interest rate effects - The benchmark against which REIT payouts are compared is the Government of Canada 10 year maturity bond. Currently, the GOC10 yields 1.95% (see Y Charts), though it can only be purchased by an individual investor for around 1.77% yield (the broker takes a cut). Is it enough compared to the yields in our table below, or other fixed income investments (see our post a few weeks back comparing best fixed income rates)? It's up to us individually to decide.

One other factor we investors need to keep in mind is that REIT prices will decline should interest rates rise. Last year, CIBC's REIT review estimated that REIT prices would fall about 12% for every 1% rise in GOC10 rates. Another review from Dundee Capital Markets in the Globe and Mail pegged the sensitivity at 13:1. In reality, after the approximate 1% rise in interest rates in 2013, REITs fell 16% on average.

Bottom line: 15 REITs we like - top half of the table - and 13 we don't like - in the bottom half.
(click to enlarge image)

There is a wide range of yields on offer from:
-  a low of 2.9% from Boardwalk (TSX: BEI.UN), which displays a high degree of safety plus past and potential growth, to
- a high of 8.5% from Dream Global (DRG.UN), a smaller, more levered, less established, portfolio in a more economically sensitive sector i.e. riskier player.

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.

No comments: