Office space is available for lease in downtown Calgary on April 13, 2016.Jeff McIntosh/The Canadian Press
Two years into a painful correction, real estate investment trusts have turned on a dime.
Since late June, the iShares S&P/TSX Capped REIT Index has surged 20 per cent. Not only has the rally turned the sector’s return positive for the year, it’s also clawed back nearly half of what’s been lost since the misery for REITs began in March, 2022.
The most obvious explanation for this rebound is recent cuts in interest rates. The REIT index peaked in 2022, the very same month the Bank of Canada started its rate-hike campaign, and it started recovering this June, the very same month the central bank started cutting.
Canadian REITs have long been sensitive to interest rates because they have large retail investor bases – and Canadians have an obsession with yield. In the aftermath of the 2008-09 global financial crisis, government bonds paid rock-bottom yields, so REITs, which offered annual distribution yields of around 5 per cent, caught fire.
But is it that simple? Will REITs keep rising if rates keep falling?
Dennis Mitchell, chief executive officer at Starlight Capital, thinks so. “When the Federal Reserve joins the party and starts cutting rates, you’ll see another leg up,” he said.
Yet within the industry it’s an open debate. Interest rates certainly matter, said Jeff Olin, CEO of Toronto-based real estate investor Vision Capital Corp., but the sector is “always driven by supply and demand.”
To prove this, he points to the Calgary office market, which was decimated after the price of oil crashed in 2014. At the time, interest rates were remarkably low – and the Bank of Canada even cut rates in early 2015 – but that wasn’t enough to resuscitate the market because energy companies were slashing head office jobs.
This time around, the interest-rate tailwind arguably has more juice because there’s so much cash sitting in short-term fixed income products, such as guaranteed investment certificates and high-interest exchange-traded funds. In late August, research analysts at Canadian Imperial Bank of Commerce estimated there is now more than $200-billion in excess funds sitting in these securities.
Falling rates, the analysts wrote, “should drive investors back into Canadian dividend-paying stocks – particularly since many of these equities have performed poorly vis-à-vis the broader market over the past couple of years.” (Utilities and telecom stocks, which tend to pay healthy dividends, have also struggled in recent years.)
Crucially, the analysts noted that upper-income Canadians are disproportionately large holders of term deposits and these investors enjoy a tax advantage if they switch back to stocks because dividend income is taxed at a lower rate than interest income.
“A simplified rule of thumb is a 4-per-cent dividend yield is currently equivalent to a 5-per-cent interest coupon, when taxes are considered at the highest tax bracket,” the analysts wrote.
The hard part for investors is that each sector of the commercial real estate market – industrial, rental apartments, office and retail properties – has its own headwinds right now, so it is risky to blindly purchase a broad ETF to get some exposure.
Rental apartment buildings, which are formally known as multifamily properties, have benefited from Canada’s immigration increase since the federal Liberals took office in 2015 – and particularly since the immigration surge during the COVID-19 pandemic, when one million newcomers came to Canada in a single year. The supply of new properties hasn’t kept up with demand and rents have soared across the country.
Lately, though, the federal government has dramatically changed course and lowered its cap on how many people can stay in the country without permanent residency. It isn’t clear yet how much that will affect demand for rental properties, which have traditionally been the dominant source of housing for newcomers, but this reversal, coupled with a sudden glut of condos in urban areas such as Toronto, is already putting downward pressure on rents.
Industrial real estate was also a bright spot in commercial real estate because of the e-commerce boom, but lately this segment has also struggled. After lockdowns lifted, e-commerce demand dropped, so new warehouses weren’t needed as feverishly. The broader Canadian economy has also slowed significantly. In all, an oversupply of new properties, particularly “large bay” properties, or giant warehouses, coupled with cooling demand has hurt industrial valuations.
As for retail properties such as large strip mall plazas, they are sensitive to changes in consumer spending in a cooler economy, and offices are navigating a structural change to demand because of hybrid work. Nationally, office vacancy sits at 18.5 per cent, according to real estate consultancy CBRE.
Across the entire real estate sector, there is also a debate as to whether REITs are really all that cheap any more.
Optimists argue that so many Canadian REITs were oversold, which is why they were trading at such deep discounts to their net asset values, and there is still more room to recover. Yet this discount is only one metric to consider. Within commercial real estate, capitalization rates, which measure annual rents as a percentage of property value, are equally important.
Typically, when REITs are cheap, their capitalization rates climb higher – because property values drop, so rents become a large percentage of total value. In recent years, capitalization rates have risen, but not all that much. REITs often use the 10-year Government of Canada bond yield as a benchmark, and the spread, or difference, between the sector’s average capitalization rate and this bond yield still remains tight by historical standards.
Another way of saying that, in simple terms: REITs aren’t all that cheap relative to one of their key benchmarks.
There’s no denying REITs have a lot going for them. Billions of dollars’ worth of cash is sitting on the sidelines and if even a fraction of that is invested in the sector, it would do wonders. Falling interest rates also lower REIT mortgage costs, which leaves more cash free to pay as distributions to investors.
And despite some economic headwinds, there are some pockets of strong performance. Boardwalk REIT owns rental properties in Calgary, which is booming, and its monthly rents for occupied units have jumped 10 per cent, year-over-year. Mr. Olin at Vision Capital is also bullish on grocery-anchored retail REITs because grocers have been faring well, plus these properties are often in prime locations that can be redeveloped into multifamily properties in the future.
But even the optimists caution investors against treating the whole sector equally. Starlight’s Mr. Mitchell said he’s talked to some retail investors and advisers in recent weeks and found some of them are focused on REITs with outsized yields. What they don’t understand, he said, is that those yields are so high because investors have sold off REITs over fears of distribution cuts or, worse, creditor protection.
The strong returns might be worthwhile, he said, but if the economy weakens, in a few months’ time investors “may pay a price.”