There is an old saying among people in the property industry: “Don’t wait to buy real estate, buy real estate and wait.” One can disparage this often-quoted statement as shameless marketing, but analysis of the historic evidence is unequivocal. Real estate is an important and profitable asset class, and always will be.
This truth does not take away from the inevitable periods of time and places when bubbles are burst, and some investors are ruined. Real estate is subject to manias, just like many other investment classes. The fact that real-estate investing is dependent on debt leverage adds to its volatile nature. The very success of real estate as an asset class creates over-enthusiasm, over-leveraging and over-speculation.
Real estate investment trusts have gone through a difficult and volatile period. Over the past five years ended in December, 2023, the Canadian REIT Index returned 4.19 per cent, including distributions, annualized. This compares unfavourably with the S&P/TSX Composite Index five-year return of 11.30 per cent annualized, including dividends. REITs have outperformed the overall Canadian bond index, which has returned 1.30 per cent over this period.
There has been an understandably big difference in the performance of various subsectors of the REIT market. On the bright side, Canadian multifamily REITs have returned somewhere in the mid-20-per-cent range in 2023. This is no surprise, as rents have soared and there are chronic supply shortages in major cities.
Most analysts seem to believe that the party for multifamily REITs will last forever, but I am less optimistic. Typically, when there is a consensus about an asset booming for the foreseeable future, that is the time to take profits. These REITs are usually the least volatile subsector and prices are expensive. Yields are around 3 per cent, which is thin relative to bonds.
An important point here: There is a difference between demand and effective demand. Yes, Canada needs more homes, but Canadians cannot afford them. The average rent in Toronto is $2,700 a month, according to Zumper. Good luck being able to carry that rent on a $20-an-hour job at a call centre. It will also take time to build these new units, so REITs will not be able to monetize this opportunity quickly.
Industrial REITs also look expensive right now. Industrial property tends to be stable compared with office and retail property. There’s no great value to be had here, as their lower yields relative to other REIT segments would suggest.
What about office building REITs? They had another rough year in 2023 after a poor 2022. The sector was hit by rising rates, and COVID-19 accelerated the “work from home” movement. In Canada, there are only two names in this sector: Dream Office D-UN-T and Allied REIT AP-UN-T. Dream recently cut its distribution in half, while Allied reported a $510-million write-down on its property portfolio. Sounds discouraging, but these REITs may be oversold, and current yields of above 10 per cent are very generous compared with the multi-family sector and bonds.
Employers are forcing workers back to the office, demanding attendance on a more frequent basis, believing that productivity has waned. If employers want workers back in the office, they will be obliged to go. There will still be many people working from home in the future, but commercial real estate will still be viable, especially when you consider expected population growth. The market is over-discounting this.
Of course, economic weakness could cause a commercial real estate crisis, but prices have already been sharply reduced. There is no speculative bubble. There is also enough capital for players to swoop in and buy buildings, which could bolster office REITs.
These are, however, speculative plays. It may be safer to consider buying a large, well-diversified office firm in the U.S. (there aren’t many REITs that target this specific sector). The U.S. economy, in my view, also has a better long-term economic outlook than Canada. Two of the largest U.S. office names are Boston Properties BXP-N and Vornado Realty Trust VNO-N.
Another attractive segment right now are retail REITs, which are inexpensive historically and are relatively undervalued; consider that they pay yields well above multifamily REITs. People are also increasingly getting back to their pre-COVID-19 lives, and that includes going out shopping. First Capital REIT FCR-UN-T and Crombie REIT CRR-UN-T are two firms in retail that look stable and solid.
Taken as a whole, the stock market is expensive right now. If the economy is weaker than expected, equities will fall even more than office REITs, which are cushioned by fat yields. Today’s dogs could easily become tomorrow’s stars.
REITs will continue to have price volatility. However, they do provide the investor with income and are an inflation hedge as landlords raise rents. REITs should have an allocation in all balanced portfolios, as they do not perfectly correlate with equities or bonds, thus increasing diversification and reducing portfolio volatility over the long run.
A smart approach is to be diversified and make sure to invest with trusts with strong balance sheets, including comfortable debt levels and low payout ratios. The iShares S&P/TSX Capped REIT Index ETF XRE-T gives the investor exposure to a diversified portfolio of names.
Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed income and asset mix strategy. He is a former lead manager of Royal Bank of Canada’s main bond fund.