The REIT Sector The domestic real estate investment trust sector never regained the heights hit just before the taper tantrum of 2013 and, with the U.S. Federal Reserve threatening to tighten monetary policy in December, the sector is once again under pressure.
The performance history of the industry, however, suggests fears are overdone. The S&P/TSX REIT Index has fallen 9.2 per cent since late July, reflecting fears that a U.S. Federal Reserve rate increase will push Canadian bond yields and borrowing costs higher, and also make bond investments more competitive with income-generating REITS.
But a potential interest rate hike by the Fed still leaves domestic REITs with a huge distribution yield advantage over bonds, even if government of Canada bond yields climb with their U.S. counterparts. In addition, the sector is as attractive as it's been in recent years based on trailing price earnings ratios.
The first chart shows the performance history of the S&P/TSX REIT Index against its distribution yield advantage over government of Canada bonds. The grey line represents the extra income available in REITs by subtracting the bond yield from the index yield. Currently, the annual income yield for the index is 5.8 per cent, and the five-year bond yield is 0.7 per cent, so the last data point on the chart shows the difference, 5.1 percentage points, on the chart.
The orange line on the chart shows the forward two-year simple return (not including income) for the index. For example, the first data point on the orange line indicates that between October, 2006, and October, 2008, the REIT index generated a 0.38 per cent return.
Except for post-crisis volatility, the pattern has been consistent in the past decade - the more the REIT distribution yield exceeds bond yields, the better two-year return investors can expect. The chart strongly suggests that two-year returns in the sector will improve over the next year - the orange line should climb to match the grey line.
The second chart shows the performance of the S&P/TSX REIT Index relative to its trailing 12-month price earnings ratio, beginning in January, 2012 (changes in the index constituents makes comparisons over longer periods largely irrelevant). At 16.7 times trailing earnings, the index is trading below the four-year average of 17.3.
The domestic REIT sector, with an income yield five percentage points higher than bonds, does not appear endangered by a 25 basis point rise in bond yields. Valuations are not excessive. This doesn't mean, however, that investment in the sector is a guarantee of outperformance. A continued weak Canadian economy, for instance, could cause office and apartment vacancies to rise outside of Calgary, where they are already a significant drag on local REIT income and profits. A greater-than-expected rise in bond yields and borrowing costs would also reduce REIT profits as existing corporate debt issues mature and new financing results in higher interest expenses.
Economists surveyed by Bloomberg see a 67 per cent likelihood of a Fed hike by December, and an 89 per cent chance of higher policy rates by the end of 2017. Investors can expect the Canadian REIT sector to remain volatile before the Fed finally acts, but should take a close look at financially healthy investments in the sector during this period.
Thu, 13 Oct 2016 17:14 EDT