A Monopoly game that investors can win
A Canadian fund manager who specializes in REITs tells investors what to look for in these real estate trusts and names his four favourites.
Some people live in them. Others work in them. And millions of people shop in them.
It’s as though we were on a giant Monopoly board.
And all of the properties (except Jail) are owned by Real Estate Investment Trusts. REITs.
They’re also the only class of income trusts that will not be encumbered with the distribution tax in 2011 (at least those that can prove they do the bulk of their business in Canada).
But are they a good investment?
Mr. Dennis Mitchell thinks so. He manages a fund devoted entirely to REITs. Naturally, he studies these investments from every possible angle.
He shares his approach and the results of his analysis with the readers of Investor's Digest of Canada. And he names his four favourite REITs.
But he begins in cyberspace.
A 10-foot pole
As he was perusing various investment blogs, Mr. Mitchell ran across two very different comments on Real Estate Investment Trusts.
“I wouldn’t touch REITs with a 10-foot pole.’
“I love REITs, I’m not sure what I would have done without them.”
For Mr. Mitchell, the reality of REITs lies somewhere between these contrary views. The best of these trusts will bring a steady stream of income into a well-balanced portfolio.
They do it with rents. Each real estate trust owns a portfolio of commercial real estate. It may be apartments or condos, office or industrial buildings, or shopping malls.
Tax-efficient
The proposition is simple for real estate trusts. Generate predictable revenue streams based on steady occupancy rates. Their expenses are operating costs (like utilities), interest expense and depreciation expense.
They are not built for vigorous growth. There are only so many shopping malls or office buildings that can be built in Canada (although there seems to be no discernable limit on condo building in some cities).
That means REITs don’t plough a lot of money back into the business and can pay out the majority of their free cash flow in distributions. These distributions are taxed once, in the hands of the investor.
Here’s one big advantage, says Mr. Mitchell. Since depreciation expenses aren’t counted as cash, a healthy portion of the distribution is classified as return of capital, or ROC, and not taxed until the units are sold.
“This makes the distributions very tax-efficient and attracts significant capital into the space, despite the low growth potential of the sector.”
Management is the key
Mr. Mitchell and his colleagues judge REITs on four criteria — management, payout ratios, leverage and asset strategy.
The last three of these are all important, he says. The payout — the percentage of earnings needed to maintain the distribution — must be sustainable over time. Leverage, or debt, should be low. And the assets must be strong real estate portfolios that produce recurring cash flow.
But management is the key, says this fund manager. “A committed, talented and aligned management team” will create extra value and compound capital at high rates of return for unitholders.
“However, a smart, hard-working but unprincipled management team will find myriad ways to rob investors of their hard-earned capital.”
A good score
Having tested REITs with these four criteria, Mr. Mitchell considers one more variable — risk. He and his team judge potential risk in order to determine what return they should receive for their investment.
They don’t measure risk by the volatility of the unit price — a lower price is a buying opportunity. Instead, they gauge a REIT’s ability to create free cash flow based on its adjusted funds from operations (AFFO).
Invariably, a good score comes from those REITs holding “longer-term leases with strong tenants in quality assets.”
Four high-scoring REITs stand out for this fund manager.
Canadian REIT (TSX-REF.UN) owns a large portfolio of retail, commercial and industrial properties. It is “one of the best REITs in the country,” says Mr. Mitchell. It scores four out of four on his criteria and was the only REIT to increase its distribution during the financial downturn. It trades at $28.88 and yields 4.8 per cent on its distribution of $1.38.
Boardwalk REIT (BEI.UN) is another big favourite with this team. It’s Canada’s single largest apartment landlord. It’s sitting on tons of cash and could have much more by the end of this year thanks to its access to more financing from Canada Mortgage and Housing (CMHC). Boardwalk trades at $39.42 and yields 4.8 per cent on a distribution of $1.80.
Allied Property REIT (TSX-AP.UN) also has a perfect score on this manager’s criteria. It has a big portfolio of urban office buildings and one of its hottest properties is along King Street West in Toronto, an area that’s being rapidly “gentrified.” It trades at $19.72 and yields a solid 6.6 per cent on its distribution of $1.32.
Northern Property REIT (TSX-NPR.UN) holds apartments and other residential properties in the Northwest Territories, Nunavut, Newfoundland, Alberta, and British Columbia. Its far-flung properties churn out high yields thanks in part to low CHMC-insured financing. It is trading at $22.10 and yielding 6.4 per cent on the distribution of $1.48.
Interest rates will rise, Mr. Mitchell concedes. But if Canada’s long-bond yields remain below five per cent, mortgage rates should remain favourable and real estate values should hold firm.
What’s more, he tells his readers in Investor's Digest of Canada, the best of these trusts should benefit from a flow of funds out of income trusts and into tax-protected REITs as the 2011 tax deadline comes closer.
A lot of Canadian cash goes into living, working and buying in REITs every year. This analyst believes wise investors will take some of that cash back and give it a home in their portfolios.
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