Why higher rates don’t equal lower profits for REITs
Many insist higher interest rates will undercut REITs, but this analyst argues that the best trusts will do even better — like these seven.
Interest rates have gone up. Not by much, but it’s a start.
And this unleashes a flood of speculation as to how they will affect everything from inflation to housing to your summer vacation.
But today we zero in on one area of concern — the one group of income trusts that stand to avoid the 2011 distribution tax. Real Estate Income Trusts, or REITs.
Are higher rates about to undermine the foundation of these trusts?
A month ago, we heard from an expert on REITs who offered his top picks in the field (see Daily Buy-Sell Adviser, May 19).
Now we return to the same source for an inside assessment of their future under a regime of higher rates.
Mr. Dennis Mitchell manages a fund devoted to REITs. Of course that gives him an interest in seeing REITs succeed. But it also means he must undertake a hardheaded analysis of these investments as he manages his fund under changing circumstances.
Writing in Investor's Digest of Canada, he explains why he thinks rate worries are overblown. And he identifies seven REITs that will do just fine as rates go up — in some cases, even better.
A low curve
The problem is one of perception, says Mr. Mitchell. Investors are assuming that REITs are highly leveraged and that higher rates will cut deep into their credit lines.
“While I admit there is a certain logic to this,” this fund manager replies, “this type of superficial thinking fails to capture the many moving parts that go into companies, their strategies and operations.”
To begin with, the long end of the yield curve is likely to remain low for some time, in Mr. Mitchell’s opinion. He uses the example of Australia, which began raising the target for the cash rate in October 2009.
Over seven months, the rate went up 150 basis points (bps), from 3 to 4.5 per cent. In response, five-year Treasury bonds actually fell from 5.3 to 5 per cent while short rates were rising.
“This is likely a good template for what awaits Canada when we begin our own tightening cycle,” states this analyst. And today’s cautious words from Mr. Mark Carney at the Bank of Canada tend to support his view.
Not a penny drawn
Now Mr. Mitchell turns his attention to the 11 REITs in the S&P/TSX Capped REIT Index and looks at their leverage. Collectively, they have $1.8 billion on their various lines of credit.
At the first of April, there was only $443 million drawn on those lines, about 2.4 per cent of their combined market capitalization. A 200 bps rise in the overnight rate (it was restored to 50 bps on June 1) would only increase borrowing costs by less than $9 million.
Indeed, two REITs have not drawn a penny on their lines of credit.
Chartwell Seniors Housing REIT (TSX-CSH.UN) has seen its unit price rise fairly steadily. It trades at $7.39 and yields 7.1 per cent on its $0.54 distribution. Cominar REIT (TSX-CUF.UN), with major commercial real estate interests in Quebec, has been trading in a narrower range and is currently at $19.39. It yields 7.4 per cent on a distribution of $1.44.
Three others are keeping “extremely low balances,” says the fund manager. Dundee REIT (TSX-D.UN), which deals in office and industrial properties, has seen its price almost double over the past year. It is at $24.75 today and yields 8.9 per cent on its $2.20 distribution.
The next two are among the four favourites Mr. Mitchell recommended in his last article. Boardwalk REIT (TSX-BEI.UN) is Canada’s largest apartment landlord and the only REIT to increase its distribution during the financial crisis. Trading at $39 a month ago, it is now at $40.78, yielding 4.5 per cent on the distribution of $1.80.
Canadian REIT (TSX-REF.UN), “one of the best REITs in the country” according to this analyst, has a large portfolio of retail, commercial and industrial properties. It stands just where it did a month ago, trading at $28.73 with a yield of 4.8 per cent on its $1.38 distribution.
Cash flow growth
The last piece of the puzzle is mortgage maturities and their impact on funds from operations (FFO). If the refinance rate were to rise by 200 bps each year, interest costs for these REITs would rise by $27 million this year and $44 million in 2011.
This would add up to 4.8 per cent of the REITs’ aggregate 2009 FFO of $1.5 billion. “Again, not the stuff of commercial real estate meltdowns,” comments Mr. Mitchell.
In fact, several REITS would actually “enjoy significant cash flow growth from refinancing debt at current interest rates over the next two years,” he tells his Investor's Digest of Canada readers.
Doing the math, he calculates that RioCan REIT (REI.UN) would actually save $4.7 million a year in refinancing. This trust, which saw a significant rise in its unit price over the past year, trades today at $19.21 and yields 7.2 per cent on the distribution of $1.38.
The same goes for Canada’s largest apartment landlord, Canadian Apartment Properties REIT (TSX-CAR.UN). If it secures refinancing at 3.5 per cent, it saves $2.7 million annually. CAP REIT is trading near its 52-week high at $15.57 and yielding 6.9 per cent on the $1.08 distribution.
Ditto for Boardwalk REIT, by the way. It could save $3.8 million annually on refinancing.
In short, if you want to take advantage of the fact that REITs can escape the trust tax, don’t let higher interest rates stop you.
If this analyst’s calculations are right, Canada’s best real estate trusts are still looking up at very high growth ceilings.
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