An Overview of the Canadian REIT Market
Posted on November 25th, 2009
There are currently about 28 Real Estate Investment Trusts (REIT) that trade on Canadian exchanges. Although we believe that there are good opportunities to be found in this sector, we stress that investors enter into the sector on a very selective basis - pick the best REITs and not just any REIT. Yields in the sector currently range from as low as 4.5% to as high as 14.0%. In our opinion, the REITs with higher yields (over 9%) nearly all carry a level of risk that we find unacceptable, even in our Aggressive-Risk class. For us, we have found that the real opportunities exist within the 6% to 7% range.
One factor to consider with the REIT sector is the high debt levels. All REITs have debt and this is not necessarily negative. Similar to utilities companies, REITs typically have a relatively stable and predictable cash flow stream and therefore can incur higher debt levels than companies with less stable cash flow (cyclical companies). The average total debt-to-cash flow ratio (a ratio used to assess debt level) in the sector is 15 times, but we see some REITs with ratios beyond 20 times and as high as 30 times. The average cash flow-to-interest expense ratio (a ratio used to assess capacity to make interest payments) for the sector is about 2.13. Once again, we have found several REITs with ratios less than 2 times and even approaching 1 times – meaning that operating cash flow is less than the interest expense for the period. We do not find the average debt levels in the sector to be overly troublesome; however, debt levels beyond the averages will generally carry too much risk for us.
When selecting a REIT there is much more to consider than just raw numbers, but some of these numbers do represent financial risk and, generally, we would prefer to invest in REITs with lower than average total debt-to-cash flow and higher than average cash flow-to-interest expense. We apply the same rationale to the payout ratio. The average payout for the sector is well over 90% and several REITs (even well established REITs) are paying out over 100%. Now since the purpose of the REIT is to pass on cash flow to investors, it stands to reason that they should have a high payout ratio and we are not necessarily uncomfortable with a payout ratio of 90%. However, a lower payout ratio (based on past and expected cash flow) is an indication of less risk. If the economic environment results in a decrease to cash flows or debt refinancing at less favourable terms, then the REITs with lower payout ratios will be under less pressure to lower the distribution. As well, in growth periods, we believe that these REITs will be in a better position to increase distributions on a consistent basis.
In the November edition of the Income Stock Report, we are featuring a REIT that we believe to embody the more favourable traits of the sector - a quality property portfolio, lower debt levels, lower payout ratio and a reasonable yield.