REIT ride nearing an end: CIBC

Let’s hope REIT investors have enjoyed the ride over the past 25 years because the next decade and more won’t be as attractive.

That’s the big picture outlook presented by the real estate equity analysts at CIBC World Markets. The six person team has undertaken a four-part series — titled Beyond the Headlines — that looks at the way the sector has developed (the industry’s market cap is more than $60 billion and nine REITs now have a market cap of more than $3 billion, compared with one nine years back), the challenges ahead and the strategies REITs may employ going forward.

“After 25 years of robust growth, Canadian REITs now face material growth constraints,” says the first of the four reports. And the constraints arise from two main factors: the arrival of highly competitive non-taxable pension funds, which have considerable cost of capital advantages over REITs, and capital gains recognition by the REITs themselves (when capital gains are made, unit holders receive distributions, which include taxable capital gains.)

In effect the report is saying the industry has been largely built on the basis of a series of acquisitions that have been easily financed with strong equity markets and lower interest rates. How low? On Wednesday BBB-rated Rio-Can paid 2.194 per cent for four-year debt. Previous borrowings have varied from 2.19 per cent to 5.95 per cent.

From now on those opportunities won’t be available to the same extent. First there is competition from the pension funds which covet real estate assets because the income flows match their liabilities; and, secondly because the large REITs have reached economies of scale, acquisitions “must necessarily be larger to be meaningful.”

In such a world “internal growth opportunities take centre stage, including development and redevelopment.” Add in the expected rise in interest rates, or in the report’s words, “the tailwind of refinancing at lower rates is fading,” and the future is not as promising as the past.

As well, capital gains taxation looms large. In the past that wasn’t the case because “almost every REIT enjoyed a high tax basis on its portfolio, providing ample depreciation tax shield, augmented by higher leverage than most carry today,” the report reads.

Indeed in the first report — two others have now been released — considerable attention is given to the way in which Canadian REITS are taxed on capital gains — in short they don’t have the same advantages as REITs in other parts of the world.

In the U.S. capital gains can be deferred through a like-kind exchange. In that situation, taxes are not paid provided the owners invest the proceeds within a period of time. (Similar policies exist in Japan, Germany and Ireland while in Hong Kong and Singapore there are no capital gains taxes.)

Reached Wednesday, CIBC analyst Alex Avery said two factors could change his thesis: either a “substantial reduction” in property prices, or a “significant” increase in supply.

“But I don’t see a lot of scenarios where the recognition of capital gains tax isn’t a significant inhibitor to REIT growth,” he noted adding that such recognition “prevents REITs from recycling capital efficiently.”

What about a change in the tax treatment of capital gains or introducing a “likekind” exchange? “That’s exactly what I hope happens,” said Avery, who spearheaded the four reports to bring the sector’s fundamentals to the attention of all REIT participants. “A change in policy would restore the growth opportunity that REITs previously enjoyed,” he added.