Jumping off the REIT bandwagon

That pop you heard might have been the bubble finally bursting — at least for real estate investment trusts, if not housing.

Rising bond yields have brought down the publicly traded real estate sector since it hit a record high at the end of April. The iShares S&P/TSX Capped REIT Index Fund dropped about 12% before recovering about two percentage points off that fall in the past week or so.

Now the question is whether it’s time to plow back into the REIT sector or get out for good.

“We’ve always said the biggest risk for the real estate sector is interest rates rising and investors looking for more upside elsewhere,” said Michael Smith, an analyst with Macquarie Equities Research, adding rates are rising as world economies improve. “This is not because REITs are bad, but others look better on a relative basis.”

Mr. Smith thinks the U.S. recovery has “some legs” to it, which will have an impact on REITs, but that doesn’t mean it’s time to abandon Canadian REITs.

He thinks the REIT market will be protected by the desire for yield that investors continue to crave. “While this outlook may not seem overly attractive, investors can continue to earn yields of 4% to 5%. This may seem low, but is quite favourable compared to the S&P/TSX’s flat performance over the last seven years,” Mr. Smith said in a recent report.

Tom Hofstedter, chief executive of H&R REIT, the country’s second-largest, said the knee-jerk reaction, after a rise in rates, is for a sharp decline in valuations.

“Then it claws its way back, which is what it is doing. The market overshot itself and now it’s coming back,” said Mr. Hofstedter.

The impact on REITs really depends on how high interest rates ultimately go. The higher they go, the more damage. But a small half percentage point increase shouldn’t unduly impact operations and growth, says the chief executive.

Michael Missaghie, portfolio manager with Sentry Investments, runs a dedicated real estate fund so he has to be in the sector. A decline has created an opportunity for him and others looking for higher quality REITS.

“With this pullback, you are going to see investors like us making sure the quality of our portfolio is at the higher end,” said Mr. Missaghie. “There is more value in higher quality business, you can get a better risk adjusted return.”

He says REITs are trading slightly above historical free cash flow multiples, which makes sense in an environment of low interest rates and low economic growth.

But the latest pullback has REITs trading at a 5% to 7% discount to net asset value while the sector usually trades at premium to NAV — creating room for growth.

“We expect the yields to be solid and in place,” said Mr. Missaghie, who can see a total return of 10% to 12% annually.

The other issue for investors is: Where else will they get the yield that REITs continue to offer? The iShares index continues to offer about a 4.5% yield — a lofty level compared to bonds and GICs if you feel confident about your capital.