Steve Ladurantaye
CTV News 7/6/2010

For income-minded investors, real estate investment trusts have long been a staple of the portfolio.

REITs are a way for investors to participate in real estate without actually owning any real estate. That’s because the trusts own and manage the buildings, and its investors own units that can be traded in the market, providing the liquidity that you can’t get as a landlord.

But with the economic recovery uncertain, it’s important to understand how the companies work and how to pick the winners from the losers, said Dennis Mitchell, vice-president and senior portfolio manager at Sentry Investments, where he manages the $400-million Sentry REIT Fund.

The fund has gained 33 per cent in the last year, compared to the REIT group average of 22 per cent (the S&P/TSX capped real estate index returned 38 per cent). It has an average annual return of 5.2 per cent since its inception.

Here Mr. Mitchell fields questions on the state of today’s REIT market.

What sort of investors should be looking at real estate investment trusts?
The No. 1 thing REITs provide is very tax-efficient, monthly income. For accounting purposes, much of the cash flow is classified as return of capital, which is generally not taxed when the investor receives it. It’s accounting return of capital, not economic return of capital – you’re not actually receiving your own money back.

Why does that matter?
Generally, return of capital isn’t taxed when the investor receives it. It reduces the investor’s cost base and when they sell the unit, it gets taxed as a capital gain. Since capital gains taxes are lower than earned-income tax rates, the distributions from a REIT tend to be more tax efficient than interest income from a bond. They are also provide more consistent income than bonds since most bonds pay semi-annual coupons while REITs pay monthly distributions.

I always liken REITs to the three-man in basketball – somebody who can hit the outside shot and also drive to the hole and finish. With REITs, you get consistent stable income but also growth potential as well. Now that growth potential means that you’re exposed to a downside as well, but everything exposes you to a downside in some way, even bonds.

What is the downside?
REITs do poorly in deflationary environments, when demand for commercial real estate is shrinking because the companies themselves are downsizing or going bankrupt. REITs tend to under perform, because occupancy and cash flows both decline and distributions come under pressure. In addition, the actual value of their assets decline as well.

You also have to worry about spikes in long-term interest rates. I’m not really talking about benchmark rates like the overnight rate in Canada. Generally, if the overnight rate is going up, then the economy is doing well and inflation is a concern. REITs tend to outperform during these time periods as the demand for commercial real estate increases.

What we are concerned with are spikes that are driven by macro shocks. If Greece defaults on its sovereign debt, or the U.K. restructures its sovereign debt, it would drive a huge risk premium into everything, especially long rates. The long end of the yield curve ratchets up because people perceive more risk in sovereign debt and demand more return for putting their capital at risk, especially over longer periods of time. That raises the cost of capital for everyone, but real estate and utilities tend to be relatively highly levered so they are exposed more than other sectors.

What are main differences between REITs in Canada and in the U.S.?
The valuations – REITs are generally valued based on AFFO [adjusted funds from operations] multiples. There’s usually a two-multiple gap between U.S. and Canadian REITs, with U.S. REITs getting a premium for growth. Canadian REITs are trading around 14 times AFFO, which is historically where we’ve traded over the last 12 years. In the U.S., REITs are at 21 times AFFO, which is much higher than where they usually trade and a big premium to Canadian REITs.

Why so high?
Good question. There’s nothing fundamental going on that would justify that kind of spread. When I talked to my colleagues in the U.S., one guy said they were looking through the trough to 2012. Another guy said it’s all a leap of faith. Either way, it spells overvaluation and we sold our U.S. REIT positions in May. U.S. REIT multiples need to decline to 16 times before they are fairly valued, which means U.S. REIT share prices have to fall by another 5 [to] 10 per cent before I’m all that interested again.
Link to balance of questions/answers

Grandpa: "Leap of Faith" not only recaps REIT "investors", it is applicable to the U.S. Equity market at large. Wall Street has afforded the Main Street investor absolutely zip during the prior decade while they continued to rake in phenomenal compensation packages. 10 years later, we taxpayers have an unprecedented government incurred debt placing a criminal financial burden on our grandchildren.

Economic data is at best anemic and yet CNBC and Wall Street want Main Street to continue investing in the equity market based on a "Leap of Fath".