Should you hold REITs while interest rates rise?

In a rising rate environment, apartment REITs are attractive because they have short-term leases which gives them greater flexibility to increase their lease rates. But you may already be too late to enjoy that party. However RioCan’s flagship in downtown Toronto highlights that REIT’s strategy to focus on mixed-use development in its major markets.

REITS_and_Rising_Interest_RatesThe S&P/TSX Real Estate Investment Trust (REIT) Index has outperformed the wider market by a large margin this year. Since the beginning of the year, the index is up 7.7 per cent. The S&P/TSX Composite Index, meanwhile, has struggled to get out of the red. It’s down 0.3 per cent over the same period.

The outperformance of REITs may seem counter-intuitive. After all, as interest-sensitive investments, they’re widely seen as a vulnerable to rising interest rates.

Yet the outperformance of REITs may not be as unusual as it seems. According to CIBC World Markets, there have been occasions in the past where the sector has outperformed in rising rate environments. What’s more important to them than the impact of rising rates on REITs is the strength of the economy. If the economy is doing well, REITs can benefit through rising funds from operations, even though servicing their debt may be more costly due to rising rates.

It’s not necessarily a good idea, therefore, to abandon your REITs when interest rates undergo a sustained rise. Instead, you may want to hold on to them, and even add to them on a selective basis, especially when their prices weaken.

Some argue that you may want to emphasize some REITs over others in the current environment. Apartment REITs, for example, are seen as attractive because they have shorter-term lease durations than other types of REITs. This gives them greater flexibility to increase their leases in a rising-rate environment.

As with many good-news stories, however, there’s a drawback, as investors have caught on to the idea and bid up the prices of these securities. Contrarians can find better value elsewhere.

RioCan focusing on its major markets

One such opportunity is RioCan Real Estate Investment Trust (TSX—REI.UN) which owns, manages, and develops retail-focused, increasingly mixed-use, properties located in prime, high-density, transit-oriented areas where, increasingly, Canadians want to live and work and shop.

RioCan has made progress on both its strategic dispositions and its development program. The REIT has surpassed the halfway mark of its $2.0-billion disposition target with $1.2 billion of secondary market assets sold or under firm or conditional contracts.

Meanwhile, it has made significant leasing progress at the office component of its new flagship development, ‘The Well’, in downtown Toronto—a retail, office and residential mix of over 3 million square feet.

For the six months ended June 30, 2018, RioCan’s funds from operations (FFO) were $294.5 million, or $0.92 a unit, compared with $289.4 million, or $0.88 a unit, in the same period of 2017. The increase occurred despite significant dispositions completed in the latest period and $4.3 million in one-time severance costs.

Same-property (properties owned and operated in both periods) net operating income (NOI) rose 2.3 per cent to $324.9 million. Same-property NOI for properties in Canada’s six major markets rose 2.8 per cent, while same-property NOI for secondary markets decreased 0.1 per cent.

RioCan expects continued organic growth over the short and long term as it continues to focus on its major markets, where it believes it can prosper despite a difficult retail environment.

RioCan trades around a reasonable 13.5 times its likely 2018 FFO of $1.84 a unit. Its annual distribution of $1.44 a unit yields about 5.8 per cent.

Buy for growth and income. 

This is an edited version of an article that was originally published for subscribers in the October 5, 2018, issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.

Money Reporter, MPL Communications Inc.
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