Canadian real estate investment trusts were designed in 1993 to attract capital from public investors back into real estate after a severe meltdown in commercial property markets. Over 30 years later, are the trusts still relevant investment vehicles?
“The coming out party for REITs was late 1996 and 1997 where we had a slew of IPOs (initial public offerings),” said Stephen Sender, a trustee and director for Allied Properties REIT and Sienna Senior Living, who moderated a discussion at the Sept. 10 RealREIT conference in Toronto that explored the evolution of Canadian REITs and the advantages and disadvantages of the current model.
“When they started out, the whole idea was basically to earn a distribution monthly and the orientation was almost entirely towards small, private, individual investors, which we like to call retail investors. And hence, that’s how the REIT market got going.”
Canadian REITs have evolved from having portfolios of high-yielding properties in externally managed vehicles to serving two primary purposes: being strong real estate platforms and strong dividend payers.
“I started looking at REITs around 2006 or 2007, which was just on the cusp of the global financial crisis,” BMO Capital Markets managing director and REIT analyst Mike Markidis told the attendees. “At that point, capital structures were very finely tuned, the yields were high, there was M and A (mergers and acquisitions) in the space, and valuations were getting buoyed.”
Distributing income to shareholders
Canadian REITs weathered the subsequent financial crisis relatively well compared to those in other countries and they rode a tailwind even through the onset of the COVID-19 pandemic in 2020 – until interest rates started to increase.
“We just went through a painful period of adjustment,” Markidis noted, “but I think, generally speaking, REITs have done a very good job. They’re obviously smaller in terms of market cap, but some of that would be cyclical in terms of the interest rate cycle.”
Canadian REITs are required to be configured as trusts and aren’t taxed if they distribute their net taxable income to shareholders.
“The REIT model has a role, and it brings exposure to real estate in a liquid way to many investors,” Choice Properties chief financial officer Mario Barrafato said. “But when you pay out 89 per cent of your cash flow every month, if you want to grow, you have to go raise it again. You need to develop a platform and have a strategy and a reputation that makes you investment-worthy.
“So I think the discipline of the REIT is really important.”
REIT structure may not be good for the long term
KingSett Capital chief executive officer Rob Kumer agreed REITs have generally done a good job of adapting to challenges in different operating circumstances and providing a liquid way of earning a distribution yield with professional management and good assets.
However, his view of real estate’s place in the investment world differs from what the REIT structure allows.
“I view real estate as an ever-evolving asset that requires reinvestment and sometimes reinvention, and sometimes you scrap it and build something else,” Kumer said. “I love investment in real estate because of all the different things and all the different opportunities it presents over a long period of time.
“So the idea of distributing all the cash so that every time you want to do something that requires capital, you have to go find it, borrow it, raise it or find it in other parts of your investment portfolio, I just don’t think that lends itself to long-term real estate investment.
“I think we should be viewing real estate as a total growth vehicle, not as a yield vehicle. And I think, by and large, the REIT market markets itself as a yield investment play.
“And that’s not the way I fundamentally view real estate. I view real estate more as a total growth asset class and I think it requires a different kind of perspective for the long term.”
Favouring a more return-focused approach
QuadReal executive vice-president of Canadian investments Jamie Manley offered a viewpoint similar to Kumer’s outlook.
“I completely agree that REITs certainly have a place in terms of offering a segment of investors ample access to liquidity, good assets, good distribution yields, et cetera,” he said, “but everywhere I’ve worked, we’ve always been completely total return-focused.
“I’ve seen the power being able to continue to harness and tap into the true potential of each property as cycles and trends change. With the ability to reinvest in assets, we’ve done really well and have been able to be rewarded for that.”
Canadian and American REIT models
Sender said many Canadian REITs have put themselves in a position where they have high leverage and a high payout ratio, which limits what they can do. He’d prefer a situation where companies can modify their approaches depending on the circumstances.
Kumer said the American REIT market is based on lower leverage, much lower payroll ratios, lower yields and more of a total return focus. Many Canadians thought the American model was the right way to go until the credit crisis that ended the first decade of this century, according to Sender.
“When the credit crisis hit, stuff hit the fan big time,” he said. “What we discover is when people are not committed to paying out all their cash flow and reinvesting their undistributed earnings, you’re subject to what’s called reinvestment risk.
“They may not get it right, and a number of U.S. REITs were taking inordinate amounts of risk in terms of joint ventures and God only knows what else they were doing. And then the stuff hit the fan in 2008 and 2009 and the Canadian REITs, with their high payout ratios and mortgages through Sun Life and Great-West Life, hung in there.
“And they were champs.”
