What are we looking for?
Canadian REITs.
The screen
In Wednesday's edition of The Globe and Mail, reporter Brent Jang wrote about the continued inflation of home prices in the city of Vancouver.
In a low interest rate environment with an influx of demand from foreign investors, these higher prices make it difficult for investors with modest means to gain exposure to an income generating asset like a rental property.
This week, I turn my attention again to the Canadian real estate investment trust (REIT) space, which may act as a viable liquid alternative to the traditional brick-and-mortar investment.
Recall that one of the key metrics when looking at REITs is the funds from operations (FFO), which adds back the depreciation and amortization charges to a REIT's operating earnings per share to remove the distorting effects of these non-cash charges.
The higher the FFO is, ultimately the more income a REIT is able to generate for its unitholders through dividends. For this week's strategy I rank the universe of Canadian REITs based on these factors:
– funds from operations;
– dividend yield;
– debt to equity (lower debt-to-equity ratios imply less leverage and are desired).
Only Canadian REITs were considered as the universe of potential investments.
There are currently 38 REITs in the CPMS database.
To qualify, REITs must have a payout ratio on trailing cash flow of less than 90 per cent.
More about Morningstar
Morningstar Research Inc. provides independent investment research in North America, Europe, Australia and Asia. Its research tool, Morningstar CPMS, provides quantitative North American equity research and portfolio analysis to institutional clients and financial advisers. CPMS data cover more than 95 per cent of the investable North American stock market. With more than 110 equity and credit analysts, Morningstar has one of the largest independent institutional equity research teams in the world.
What we found
I used CPMS to back-test the strategy from November, 2005, to September, 2015.
During this process, 10 REITs were purchased and equally weighted.
REITs would be sold if they fell outside the top 50 per cent of the ranked universe or if the payout ratio on cash flow reached 100 per cent or more.
Over this period, the strategy produced an annualized total return of 11.2 per cent while the S&P/TSX total return index produced 5.1 per cent. The top 10 REITs that qualify today are listed in the table.
As always, investors are encouraged to conduct their own independent research before purchasing any of the investments listed here.
Ian Tam, CFA, is a relationship manager for CPMS at Morningstar Research Inc.