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It was fun while it lasted, but it looks like the party is over for REIT investors. Only two strategies are realistically available to investors – reduce holdings in the sector, or hunker down in the highest-quality trusts available and accept lower returns.
The S&P/TSX REIT Index generated an 18.2-per-cent average annual total return over the past three years. Investors became used to tossing money at the sector and raking in profits. But the surprisingly ugly performance of the S&P/TSX REIT index in May – a decline of 6.0 per cent – is a reminder that goods things don't last forever.
The problem is that rising interest rates make the return on risk-free government bonds more competitive with the less-dependable yields in the real estate sector.
After years of steady declines, the yield on U.S. Treasuries spiked during May, dragging Government of Canada yields with it. And, as Macquarie REIT analyst Michael Smith writes, "REIT Rule No. 1 is: No one will be spared in a rising interest rate environment."
His solution is to shift assets from higher-yielding, more speculative investments into safer products such as Boardwalk REIT, an owner of apartment buildings, where he believes demand for space is assured even if the broader sector slows. But Boardwalk's indicated yield is only 3.2 per cent – a full 200 basis points lower than the sector average. (A basis point is 1/100th of a percentage point.) If investors are going to emphasize safety, it appears they'll have to accept lower returns.
In terms of technical analysis, the broad REIT sector is still flashing extremely oversold levels. The first inclination for seasoned investors is to sift through the carnage in search of deals. But if no one will be spared, then the real question is whether investors with a three-year time horizon want to be invested in the Canadian REIT sector at all.
Investment in domestic real estate has exploded in recent years and the market capitalization of the iShares S&P/TSX Capped REIT ETF has increased tenfold since 2006. The market capitalization of the S&P/TSX REIT Index has gone from 1 per cent of the S&P/TSX Composite at the end of the financial crisis to over 2.5 per cent today.
The sector can now be listed as exhibit A under "crowded trade" in the investment dictionary. Crowded trades, where almost every investor who's going to add money has already done so, are inherently dangerous to portfolios.
Another risk in the short term is that investors who remain in the sector will be left holding the bag as assets move out. In May, Mr. Smith noted that "REITS … are being used as a source of funds for higher beta trades, such as U.S. financials" and that "we are less positive on the Canadian REIT sector as we see an uphill battle from a flow of funds standpoint."
So interest rates are rising, or at the very least have stopped going lower, and investment assets have already started heading for the exits. REIT investors should follow suit, at least for a portion of their holdings.
Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here to read more of his Insights , and follow Scott on Twitter at @SBarlow_ROB .
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