A matter of trust

Real estate investment trusts (REITs) pose risks that can extend beyond typical investment concerns.

Leverage, external management and potential conflicts of interest, like related-party transactions, are part of navigating risks for the largely retail-oriented Canadian REIT marketplace, according to a Raymond James whitepaper published in 2012. Given these caveats, using and diversifying with REIT ETFs seems like a good idea.

Real estate portfolios

Canadian insurance companies and pension funds eagerly added real estate to portfolios 30 years ago to participate in strong commercial property markets, and diversify traditional portfolios of bond, stock and mortgage holdings. Real estate funds evaluated only one-third of their portfolios annually based on transactions, so a lag in timing and subjectivity smoothed returns, making valuations stable.

In risk-adjusted terms, lower volatility — a result more of the valuation cycle rather than portfolio management expertise — helped managers look good. The chart “10-year total return and volatility,” this page, shows directly held property had low volatility — close to bonds — but returns similar to publicly traded property equity.

Cohen & Steers, a global investment manager, believes direct real estate holdings’ volatility is understated when compared with publicly traded holdings.

Still, real estate can anchor an income portfolio. But when income is the primary investing goal, yields can be deceptive when property markets overheat. Investors may face the risk of falling values.

The S&P/TSX Capped REIT Index (iShares; XRE) and the FTSE Canadian Capped REIT (Vanguard; VRE) are largely weighted by capitalization based upon 15 securities (XRE) and 19 securities (VRE) respectively.

Dow Jones Canada Select Equal Weight REIT Index (BMO; ZRE) is different with 20 securities each accounting for about 5% of the fund. Cohen & Steers Global Realty Majors Index (iShares; CGR), the only global real estate ETF trading in Canada, has 75 holdings (see “TSX-listed real estate ETFs,” this page).

TSX-listed real estate etfs

Largest U.S.-listed real estate etfs

U.S.-listed ETFs offer more variety with similar expenses. Notable exceptions include: iShares CGR 0.63% (Canada) and ICF 0.35% (U.S.), based on the same index, and Vanguard REIT’s expense of 0.10%, which is very low. International REITs feature higher yields but with more country and currency risk exposure.

In a move harkening back to the Canadian income-trust craze, U.S. companies, ranging from private prisons, billboards, and cellphone tower companies, are interested in converting to REITs. Although 75% of REIT income in the U.S. must be derived from rent income, definitions are blurring.

For instance, Iron Mountain, the document management, storage and shredding specialist is moving toward REIT conversion based on the rental of document storage space. Together with master limited partnerships, the income-generating market is developing rapidly, and tax considerations for Canadian residents notwithstanding, will be entertaining to follow.

Institutions hold 86% of U.S. REITs, but small size and lack of liquidity, among other factors, have led to limited institutional interest in Canada, according to Andrew Kavouras of Canadian-based public real estate specialist Presima, a part of National Australia Bank Group. Accordingly, retail investors own 70% of Canadian REITs. Appropriately, small- and mid-cap REITs represent 60% of the U.S. market versus 80% in Canada. As ETF sponsors look to global markets for product, research from Presima is instructive. REITs with lower leverage and better interest coverage outperform more leveraged instruments. This may seem counterintuitive, but the REIT structure itself suggests that access to capital to take advantage of attractive opportunities relies on a strong balance sheet and flexible sources of funding — things the American REIT market does well. With reduced leverage and stronger financials, REITs and REIT-based ETFs seem poised to offer investors continuing success.

Mark Yamada

Investments

Mark Yamada is president of PÜR Investing Inc., a software development firm specializing in risk management and defined contribution pension strategies.