By Guest Blogger Ryan Lewenza
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Often our clients can provide great insight on the economy and markets. Case in point, a client quipped to me once that he finds it amusing how people will rush out to the malls in great numbers and haste to buy some 50 inch flat screen TV or a new pair of khakis during marked down sales events, but when the stock market goes on sale, crickets!
I spoke to this in a recent blog post on investor behaviour. During bear markets stocks fall dramatically, thus “going on sale”, but it’s hard to convince investors that these events often represent the best long-term buying opportunities. I believe one of these opportunities is surfacing in Canadian real estate investment trusts or REITs.
Since the market peak on February 20th, REITs have been hit hard, declining over 30%, far worse than the TSX at -20%. With the global pandemic effectively shutting down the global economy, investors are concerned that many of the REITs will be negatively impacted and that dividend payments could be cut. Commercial building REITs have also received a thrashing as many expect this pandemic to cause more people to work from home. While I agree with these concerns, I believe REITs remain a core long-term holding and the recent weakness is creating an opportunity.
Canadian REIT Returns since Feb 20th
Source: Stockcharts.com, Turner Investments
First, the long-term strong performance of REITs is undeniable. The 10-year cumulative return of the S&P/TSX REIT Index ETF is 100%, almost double that of the TSX at 58%. And this doesn’t even include the dividends, which is one of the main reasons you buy REITs.
REIT Returns since 2010
Source: Stockcharts.com, Turner Investments
Speaking of which, with the big drop over the last few months, the REIT Index dividend yield has spiked from a 10-year low of 4% in January to now near a 10-year high of 6.5%. The concern is that many of these REITs will cut the dividends and I would not be surprised to see this happen to a few of them, but that’s why you buy ETFs. Spread the exposure across a number of different industries and companies.
REIT Yield Has Risen to 6.5%
Source: Stockcharts.com, Turner Investments
One critical driver of REITs are interest rates and I illustrate this relationship below. As interest rates have declined over the last 10 years, REIT prices have continued to rise. This negative correlation simply means low interest rates are generally good for REITs. This stems from two key reasons. First, REITs utilize debt to run their businesses and grow, so low interest rates result in lower borrowing costs. Second, REITs and their dividends look more attractive when interest rates are low, which we expect to continue for some years. I continue to believe that interest rates will stay low for long, which supports REITs in a number of ways.
REITs are negatively correlated with interest rates
Source: Stockcharts.com, Turner Investments
Finally, with the sell-off in prices, valuations for the sector are looking attractive. There’s a few different ways to look at REIT valuations – prices to funds from operations (P/FFO) and prices to net asset value (P/NAV). On a price to NAV basis, the Raymond James REIT analyst calculates P/NAV at a record 33% discount, even worse during the financial crisis when they traded at a 25% discount. Admittedly, the near-term outlook is uncertain but a lot of that looks priced in already. Yes things look cloudy in the short-term, but people are going to shop again and go into the office.
Canadian REIT Sector P/NAV
Source: Raymond James Ltd.
Life is highly uncertain right now, which can help obscure the long-term value of assets. But I believe there is value surfacing in the REIT sector. Timing this stuff can always be difficult in the short-term, but longer term, value usually delivers good returns for patient investors. Until then, clip those great dividend yields.
Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.