Why Canadian REITs May Be Your Biggest Loser in 2017

Canadian REITs such as RioCan Real Estate Investment Trust (TSX:REI.UN) are in danger due to potential real estate market correction.

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Real estate investment trusts (REIT) such as RioCan Real Estate Investment Trust (TSX:REI.UN) have gained popularity as a relatively safe way to invest in the real estate market and diversify risk. An assortment of Canadian REITs offer exposure to different geographical regions and asset classes (commercial vs. residential vs. retail) with small minimum investments.

Here are some of the largest macroeconomic risks associated with any REIT investment, and why these risks may be growing for Canadian REITs in particular.

Macro risk: Canadian housing market in bubble territory

A number of recent reports have highlighted the extent to which Canada’s housing market has ballooned far past other bubbles (notably, the U.S. housing bubble in 2007/2008). A UBS report noted that Vancouver’s housing market is currently the most overvalued market in the world with the biggest risk of a correction.

Toronto has also been singled out as having the potential for a correction in its booming condo market, as money floods from Vancouver to Toronto following the recent 15% tax on foreign investors implemented in the Vancouver market.

Looking at Canada’s market from a fundamentals standpoint, it appears to be quite simple. House prices are rising much faster than incomes are growing and have been doing so for some time due to speculation and international investment. Canadians now owe more per capita than any other major developed country, and any lending over and above current levels would be overly risky.

Source: PBO
Source: PBO

REIT debt-level assessment necessary

Similar to how many corporations manage their capital structure (a fancy way of saying managing their debt as a percentage of assets), REITs actively manage their capital structure and try to maintain an indebtedness level from year to year.

As such, any significant fluctuations in the company’s debt level year over year should be taken into consideration in addition to the larger issue, which is the debt level itself. In general, large residential REITs aim for debt levels around 50-60% of asset value, but many small-cap REITs have debt-to-book-value ratios much higher than 100%.

The key here is to assess the debt portfolio held by each REIT and minimize risk accordingly. The enterprising investor needs to know how much debt is held by the REIT to gauge what the maximum capital loss would be for the REIT to stay afloat. In Warren Buffett’s words, a substantial margin of safety should be sought out when investing in any REIT.

Upside: REIT distributions not tied to property prices

One primary consideration for buying REITs is the frequent and relatively large cash distributions received per share. While the principal value per share of each REIT may be hit by a market correction, unless the market correction is so severe as to put a REIT under due to excessive debt levels, it can generally continue to operate and continue to provide distributions.

The key here is to assess the REIT’s cash flow position and its long-term ability to continue to provide distributions in time of stress. If the company is having to borrow money to pay distributions, for example, this should be a major red flag.

Another upside: REIT exposure to Vancouver and Toronto is generally limited

One of the advantages of REITs is clearly the diversification effect of investing in multiple geographic areas. Doing so means a crash in Vancouver might only affect 10% or 20% of the REIT as opposed to the entire fund. Most REITs are generally focused in two or three markets with Ontario (Toronto) and Quebec (Montreal) taking precedence over Vancouver, generally (Alberta typically gets more investment from REITs than B.C., especially for commercial real estate).

That said, as we found out with the U.S. housing market crash, where mortgage-backed securities were often rated AAA due to the “diversification” effect of property diversification across geographic regions, a complete market meltdown isn’t out of the question. In fact, a recent report from CMHC showed that nine out of 15 largest markets in Canada are overvalued. The spillover effects from these overvalued markets are causing the tide to rise overall–not a good trend.

Risk is not limited to REITs

The current housing situation in Canada warrants a look at some of the private lenders that have benefited thus far from the wild price increases of late, but are also potentially overexposed to these same risks as REITs.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Chris MacDonald has no position in any stocks mentioned.

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