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Is the Market Overvalued? A Look at REITs

With the TSX showing an impressive one-year return of 18%, and five-year return of 26% and trading at all-time highs, investors should be feeling nervous. Are valuations getting ahead of themselves or is there room to go higher?

I prefer to answer this question by looking into the different segments of the market and making a case-by-case conclusion, and hopefully finding the areas where we can find the most value. Let’s now take a look at the real estate investment trust (REIT) sector and delve a little deeper.

The REIT index has a one-year return of 8.4% and is relatively flat on a five-year basis. But that’s not the full story. Investors have enjoyed very attractive dividend yields in this sector, which have been even more valuable as bond yields have been so low and unattractive.

We certainly have to compare these returns against economic fundamentals and market valuations to formulate an opinion on whether the market is overvalued or not. From a macroeconomic perspective, the REIT sector is looking shaky when we consider that rates are on the rise. Firstly, a rise in interest rates will make borrowing more expensive for REITs, which will affect their levels of profitability and their ability to make acquisitions. Secondly, a rise in rates will mean that bonds become a viable alternative again, thus increasing the competition for investors’ dollars.

RioCan Real Estate Investment Trust (TSX:REI.UN) is one that I would stay away from, as it is tied to the success of Canadian retailers; in the competitive retail environment, and this environment where rates are expected to rise, this is a risky proposition. The company has a 5.3% dividend yield and trades at a P/B of 1.1 times.

I would rather invest in a REIT that can benefit from secular trends that are here to stay for the long term and less sensitive to interest rate movements.

Although Chartwell Retirement Residences (TSX:CSH.UN) trades at a much higher P/B of 3.5 times and has a lower dividend yield of 3.65%, it is supported by the fact that in the coming years, demand is expected to increase more than the new supply of retirement homes. Currently, occupancy levels are at 92.5% after many quarters of steady increases, and the leverage to increases in occupancy rates is very significant.

Another one I would look at is NorthWest Healthcare Properties REIT (TSX:NWH.UN), which is currently trading at a dividend yield of over 8%. The dividend is supported by the company’s high-quality global, diversified portfolio of healthcare real estate properties located throughout Canada, Brazil, Germany, Australia, and New Zealand. Healthcare properties generally have stable occupancies and long-term leases which make the underlying REIT attractive for long-term investors.

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Fool contributor Karen Thomas has no position in any stocks mentioned. NorthWest Healthcare Properties is a recommendation of Stock Advisor Canada.

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