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Why I Would Avoid Office REITs Right Now

In the world of real estate investment trusts (REITs), investors have options to choose from across a number of sectors. From traditional residential or retail REITs to industrial and office REITs, investors must choose which sectors they want exposure to as well as the portfolio and management company they wish to invest in.

I’m going to talk specifically about the risks involved with office REITs using Dream Office Real Estate Investment Trst (TSX:D.UN) as a proxy for the sector.

Office fundamentals unique and challenging in current environment

A wide variety of office REITs across the country invest in portfolios of office space that’s typically geographically dispersed to diversify some of the regional risk associated with Canada’s real estate markets. Dream Office REIT has a unique and significant level of exposure to Alberta’s office market — a market which has underperformed the larger Canadian market for some time now.

The fundamentals of Dream Office REIT’s business have slowly begun to rebound from results posted last year, which showed a significant deterioration with its vacancy rate and revenues, forcing the company to post a fair-value loss of nearly $750 million for the first six months of last year related to softening in the Alberta market. Oil prices have begun to stabilize of late; however, long-term headwinds with respect to the oil market and the Alberta economy still plague Dream REIT’s prospects moving forward, resulting in the company’s lower-than-average valuation multiples and higher-than-average dividend yield compared with its peers in the REIT space.

The company’s current dividend yield of more than 7.5% and current price-to-book ratio of less than one, while attractive for value investors, represents a significant risk premium for this company compared to the broader market. Investors expecting a slow and stable office market to continue into the future have bid up the share price of Dream Office REIT of late; shares now trade slightly higher year to date.

Bottom line

The office real estate sector is one which is typically more sensitive to larger macro-economic data relating to the strength of corporate earnings and specific geographic areas that are reliant on corporate growth, such as the Alberta economy and the oil and gas industry. While Dream Office REIT is diversified across Canadian markets, long-term investors interested in a position in an office REIT such as Dream will need to attempt to quantify the long-term growth rate of corporate earnings in Canada and the health of specific regions of the country — something which has proven to be very difficult to do.

Stay Foolish, my friends.

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

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