I appreciate real estate investment trusts (REITs). These nifty financial instruments combine the capital appreciation prospect of stocks, with the reliable and steady income of bonds. Easily accessible and highly liquid, these trusts have made passive investing a breeze.
However, not all REITs are created equally. The underlying portfolio is nearly always concentrated in certain types of properties or specific parts of the world. This allows income-seeking investors — me included — to customize our portfolio’s exposure depending on the market cycle.
At the moment, it seems that the market for residential real estate in Canada, particularly in southern Ontario’s Golden Horseshoe region is overheated.
Even after the house price collapse in Vancouver and Calgary over the past few years, condominiums in Toronto are still selling at multiple times the city’s median household income.
Household debt ratios in Canada are at a record high and currently trading at a significant multiple to gross income, which should serve as a red flag for potential investors. REITs like InterRent Real Estate Investment Trust (TSX: IIP.UN) are particularly exposed to this phenomenon.
As I discussed in an article last month, nearly a third of InterRent’s portfolio is concentrated in the Toronto-Hamilton region. Meanwhile, the company carries nearly as much debt ($855 million) as the value of its equity.
A downturn in the Toronto market could have a significant impact on InterRent’s debt service ratios and the value of its underlying assets, which will ultimately be reflected in the REIT’s lofty valuation.
At the moment, the stock trades at 40 times adjusted funds from operations (AFFO) per unit, which is excessive by any standard.
I can’t predict the future, and there’s always a chance Toronto’s real estate market thrives despite the debt burden and current valuation, but I wouldn’t be comfortable holding InterRent as a value investor.
Instead, I believe that investors should diversify overseas, where property valuations are more reasonable and household debt ratios are considerably lower. Inovalis REIT (TSX: INO.UN) is the perfect option for this type of exposure.
Inovalis owns and operates 14 properties spread across Paris and Germany. These properties are office buildings and commercial units rather than residential houses, which limits the risk exposure even further.
Germany’s corporate debt-to-gross domestic product ratio is below the European Union average and its own historical average.
Meanwhile, London’s loss in the Brexit negotiations is seen as Paris’ gain. The steady flow of corporations over the English channel should push demand for office space in Paris and Frankfurt much higher, which should ultimately benefit Inovalis.
The REIT currently trades at a 13% discount to book value and offers investors an 8% forward dividend yield. For contrarian investors willing to look beyond Canadian borders, I believe Inovalis is a great bet.
Bottom line
The debt cycle is a critical element of the global property market. At the moment, Canadian households seem to be over-leveraged, which is why I would bet on European offices through Inovalis rather than Toronto-exposed InterRent.
