This year, almost all Canadian real estate investment trusts (REITs) saw their stock prices plunge double digits. Some even fell to all-time lows after they slashed their distributions. What is wrong with Canadian REITs? Is this dip a warning sign to stay away or an opportunity to grab a value stock? The answer differs from REIT to REIT.
What is wrong with Canada’s REITs?
REITs take mortgages and long-term debt to buy a property and develop it. Hence, they carry significant debt capital. In 2011, many real estate firms opted to raise equity capital by forming a REIT. However, creditors get payment priority if the REIT does not have enough cash flow.
Canada’s REITs have a weighted average interest rate of 3.5% and a five-year commercial mortgage at the going rate of 5.5%. In 2023, many mortgages were renewed at the new higher interest rate, as the Bank of Canada increased the base interest rate from 0.25% to 5%. Most REITs had not factored in a high interest rate into their model, which strained their cash flows.
Adding to higher interest rates, slowing commercial activity forced many businesses to renew or reduce their office lease. Office REITs took a hit as fewer tenants renewed their leases, and some reduced their leased space. A decrease in the occupancy ratio saw their distribution payout ratio cross 100%. Such a high ratio is unsustainable for longer. To get some financial flexibility to make mortgage payments, a few REITs slashed distributions.
Canadian REITs that slashed distributions
Slate Office REIT’s (TSX:SOT.UN) occupancy rate fell to 78.6% in the third quarter from 81.9% a year ago. The REIT slashed its distribution by 70% in April when its payout ratio reached 160.4% in the March quarter. Hence, its stock lost 82% of its value year to date. Its stock price has fallen below $1. Moreover, the stock has lost trading volume, with only 9,000 shares exchanging hands compared to its average volume of 150,800. In terms of both trading and fundamentals, Slate Office REIT is a stock to stay away from as its performance is unlikely to improve anytime soon.
True North Commercial REIT (TSX:TNT.UN) slashed its distribution by 50% in the first half of 2023. It sold some of its property and used the proceeds to buy back 208,400 units. Moreover, it consolidated its units in a 5.75:1 ratio to add value for shareholders. It is still holding a few properties for sale. Such downsizing is necessary to survive in a downturn. However, it does not instill confidence in the sustainability of the REIT. Even though the REIT’s units are trading above $6.7, the stock has lost 80% of its value year to date. It is a risky investment. Hence, it is offering a double-digit distribution yield.
If True North can sustain a recession, it could grow significantly during the economic recovery. But its chances are bleak. Hence, I would avoid investing in it.
Canadian REITs that show resilience
While office REITs were the worst hit by rate hikes and retail REITs by the pandemic lockdown, a few showed resilience to such market conditions. And behind this resilience is a lower payout ratio, higher occupancy rate due to large tenants, and lower debt.
CT REIT (TSX:CRT.UN) earns 90% of its rental income from parent Canadian Tire. Its debt is lower than its equity. As the parent is the tenant, the trust did not face any occupancy issues or decline in cash flows. It did face rising interest expenses, but a relatively lower debt kept its payout ratio within a comfortable level of 72.5%. Its stock price fell 13.3% year to date, which inflated its distribution yield to 6.6%. This stock can add value to your portfolio with its strong fundamentals.
Investing tip
Smart Centres and Choice Properties REIT are on the brink of a distribution cut as their payout ratio is hovering around 95% and above. They are holding on to their current distributions for now. However, another rate hike or a prolonged high rate could increase the risk of a cut. If you are considering buying them, wait and watch till the December 6th interest rate decision of the Monetary Policy Committee.
