As I noted in an earlier post (See Asset Class Returns for 2009), Canadian REITs were red-hot last year, posting a total return of 55.3%. While REITs are still roughly 25% off their all-time highs, several valuation metrics suggest that they may not be big bargains any more.

Take the distribution yield, for instance. The cash yield on the iShares CDN REIT Sector ETF (TSX: XRE) is approximately 5.45%, a spread of less than 2% over the 10-year Government of Canada bond, which is currently yielding 3.55%. Historically, the REITs have yielded as low as 0.73% over bonds and as high as 10%, suggesting that current yields are at the low end of the range.

Many REITs are also trading at a premium to analyst estimate of net asset value (NAV). RioCan (TSX: REI.UN), the largest REIT in Canada, for instance, is trading at $19.90 but TD Securities analysts estimate the NAV per unit to be just $16.30. RioCan’s current 22% premium to NAV is also in the higher end of its historical range suggesting that Canadian REITs may not be screaming bargains any more.

This article has 15 comments

  1. I am always reading that REITs is a good alternative to buying rental property.

    With the low returns I am not sure.

    What is the average return for a rental property?

  2. Hard to think of what’s a bargain these days, at least as stocks are concerned. It’d be nice to see better value in the REITs. At the right price, they are excellent investments to hold inside a TFSA.

  3. I certainly agree with you Sam and CC that Canadian REITs are either fair or close to over-valued, I don’t think this is true with ‘most stocks’.

    Depending on how strong a recovery we see, valuations are still well below where they were pre-crash, and if earnings bump up by 15-50% in some industries, back to 2007 levels, then there are a number of areas that still look interesting.

    • Canadian Capitalist

      @Sampson, @Sam: I agree. Earnings estimate for 2010 for the TSX Composite is between $720 and $750. Earnings yield on the TSX is 6.1% compared to 10-year bonds yielding 3.55%. At current levels, stocks provide a 2.5% spread over 10-year bonds. Not exactly screaming buys but not too bad either. Of course, my expectations for stocks are modest to begin with and a 2% premium is something I can live with.

  4. REITs and stocks are fairly valued. It will be difficult for investors to see significant gains in their portfolios this year without being very picky with their investment choices.

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  6. Similar to a P/E ratio for a stock, I personally measure REITs in terms of Price to FFO (Funds From Operation). Using a Price to FFO ratio, many REITs are overvalued, not necessarily because of a runup in price, but rather due to a dip in their FFO. There are a lot of REITs which are now distributing at or above 100% in terms of their payout ratio, which means that their distributions may not be sustainable if the recession keeps dragging down their earnings (or FFO).

    So, it seems to me as though investors have priced REITs like they are anticipating a V-shaped bounce back in the economy. Nobody has a good crystal ball, but for me, I’m not so sure that our economy will rebound so sharply.

    I should change my name on this blog to something related to being Bearish. Does anybody know where the market analogies to the Bull and Bear even comes from? That might make a good trivia question someday…

    • Canadian Capitalist

      @Phil: There has been some speculation among analysts that RioCan might cut its distributions because its DPU has been exceeding its AFFO for a few years now and this state of affairs isn’t likely to change in the near future. For 2010, REI.UN’s AFFO is estimated to be $1.17 per unit whereas its DPU is $1.38. So, I agree with your point that looking at distributions might not be the whole story. Regardless, I share your bearish sentiment though I keep a 5% allocation to REITs.

      I heard somewhere that a bull market is named for the way a bull attacks — goring someone by its horns upwards and a bear attacks by slashing downwards. Not sure if there is any truth to that or its just an urban legend.

  7. I was thinking of using REI.UN for part of my TFSA this year, but now I’m not so sure. Seems this and other REITs are valued kinda high. This also makes XRE a non-buy for me in the TFSA.

    @Phil, I agree – seems many REITs are paying out more than they earn – over 100%. How on earth is this sustainable?

    The Big Six banks are all, usually, between 40% and 55%.

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  9. No more bargins in REITs… RioCan trades at a large premium to NAV because it is the go-to name for large institutional investors… Take a look at Canadian REIT (REF.un). This is the most conservatively managed REIT in Canada. The current yield is 5%, but it should be noted that they have the lowest payout ratio.

  10. In general we agree that the entire TSX REIT sector is over valued today. However, there remain some good holds. At present our RI.ca FUND remains overweight short, especially the hotel REITS as we await Q4 and EOY reports.

    As for RioCan, (we do not hold a position in) currently their payout ratio greatly exceeds Distributions. Yet this is nothing new and perfectly acceptable for development oriented retail REIT. However, they will be challenged to structure themselves to qualify as a REIT come 2011. Nevertheless, RioCan remains one of, if not the best managed REITs in North America and their ability to continue to meet distributions is far from in doubt.

    A bigger question will be the effect of higher interest rates later in 2010?

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  13. If REITs have run their course and one agrees that the Canadian real estate sector is a bubble waiting to burst, does it make sense to invest in a REIT that shorts Canadian Real Estate? Is there such a REIT?