Not too long ago, investors couldn’t get enough of Real Estate Investment Trusts (REITs) bidding up the asset class so much that the asset class didn’t yield much of a premium over 10-year Canada bonds. How things have changed! Today, XRE (iShares CDN REIT Sector Index Fund) yields 6.8% compared to 3.85% for the 10-year Govt. of Canada bond and has fallen close to 10% since New Year’s Day. Significantly, many REITs are currently trading at significant discount to analyst estimates of NAV. For instance, RioCan (TSX: REI.UN), the biggest REIT in Canada, which makes up close to one-quarter of the index trades at a 18% discount to TD Newcrest’s estimate of NAV. It is always possible that REITs could trade even lower but this may be a good time to tip your toes in the sector.

[1 year stock chart of iShares CDN REIT Sector Index Fund (TSX:XRE)]

This article has 32 comments

  1. Picked up half a position in Calloway REIT today at just under $21. 7.4% yield! Yeah, baby. The market must love me very much. Oh behave…

    Seriously though, let’s not celebrate too early. Bellwether REIT, Riocan, was yielding 8.4% exactly 5 years ago today. Dipping in with one toe is fine, but probably prudent to conserve some cash for the real bargains down the road.

  2. Thanks for the heads up – this might get me to get into the REIT asset class finally.

    I’ll start looking closer at RioCan tomorrow.


  3. Canadian Capitalist

    FJ: Yes, RioCan could get cheaper from here. But, one of the valuation metrics for REITs is the spread over bonds. Five years back, bonds were yielding 5%, so the spread would have been 3.4% compared to the 3% spread today. That’s why I think this may be a good buying opportunity. That said, I still have some powder dry to come up to my 5% allocation to this asset class.

  4. I’ve been watching the yield of H&R go up to around 7.25% right now. Outside of my RSP, I mainly only make leveraged transactions and right now that only represents a 1% spread over my cost of capital (interest rate on an investment loan). To me, that is my most important unit of measure as I generally require my leveraged investments to be able to carry themselves (the distributions need to cover the interest paid on the investment loan). As a result, I think I can afford to continue to wait and see if the price of H&R drops even further.

  5. Phil – do you not consider the tax rebate as part of the ability of investments to “carry themselves”?

    For my leveraged investments I calculate the dividends (minus income tax) + tax rebate when I consider the cash flow.

    As CC has mentioned before, if those dividends are partly ROC then you lose that part of the deductibility of the loan.


  6. Canadian Capitalist

    Mike: Since REITs are flow-through entities, the distributions don’t get favourable tax treatment like dividends do. So, assuming the entire distribution of HR.UN is taxable, the tax rebate on the loan is cancelled by the tax on the distribution at the marginal rate.

    Phil: My personal opinion is that a 1.25% spread at a time when interest rates are predicted to fall is pretty good. That said, REITs could fall even more from here and better bargains may be had.

  7. CC- thanks for the clarification – I forgot about that.

    According to their webpage for 2006 about 45% of their dividends were ROC.

    Assuming I’m reading it correctly.


  8. Canadian Capitalist

    Mike: RioCan isn’t very different either. 30% to 60% of distributions has been ROC over the past nine years:

  9. I’m not really familiar with REITs. So, with the ROC does that mean that there will come a time when your initial investment could be entirely returned to you? And you would have to pay capital gains on your entire holding if you cashed it in?

  10. XRE showing a div of $1.37 for a yield of 10.6% today, bought some at $12.99 a share.

  11. Canadian Capitalist

    Bryce: Yes, it is possible. The ROC is used to reduce the Adjusted Cost Base. I’m not sure what happens when ACB becomes zero. You may have to pay capital gains on the ROC portion thereafter.

    venter: According to iShares (Link) XRE had a cash distribution of 0.87728, which would imply a yield of 6.75%.

  12. I’m interested in setting up a portfolio that will be used for charitable giving in the future. Since giving means paying no capital gains on the donated security it would be in my best interest to make as much of the donated security be capital gains. I wonder if REITs would be a good candidate for that?

  13. To FourPillars. The problem is that my bank requires me to pay at least the interest on my investment loan each month. As a result, I need all of my leveraged investments to carry themselves in absolute terms, not just on an after-tax basis because I only file my taxes once a year (thankfully). So for me, this also generally excludes any investments which do NOT distribute monthly (most banks and such distribute quarterly).

    CC. I don’t like to hang my hat on betting what the Bank of Canada is going to do with interest rates in the future. Generally speaking, I don’t want to dive in when the spread between the investment yield and my cost of capital is only 1% or 1.25%. At 1%, it would theoretically take 100 yrs for that investment to become mine. The higher the spread, the higher the return, but I would think that 2% (a 50-yr amortization) should be the MINIMUM acceptable. Is H&R’s unit price or is my cost of capital going to drop to the point where I will get a 2% spread? I have no idea, but I can afford to wait for now.

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  15. Canadian Capitalist

    Phil: That’s probably a smart route for a leveraged investor. I keep forgetting that your leverage strategy is different than mine – I simply use leverage as a liquidity tool and plan on paying down the loan within a year.

    Bryce: The capital gains from just the ROC portion is likely to be relatively small. If you figure 50% of distributions is ROC, it is only 3.5%. You may also get a capital gain from the increase in unit values but that’s an iffy proposition.

  16. Phil – from an immediate cash flow perspective it makes a lot of sense to look for a dividend that matches the interest cost.

    My point about losing the deductibility of part of the loan is valid though. Gettin ROC in a dividend is equivalent to selling shares which means the loan covering the amount that you have “sold” is no longer eligible for interest deductibility.


  17. CC – good point. I guess for this format I should probably just have a diversified strategy and donate the better performing securities when I’m rebalancing.

  18. I checked the ishares site, the 10.6% I saw on stockchase is based on the Q4 distribution of $0.34247 (annualized gives the $1.37). Why is the Q4 dist. so much larger than Q1-3?

  19. Canadian Capitalist

    venter: Not sure why there is a significant spike towards the end of the year. It doesn’t look sustainable and in any case a 6.75% yield sounds about right.

  20. CC. Actually, I have paid down my leverage using my earnings in the past as well. The thing is, I prefer to be in the “driver’s seat”, so to speak, meaning that I will pay down my leverage with my earned income if I have extra money sitting around after my regular bills are paid, have already maxed out my RSP, etc. So, if I am using my earned income for major purchases or for taking vacations or whatever, then at least I will rest assured knowing that my investments can carry themselves against my cost of capital.

  21. I was hoping to get some advice from those of you that are used to making leveraged investments. I’m a relative newbie to this so forgive me if this is a silly question. What do some of you consider a good CC for the money borrowed to fund an investment? Is prime too high? What are the best institutions to get good rates? Also, do the rates fluctuate as time goes on? I had called one of the big banks to ask about taking money out from my line of credit and they said that the rate did not fluctuate and would stay at the rate I originally borrowed at. Meanwhile, a discount brokerage told me that the interest charged on the money borrowed in a margin account would fluctuate with the prime rate. I’m surprised that they would have different policies. Any insight?

  22. Canadian Capitalist

    Steve: What does CC in your comment refer to?

    When I borrow to invest, it is from a secured line of credit at prime, which fluctuates. Margin loans are typically more expensive (usually prime + 1%). Some of the smaller brokers currently have attractive margin rates but I have no personal experience with them.

  23. That was a typo. I meant COC (cost of capital).

  24. So perhaps the bank representative was wrong when she told me that the interest rate I was borrowing at would not change? I was finding it a little too good to be true.

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  26. Phil S,

    if you like leverage and making money off the spread then consider XRE it gives you more margin that reits

    the canadian reits trading above 3$ a share are margined at 50%

    XRE bieng an ETF gives 70% margin,, ie you only need to put up 30% of the price.

    so you get even more leverage.

    if you brokerage account charges 3% and XRE yields 10%

    then you margin it you end up with 27% yield instead of the 7% spread 🙂

    but you know margin works both ways.

  27. CC,

    Government 10-year bond is at 3.4% right now. Let’s be conservative and assume this year’s XRE cash distribution only reach 60 cents whole year. That would be roughly a 5.7% yield. Still higher than bond.

    Would it be even a better time to buy XRE now?

    • Canadian Capitalist

      @PC: I think REITs are reasonably valued now. I use RioCan as a proxy for the sector. RioCan yields 8.2% now, a healthy spread over bonds though some of it is in the form of Return of Capital. RioCan has bounced sharply off the lows, the yields were even better a few months back. However, compared to where REITs were trading prior to 2008 or even when I wrote that post, the values seem a lot better now.

  28. Would it be better to hold a reit inside or outside an RRSP as far as tax implications are concerned?

  29. Could I get an update on whether or not reits are a good investment as of Jan 2011. What do you think of IYR a US reit? Thanks.

  30. I had the same question as Jazz. What are the tax implications / considerations for holding the iShares real estate investment trust (REIT) exchange traded fund XRE? Does XRE receive favourable income tax consideration in Canada? Or, is it better to hold the XRE ETF in a non-taxable account (RRSP or TFSA)?

  31. @Jazz, @DivsRgood: Generally speaking, it is better to hold income producing assets in tax-deferred accounts such as RRSPs and TFSAs. If you don’t have contribution room then taxable accounts are an okay place to hold REITs because the bulk of the distributions are in the form of tax-advantaged return of capital or capital gains.

    I’m a passive investor and the asset allocation dictates how much should be in REITs. For what it’s worth, I think REITs are fairly valued right now. They offer a healthy premium over bonds and trade at a slight premium to analyst NAV estimates. But you should keep in mind that this is just guesswork and involves a number of variables that are constantly changing.