Ian Tam: The Canadian real estate markets continue to make headlines over the last number of months specifically regarding inflated house prices in Toronto and Vancouver. Recent headlines point to the fact that the addition of tougher lending rules and slowly rising interest rates mean that there are softening prices for fully detached homes while demand for single unit condos continue to remain steady. All this said the continued relative volatility of home prices may make it a bit tougher for investors looking for exposure to brick and mortar assets in this market.
As an investment there are couple of disadvantages in investing in real estate directly. Namely maintaining the actual property and secondly the illiquid nature of real estate. For income seeking investors who would like to benefit for the nature of real estate REITs or real estate investment trusts could offer a valid liquid alternative. REITs are basically a pool of industrial, commercial and residential properties managed by company distributing their income from these properties through the form of dividends. REITs are exchange traded and can be a great diversifier for a larger portfolio.
Today I use Morningstar CPMS to build a REIT strategy for the Canadian markets. In Canada there is about 37 or 38 REITs that are exchange traded and to create a strategy to look for the best REITs I use Morningstar to see CPMS to rank those 37 or 38 companies across a number of fairly specific metrics.
Firstly I look at funds from operations. I also look at annual and quarterly cash flow momentum. And as a quick reminder our momentum metrics basically take the last four quarters in this case for operating cash flow and compares against the same number four quarters ago for annual cash momentum and one quarter ago for quarterly cash momentum. I also look at cash flow to debt this is a leverage metric just to make sure that companies aren’t overly leveraged, and they are able to cover their debt through their cash.
I also look at estimates from the street. So here we look at today's consensus estimate for cash flow per share from a number of broker dealers across Canada and compare that number against what it was three months ago and of course I want that moving in the positive direction. And lastly to make sure the REITs that I invest in are moving in the right direction I also look at the total return of said investments over the last three months and over the last nine months.
I then use Morningstar CPMS to back test this model. So what's happening here in the background is I am starting with basically $1 million cash and using that $1 million I would have invested in the top 10 REITs that existed back in January of 2006 using also the information available at that time. At the end of each subsequent month what I'll do is I'll check to see if any of those REITs that I own fall below the top half of my universe which again today consists of 38 companies. If they do, I sell that stock, or I sell that REIT I replace it with the next highest ranking stock.
And essentially what I am doing is just doing that same process over and over again in this case for the last 10 years or so. Whenever I receive a dividend or distribution from a REIT I keep it in cash at the end of the next subsequent month I'll use that cash to make sure I am evenly weighted or equally weighted across my full portfolio.
Great so here you can see that had I followed this methodology in investing my total return on annualized basis would have been about 12.1%. And what I did here is I compared my strategy against the Morningstar Canada REIT Index which over that same time period returned about 8.4%. Moreover, if we look at some of the stats on the screen there were a number of quarters where the REIT index was down or showed negative returns. Of those quarters my strategy beat the benchmark or beat that index about 82% of the time which again speaks to the nature – the defensive nature of this type of a model.
The companies that meet my requirements are listed in the table in this article. Of note is RioCan REIT one of the largest companies in this industry that owns, develops, and operates a portfolio of retail focused mixed use properties. RioCan's tenants consist of grocery stores, super markets restaurants, cinemas, pharmacies as well as corporate buildings.
For more information please feel free to visit the link in the text of this article for Morningstar's Glossary on REITs. From Morningstar Research I am Ian Tam.
| Rank | Symbol | Company | Funds from Operations ($CAD/Share) | Annual Cash Flow Momentum (%) | Quarterly Cash Flow Momentum (%) | Cashflow to Debt Ratio | 3M Total Return (%) | 9M Total Return (%) | Dividend Yield (%) |
|---|---|---|---|---|---|---|---|---|---|
| 1 | GRT.UN | Granite REIT | 13.2315 | 3.9821 | -5.6088 | 0.2393 | 9.3819 | 20.4158 | 4.8 |
| 2 | CAR.UN | Cdn Apartment Prop REIT | 6.1 | 4.2 | 2.2 | 0.1 | -2.3 | 25.2 | 2.9 |
| 3 | ACR.UN | Agellan Comm. REIT | 2.2 | 3 | 1.5 | 0.2 | 11.5 | 33.6 | 5.7 |
| 4 | AP.UN | Allied Properties REIT | 4.8 | -7.5 | 0.1 | 0.1 | 9.7 | 13.8 | 3.5 |
| 5 | SMU.UN | Summit Industrial REIT | 2.3 | -2.7 | -3.7 | 0.1 | 12.7 | 25.8 | 5.1 |
| 6 | SRU.UN | SmartCentres REIT | 2.2 | 14 | 1.9 | 0.1 | 9.3 | 17.2 | 5.5 |
| 7 | REI.UN | RioCan REIT | 1.9 | 12.9 | -1.1 | 0.1 | 3.5 | 9.5 | 5.9 |
| 8 | KMP.UN | Killam Apartment REIT | 2 | 2.1 | 0.5 | 0.1 | 2.9 | 19.7 | 3.9 |
| 9 | HR.UN | H&R REIT | 2 | 1.4 | -1.7 | 0.1 | 10.9 | 10.5 | 6.3 |
