The real estate investment trust (REIT) market in Canada continues to grow and develop. Does this signify an investment opportunity for institutional investors?
A REIT is an investment vehicle structured to enable trust income to flow through to investors in the form of dividends and return of capital without incurring taxes at the trust level. REITs can issue units privately or they can list them on a recognized exchange. The market of listed real estate securities continues to grow in Canada, with over 30 REITs and real estate operating companies (REOCs) listed on the Toronto Stock Exchange (TSX).
As of the third quarter of 2010, the REIT market had an aggregate capitalization of $29 billion. In comparison, the Institutional Property Databank Index (IPD) had an aggregate market capitalization of $94 billion.
REIT advantages
Institutional investors are attracted to the liquidity REITs provide relative to direct investments. In stark contrast to direct real estate allocations, REIT allocations can be entered and exited just as quickly as other publicly listed strategies.
During the 2008 global equity market decline, many institutional investors breached their asset mix guidelines due to an excess of real estate. Due to the illiquid nature of direct real estate, investors had little opportunity to rebalance their portfolio. This problem would not occur with a REIT portfolio.
- Relative to direct investments, REITs have other advantages as well.
- Liquidity – REITs have daily liquidity on the TSX
- Daily pricing – REITs trade daily on the TSX
- Transparent pricing – REIT prices are openly quoted on the TSX
- Governance – REITs must adhere to the financial reporting and corporate governance standards of the TSX
- Long-term focus – REITs are corporations set up to exist indefinitely
- Alignment of interests – Management tends to hold large positions in the trusts
- Fundraising – REITs can quickly access new capital through equity or debt offerings in the capital markets
- Transparent performance measurement – Investors can objectively compare a manager’s performance with three exchange based indices: Scotia Capital REIT Index, S&P/TSX Capped REIT Index and the Dow Jones Canada Select Equal Weight REIT Index
- No minimum or maximum investments – REIT investors decide how much or how little to invest
- Availability – REITs are continuously investable
- Flexibility – Investors can build portfolios of custom REIT portfolios based on cap size, sector and geographic exposures.
Other considerations
The liquidity and availability of REITs make them appealing. However, the asset class should also be attractive from a risk and return perspective, particularly in comparison to direct real estate.
Over 10 and 15 years, the Scotia Capital REIT Index (SC REIT) exceeded the IPD return, and in fact has been the strongest of all the major asset classes. Clearly, REITs offer an opportunity to earn attractive rates of return.
A key advantage of direct real estate is the low volatility of the returns. This is not the case for REITs. As evident in the following graph, REITs exhibit a high level of volatility over rolling five-year periods. The volatility is even more dramatic when viewed over annual periods. The level of volatility is similar to equities.
Another key advantage of real estate is its low correlation to other major asset classes. Over the past 10 years, REITs have shown high correlations to Canadian equities (S&P/TSX Composite). In fact, during 2008 when true diversification was scarce, the SC REIT Index exhibited an increased level of correlation with the S&P/TSX Composite Index.
The high and consistent investment income, or yield, is another key attraction of real estate and REITs.
In the past eight years, the yield on the IPD Index was very stable, slowly trending downwards until 2008 and raising slightly thereafter. The DEX UBI yield stayed within a tight range, fluctuating from month to month on investor sentiment. The yield on the SC REIT Index was quite volatile, ranging from 5% to 12%, with notable monthly and annual movements.
The REIT yield volatility was a function of the index price volatility. As the SC REIT Index yield rose from 6% to 12% in 2008 and 2009, the market value of the index fell 50%. Therefore, REITs were not distributing increased income; rather, the income was measured against a smaller capital base. In fact, in 2009, while market values were recovering, several REITs reduced their distributions.
Liquidity vs. diversification
While the primary attraction of REITs for institutional investors is the liquidity of the asset class, their functionality as a proxy for direct investment in real estate is questionable due to high volatility and a high correlation with Canadian equities.
REITs simply do not offer the diversification benefits that make direct real estate a valuable addition to investors’ portfolios. In addition, a lack of available vehicles limits the accessibility for institutional investors. As a result, open-ended and closed-ended pooled funds will likely remain the favorite vehicle for institutional investors seeking exposure to commercial real estate.
Jeffrey King, jeffrey.king@aonhewitt.com, is a senior investment consultant in Aon Hewitt’s Regina office. He appreciates the assistance provided by Derek Bissonnette and Joel Uncles, also with Aon Hewitt, in the preparation of this article.