Digging through the debris of Canadian REITs (Part 2)
NOTE: This article discusses Canada Real Estate Investment Trusts (REITs). They are structured as either open-ended or closed real estate mutual fund trust. Therefore if you are not a Canadian investor, please carefully consider the tax implications and/or consult with a tax lawyer or accountant before investing.
Hi everyone,
For the second part on Canadian REITs. I’m just going to quickly go through how I grouped the REITs and how I put together a basket of 5 REITs that I would buy.
This isn’t going to be an in-depth dive into each REIT. But in the New Year, I’ll do a deep dive every couple of weeks for each of the REITs that are in my “buy basket”.
Again just to re-iterate one of the main points from my last article (which you can find here), I believe that we will not be returning to a ZIRP (zero interest rate) environment and that nominal interest rates will be significantly higher than during the 2010s.
Deglobalization continues (the brewing trade war between the EU and China over autos is just the latest example). Governments continue to spend which makes the decade of fiscal austerity seem like a remnant of the past. And I still, like the BIS, believe that an aging population is an inflationary population.
So let’s get started.
I’ve grouped all of the REITs into 5 categories: “circling the drain”, “too much debt”, “meh valuation isn’t compelling”, “avoid” and “buy basket” (I’ve already changed my mind and got rid of “too early”).
Now I profess that I’m not an expert on all of these REITs and my opinion can (and will likely) change over time. But I’ve emphasized REITs with modest debt levels, good real estate assets, and a history of value creation.
Circling The Drain
There are a handful of REITs that will likely go bankrupt through this cycle and the equity investors will be wiped out. Right now I have 5 on the list. Whether it’s too much debt, properties not performing, bad capital allocation, and/or taking too long to cut the distribution; it doesn’t matter. The markets are already pricing in bankruptcy for most of them.
They are American Hotel Income Properties (HOT.UN), Dream Office (D.UN), Inovalis REIT (INO.UN), Melcor REIT (MR.UN) and Slate Office (SOT.UN). Odds would say that maybe one of them survives. In the past, I would be trying to figure out which one. But it’s a frustrating (and volatile) game that I’m just not interested in playing anymore so they are all automatic passes.
Too Much Debt
This one is pretty self-explanatory. Many REITs are just way too over-indebted for an environment with long-term interest rates likely to remain at or above 3% (and then add in term premium and credit spread).
The REITs in question are BTB REIT (BTB.UN), European Residential REIT (ERE.UN), H&R REIT (HR.UN), Morguard North American REIT (MRG.UN), Morguard REIT (MRT.UN), NorthWest Healthcare Properties REIT (NWH.UN), and Northview Residential REIT (NRR.UN0.
And it’s a shame too because I like a bunch of them who have very good long-term track records and/or business & assets that I like. But their debts are just too high and with most of them paying out close to (or more) than 100% of their cash flows, I don’t see any near-term pathways for them to reduce their debt loads. Some might sell assets but so far most REITs have been very hesitant so I’ll re-assess if and when that does happen.
Meh - Valuation Isn’t Compelling
Again this group is fairly self-explanatory. In this group are all of the large residential REITs - Boardwalk REIT (REI.UN), Canadian Apartments REIT (CAR.UN), BSR REIT (HOM.UN), InterRent REIT (IIP.UN), Killam Apartment REIT (KMP.UN), Flagship Communities REIT (MHC.UN) and Minto Apartment REIT (MHC.UN) fall into this category.
Overall their assets are performing well (remember the occupancy chart) and the debt in most cases is manageable. But you’re paying up for these REITs; as a group they’re trading around a 5% cash flow yield. With a valuation like that, why not just buy some long-dated corporate bonds?
There are also a bunch of commercial and industrial REITs in this group including Choice Properties REIT (CHP.UN), Crombie REIT (CRR.UN), CT REIT (CRT.UN), Dream Industrial REIT (DIR.UN), Granite REIT (GRT.UN) and Nexus Industrial REIT (NXR.UN).
Industrial REITs have been the hottest part of the market for a couple of years now (the Sleepy Portfolio’s Summit Industrial REIT was bought at a very hefty premium). But again I don’t have anything bad to say about these industrial REITs. It’s just that the valuations are high and risk/reward isn’t that enticing.
Avoid
In this group are just a bunch of REITs that I’ll be avoiding because I just don’t understand them, their business model, the valuation or they did something dumb.
Let’s start with Automotive Properties REIT (APR.UN). This is a subsidiary of the Dilawri Group, Canada’s largest automotive dealership group. Automotive sales are very sensitive to consumer spending and yet the REIT’s valuation is roughly in line with the industrial and residential REITs. On top of that, car dealerships have become very specialized buildings so if the Dilawri Group is forced to close some of their dealerships, will they be able to re-lease them in a timely manner? I have no idea and the name is going into my “too hard - avoid” bucket.
Next is True North Commercial REIT (TNT.UN) which as its name implies is a commercial and office REIT. Occupancy is very good thanks 40% of the portfolio being leased to government tenants. The balance sheet is also in very good shape. What I don’t understand is the valuation. It’s the only REIT that trades at a premium to NAV and trades at a free cash flow yield comparable to the residential/industrial REITs. I’m probably missing something here but again it’s just going into the “avoid” bucket for now.
Next, there’s Dream Residential REIT (DRR.UN) which was a newish IPO from last year. It’s a collection of residential buildings in the US Sunbelt which sounds great and trades at a very big discount (compared to the other residential REITs). But there are some real problems, it’s a tiny REIT with a market cap under $100 million and highly illiquid. Meanwhile, management is busy buying back units which is only making the problem worse. I’ve also asked a couple of people in the industry about the name and they’ve all told me that the assets aren’t very good and it’s not worth the effort. So another name for the avoid bucket.
Lastly, there’s Artis REIT (AX.UN), which is the poster child of doing everything wrong over the last couple of years. Management thought that REITs were too cheap a couple of years ago so they went out and started investing in other REITs. They’ve poured over $500mm into these investments and most of it went down the drain. Meanwhile, their balance sheet is a disaster. They had 90% of their debt maturing in 2023 and 2024 and didn’t have any hedges in place. They’ve managed to roll some of their debt over into 2024 and 2025 but most of it has gone into floating credit facilities which is very expensive and I think very risky. So management is in the penalty box and it’s going to take a very long time to turn this business around.
Buy Basket
So that leaves 5 REITs that I think are compelling buys (plus one extra for lower-risk investors). Those five REITs are:
Allied Properties REIT (AP.UN)
Primaris REIT (PMZ.UN)
RioCan REIT (REI.UN)
Slate Grocery REIT (SGR.UN)
SmartCentres REIT (SRU.UN)
Again, I’ll do an in-depth dive in the New Year but here’s a summary of why I like each REIT.
Allied Properties (AP.UN) has a great long-term track record of creating value with its differentiated model. They provide upscale office space in core urban markets. This business has been hit hard recently with the “white collar” recession and layoffs. But they recently sold their data centre business and used the proceeds to de-lever. Additionally, “The Well” which is a massive complex on the corner of Front & Spadina in Toronto is coming online which will give their financials a real boost. Even though the units have rebounded from $15/unit in October to $19/unit today, it still remains one of the cheapest REITs out there.
Primaris REIT (PMZ.UN) is the last remaining publicly traded mall operator. They own Tier 2 and Tier 3 malls across Canada which sounds scary. But occupancy is close at a 5-year high, the valuation is compelling and they have by far the lowest debt out of any REIT. So they should be able to weather a downturn in consumer spending for a long period.
Then there’s Slate Grocery REIT (SGR.UN) which owns grocery properties all across the United States. Again, the valuation is compelling with a ~40% discount to NAV and double-digit cash flow yield. And I expect the US economy will outperform Canada. The downside is that the Slate Office REIT has performed poorly and investors may hold that against the Grocery REIT.
Lastly, there’s RioCanad REIT (REI.UN) and SmartCentre REIT (SRU.UN). These are boring picks because they’re two of the largest and best-known REITs in Canada. But I like them because they both have low debt loads, they don’t pay out all of their cash flows (60% and 80% payout ratios respectively), and have an enormous amount of liquidity available to them. All the while trading close to a 10% cash flow yield.
If they play their cards right, I think they can use this period of higher interest rates to aggressively acquire the best assets and that will set them up for the next decade. Much like Canadian Natural Resources (CNQ) and Tourmaline (TOU) did in the Canadian oil and gas space during Covid.
Lastly as a bonus pick if AP.UN, PMZ.UN and SGR.UN are too risky would be Plaza Retail REIT (PLZ.UN). It’s a retail REIT but its focus is on grocery and pharmacy-anchored tenants (much like Slate). The company trades around an 8% cash flow yield with a solid decent balance sheet and good assets. The only real downside is that their focus is on eastern Canada so organic growth will be limited.
Thanks for taking the time to read my write-up and have a Merry Christmas and Happy New Year.
Disclosure: I may be long and have a beneficial interest in any or all of the above-mentioned securities. I may change my holdings at any time post-publication.
Disclaimer: This newsletter and/or any other articles that I publish should not be construed as investment advice. None of the strategies or securities mentioned should be considered as an investment recommendation to buy or sell. I am not an investment advisor and I highly recommend that anyone considering this investment strategy or any of the securities first consult with a registered investment advisor to assess both the suitability and risk of any strategies or securities that are mentioned.