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Analyst raises warning flag about REITs

by Wayne Cheveldayoff, 2004-09-16

Investors have done well holding real estate investment trust (REIT) units in recent years. But a recent analyst report raises a warning flag about this corner of the income trust market and concludes that some REITs will perform a lot better than others in the coming year.

By holding units of a REIT, investors have a direct ownership interest in property, such as apartment buildings, hotels, shopping centers and office buildings.

REITS pay distributions each year from the rents they receive. The distributions, which are partly taxable and partly tax deferred, currently produce annual yields of between approximately 7 and 10 per cent.

Most REITs took a significant beating last spring, with unit prices falling up to 15 per cent in the midst of interest rate fears, which raised the possibility of a collapsing real estate market.
But unit prices have bounced back as rate fears eased over the summer and most REITs are now trading at or near the highs reached in the early part of the year.

There are always things for investors to worry about when it comes to REITs. For a REIT that owns apartment buildings, a key concern is whether there will continue to be enough renters to cover all expenses and maintain distributions (especially since renters are increasingly attracted to home ownership by low mortgage rates).
Similarly investors in shopping centre REITs could get blindsided by a slump in retail sales that could lead to a bankruptcies of commercial tenants.
Some investors have taken comfort in sticking with REITs that are earning more than they are paying out in distributions, which should in theory provide a cash cushion for a REIT to survive a temporary downturn without cutting distributions. (A disruption of distributions is certainly possible. Two hotel REITs, Legacy Hotels and Royal Host, had to reduce or suspend distributions throughout the severe industry downturn in 2003.)
But a recent report by RBC Capital Markets analyst Neil Downey warns that investors shouldn’t necessarily rely on the REITs’ stated distribution payout ratios when making investing decisions. In effect, if a REIT says it is paying out 96 per cent of cash flow, it may not be counting everything and the picture may be somewhat different.
Rather, he suggests that it is important to dig into the detailed numbers as he has to focus on what he calls Adjusted Funds from Operations (AFFO).
The problem with using the REITs’ own reported distribution payout ratios is that they don’t capture all the capital expenses that REITS normally incur over the years.
For example, for apartment and seniors housing REITs, the stated payout ratios capture ongoing repairs and expenses for the properties while at the same time failing to provide a reserve for long-term capital replacement, which may include everything from parking garages to elevators, boilers, roofs, balconies or in-suite renovations. There are similar problems with other types of REITs.
Taking these extra expenses into account in his AFFO calculations, the RBC analyst finds that REITs as a group are much closer than it seems on the surface to paying out all they earn, and some REIT payouts actually exceed what is being earned. In this category are Alexis Nihon, TGS North America, Summit, O&Y, CHIP, InnVest and Retirement REIT.
In assessing REITs and making his recommendations, Mr. Downey looks at all aspects of a REIT including the value of properties owned and leverage (debt), which, if it is low, could mean some room to raise borrowings and distributions.
He concludes that cash distribution growth in the next 12 months can be expected from only 12 of the 22 REITs he covers.
The REITs expected to raise distributions include Allied Properties, Borealis Retail, Calloway, Cominar, CREIT, H&R, IPC US, Legacy Hotels, Northern Property, O&Y, RioCan and Royal Host.
“But even the ‘distribution growers’ are expected to post only low single-digit increases,” Mr. Downey states.
“Excluding the more volatile lodging REITs (which are at early states of a cyclical recovery and in some instances have relatively low payout ratios, from which we expect large percentage increases in cash distributions over the next several years), we believe the overall industry can grow distributions by 2.1 per cent in 2005 relative to 2004.
“For the 10 (non-lodging) REITs from which we expect distribution increases over the next year, we believe the year-over-year increase will average +3.6 per cent.”
With income trusts, it is always better to hold the units of those with the potential to increase distributions, since their units tend to go up in price or hold their value better in a down market.
Investors with REITs not mentioned above as ‘distribution growers’ may want to look at doing some portfolio adjustments.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at and he can be contacted at

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©2004 Wayne Cheveldayoff