Why Canadian REITs are such risky bets

Real estate investment trusts (REITs) aren’t to be avoided as interest rates rise, except in Canada, where lower cash-flow growth and higher leverage make them riskier bets, according to Corrado Russo, global head of securities at Timbercreek Asset Management.  

“If you look at the empirical evidence, REITs actually outperform in a rising-rate environment,” Russo said. “They tend to do better both on a relative and on an absolute basis.”

Toronto-based Timbercreek analyzed the performance of US REITs over the past nine rate-hike cycles by the US Federal Reserve and found that the these REITs rose in eight of those nine periods.

“It’s counter to perception, but real estate is much more correlated to a strong economy than it is inversely correlated to interest rates,” Russo said.

This is less true in Canada because REITs tend to have much longer lease terms and less tenant turnover, meaning fewer opportunities for landlords to raise rents. This leads to a steady cash flow and amplified leverage, creating bond-like securities that are more sensitive to interest rate shifts than their global counterparts, Russo said.

Some of this divergent performance is playing out this year as the Federal Reserve and the Bank of Canada (BoC) raise borrowing costs. The largest ETF tracking Canadian REITs, the iShares S&P/TSX Capped REIT Index ETF, is down by 1%. In contrast, its US and global counterparts are up 1.7% and 2.6% respectively.

“In an income environment, they outperform; when people want growth, they underperform. And in a rising rate environment, people want growth. If you want to protect against interest rate rises in Canada, you should be going outside of Canada to get your REIT exposure,” Russo said.

He recommends US industrial and data-center REITs, German office REITs, as well as exposure to undervalued Hong Kong REITs.