REITs, REOCs face day of reckoning from higher interest rates

The 20-year boost that falling interest rates have given Canada’s real estate sector appears to be coming to an end – rates really have only one way to go from their current rock-bottom state – and that could prove to be a nasty time for REITs and real estate operating companies (REOCs).
In a recent report, Neil Downey, managing director of global equity with RBC Capital Markets warned higher rates “will be a headwind for the entire listed property sector. It is unlikely that any REIT or REOC will be completely immune.”
A key issue for real estate companies, he added, is just how fast rates rise. Slow and gradual can be coped with, while quick increases will prove challenging to even the best-run and best-positioned companies.
Unlike bonds, he noted, listed REITs and REOCs have the ability to generate higher cash flows over time. So while the total rise in interest rates in the future is important, just how fast rates rise could prove to be the key issue for many companies.
Best of both worlds
Over the past year and a half in particular, REITs and REOCs have enjoyed the reinforcing benefits of ultra-low base rates (determined by the Government of Canada bond yields) and attractive (sometimes declining) credit spreads, which combined “have allowed for the capture of interest rate roll-down within virtually all REIT/REOC debt capital structures.”
Cheaper debt, combined with property acquisitions, contributions from new developments and organic net operating income growth, has fuelled funds from operations growth at a time when investors are hungry for income-producing investments such as REITs.
Publicly listed REITs and REOCs are major components of the interest rate-sensitive segment of the public markets, Downey noted, along with financial services companies, pipelines and utilities. He noted that the Canadian REIT vehicle is now approaching its 20th anniversary, “and without question, interest rates have provided a tailwind over many, if not most, of the past 20 years.”
When Ben’s music stops
Ben Bernanke and the U.S. Federal Reserve will take their collective thumb off the interest rate scale at some time in the future. If rates rise gradually, earnings growth should allow REITs and REOCs to ride out the effects of more expensive debt.
However, “sharp upward moves in yields can be problematic to valuations,” according to RBC’s Downey.
So just who do higher rates hurt the least and the most?
RBC ranked REITs and REOCs against five criteria to determine which ones will ride out a tide of higher rates and which ones will take on water.
The investment firm looked at: operating leverage; financial leverage; valuation; AFFO payout ratio; and asset quality.
Winners & losers
Based on its analysis, RBC came up with a list of winners and losers in a rising interest rate environment published on June 4, 2013.
Those that were judged best-structured to prosper in a future of higher interest rates, along with their scores, were:
Canadian Real Estate Investment Trust (Score: 23, Rank: 1)
Brookfield Canada Office Properties (Score: 22.5, Rank: 2)
Morguard Corp (Score: 21, Rank: 3)
Allied Properties REIT(Score: 21, Rank: 3)
Boardwalk REIT (Score: 20, Rank: 5)
Northern Property REIT (Score: 20, Rank: 5)
CAP REIT (Score: 19.5, Rank: 7)
First Capital Realty (Score: 19.5, Rank: 7)
Huntingdon Capital Corp. (Score: 19.5, Rank: 7)
Brookfield Cda Office Prop (US$) (Score: 18.5, Rank: 10)
RioCan REIT (Score: 18.5, Rank: 10)
Chartwell Retirement Residences (Score: 17.5, Rank: 12)
Granite REIT (Score: 17.5, Rank: 12)
Morguard REIT (Score: 17.5, Rank: 12)
Calloway REIT (Score: 17.5, Rank: 12)
Killam Properties Inc. (Score: 17, Rank: 16)
H&R REIT (Score: 17, Rank: 16)
Dundee REIT (Score: 16.5, Rank: 18)
InnVest REIT (Score: 16.5, Rank: 18)
Cominar REIT (Score: 16.5, Rank: 18)
Extendicare Inc. (Score: 16, Rank: 21)
Artis REIT (Score: 16, Rank: 21)
Leisureworld Senior Care Corp. (Score: 16, Rank: 21)
Regal Lifestyle Communities Inc. (Score: 16, Rank: 21)
Plazacorp Retail Properties Ltd. (Score: 16, Rank: 21)
NorthWest Healthcare REIT (Score: 15.5, Rank: 26)
Pure Industrial REIT (Score: 15.5, Rank: 26)
RetroCom REIT (Score: 14.5, Rank: 28)
Partners REIT (Score: 11.5, Rank: 29)



Paul is a writer, editor and media trainer based in Toronto with over 25 years of experience as a business reporter. He has written for Canada’s major news services on…

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Paul is a writer, editor and media trainer based in Toronto with over 25 years of experience as a business reporter. He has written for Canada’s major news services on…

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