With an end to the era of historically low interest rates finally in sight, many Canadian real estate investment trusts (REIT) suffered sharp declines last year. However, some analysts and industry observers note that despite what the plunge in unit prices might suggest, REITs remain in solid financial shape and could even outperform their financial sector peers this year.

The selloff began in earnest in late May, following the US Federal Reserve’s announcement that it was considering when to start tapering its extraordinary stimulus. Traders began indiscriminately dumping dividend-paying stocks with the assumption that income investors would eventually abandon such securities in favor of fixed income.

From its trailing-year peak in late April through its trough in early September, the Bloomberg Canadian REIT Index (BBCREIT) fell 17.7 percent on a price basis, in contrast to a 2.9 percent gain for the S&P/TSX Composite Index (SPTSX). Since that near-term bottom, the BBCREIT has risen 6.5 percent, not yet enough to make up for the earlier loss and still lagging the broad market’s momentum.

REITs were hit especially hard since so much of their growth the past few years has been driven by expanding their portfolios of investment properties via cheap financing.

Low interest rates also forced the subset of retail investors who would normally invest in fixed-income securities, such as bonds, to pile into dividend stocks in pursuit of yield.

This allowed REITs to also raise financing via secondary equity issuances, as demand for yield seemed to overshadow any concerns about potential dilution. In 2012, for instance, real estate firms issued CAD7 billion worth of equity, according to The Globe and Mail.

But all this attention from investors spurred gains in unit prices that outpaced fundamentals. In other words, the sector was probably overdue for a correction anyway, even though this latest one also foreshadows a change in strategy that won’t produce the same heady growth fueled by borrowing and equity issuances.

In a rising-rate environment, of course, REITs’ cost of capital will be higher. And demand for secondary equity issuances will wane. In fact, such issuances have already fallen substantially. The peak for such issuances occurred during the first quarter of 2013, when REITs issued more than CAD1 billion in equity. By the fourth quarter, equity issuances had fallen to just CAD330 million.

At the same time, the Fed has predicated its taper on a strengthening economy. Although we’re writing about Canadian-domiciled REITs, a US economic rebound will be key for Canada’s own resurgence. The US is Canada’s largest trading partner, accounting for roughly three-quarters of the country’s exports, and a return to export-driven growth will boost the country’s flagging economy as well as the prospects of REITs’ tenants.

Additionally, a number of Canadian REITs have diversified their portfolios by investing in US properties, so they’ll have at least some exposure to a rising US economy.

Assuming the economy is truly gaining momentum and rates will continue heading higher, then REITs will simply shift to focusing on internal growth, through development of land holdings, and redevelopment or intensification of existing properties. These latter approaches allow for higher rents as the result of significant property upgrades or increasing the number of tenants by building up instead of out.

Equally important, stronger economies allow for rising rents, another potential driver of organic growth. In January, Raymond James analyst Kevin Avalos said REITs could see their funds from operations (FFO), the primary measure of a REIT’s profitability, rise by 6 percent this year on a per-unit basis, with particular strength among those positioned for internal growth as rates rise.

By comparison, the average increase in FFO per unit among diversified Canadian REITs in 2013 was 7.1 percent. In other words, there’s still potential for future growth, even if it’s derived from internal sources.

At the outset of the year, analysts were predicting the average REIT would gain 13 percent in 2014, based on a Bloomberg survey of consensus 12-month price targets. By contrast, the stocks of sector peers in insurance and banking were forecast to rise by an average of just 3.1 percent and 2.3 percent, respectively. The BBCREIT has climbed nearly 3 percent year to date, so this latest ascent has only just begun.

And those with a more short-term focus could also see a nice payday. According to the Financial Post, investment banking insiders say that some public and private entities are conducting their due diligence on the industry and preparing to make bids should unit prices soften again. A number of REITs already trade below their net asset values, making for attractive acquisitions.

But that’s essentially a guessing game. We prefer to buy and hold for the long term, while reinvesting our distributions.

Portfolio Update 

Manitoba-based Artis REIT (TSX: AX-U, OTC: ARESF) is a diversified real estate investment trust (REIT) that’s built a portfolio of commercial property with high-quality tenants that’s diversified both geographically, with properties in the US and Canada, as well as in terms of its holdings, which consist of office, industrial and retail properties.

At year-end, the breakdown of its portfolio in terms of property net operating income (NOI) was 25.6 percent retail, 50.5 percent office, and 23.9 percent industrial, with Canadian properties accounting for 80.1 percent of the portfolio and US properties the balance. Though the pace of acquisitions is slowing, as we discuss further below, Artis’ long-term strategy calls for US properties to increase to as much as 30 percent of the portfolio.

The percentage of Artis’ portfolio under lease in terms of both occupancy and commitments on vacant space, ticked lower by a tenth of a point at year-end, to 96.2 percent, compared to a year ago. But that’s consistent with its performance in recent years and compares favorably to its peers.

During the fourth quarter, the CAD1.98 billion REIT saw its NOI increase by 12.5 percent, to CAD75 million, versus the year-ago period, while same-property NOI rose 3.7 percent. Artis grew funds from operations (FFO), the primary metric of a REIT’s profitability, by 15.3 percent, to CAD45.4 million, versus the year-ago period.

Adjusted funds from operations (AFFO), which is FFO net of allowances for normalized capital expenditures and leasing costs and excludes straight-line rent adjustments and unit-based compensation expense, climbed 13.4 percent, to CAD38.5 million.

On a per-unit basis, diluted FFO increased by 2.9 percent, to CAD0.35, while diluted AFFO was flat, at CAD0.30. The payout ratio based on FFO improved by 2.3 percentage points, to 77.1 percent,  while the AFFO payout ratio remained at 90 percent.

For full-year 2013, NOI grew 23.5 percent, to CAD296.9 million, while FFO jumped 30.9 percent, to CAD183.5 million. However, the REIT conducted a secondary equity issuance last May that increased units outstanding by more than 10.4 million, so these results shrink when adjusted on a per-unit basis.

Diluted FFO per unit climbed 12.3 percent, to CAD1.46, while diluted AFFO per unit increased 9.6 percent, to CAD1.26. Both payout ratios declined, with the FFO payout ratio dropping 9.1 percentage points, to 74 percent, and the AFFO payout ratio falling 8.2 percentage points, to 85.7 percent.

During the year, Artis acquired 13 properties for CAD533.5 million in the US and Canada, a majority of which was office space. It also sold two industrial properties for which its net proceeds were CAD11.3 million. The REIT ended the year with a portfolio of 232 investment properties, totaling nearly 25 million square feet, valued at nearly CAD4.9 billion, up 14.8 percent from a year ago, and with a capitalization rate of 6.41 percent.

There were no acquisitions during the fourth quarter, and management expects the pace of deals to slow until REIT unit prices, property capitalization rates, and interest rates stabilize. As we detail further below, the US Federal Reserve’s decision to taper caused a sudden spike in bond rates and a corresponding decline in dividend-paying equities, such as REITs.

The REIT’s schedule of expiring leases is staggered over the next four years, with an average of 12.7 percent of total square footage per year coming off contract during this period. The weighted average term to maturity among all of its leases is 4.7 years, while the average lease among its top 20 tenants, which account for 19.4 percent of gross revenue, doesn’t expire for another 7.4 years. Management has already secured renewals or commitments for 36.3 percent of the 2014 expiries.

In 2013, the weighted average rental rate increase was 7.2 percent versus 2.6 percent in the prior year. For 2014, the company’s analysis shows that in-place rents are priced about 7.1 percent below market, which suggests rents among expiries could rise by a similar percentage this year.

Artis is making strides toward reducing its leverage. Its total long-term debt to gross book value stands at 49 percent, down 2.5 percentage points from a year ago. Meanwhile, the cost of existing debt remains manageable, with the weighted average interest rate on mortgages and other loans at 4.27 percent, down 15 basis points from last year.

In preparation for rising rates, management has moved to hedge its floating-rate debt, with the unhedged portion of these obligations now at 10.2 percent of total debt, down 5.6 percentage points from a year ago.

In terms of liquidity for funding continuing operations as well as financing future acquisitions, the REIT ended the year with CAD48 million in cash on its balance sheet and has another CAD80 million available from its credit revolver.

On Bay Street, analyst sentiment remains largely bullish, with six “buys,” three “holds,” and no “sells.” The consensus 12-month target price among the six analysts for which we have recent data is CAD17.04, which suggests potential appreciation of 9.1 percent above the current unit price.

Analysts forecast FFO per unit will remain flat for full-year 2014, but rise by 3 percent, to CAD1.50, in 2015.

Artis’ units closed at a two-year low in early September, at CAD13.45, as investors fled REITs and other income-oriented equities due to fears that eventual Fed tightening would compel retail investors to abandon such securities in favor of fixed income.

However, the Fed is unlikely to allow rates to rise too much until there’s greater evidence of a resurgent economy. Assuming such a rebound is underway, the cost of borrowing to expand REIT assets will be higher, and dividend-paying securities will face increased competition from fixed income.

This will force Artis to retreat from the external growth it’s pursued over the past several years thanks to the abundance of cheap financing amid historically low interest rates. In the past, the REIT has done about CAD300 million to CAD600 million in acquisitions per year. But this year, management believes that number could come in at a lower range, between CAD100 million to CAD300 million.

Fortunately, the REIT should enjoy greater organic growth, not only from refocusing on improving internal operations, such as by redeveloping existing properties or pursuing intensification, but also because a stronger economy usually translates into the ability to charge higher rents.

On a price basis since the earlier low and through the end of February, Artis’ units have risen 16.5 percent in local currency terms and 9.3 percent in US dollar terms. This compares favorably to the Bloomberg Canadian REIT Index (BBCREIT), which hit its two-year low around the same time, and has since climbed 6.9 percent in Canadian dollar terms and 0.4 percent in US dollar terms.

Over that same period, the S&P/TSX Composite Index (SPTSX) gained 10.5 percent in local currency terms and 3.7 percent in US dollar terms, while the  S&P 500 rose 11.2 percent, and the Bloomberg NA REITs Index (BBREIT), which tracks US REITs with market caps of USD15 million or greater, increased by 6.5 percent.

Over the period since we first recommended Artis in early-September 2007 through the end of February, the units have gained 60.6 percent on a total-return basis in local currency terms and 53.3 percent in US dollar terms.

That performance slightly lagged the 59.5 percent return of the BBCREIT in US dollar terms, but soundly beat the SPTSX by 23.3 percentage points in US dollar terms. It also surpassed the BBREIT’s 34.7 percent return and the S&P 500’s 45.6 percent return.

The REIT’s CAD0.09 monthly distribution hasn’t budged since mid-2008. Management has stated that it would like to get its AFFO payout ratio down to 80 percent and its total debt to gross book value down to 45 percent before it will consider increasing the distribution, especially considering the higher cost of capital down the road.

But the payout is well covered at current levels and offers an enticing yield of more than 6.9 percent. Artis REIT remains a buy below USD16 in our Conservative Portfolio.