Just over a year ago, in the June 2013 issue of Canadian Edge, we profiled Canadian real estate investment trusts (REIT) in an In Focus feature entitled “The REIT Rout.”

It was mere weeks after then-Federal Reserve Chairman Ben Bernanke introduced the word “tapering” to the investor’s lexicon and catalyzed a storm of speculation and fear about and of rising interest rates due to the Fed’s indication that it’s program of monthly bond purchases designed to keep a lid on borrowing costs would come to an end.

REITs, which had enjoyed an extraordinary run in the market as traditional bond buyers hungry for higher yields rotated into a sector of the equities market perceived to be a relatively safe, secure source of consistent income, suffered immediately.

But interest rates have remained within an historically low range, even as the Fed has greatly scaled back its bond-buying, or “quantitative easing,” program to the point that it will likely end in October.

At the same time, it remains an open question when the Federal Open Market Committee will boost the benchmark fed funds rate off its present 0.25 percent, or “zero bound,” level.

Once rates begin to rise–and they will–it seems likely that they won’t come up as fast as they did during prior tightening cycles or to the ultimate peaks of same. This is a function primarily of a long-term period of slower economic growth relative to historical norms.

At the financial and operational levels the five Canadian REITs we hold in the Canadian Edge Portfolio continue to maintain solid interest coverage ratios, due to generally steady operating income growth and interest expense savings on debt refinancing.

Their continued health is supported by the relatively sound state of the Canadian economy and the currently reasonable balance between demand and supply of commercial real estate (with the exception of the Canadian office market, which is experiencing sluggish demand and an increase in sublet space, and has new supply coming online in 2014-2015). Residential apartment REITs stand to benefit from the fact that it’s becoming harder for a family to buy a home in much of Canada.

The bottom line is Canadian REITs will continue to benefit from a low interest rate environment for the foreseeable future.

And their steady, relatively high yields will continue to benefit income-focused investors.

Unsettling Dream

Dream Office REIT (TSX: D-U, OTC: DRETF) has rebounded from its post-“taper tantrum” low but has lagged its REIT peers in the CE Portfolio.

For the first half of 2014 the office-focused REIT posted a US-dollar total return of 5.2 percent compared to 9.5 percent for the S&P/TSX Capped REIT Index and an average of 8.7 percent for the five Canadian REITs held in the CE Portfolio.

Portfolio occupancy as of March 31, 2014, was strong at 94.2 percent, though on a comparative property basis occupancy dipped by 10 basis points from Dec. 31, 2013.

That’s consistent with research compiled by Canadian credit rating agency DBRS, which recently noted that while occupancy levels remain healthy across each real estate subsector, in the mid- to high 90 percent, the office segment experienced a slight decline due to decreased tenant demand and a general increase in sublet space.

According to Commercial Real Estate Services (CBRE), the Canadian office vacancy rate averaged 10.3 percent in the first quarter of 2014, the highest level since the third quarter of 2005. This represents an increase of 60 basis points quarter over quarter and 170 basis points year over year.

The market also saw negative net absorption for the fifth consecutive quarter, an accumulation of 1.46 million square feet for the first quarter of 2014.

These results were largely attributed to the lack of new demand for office space, as tenants are reducing their overall space needs to adopt new workplace strategies as well as a continued increase in sublet spaces, which nearly doubled compared to the first quarter of 2012.

We’ll wait for confirmation in second-quarter numbers that this trend has captured Dream Office, which has outperformed the office segment on an occupancy basis.

But on initial impression it seems likely that vacancy rates in the Canadian office market could face upward pressure in the near term due to sluggish demand and new supply coming online in 2014-2015, which could lead to flat or declining rental rates.

Dream Office, with all of 24.5 million square feet of leasable property devoted to office space, continues to post solid financial results.

First-quarter comparative net operating income (NOI) was up 0.6 percent to CAD106.7 million, driven by increases in western and eastern Canada and Calgary downtown due to higher rental rates on new leasing over the past year and the benefit of step rents, offset by slightly lower occupancy. Total NOI for the quarter was up 8.2 percent to CAD116.1 million, aided by properties acquired in 2013.

Adjusted FFO per unit grew by 1.6 percent to CAD0.62, while FFO per unit was up 1.4 percent to CAD0.73. Distributions were 90.3 percent of AFFO per unit, 76.7 percent of FFO per unit.

Dundee management maintains a strong, conservative balance sheet, with leverage stable at 47.6 percent and an interest coverage ratio of 2.9 times.

We are reducing our buy-under target on Dream Office REIT–formerly Dundee REIT–to USD33, with another review of its long-term viability following the release of second-quarter financial and operating results on Aug. 7.

Industrial Might, Retail Dubiety

Artis REIT (TSX: AX-U, OTC: ARESF) has performed well on the TSX since its Sept. 9, 2013, rising-interest-rate-fear-induced low of CAD13.45, with a total return in US dollar terms of 17.6 percent through June 10, 2014, trailing only slightly the 18.1 percent total return for the S&P/TSX Composite and far outpacing the S&P/TSX Capped REIT Index’ 11 percent gain.

For the first six months of 2014 Artis has produced a total return of 9.3 percent.

Results for the first three months of 2014 support the rally, and Artis’ debt profile suggest it will be able to handle what will likely be a modest rise for official and market rates in North America commensurate with a longer-term, slower-growth trajectory.

Artis’ office segment accounted for 53.4 percent of 2013 revenue, and significant retail (23.4 percent) exposure also is a concern. But industrial (23.2 percent) exposure should offset at least some of the potential weakness in the former two categories.

As of March 31, 2014, office accounted for 36.4 percent of Artis’ 24.3 million square feet of leasable property, retail accounted for 17.5 percent and industrial 46 percent.

RioCan REIT (TSX: REI-U, OTC: RIOCF), with 96.3 percent of its 49.1 million leasable square feet devoted to retail, has actually been the top-performing CE Portfolio REIT over the first half of 2014 with a total return in US dollar terms of 12.8 percent.

Canadian retail was a relatively active segment of the overall real estate market during the first quarter, as there was a high level of investment and merger and acquisition activity despite the fact that retail sales growth remained soft at 3.8 percent. Pre-recession levels averaged 5.3 percent from 2003 to 2008.

According to CBRE, real estate under construction totaled 14.4 million square feet at the end of 2013, representing approximately 4.4 percent of total retail inventory. Construction was related to power center, mixed-use, development and mall upgrades and expansion.

Over the past year mergers and acquisitions included H&R REIT’s (TSX: HR-U, OTC: HRETF) CAD4.6 billion purchase of Primaris REIT and Crombie REIT’s (TSX: CRR-U, OTC: CROMF) acquisition of 68 retail properties (formerly owned by Safeway Inc (NYSE: SWY)) from Empire Company Ltd (TSX: EMP/A, OTC: EMPRF) and Sobeys Inc.

Competition for space should moderate due to the recent surge in investment, while declining interest in Canada from foreign retailers, rationalization by struggling retailers and growth of online shopping clouds the outlook for the retail real estate segment.

RioCan’s advantage stems from its growing exposure to the US retail market.

First-quarter operating funds from operations (FFO) increased by 2 percent to CAD127 million for the three months ended March 31, 2014. Operating FFO per unit were up 2 percent to CAD0.42.

And RioCan’s concentration in Canada’s six major markets–Calgary, Edmonton, Montreal, Ottawa, Toronto and Vancouver–increased to 72.2 percent of annualized rental revenue from 71.7 percent as of Dec. 31, 2013.

National and anchor tenants represented about 86.4 percent of RioCan’s total annualized rental revenue as of March 31, a slight increase from 86 percent a year ago. No individual tenant comprised more than 4.4 percent of annualized rental revenue.

Overall occupancy was in line at 96.8 percent as of March 31, 2014, compared to 96.9 percent as of Dec. 31, 2013.

RioCan renewed 1,282,000 square feet in the Canadian portfolio during the first quarter at an average rent increase of CAD1.02 per square foot, representing an increase of 7 percent and a renewal retention rate of 91.2 percent.

Same-store growth was 3.1 percent in Canada and 3 percent in the US.

A strong balance sheet supports continuing growth via property acquisitions and development on both sides of the Canada-US border. RioCan REIT is a buy under USD27.

As for more diversified Artis, the Canadian industrial market continued to operate under relatively healthy fundamentals during the first quarter, with a lower national availability rate, higher net asking rental rate and positive net absorption.

According to CBRE, the overall national availability rate was at 5.6 percent, a 20 basis point quarter-over-quarter improvement. The average net asking rental rate was CAD6.01 per square foot, just shy of the record high of CAD6.02 per square foot recorded in the third quarter of 2013. The market also recorded 5.1 million square feet of positive net absorption during the first quarter, well above the 10-year quarterly average of 3.6 million square feet.

Of the major industrial markets, Edmonton, where Artis owns 10 industrial properties, experienced the most significant rise in rental rates, with a record high of CAD10.83 per square foot in the first quarter, accompanied by the lowest availability rate in Canada at 3.9 percent and 1.4 million square feet of positive net absorption.

These were primarily the result of higher demand from the transportation and warehousing sectors in the region.

There are currently approximately 13.4 million square feet of construction in progress. Most of the construction is in the Greater Toronto Area (43.7 percent of total square footage under construction), which was driven by increasing demand for distribution centers from retailers.

Demand for industrial space should remain strong, and rental rates should continue to increase moderately as the Canadian manufacturing sector expands and retailers continue to invest in their distribution networks. REITs with industrial exposure, including Artis, should benefit from strengthening fundamentals.

Artis posted an 8.1 percent increase in first-quarter property NOI and 2.8 percent growth in same-property NOI from the prior corresponding period. Revenue for the three months ended March 31, 2014, was up 13.7 percent to CAD123.7 million.

Occupancy as of March 31, 2014, was 95.5 percent, 96.3 percent including commitments.

FFO were up 6.4 percent to CAD47.6 million compared to the same period of last year, though FFO per unit declined by 5.3 percent to CAD0.36 due to new-unit issuance. The FFO payout ratio was 75 percent.

Artis REIT is a buy under USD16.

The Apartments

It’s increasingly difficult for families to buy homes in Canada, and affordability is forecast to get worse from here.

But this is good for residential apartment REITs, including Conservative Holdings Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF) and Northern Property REIT (TSX: NPR-U, OTC: NPRUF).

The Royal Bank of Canada’s (TSX: RY, NYSE: RY) affordability index deteriorated in the first quarter of 2014, the third of the last four that it’s gotten worse, with the deterioration particularly acute in the hot markets of Toronto, Calgary and Vancouver.

And if prices continue on their present trajectory in key Canadian markets in the near term, affordability could come under further upward pressure.

The eventual normalization of interest rates will lead to higher mortgage costs, which could overwhelm other parts of the affordability equation.

The affordability index measures the percentage of pre-tax household income that is needed to service the cost of owning a home at current market prices, including payments for a mortgage, utilities and property taxes. A reading of 50 percent means service costs swallow up half of a household’s pre-tax income.

Nationally, the index rose by 0.1 points to 43.2 percent for detached bungalows and 0.3 points to 49.0 percent for two-story homes, while the measure for condos dipped 0.1 points to 27.9 percent.

But that was an average calculation. Vancouver’s affordability index rose 0.9 points to 82.4 percent, Toronto’s by 0.2 points to 56.1 and Calgary’s by 0.9 points to 34.5.

In Ontario as a whole, the affordability measure of 44.9 percent for bungalows and 51 percent for two-story homes represented a 24-year high.

Still, the affordability measure has more relevance to newer home buyers since the vast majority of Canadians will have bought their homes in the past, when prices were lower.

And there was good news in some markets. The affordability index fell 0.5 points to 36.4 percent in Ottawa and by 0.2 points to 32.9 percent in Edmonton.

The Atlantic region remained relatively soft with declines of 0.4 points to 31.2 percent and 25.9 percent for bungalows and condos, respectively. The index rose a modest 0.2 points to 36.2 percent for two story-homes, still well below the long-term average for the region.

Canada Mortgage and Housing Corp recently forecast that national home prices would continue to rise, although at a more moderate pace, this year and in 2015.

CAP REIT, at its May 28, 2014, annual general meeting, announced a 2.6 percent increase in its distributions from a monthly rate of CAD0.09583 per unit (CAD1.15 on an annualized basis) to approximately CAD0.09833 per unit (CAD1.18 on an annualized basis), effective for the June 2014 distribution payable on July 15, 2014, to unitholders on record as of June 30, 2014.

This is the 11th increase in CAP REIT’s distributions, reflecting a “positive future outlook.”

CAP REIT posted a 9.1 percent year-over-year increase in first-quarter normalized funds from operations (NFFO) per unit to CAD0.395, despite a 9 percent increase in the average number of units outstanding.

The payout ratio based on NFFO was 74.7 percent, down from 79.3 percent a year ago.

Operating revenue was up 9.7 percent to CAD126.5 million, as high and stable occupancy, which was 97.9 percent as of March 31, 2014, growth in average monthly rents of 2.9 percent and contributions from acquisitions offset the effects of unseasonably cold temperatures and major Ontario ice storms.

Operating expenses were up 6.4 percent to CAD55.2 million.

Management noted that ongoing energy saving initiatives contained energy costs, despite the record cold temperatures across the country, and effective cost management resulted in reduced costs associated with the ice storms and overall repairs and maintenance.

Net operating income (NOI) grew by 12.4 percent to CAD71.4 million, while NOI margin was 56.4 percent, up from 55.1 percent a year ago. Same-property NOI was up 5.3 percent compared to the prior corresponding period.

CAP REIT’s subsidiary in Ireland, Irish Residential Properties REIT Plc, completed a EUR200 million initial public offering and listed on the Irish Stock Exchange on April 16. Growth for the Irish subsidiary, which will be driven by favorable apartment market metrics in Dublin, will allow CAP REIT to generate a stable and growing stream of fee revenue from our asset and property management activities.

Ontario, including Toronto, where home affordability is on the upswing, accounts for approximately 55 percent of CAP REIT’s rental suites and total NOI. The REIT also has significant exposure in Quebec, including Montreal, and British Columbia, including Vancouver.

Canadian Apartment Properties REIT is a solid buy for stable income up to USD25.

Northern Property, meanwhile, reported an 8.3 percent increase in first-quarter total revenue to CAD45.4 million, while NOI grew by 1.9 percent to CAD23.9 million.

Northern Property’s primary exposure is to oil and gas-producing regions in Alberta, British Columbia and the Northern Territories. Recent results have been colored by the pullback in new exploration and drilling activity, but the trend seems to be reversing in its favor.

FFO declined by 2.4 percent to CAD15.5 million, while FFO per unit slipped by 2 percent to CAD0.49. The payout ratio for the period based on FFO was 81.5 percent.

Management attributed the declines to the impact of severe winter weather and weaker hotel and execusuite performance as well as “stubbornly higher” vacancy rates in Yellowknife, Northern Territories, and Fort McMurray, Alberta.

Utility costs were also higher–by CAD900,000, taking CAD0.03 per unit off FFO–due to increased consumption owing to colder temperatures.

Total residential vacancy loss for the three months ended March 31, 2014, was 8.8 percent compared to 6.4 percent for the same period of 2013 and 6.7 percent in the fourth quarter of 2013.

Stabilized vacancy for the three months ended March 31, 2014 was 7.8 percent.

Financing costs also increased compared to the first quarter of 2013, as mortgage interest expense was higher due to a higher number of leveraged properties.

Northern Property acquired five residential units in Iqaluit, Nunavut, bringing the total to 9,905 multifamily units as of March 31. The REIT also purchased 30,000 square feet of commercial space in St. John’s, Newfoundland.

On the development front, Northern Property completed the 189 multifamily-unit project in Regina, Saskatchewan, at a cost of CAD26.7 million. Lease-up is progressing, with approximately 70 percent of the project currently leased.

Northern Property also completed 39 multifamily units in Iqaluit at a total cost of CAD9.2 million, with lease-up expected to be completed during the second quarter.

Management noted that, moving into the more favorable spring and summer seasons and based on the allocation of significant resources and efforts to leasing, customer service and the maintenance of its properties, it’s seeing signs of improvement in the portfolio that should translate into better performance in coming quarters.