There’s no doubt about it: Canadian real estate investment trusts (REIT) have been huge winners since global stock markets bottomed in March 2009.

In fact, they’ve been far and away the top-performing sector in the Canadian Edge How They Rate coverage universe.

Conservative Holding Artis REIT (TSX: AX-U, OTC: ARESF) has returned 447 percent since Mar. 9, 2009, including a recovery from a 70 percent decline the preceding six months.

The latter was due to vastly overblown worries about what was then its Alberta-focused portfolio.

But even RioCan REIT (TSX: REI-U, OTC: RIOCF), the largest and arguably most highly regarded company in the sector, is up 323 percent from the bottom.

As the figures I present in Portfolio Update show, 2012 has thus far been a mixed bag for Canadian markets, just as it’s been worldwide. The broad-based S&P/Toronto Stock Exchange Composite Index is up just 3.6 percent including dividends, as energy stocks in particular have languished.

In stark contrast, the 16 REITs I track in How They Rate have returned an average of 34.5 percent year to date.

There have been some standouts, such as comeback pick Interrent REIT (TSX: IIP-U, OTC: IIPZF), an apartment-focused operation that was hanging on for dear life a couple of years ago after slashing its distribution by more than two-thirds. Management’s success at engineering a turnaround has been justifiably rewarded in the market place.

Even the year’s worst performer among those we track, however, has a better than 10 percent return, multiplying the gains already rolled up over the previous three years.

In fact, only three of the 16 aren’t up by more than 20 percent.

There are some very good reasons for REITs’ run: high quality assets, reliable business growth, a return to dividend growth, strong balance sheets, low interest rates in Canada and the public’s desire for safe havens to name a few.

The question is, are these enough to lift the group to further gains in the rest of 2012 or are these stocks fully priced for all their good news and more and due for a rest/pullback?

The Case for REITs

Since late 2009 Canadian REITs have enjoyed their lowest borrowing rates in history. And they’ve put low-cost capital to very good use, embarking on an unprecedented expansion by accumulating high-quality properties from distressed owners. Several, such as RioCan, have picked up properties in the US as well.

Because rates were so low many if not most REITs raised capital first, with the idea they could easily deploy it later. Then, as the stock market recovery unfolded, they took advantage of higher unit prices to issue equity as well.

At the time, management of REITs like RioCan assumed that distressed owners would have to sell sooner rather than later. As it turned out, however, bargains were slower to emerge, as strapped owners held on. And the result was many REITs have had large amounts of capital left undeployed for longer than they expected.

Up until recently that’s been a real drag on funds from operations. Even with their cost of capital so low, REITs’ cash balances have earned even less. The result has been dilution, higher-than-anticipated payout ratios and a general lack of distribution growth.

That’s now started to change, with a vengeance. Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF), for example, hadn’t raised its distribution since October 2003. But last month management announced a payout boost of 3.3 percent. And with a second-quarter payout ratio of just 79 percent and more acquisitions on the way, there’s every indication there’s more to come.

Of the 16 REITs I track in How They Rate, six have increased their distributions over the past 12 months. And based on the upward trajectory of profits and management statements, their ranks are likely to swell in the coming months. That includes RioCan, though its payout ratio is still somewhat high at around 90 percent.

Note that REITs’ relevant measure of profitability is funds from operations. Earnings per share are meaningless and misleading as a gauge.

Such low capital costs have also dramatically reduced REITs’ operating and balance sheet risks in recent years. Management typically evaluates properties on projected returns, balanced against risks.

The higher the quality of the property–i.e., the newer the facilities, the higher the occupancy–the higher the selling price and the lower the projected return.

Low capital costs, however, dramatically lower the bar for what’s considered an adequate return. For example, a project with a projected rate of return of 8 percent isn’t worth the trouble if a REIT’s cost of capital is 8 percent. But it’s a potential goldmine if rates are close to 3 percent.

As a result, REITs have now entered a new phase of expansion, where they can build cash flows by acquiring high-quality properties with low-cost money. In so doing they can keep their occupancy rates high, maintenance expenses under control and rents rising.

The 16 REITs in the table “Canada’s Property Plays” have an average occupancy rate of 95.8 percent of their available property. That’s a fantasy number for most US REITs, which have historically hovered in the low 90 percent range. And it’s been a major factor enabling Canadian REITs to stay strong as businesses during market downturns.

Canadian REITs also have dramatically more conservative financial policies than their US counterparts. That’s demonstrated by debt-to-book value and debt-to-capital ratios that are much lower as well as by the lack of debt maturities most have between now and the end of 2013.

A sudden credit crunch could make it more difficult for Canadian REITs to borrow to finance more acquisitions and construction. But management wouldn’t be forced to borrow at loan-shark rates to make ends meet, as so many US REITs were forced to do during the 2008-09 crisis. That’s still a major source of dividend cuts in that sector, including a more than 30 percent reduction by former industry icon Washington REIT (NYSE: WRE) in July.

In recent months there’s been no shortage of wags forecasting doom for the Canadian real estate market. Most cite rising household debt and the country’s dependence on resource exports to Asia as key vulnerabilities.

What’s not said is Canadian REITs have seen this before and are more than prepared for a downturn. In fact, high occupancy and low debt have been their hallmark since I began tracking them in the first issue of Canadian Edge in mid-2004.

Staying conservative enabled them to not only survive the ill effects of the crash of 2008-09 but also to take advantage of conditions to build the prosperity we’re seeing now.

The bottom line: Over the next six to 12 months we’re going to see Canadian REITs’ payout ratios come down.

Should economic and credit conditions tighten a bit, distribution growth would likely be less than otherwise, but it will nonetheless resume for many REITs and continue for others.

Coupled with investors’ desire for safety and yield, that’s bound to keep REITs a popular sector for the rest of 2012 and beyond. And that’s not even taking into account the potential for sector mergers and spinoffs.

Conservative Holding Dundee REIT (TSX: D-U, OTC: DRETF) is responsible for one of each this year. First the company completed the takeover of the former Whiterock REIT, becoming the country’s largest office property REIT. Now it’s spinning off light industrial properties–many of which it acquired with Whiterock–into a wholly new REIT. (See Portfolio Update for details.)

Given the average size of the 16 REITs under coverage is CAD2.6 billion of market capitalization, I expect most of the activity will involve their purchases. But all are also small enough to be swallowed by a larger rival. That includes RioCan, whose CAD8.3 billion market cap makes it one of the larger REITs in North America.

Takeover fever can be a powerful force for pushing up stock prices in the right kind of market. And it could prove a valuable bonus for Canadian REIT investors into 2013, even as the underlying companies remain among the most conservatively run you’ll find in any industry.

The Case Against REITs

The case against Canadian REITs basically boils down to value.

No stock rises forever in a straight line. And though these companies have arguably one of the most sustainable business models around, they are also very much in favor and have benefitted immensely from buying momentum simply because their share prices have been rising.

Average yields that were well in the upper single digits a couple years ago are now decidedly in lower single digits. They’re still generally superior to US REITs’ payouts, particularly considering they’re much safer.

But the yield gap has shrunk especially for US investors, who are withheld 15 percent of distributions by the Canadian government even if the REIT is held in an IRA. That’s because Canadian REITs don’t pay corporate taxes.

On the plus side, US investors can get back the withholding tax if Canadian REITs are held outside IRAs by filing a Form 1116 with their US taxes. And dividends are taxed at 15 percent on this side of the border like any other corporation. But there is no recovery mechanism for Canadian REITs held in an IRA.

My view is Canadian REITs are still a much better deal than US REITs, even for US investors, despite the lower yield gap.

For one thing, your distributions are paid in Canadian dollars, giving you an inflation hedge in what’s set to be a strong currency for years to come. For another, the underlying businesses are still getting stronger, even while US REITs are floundering.

Today’s high prices, however, are also due to what are still very low Canadian interest rates, which both facilitate capital raises and increase REITs’ investment appeal.

A push to higher rates would certainly unwind some of that upside momentum and bring down valuations.

Also, while although underlying businesses have demonstrated strength in down markets, Canadian REITs’ unit prices have occasionally taken hits on economic worries.

Even RioCan, for example, took a major hit in the second half of 2008. So did Northern Property REIT (TSX: NPR-U, OTC: NPRUF), despite consistently raising dividends each year. Any disappointment on the economic front could also take down prices.

As with other Canadian Edge recommendations, my strategy is to keep holding stocks so long as the underlying businesses financing the dividends are solid. That was definitely the case for all CE Portfolio REITs during the 2008-09 crisis. And we’ve been rewarded manifold times for sticking with them.

On the other hand, holding on during a bad time for the market is a lot harder it you’ve bought when REITs are trading at lofty prices. And as the 2008 crisis proved, some REITs inevitably find themselves exposed when the crisis kicks in.

Lanesborough REIT (TSX: LRT-U, OTC: LRTEF), for example, still trades under a buck as it struggles to meet debt obligations by selling assets. Its original sin was investing heavily in oil patch properties just before the late 2008 crash, and it’s still paying the price.

I don’t see that happening with any of my recommendations. In fact, the worst thing that could happen to most of them is probably a 15 percent to 20 percent correction, taking them back below my target buy prices.

These are set on a combination of safety and quality criteria, as laid out in my CE Safety Rating System. I then add the yield and projected growth to calculate a prospective annual return.

For example, if RioCan yields 4.8 percent and is increasing its dividend 4 percent a year, the prospective return is 8.8 percent.

Typically, I like to see a 10 percent prospective return matched with a high Safety Rating (“5” or “6”) for my Conservative Holdings to rate a buy. I’m willing to go a bit lower with the REITs, given that distribution growth is only starting to kick in and the fact that they’re so well positioned.

Unfortunately, that number for many of the REITs in the coverage universe is a lot closer to 5 percent just now. That’s clearly worse than other sectors I choose for Conservative Holdings. And it’s a valuation that’s historically meant the group is due for a rest.

There are some exceptions of REITs that still rate buys at current prices. Morguard REIT (TSX: MRT-U, OTC: MGRUF) is one, paying 5.4 percent and raising its dividend 6.7 percent this year. That’s a prospective return of 12.1 percent for a company that draws all six CE safety criteria. I rate Morguard REIT a buy up to USD18.

As for the rest, however, we need to see either a distribution increase or a drop in price to below my targets. Distribution increases will push up target prices. But at these levels it’s time to have a little patience.

In fact, those who’ve ridden our favorites up the past few years may even want to take some money off the table as a partial profit, particularly if a REIT has grown to a disproportionate part of your portfolio.

This advice may not make investors who want to buy now very happy. All I can say is nothing is a buy at any price and you always do better trying to buy on downturns rather than when everyone else wants in.

As we’ve seen again and again in these volatile markets, no drop in a stock is permanent unless it’s eventually matched by deterioration at the underlying business. Conversely, no rise in a stock is permanent unless there’s a corresponding gain in the value of the underlying operation.

The only way to really build value in a portfolio is to follow the underlying value of the company. And that’s our aim at Canadian Edge, both for sectors that have performed poorly this year, such as Energy Services and those that have blown the doors off, like our first-rate REITs.