The bear market in US real estate keeps getting nastier. Selling prices for existing homes are off 16 percent from a year ago, their sharpest decline in decades. Home building is depressed, and commercial property is softening as well, as businesses pull in their horns.

In stark contrast, despite lower first quarter GDP, Canadian real estate looks healthier than ever. Check out the map “Canadian Housing Outlook,” which has information by province on average home selling prices, economic growth and forecasts for price and volume for full-year 2008 home sales.

Over the last 12 months, five Canadian provinces have registered double-digit increases in selling prices for existing homes. Emerging energy producer Saskatchewan took the prize with an astronomical 44.5 percent growth rate. Every other province scored solid gains as well except Alberta and Prince Edward Island. And Alberta’s dip was mainly a pause after several years of runaway gains.



As for 2008 forecasts, only Saskatchewan and Newfoundland/Labrador expect to see rising volumes of home sales from last year’s record levels. In fact, the Canadian Real Estate Association (CREA) looks for activity to taper off about 11.5 percent from 2007’s record pace.

Every province, however, is anticipating higher selling prices. CREA looks for 5.3 percent price growth nationally in 2008, followed by an additional 4.2 percent in 2009.

Overall economic growth in Canada has already gone negative from last year and is expected to remain subdued into next year. The primary reason is the drag from the US economy, which still consumes more than 70 percent of Canada’s exports. US and Canadian financial institutions are also linked, with several of the latter taking writeoffs because of exposure to deadbeat mortgage securities based on subprime loans.

As this month’s Canadian Currents points out, however, Canadian banks are still in far better shape than their US counterparts. They never went to the excesses US banks did lending to less-creditworthy customers. The rate of subprime loan defaults in Canada is a tiny fraction of what it is in this country, as are troubled adjustable-rate loans. And there are actually signs that certain areas of banking activity are picking up.

Consequently, mortgages are being funded at reasonable rates. Coupled with very low unemployment and strong consumer confidence, that’s a powerful underpinning for Canadian residential property. And those favorable fortunes are also reflected in the leasing market, including apartments, shopping malls, office buildings and industrial properties.

Advantage Canada

A strong Canadian property market has brought salad days for Canadian REITs. During the first quarter of 2008, residential REITs—which own and rent apartments—posted some of their best results ever, as both rents and occupancy rose and new properties were added. Commercial property REITs also surged as demand for office, industrial and even retail shopping center space remained robust.

Canadian REITs across the board continue to expand as they’ve done in recent years. Most deals have been outright acquisitions of properties held by others. But we’re also seeing a rising number of so-called “greenfield” projects, such as RioCan REIT’s (TSX: REI.UN, OTC: RIOCF) Vaughn, Ontario, retail center project.

Greenfield profits are strong confirmation that REITs are getting all the financing they want, both from banks and by issuing shares. REITs are the only trust group fully exempted from 2011 taxation and rules restricting share issues, and they’ve taken full advantage.

Canadian Finance Minister Jim Flaherty announced Dec. 20, 2007, long-promised technical amendments to the specified investment flow-through (SIFT) rules released Oct. 31, 2006, and enacted in June 2007.

As originally devised, qualifying REITs couldn’t own more than 25 percent of their assets outside of Canada and couldn’t generate more than 25 percent of their revenue from such assets. The amendments remove such restrictions; REITs will be able to hold real or immovable property anywhere in the world–a huge concession for those that own property in the US.

To qualify as a REIT, the trust must derive at least 75 percent of its revenue from rent and other specified sources. If the trust holds real estate properties indirectly through a subsidiary trust, this test is arguably not met. The amendments clarify that rent won’t lose its character simply because it’s paid through a subsidiary trust.

A REIT must hold 75 percent of its assets in certain qualifying assets, including cash. The amendments expand the definition of cash for this purpose to include amounts on deposit with financial institutions, bankers’ acceptances and other highly liquid, short-term investments.

Currently, nominee corporations must hold title only to property owned by the REIT or by the REIT together with other entities. The proposed amendments expand the rules to permit the nominee corporation to hold legal title to property owned by subsidiaries of the REIT.

Another sign of strength is distribution growth. The ability to expand operations and dividends at the same time is the clearest possible sign that business is booming.

Canadian REITs have gotten little credit in the marketplace for their strong business performance. In fact, convinced that what’s happening in the US will inevitably spread north, investors on both sides of the border dumped them in droves early this year.

That’s partly reversed for the stronger REITs. But much of the sector is still deeply in the red for the year, including several REITs that increased distributions at least once over the past 12 months. And even the outperformers sell for very modest multiples to book value, a stark contrast with their infinitely more challenged US counterparts.

Canadian REITs have long held a substantial yield advantage over US rivals. That’s the case today, despite the pasting taken by some US REITs in recent months.

For example, RioCan has a yield of 6.4 percent. That’s 5.44 percent, taking off the 15 percent withholding by the Canadian government and assuming no attempt to reclaim it by filing a Form 1116 with your US taxes. In contrast, US retail giant Kimco yields just 4.1 percent, despite a sharp drop in its first quarter funds from operations (FFO).

The yield advantage is even greater when taking into account US taxes. RioCan’s dividend, like all Canadian REITs’, is fully qualified for tax purposes. In contrast, Kimco’s dividend was 56 percent ordinary income in 2007 and 66 percent ordinary income in 2006. The rest was capital gains and tax-deferred return of capital, typical of most US REITs.

Canadian REITs aren’t without risks. For one thing, there’s still some confusion about which of today’s lineup will qualify as REITs in 2011. The government has since clarified most of the rules—such as allowing REITs to invest in the US but less-conventional enterprises such as hotels and retirement communities still exist in a gray area.


More dangerous are the continuing threats to the health of the Canadian economy itself. A drop in natural resource demand from China, for example, would take a real bite out of GDP.

The country’s central bank has plenty of weapons at its fingertips to spark up growth in a pinch. Inflation is well within its designated range and far below US levels. The Canadian dollar is very strong. In fact, the bank has had to take action to keep it from appreciating too quickly against the US dollar. And the country’s government is still running a massive surplus, which provides a lot of leeway to cut taxes.

In short, Canada’s property market is set to stand on solid ground for some time. The best Canadian REITs will perform well as businesses. That means rising dividends and share prices.

The Right REITs

We hold four Canadian REITs, representing a range of high-quality properties from across the country, in the CE Portfolio. The group has performed well this year, with an average total return of about 7.7 percent. That’s far better than the average REIT in either Canada or the US, and it’s on top of last year’s solid gains. Yielding an average of 6.4 percent—which increased 3.1 percent in the last 12 months—they remain solid bedrock for any portfolio.

As reported in the May 16 flash alert, Artis REIT (TSX: AX.UN, OTC: ARESF) posted some of the best numbers ever for any real estate company. The REIT owns a diversified mix of office (41.8 percent of holdings), retail (32.6 percent) and industrial (25.6 percent) properties. The geography is toward Canada’s fastest-growing regions, particularly Alberta (55.8 percent) and Manitoba (30.7 percent), with lesser holdings in Saskatchewan (7.9 percent) and British Columbia (5.6 percent).

Revenue nearly doubled in the first quarter. That was an actual acceleration from the fourth quarter’s robust growth rate. Artis continued to add properties with high occupancy rates and strong rent growth potential. That’s a winning formula under any condition.

Best of all, there’s a wealth of new projects, and management has begun to share the wealth, bumping up the distribution 2.9 percent last month. There’s certainly a lot more where that came from, as the first quarter payout ratio was only 65 percent. Buy Artis REIT up to USD18.

Northern Property REIT (TSX: NPR.UN, OTC: NPRUF) is somewhat less diversified by property type, with 89 percent of the portfolio in the residential rental area. But it’s also enjoyed considerable success by focusing on stronger markets, with an accent on locations off the beaten path.

Nearly a third of the portfolio is in Alberta, and another 13 percent is in British Columbia. But there’s more than 40 percent in the extremely remote Northwest Territories and Nunavutt. Many of these properties boast the absolute safest tenants—federal and provincial government entities—and they’re literally the only game in the towns they service.

I originally chose Northern because the quality of its portfolio made it impervious to potential economic declines in Canada. As it’s turned out, management has kept that focus. But its areas of expansion have boomed as resource producers are forced to go further and further afield to meet demand.

That’s produced very high occupancy and powerful rent growth and pushed up first quarter distributable income per share by 17.9 percent. Northern Property REIT is a buy up to USD25.



The two remaining picks are focused on specific property sectors. Canadian Apartment Properties REIT (TSX: CAR.UN, OTC: CDPYF), as its name suggests, owns residential property in Ontario (67.5 percent) and Quebec (19.8 percent). Over the past year, however, it’s added facilities in the faster growing western provinces, namely Alberta (4.6 percent), British Columbia (3.2 percent) and Saskatchewan (0.9 percent).

That appears to be where management is focused going forward. Earlier this year, the REIT bought a major apartment complex in British Columbia that was already almost fully occupied. Overall occupancy stands at 98.2 percent, and rents grew 3.2 percent in the first quarter versus year-earlier levels.

The REIT’s large presence back east has held down growth in recent years. That’s because the region has benefited less from Canada’s energy bounty and was hit harder by the weak US dollar. Nonetheless, it provides ballast when tough times hit the energy patch.

Also, unlike our other REITs, Canadian Apartment pays out much closer to its cash flows. Though first quarter distributable cash per share rose a torrid 16.4 percent, it still failed to cover the dividend as the payout ratio came in at 109 percent. That’s high for seasonal reasons, namely expenses such as heating costs that don’t occur at other times of the year, and the distribution isn’t at risk.

But the combination of a high payout ratio and focus on less-cyclical regions of the country will hold down dividend growth. The tradeoff is stability. Buy Canadian Apartment Property REIT up to USD20.

Our fourth holding is RioCan REIT, Canada’s largest and oldest REIT with a focus on retail properties, particularly shopping malls. RioCan’s portfolio is also heavily focused in the eastern provinces, particularly Ontario (62.9 percent). And it continues to expand there, though Alberta and British Columbia are becoming more important.

The REIT’s hallmarks are broad diversification between tenants—none is more than 5 percent of total rents—and focus on the strongest customers. More than 80 percent of retail space is rented to so-called “anchor tenants,” which are extremely creditworthy and rarely pull up stakes. And occupancy has consistently remained stellar, clocking in at 96.6 percent at last count.

In addition, RioCan’s CEO Edward Sonshine has focused the REIT in creating new income flows, taking advantage of its superior size and access to capital, as well as weakness in property sectors most hit by the weakness in the US. That’s a strategy that may hold down near-term distributable cash flow growth. But it’s one the REIT can afford with its moderate payout ratio and modest debt, and it will pay off richly down the road.

RioCan shares have been uncharacteristically volatile this year because some of the taint of operating retail centers in the weak North American economy has rubbed off. The shares are now well off their lows but also well below their 52-week highs, a good place to buy if you haven’t already. Buy RioCan REIT up to USD25.

Best of the Rest

Together, these four Canadian REITs are solid bedrock for even the most conservative portfolio and superior alternatives to almost any US REIT. And several others in the sector are also worthy buys.

One-hundred percent focused on shopping centers, Calloway REIT (TSX: CWT.UN, OTC: CWYUF) units have suffered this year from economic concerns, slumping 10.6 percent. The REIT currently yields well more than 7 percent and trades for just 1.37 times book value, less than half RioCan’s multiple and well below those of most US shopping center REITs.

The REIT’s portfolio, however, continues to perform well. First quarter FFO surged 8.2 percent, as its shopping centers achieved 99 percent occupancy. That last fact is particularly remarkable considering the REIT’s recent growth and is a testament to solid management.

Calloway’s portfolio is heavily focused on the eastern provinces, with Ontario the largest exposure at 56 percent. But it’s also expanding rapidly into the western part of the country, which now comprises well more than 20 percent of its portfolio. That, more than anything else, is what’s firing up growth, even as management has held debt to just 43.3 percent of book value.

The payout ratio of just 83.8 percent points the way to more dividend growth. Finally, Bay Street is bullish, with seven buy recommendations, four holds and no sells. That’s a strong combination that should add up to solid total returns even if Canada’s economy softens further. Calloway REIT is a buy up to USD26.



Primaris REIT (TSX: PMZ.UN, OTC: PMZFF) is another relatively cheap shopping mall REIT. The shares aren’t down as much as Calloway’s this year but still yield more than 7 percent and trade for just 1.88 times book value.

A greater focus on the west is one reason for the slight outperformance. Ontario is still the REIT’s greatest concentration at 43 percent of cash flow. But Alberta, British Columbia, Saskatchewan and Manitoba now account for a combined 43 percent. That was a major reason net operating income rose 20.2 percent in the first quarter versus year-earlier levels, though rising expenses and share issuing held FFO-per-share growth down to just 2.3 percent.

Looking ahead, the payout ratio has been consistently under control in recent years in the mid-80 percent range. Debt is now 58.6 percent of book value, a legacy of the REIT’s recent expansion, but still very much under control. And Bay Street is definitely bullish, with seven buys, two holds and only one sell recommendation.

No one should confuse Primaris and RioCan as being on the same risk level. But for those willing to tolerate a little more, Primaris REIT remains a buy up to USD19.

Apartment REITs are natural beneficiaries of rising home prices in Canada: The higher the cost of buying a home, the cheaper the relative cost of renting. That means more room for landlords to raise rents. And with Canada’s residential markets in the pink of health, the uptrend should be set for at least a few more years.

The problem is, outside of pure-play Canadian Apartment REIT and more diversified Northern Property, the roster of apartment REITs isn’t attractive. For example, Boardwalk REIT (TSX: BEI.UN, OTC: BOWFF) continues to grow by leaps and bounds. But it’s also extremely expensive, and debt is very high. Hold Boardwalk REIT.

Meanwhile, InterRent Properties (TSX: IIP.UN, OTC: IIPZF) is also growing rapidly, boosting the number of suites in its property portfolio by 52 percent over the past year. But it’s still struggling to generate enough distributable cash flow to pay dividends. And with its payout ratio still high after last month’s 31.5 percent dividend cut, InterRent Properties is suitable to hold for speculators only.

There are, however, a handful of diversified commercial REITs worth a look. These are bets on two things: One is the health of the Canadian economy, which looks solid despite some signs of slowing; the other is management’s ability to construct an all-weather portfolio of solid properties that will grow cash flow and distributions over the long haul.

The best bets are those with measurable track records meeting their challenges, along with generally low debt, high occupancy and geographical diversity. One that’s passed the test for many years is Canadian REIT (TSX: REF.UN, OTC: CRXIF).

Canadian REIT is the very model of property diversification, holding a portfolio that’s currently 51 percent retail, 26 percent office and 23 percent industrial. Geographically, it’s positioned roughly a third each in Alberta and Ontario, equal slices around 10 percent in Atlantic Canada, British Columbia and Quebec, and very small slices in the US and “Prairie provinces.”

Occupancy rates have consistently been in the high 90s and stood at 96.8 percent at the end of March. A 7 percent boost in first quarter FFO left the payout ratio at barely 60 percent, pointing the way to more-modest dividend growth, such as April’s 2.3 percent increase.

Finally, rents are rising, and debt is modest. The current yield is on the low side, but if quality is what you’re after, Canadian REIT is a solid buy whenever it trades below USD30.

Morguard REIT (TSX: MRT.UN, OTC: MGRUF) is similarly diversified, with 34 percent office, 63 percent retail and the rest invested in an array of other properties. Geographically, it’s most concentrated in Ontario (55.6 percent) but also holds 34.2 percent of its portfolio in the energy-rich provinces of Alberta, British Columbia and Saskatchewan.

Coupled with cautious management, the result has been steady returns year in, year out. First quarter occupancy rose to 95 percent from 94 percent a year ago, and rising margins—particularly for office properties—spurred a 16.7 percent jump in FFO per share. That pushed the payout ratio down to just 81.1 percent.

Up modestly for the year, Morguard REIT yields nearly 7 percent and is safe enough for any portfolio if bought below USD14.

New discoveries of natural gas in Quebec could be a major plus for the provincial economy. But even with the weak US dollar hurting tourism and industrial exports, Canada’s francophone province is showing signs of solid growth. Those who want a direct bet on its future prospects will want to check out Cominar REIT (TSX: CUF.UN, OTC: CMLEF), which holds a portfolio of office buildings, industrial facilities and retail shopping centers located entirely in Montreal (46.9 percent), Quebec City (48.5 percent) and Ottawa (3.6 percent).

Twenty percent owned by management, the REIT continues to expand its portfolio, inking the purchase of two more industrial properties in May for CAD23 million. First quarter distributable cash flow rose 35.1 percent, enabling management to lift dividends by 6.2 percent. That brought total 12-month distribution growth to 14.3 percent.

Despite these strong results, the REIT is up only about 5 percent this year. It still yields more than 7 percent and sells for just 1.78 times book value. That adds up to a buying opportunity for Cominar REIT anytime it trades below USD22.

H&R REIT (TSX: HR.UN, OTC: HRREF) focused on only one portion of the REIT market—office space—and it’s very good at it. Despite a steady diet of acquisitions, occupancy has consistently been more than 99 percent, and rents have continued to rise.

First quarter distributable income surged 18 percent, pushing the payout ratio down to 85.5 percent. That, in turn, opens the door to more robust dividend growth, such as the 5 percent increase in the last 12 months.

Meanwhile, the REIT already yields well more than 7 percent and sells for just 1.73 times book value. That’s a cheap way to buy solid office properties, particularly compared with US office REITs such as Boston Properties, which yields less than 3 percent and sells for 3.21 times book. Buy H&R REIT up to USD24.

At Your Own Risk

There are a half-dozen REITs yielding 10 percent or higher tracked in the How They Rate Table. My advice on these is to invest only what you can afford to lose. High yields like these always indicate elevated risk. And if there’s a dividend cut, it will take the offending REIT’s share price down with it.

Three, however, are worth a look now. One is Huntington REIT (TSX: HNT.UN, OTC: HURSF), a small but rapidly growing newcomer that’s having real trouble translating growth into profits. The 175 percent payout ratio is clearly unsustainable, and management is in the midst of a strategic review that will conclude in the third quarter.

On the plus side, the REIT trades for barely book value, and its portfolio is heavily weighted in Manitoba (56 percent), which has one of the country’s strongest markets. Huntington REIT is a buy up to USD2.50 for speculators only.

InStorage REIT (TSX: IS.UN, OTC: IGREF) is tapped into one of North America’s most intractable trends: accumulation of merchandise. Facilities are currently focused on the Ontario market (60.7 percent of facilities), but there’s plenty of opportunity around the country. The REIT has properties in Alberta (14.9 percent), Quebec (16.9 percent) and Saskatchewan (7.5 percent).



The chief drawback is the unsustainably high payout ratio—217 percent in the first quarter—which was pushed higher by costs and a 56.1 percent jump in outstanding shares. But selling for just 66 percent of book value and a yield of more than 12 percent, a lot of risk is priced in already. InStorage REIT is for speculators up to USD5.

Finally, InnVest REIT (TSX: INN.UN, OTC: IVRVF) is the most profitable player in an industry (resorts and hotels), currently being strained by the fall in the US dollar and slumping US economy. US tourism to Canada has fallen to its lowest level since record-keeping began in 1972.

The good news here is that the REIT’s facilities are first rate, giving them a real element of recession protection, as evidenced by a 4.6 percent increase in revenue per available room in the first quarter. Cash flows are seasonal, with outflows in winter balanced by huge inflows in the warmer months. That looks like it will remain the case at least for the rest of 2008, supporting the huge dividend.

Selling for just 1.25 times book value, InnVest REIT is a buy for aggressive investors willing to live with some dividend risk up to USD10.