Basement bargains

Why this may be the best time to start buying real estate

John Heinzl
Globe Investor Magazine online, February 19, 2009

John Heinzl is an investing reporter and columnist with The Globe and Mail's Report on Business.

Great fortunes have been made in real estate. Look at Donald Trump, Robert Campeau and the Reichmanns. Great fortunes have also been lost in real estate. Look at Donald Trump, Robert Campeau and the Reichmanns. Why would any sane person want to get mixed up in an industry notorious for epic booms and catastrophic busts?

Because as long as you're prudent about it, real estate is one of the best long-term investments. And the time to take the plunge isn't at market tops. It's during economic slumps, when there are bargains to be had.

Which brings us to real estate investment trusts. By investing in office buildings, shopping centres and other properties, REITs let you experience the thrill of being a landlord, without the hassles of evicting deadbeat tenants. The best part? Right now, REITs are cheap.

The S&P/TSX capped REIT index was nearly cut in half in 2008. Judging by the magnitude of the decline, people fear a repeat of the early 1990s, when the real estate industry suffered a horrific fall.

But a collapse on that scale isn't in the cards this time around. The early 1990s meltdown was caused by a combination of speculative overbuilding and excessive leverage that led to sky-high vacancies and plummeting rental rates. Today, the amount of new construction has been modest by comparison. What's more, most REITs have conservative debt levels that generally range from 50% to 60% of property book values, compared with 80% or more in the bad old days.

That's not to say REIT prices won't fall any further. But because the stock market is forward-looking, it's already priced in a good chunk of the slowdown.

The trick is to stick with large, well-capitalized REITs that are best positioned to weather the downturn, and avoid the shaky ones that may be forced to chop their payouts.

How to do that? One clue is a REIT's payout ratio-the amount it distributes to unitholders as a percentage of available cash flow. The lower the ratio, the bigger the cushion in bad times. A company that stands out in this regard is Canadian Real Estate Investment Trust.

Canada's oldest REIT, it owns a diversified portfolio of more than 150 office, retail and industrial properties and pays out less than two-thirds of its funds from operations. CREIT's yield, at about 5.5%, is half of some others, but the trade-off is that investors can sleep better at night.

Gail Mifsud, an analyst at Blackmont Capital, says CREIT is one of a handful of REITs that's well-positioned to maintain its distribution even if the real estate market suffers a prolonged slump.

Another relatively safe bet is Boardwalk REIT. Because it operates apartment buildings, which provide a necessity in good times and bad, Boardwalk is less prone to boom and bust cycles. But you have to be careful here, too, because more than half of Boardwalk's rental units are located in Alberta, where the economy is slumping. Unless there's a "disaster scenario" in the province, however, Boardwalk's distribution is probably safe, says Mifsud.

That's not necessarily true for other REITs. For example, retail landlord Rio- Can, Canada's largest REIT, is paying out close to 100% of its funds from operations, which means it could be vulnerable to a distribution cut if rental rates drop and vacancies rise sharply.

But given RioCan's mix of solid tenants, such as Canadian Tire, Shoppers Drug Mart and Wal-Mart, the recession would have to get very ugly indeed before that happens, said Dennis Mitchell, portfolio manager with Sentry Select Capital. "Those are large retailers that aren't really in jeopardy right now," he says. "The question is, how prolonged is [the recession] going to be?"

If it's a long, vicious downturn, then all bets are off. But if the economy starts improving later this year or early in 2010, as many expect, then now-when things are cheap-may be the time to start building your real estate fortune.