April 16, 2008

US vs Canadian Real Estate Securities

Real estate securities, which had factored in a good deal of positive news at the start of the year, ended 2007 with considerable pessimism priced into their shares. Overall, REITs were trading at an 18% discount to their underlying net asset value as of December 31, 2007, compared with a premium of 13% at the end of 2006, and compared with a historical average premium of 5%. The size of this discount suggests that the market is expecting at least a mild recession and perhaps a meaningful decline in property values. That is unlikely scenario as commercial real estate fundamentals are sound and will dampen any impact from economic deterioration. I am factoring some declines into property asset values due to higher cap rates, particularly for class B properties and secondary markets, but I do not expect a dramatic downturn.

The group’s projected earnings growth is higher than projections for the S&P 500 Index, yet REIT earnings are far less volatile than the average S&P 500 company. In addition, at 15 times FFO, PE equivalent metric, REITs have a lower P/FFO ratio than the S&P 500 (16.3x) while their dividend yield is higher (4.2% vs. 2.0%). REIT dividend yields also compared favorably with the 10-year Treasury bond’s 4.0% yield at the end of 2007. In an uncertain environment, investors could find these metrics appealing.

A comparative analysis between US and Canadian REITs, reveal that Canadian Reits are that much more undervalued than their US counterparts. The average Canadian Reit P/FFO is 12.4 times compared with 15 for the average US REIT. In addition, Canadian REITs are sporting 6.2% dividend yield compared to 4.2% for a US REIT.

The average Canadian REIT has a less of a risk profile that their US counterpart as well. Canadian REITs rely on less leverage as their long term debt to Enterprise value stand at 44%, while the US REIT stands at 48%. Also, the Canadian economic environment is much more favorable than that in the US, as the Canadian employment and consumer spending trends are much more positive than the US. Reits as a sector offer value if you pick the right ones. Canadian REITs offer much more value than US ones due to lower risk profile and cheaper valuation.

I have assembled certain metric for comparative between the two groups:

US Reit CDN Reit
Div yield 4.2% 6.2%
P/FFO 12.4 x 15 x
Entp Value/ FFO 29x 22.9x
LTD/ Entp Value 48% 44%
LTD/ Mcap 1.04 x 86%
Payout % 61% 76%
FFO/ Debt 8% 14.5%

I have already bought RioCan and I am looking at two other Canadian real estate securities that promise some value. I have listed all my watch list of potential value idea here.

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