Unlocking Opportunities on Canada's Interest Rate Cut: An Investment Guide about REITs

During a recent press conference on monetary policy, Tiff Macklem, Governor of the Bank of Canada, hinted that a rate cut could be possible in June if inflation levels continue to decline sustainably. The latest data shows that Canada's annual inflation rate for April was 2.7%, the lowest in nearly three years, and the monthly inflation rate was 0.5%, slightly lower than March's 0.6%, which also met market expectations. It is worth noting that the Bank of Canada's favored core inflation indicator, the CPI-median, saw its YoY growth rate drop to 2.6% in April, lower than the market's expected 2.7% and significantly lower than the revised 2.9% seen in March. This marks the fourth consecutive month of slowing growth in this indicator. These data reflect that potential inflationary pressures in Canada will continue to dissipate, and price pressures will continue to cool down. All signs seem to suggest that Canada's first rate cut is just around the corner.

Chart: Comparison of Canada's CPI and core CPI growth rates in the past year

The rate cut not only signals an optimistic adjustment to the economic outlook, but also opens up a new window of investment strategy for Real Estate Investment Trusts (REITs), an important bridge between real estate and capital markets. The returns of REITs often benefit from lower borrowing costs, and an interest rate cut can theoretically stimulate refinancing activities, reduce debt burdens, increase cash flow, and support dividend levels. For investors, this means that REITs may become the preferred tool for capturing the benefits of a rate cut. Therefore, in the current moment of increasing rate cut expectations, a deep exploration of REITs investment strategies is of great significance for portfolio construction.

Real Estate Investment Trusts (REITs) are a type of trust fund that pools capital from investors, which is then invested and managed by professional institutions in real estate projects. Over 90% of the post-tax net income is distributed to investors. Essentially, REITs are an institutional arrangement for investing in real estate.

Traditional real estate investments have drawbacks such as large capital requirements, lack of liquidity, difficulty in cashing out, and high transaction taxes. REITs retain the benefits of traditional real estate investments while eliminating these drawbacks:

(1)Regular Mandatory High Dividends: Most countries require REITs to distribute at least 90% of their net income to investors annually, providing a steady cash flow. Dividends are typically paid quarterly or semi-annually. However, it's important to note that distributions are still subject to the operational performance of the REITs and carry volatility risks, thus not guaranteeing returns.

(2)Lower Investment and Higher Liquidity: Compared to direct real estate investments, REITs offer higher liquidity and lower investment amounts.

(3)Lower Transaction Costs: Purchasing index REITs is akin to buying mutual fund stocks, which is cheaper compared to the high taxes and fees associated with direct real estate investments.

(4)Professional Management: REIT management teams are usually composed of real estate professionals who are more attuned to industry trends.

The pricing mechanism of REITs is a complex process influenced not only by the cash flows from the underlying assets but also by factors such as capital market supply and demand, interest rates, real estate market cycles, and investor expectations. We focus on the creation and acquisition cycle of their cash flows:

(1)Cash Flow Creation: The primary income source for REITs is the rent generated from their owned and operated real estate assets. Stable leases and high occupancy rates mean more stable cash flows. Additionally, REITs can increase cash flows by enhancing their asset portfolio value and effective management, such as through renovations, new developments, proper use of financial leverage, and cost control.

(2)Acquisition Cycle: The cash flow acquisition cycle of REITs is closely related to the characteristics of their underlying assets, ranging from a few months to several decades, depending on asset types and contract terms.

Since 2009, Canadian REITs have beaten the local stock market index for 15 consecutive years, making this year's performance highly anticipated by the market. After the end of the pandemic, the development trend of the real estate industry in the local Canadian market is promising. By 2023, the annual average return rate of REITs products in this market has reached around 5.12%.

Chart: Comparison of mainstream market REIT yields

As shown in the chart, since September 2020, the REITs index return rate in the Canadian market has been much higher than those in the Hong Kong and US markets. However, guided by the US Federal Reserve's interest rate hikes, from 2023 onwards, the REITs return rates in mainstream markets have shown a downward trend. Therefore, during the period of expected rate cuts or in the early stages of a rate cut cycle, it is often the best time to invest in REITs. At this time, the market's optimistic sentiment for the future gradually accumulates, and the price of REITs has not yet fully reflected all the positive effects of the rate cut, providing potential appreciation space:

Specifically, when the market interest rate expectations decrease, REITs often become more attractive to investors. The lower interest rate environment makes the dividend yield of REITs more attractive relative to other fixed income investments. In addition, the lower borrowing costs can promote refinancing activities, attract more investors, push up the market price of REITs, and provide investors with higher returns.

Compared to other Emerging Markets, Canada's REITs are now very mature, with a rich and diverse range of products for you to choose from. Below, we will introduce the fastest-growing products among different types of REITs:

The NET Trust Fund acquires and owns multiple high-quality three-networks (telecom network, radio and television network, and internet) and unmanaged commercial real estate, with diversified investment targets, including commercial real estate in industries such as retail, energy, and catering.

As of May 30th, the total market value of NET was 100 million Canadian dollars, with a dividend yield of 7.07%, far higher than the risk-free interest rate level in the United States. In addition, NET has accumulated 101 dividends since going public, paying dividends twice a month, with a total dividend amount of 0.056 Canadian dollars per share, providing investors with stable compound returns.

Advantages: The diversified investment targets can help investors diversify investment risks in specific industries.

Disadvantages: The fund has not been listed for a long time, and the fund size is relatively small, with relatively low popularity.

CSH's main investment area is Canadian nursing homes and long-term care homes, providing care services to retirees through the leasing and sale of healthcare and retirement-type residences to generate income.

As of May 30th, the total market value of CSH was 2.963 billion Canadian dollars, with a dividend yield of 5.00%, slightly lower than the risk-free interest rate. CSH has accumulated 246 dividends since going public, paying dividends in mid-month every month, with a dividend amount of 0.05 Canadian dollars per share.

Advantages: The fund has a relatively large size and has increased by more than 25% since 23 years ago, with a promising development prospect.

Disadvantages: The dividend yield is lower than the risk-free interest rate, so the competitiveness is relatively low.

The PLZ Trust Fund focuses on retail real estate, with its investment portfolio mainly including open-air centers, standalone fast-food restaurants, standalone or anchor grocery stores, pharmacies, and other retail real estate.

As of May 30th, the total market value of PLZ was 388 million Canadian dollars, with a dividend yield of 7.95%, far higher than the risk-free interest rate level in the United States. In addition, PLZ has a high dividend frequency, having accumulated 175 dividends since going public, paying dividends once a month on average, with a dividend amount of about 0.02 Canadian dollars per share.

Advantages: The high dividend yield can attract investors.

Disadvantages: The retail industry faces competition pressure from e-commerce, and the rent and occupancy rates of physical stores may be affected.

SGR's investment industry mainly consists of supermarket-based retail properties. The company's invested assets include Blundell Square, Elgin Square, Meres Town Centre, Oakridge Village, and Salerno Village Square.

As of May 30th, the total market value of SGR was 650 million Canadian dollars, with a dividend yield of 10.65%, and the dividend return was more than twice the risk-free interest rate in the United States. In addition, SGR has a high dividend frequency, having accumulated 120 dividends since going public, paying regular dividends in mid-month every month, with a dividend amount of about 0.07 Canadian dollars per share, higher than PLZ's dividend amount.

Advantages: Supermarkets are usually sales points for essential consumer goods and have certain economic cycle defense properties.

Disadvantages: Real estate income relies on a single type of tenant, and the industry risk is relatively high.

The fund mainly invests in economical residential real estate, including communities and manufactured homes. The fund's management team owns, manages, and operates multi-family residential properties located in the United States, which belong to the industry of economical residential communities.

As of May 30th, the total market value of MHC was 362 million Canadian dollars, with a dividend yield of 3.95%, slightly lower than the risk-free interest rate. In addition, MHC has accumulated 44 dividends since going public, paying dividends once a month in mid-month, with a dividend amount of 0.067 Canadian dollars per share, higher than the dividend amount of REITs of the same type.

Advantages: Investing in economical housing provides lower-priced accommodation options, which may be more popular during economic slowdowns.

Disadvantages: The investment is limited to a specific type of economical housing, and the long-term growth potential of the product may be restricted.

NXR is a Canadian REIT whose management team enhances unit holders' value through the acquisition and management of industrial, office, and retail properties. The fund's investment direction is mainly industrial real estate, such as warehouses and logistics centers.

As of May 30th, the total market value of NXR was 484 million Canadian dollars, with a dividend yield of 9.10%, far higher than the risk-free interest rate. In addition, NXR has accumulated 126 dividends since going public. Starting from the second half of 2021, it will pay dividends twice a month, with a total monthly dividend of 0.16 Canadian dollars per share, more attractive than TNT's dividend return.

Advantages: The current development trend of the international e-commerce industry is good, which has driven the demand for industrial properties.

Disadvantages: The industrial real estate market is highly competitive, which may lead to a slowdown in rent growth.

In addition to direct real estate fund investments, related ETFs are also a stable and secure investment option. Through a diversified REITs portfolio, it can spread risks, improve investment transparency, simplify operations, and allow investors to achieve one-click diversified investments, flexibly adapting to market changes. Whether you are an investment novice or an experienced investor, it is easy to master.

Below, we recommend several ETFs related to REITs in the Canadian market, and you can choose according to your investment preferences:

Tracking 19 REITs in the Canadian market, the maximum weight for a single investment is 25%. The fund's investment concentration is on retail (36.6%) and residential (23.2%) REITs, and it does not hold any real estate service companies.

As of May 30th, the XRE fund had an asset size of 1.08 billion Canadian dollars, with a dividend yield of 5.33%, far higher than most index funds, and can rival some high-dividend stocks. The fund distributes monthly dividends. However, the management fee rate of this ETF is 0.61%, and the trading cost is high, which is equivalent to paying 61 Canadian dollars in management fees for every 10,000 Canadian dollars invested.

Advantages: XRE provides a dividend yield of up to 5.33% while spreading risks, which is very attractive to investors seeking high returns.

Disadvantages: The management fee rate is high, which will significantly increase costs when investing for the long-term and reduce the final investment return.

ZRE tracks the Solactive Equal Weight Canada REIT Index, which uses an equal-weighted method to allocate component stocks. This means that each Canadian REIT in the index is assigned the same weight in the calculation, regardless of its market value, which helps reduce reliance on large REITs and improve portfolio diversity.

As of May 30th, the ZRE fund had an asset size of 519 million Canadian dollars, with a dividend yield of 5.09%. At the same time, the management fee rate of this Canadian REIT ETF is 0.63%, higher than XRE, which is equivalent to paying 63 Canadian dollars in management fees for every 10,000 Canadian dollars invested.

Advantages: The investment portfolio is relatively diverse, which is beneficial for risk diversification.

Disadvantages: The management fee rate is also high, which will increase costs when investing for the long-term and reduce investment returns.

Amid expectations of interest rate cuts, REITs present attractive investment opportunities. However, while seizing this opportunity, investors should deeply understand and be wary of the accompanying risks. For instance:

-REITs do not guarantee investment returns. Market conditions, real estate policies, and economic cycles can all affect property occupancy rates and rents, thereby impacting the fund's income. Consequently, the principal investment may suffer significant losses.

-If the majority of a REIT's returns come from a limited number of assets and properties, the price may fluctuate sharply due to changes in individual rents.

-REITs may use their capital to distribute dividends or may engage in actions such as issuing additional shares. This places high demands on the capabilities and integrity of the actual controllers. Therefore, investors should review the fund's historical performance announcements and financial reports to understand the composition of dividends and the history of financing activities to avoid managers with questionable integrity.