Canadian preferred shares and real estate investment trusts (“REITs”) have historically functioned as a potentially compelling Yin and Yang symbiosis for an income-focused portfolio. While preferred shares are technically classified as fixed income, and REITs as equities, there are some notable similarities between the two asset classes. Both offer attractive yields, as they are currently hovering above 4%, as measured by the Solactive Laddered Canadian Preferred Share Index and the Solactive Equal Weight Canada REIT Index (“Equal Weight Canada REIT Index”) as at January 31, 2020. Both tend to provide that income in a tax-efficient manner. Canadian preferred shares offer dividends, while REITs offer a blend of income, dividends and sometimes, return of capital.
There is one factor that really differentiates the two asset classes, and that is interest rates. While low interest rates have generally dragged down the performance of Canadian rate-reset preferred shares, they have been a significant factor in contributing to positive returns in Canadian REITs.
The Solactive Equal Weight Canada REIT Index, which is the underlying index of the Horizons Equal Weight Canada REIT Index ETF (“HCRE”), was up 22.02% on a total return basis for the 12 months ending January 31, 2020, and has delivered a 11.30% annualized total return over the last five years ending the same period.
One of the biggest risk factors for REITs is financing costs. Typically, REITs use debt to acquire properties and rent out those properties to generate income, which is distributed to unitholders. Naturally, the biggest hit to revenue is the carry cost of borrowing, so when interest rates are low, the funds from operations (“FFO”) tend to skew higher. FFO is a reported supplemental measure of the operating income of a REIT. It is defined as accounting earnings excluding depreciation on real estate, deferred tax charges and gains and losses from the sale of property and debt restructuring. Analysts prefer to look at FFO over net income because gains on the sale of real estate and from debt restructuring are not seen as sustainable sources of income. Depreciation is also excluded because real estate assets are believed to better maintain their value and potentially appreciate in value.
For this reason, analysts tend to look at REITs’ valuations from the perspective of a price to FFO multiple, rather than a price to earnings multiple. According to National Bank’s 2020 Outlook report dated January 26, 2020, for the most part, the trend line over the last decade has been going up on FFOs, as the cost of borrowing has remained low and real estate has generally increased in value.
You can see this correlation clearly laid out in the chart below, which shows the Government of Canada 10-year yield versus the cumulative price return of the S&P/TSX Capped REIT Index from January 31, 2000 to January 31, 2020.
Source: Bloomberg, as at January 31, 2020.
The outlook from analysts continues to be bullish on REITs in 2020. There are a number of reasons for this, which we highlight below, but both CIBC and National Bank have put double-digit total return price total return targets for Canadian REITs this year. According to National Bank’s 2020 Outlook report dated January 26, 2020, National Bank has a 12% growth target, while CIBC, in its Equity Research report dated December 2, 2019, has about 10% price-growth target on the sector.
Interest Rates: Historically, low interest rates are a positive driver of returns for REITs. While rates might not go lower, there’s a general consensus that we are in a “lower for longer” rate environment and sharp growth in interest rates is not expected.
Income Needs: In a low-interest environment, investors will generally seek alternative sources of yield from equities, and the 4%+ current yield offered by REITs will likely remain attractive to investors.
Real Estate Prices and Rental Demand: Heightened demand for both residential and commercial real estate in Canada — particularly in key high-density urban areas, like Toronto — are not expected to decline. According to National Bank’s 2020 Outlook report dated January 26, 2020, immigration alone could provide strong baseline support for both rental demand and property prices. The report notes:
“The federal government has set ambitious immigration targets (~345,000 people annually by 2021), adding at least +100 basis points (“bps”) of population growth annually. These immigration levels could drive tight residential markets for the next several years, absent some intervention.”
Valuations: This is probably the most concerning area for REIT investors, as price to earnings ratio for the Solactive Equal Weight Canada REIT Index (Total Return) has increased by 15.9% from its June 28, 2019 level — as at January 31, 2020 — from 12.6x to 14.6x. The price to FFO ratio increased less, by only 10% from 10.1x to 11.2x for the same period. This could be seen as an encouraging sign for investors as it suggests that FFOs are better keeping up with rising REIT valuations. Macroeconomic factors including low interest rates and stable credit spreads likely support the higher valuations though, particularly if REITs continue to grow their FFOs.
The historical threshold for the yield on the S&P/TSX Capped REIT Index is 340 bps above the Government of Canada 10-year yield. We can see that the spread of 305 bps as at January 31, 2020 is near the historical average.
REIT 12-Month Trailing Yield Spread vs. Government of Canada 10-Year
Source: Bloomberg, as at January 31, 2020.
Relative Spreads over the Government of Canada 10-year by Sector
Source: Bloomberg, as at January 31, 2020.
We can also see that this yield spread is not out of line with its historical relative valuations of REIT sectors versus other yield-rich Canadian sectors, such as Canadian financials, utilities and communication services. In this case, the valuations of REITs seem to have been in line with their relative historical valuations, meaning that it could be a sustainable source of yield for income-stretched investors.
HCRE: The Total Return Approach to Canadian REITs
HCRE seeks to replicate, to the extent possible, the performance of the Solactive Equal Weight Canada REIT Index (Total Return) (the “Index”), net of expenses. The Index is an equal-weight index of Canadian-listed real estate investment trust equity securities. This is the same benchmark that is tracked by the BMO Equal Weight REITs Index ETF (“ZRE”).
HCRE has some key advantages over ZRE and other REIT ETFs in Canada. For starters, at only 0.30%, HCRE has the lowest management fee of REIT ETFs in Canada compared to 11 other Canadian-listed ETFs in the “Real Estate” Morningstar Category as at January 31, 2020¹. There are some performance benefits from getting REIT exposure at a lower fee.
For taxable accounts, HCRE has the added benefit of not being expected to pay out any distributions. Shareholders can potentially defer when they pay taxes on HCRE distributions, which are currently in excess of 4% as at January 31, 2020 — a key advantage of the ETF. HCRE does not physically hold the underlying constituent securities of the underlying Index. Instead, its return is delivered via swap agreements with acceptable counterparties: Schedule 1 Canadian banks with a minimum A credit rating. The swap agreement is a binding contractual obligation to deliver the daily returns of the underlying Index to the ETF, which is marked-to-market each day based on the change of the underlying Index. Counterparties are legally obligated to deliver the exact underlying Index returns, before fees.
HCRE is a corporate class ETF, meaning its shares represent a specific class within a corporate structure. Combined with the total return swap-based portfolio, investors are only expected to receive the total return of the underlying Index, which is reflected in the ETF’s unit price. Investors are not expected to receive any taxable distributions directly. This makes the ETF particularly attractive if its shares are held in a taxable account, where tax on Canadian eligible dividend distributions could potentially be in excess of 30%, depending on the marginal tax rate of the investor. With this ETF structure, investors can potentially defer incurring a tax liability until they sell their shares of the ETF, at which point proceeds from the sale of ETF units would likely be taxed as a capital gain.
The following hypothetical example shows the tax impact on the returns of a Canadian REIT ETF that earns annual dividends of 4.5%. This example does not take into account any management or operating fees, or expenses that would be associated with an ETF purchase.
In this example, both ETFs are held by an Ontario resident investor in the third-highest marginal tax bracket, who would have an income tax rate of 47.97% in 2020. The characterization of REIT income is difficult. If you look at the taxable breakdown of how REITs pay out distributions to unitholders, it can be a mixture of eligible dividends, foreign dividends, income and sometimes return of capital. These considerations make their reporting difficult to discern at tax time. For this illustrative example, distributions are treated as eligible dividends so as to not overstate the potential tax advantage.
It is important to note that neither HCRE, nor any of the other Horizons TRI ETFs, re-characterize investment income as capital gains.
FOR ILLUSTRATIVE PURPOSES ONLY. The above illustrative example highlights the expected after-tax performance benefits of holding HCRE versus another Canadian domiciled physically replicated Canadian REIT ETF in a non-registered account, assuming both ETFs earned/reflected a net 4.5% dividend (eligible Canadian Dividends) and track the exact same universe of securities. This example does not take into account any fees or expenses of the ETFs, or any commissions fees or expenses that would be associated with the purchase or sale of the ETF units. The example also does not contemplate any sale of the ETF units or any tax liability that would result.
** Both ETFs are held by an Ontario resident investor in the third-highest tax bracket, who would have a marginal tax rate of 47.97%, and an effective tax rate of 31.67% on eligible Canadian Dividends, in 2020. It also assumes no change in the market value of the Index constituents.
For income-focused investors, REITs potentially offer a compelling long-term solution to deal with lower interest rates, and HCRE can further enhance the appeal of investing in this sector by deferring taxation on the distributions.
Performance Table
Source: Bloomberg, as at January 31, 2020.
The indicated rates of return are the historical annual compounded total returns, including changes in unit value and reinvestment of all distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. The rates of return above are not indicative of future returns. ETFs are not guaranteed, their values change frequently, and past performance may not be repeated.
Investment Objectives
HCRE – HCRE seeks to replicate, to the extent possible, the performance of the Solactive Equal Weight Canada REIT Index (Total Return), net of expenses. The Solactive Equal Weight Canada REIT Index (Total Return) is an equal weight index of Canadian-listed real estate investment trust equity securities.
ZRE – BMO Equal Weight REITs Index ETF seeks to replicate, to the extent possible, the performance of an equal weight Canadian REITs index, net of expenses. Currently, the fund seeks to replicate the performance of the Solactive Equal Weight Canada REIT Index.
Commissions, management fees and expenses all may be associated with an investment in the Horizons Equal Weight Canada REIT Index ETF managed by Horizons ETFs Management (Canada) Inc (the “ETF”). The ETF is not guaranteed, its value changes frequently and past performance may not be repeated. The prospectus contains important detailed information about the ETF. Please read the prospectus before investing.
Horizons Total Return Index ETFs (“Horizons TRI ETFs”) are generally index-tracking ETFs that use an innovative investment structure known as a Total Return Swap to deliver index returns in a low-cost and tax-efficient manner. Unlike a physical replication ETF that typically purchases the securities found in the relevant index in the same proportions as the index, most Horizons TRI ETFs use a synthetic structure that never buys the securities of an index directly. Instead, the ETF receives the total return of the index through entering into a Total Return Swap agreement with one or more counterparties, typically large financial institutions, which will provide the ETF with the total return of the index in exchange for the interest earned on the cash held by the ETF. Any distributions which are paid by the index constituents are reflected automatically in the net asset value (NAV) of the ETF. As a result, the Horizons TRI ETF receives the total return of the index (before fees), which is reflected in the ETF’s share price, and investors are not expected to receive any taxable distributions. Certain Horizons TRI ETFs use physical replication instead of a total return swap. The Horizons Cash Maximizer ETF does not track an index but rather a compounding rate of interest paid on a cash deposit that can change over time.
¹ Compared to other Canadian ETFs in the “Canadian Equity” Morningstar category. HCRE has the lowest management fee of REIT ETFs in Canada compared to 11 other Canadian-listed ETFs in the “Real Estate” Morningstar Category as at January 31, 2020.
The information contained herein reflects general tax rules only and does not constitute, and should not be construed as, tax advice. Investor situations may differ from those illustrated. Investors should consult with their tax advisors before making any investment decisions.
The views/opinions expressed herein may not necessarily be the views of Horizons ETFs Management (Canada) Inc. All comments, opinions and views expressed are of a general nature and should not be considered as advice to purchase or to sell mentioned securities. Before making any investment decision, please consult your investment advisor or advisors.
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