ETFs offer efficient access to undervalued real estate sector

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To gain from a real estate recovery, investing in ETFs and going global can add diversification.Getty Images

It has been a challenging couple of years for real estate investment trusts (REITs).

The broad-based group of Canadian stocks tracked by the S&P/TSX Capped REIT Index is slightly negative for 2023, after being down just under 20 per cent in 2022. On the flip side, 2024 may spell a different outcome for the beleaguered REIT sector, which includes companies that own, operate or finance income-producing real estate.

“Our portfolio managers are adding to REITs here,” says Jonathan Needham, director of ETF distribution at TD Asset Management. “We’re seeing pretty attractive valuations, particularly as we’re starting to see interest rates flatten and potentially decline next year.”

Investing in REITs can be an ideal way to add real assets such as housing into a portfolio without the headache of an actual rental property. One challenge is buying and holding enough REITs to stay diversified, which is why exchange-traded funds (ETFs) can be a solution. A REIT ETF can be a passive means of gaining wide exposure to the top-performing REITs on the market.

A few trends point to promising signs for REITs. In Canada, a population boom thanks to an unprecedented wave of immigration represents a tailwind for REITs with a heavier weighting in residential properties.

The Bank of Canada is also eyeing potential interest-rate cuts in response to a cooling economy. That will provide support for residential properties as well as commercial, some of which have fallen deeply in value since the onset of the pandemic.

“We’ve seen some residential projects get delayed as rates have headed up. The consensus is interest rates are going to start coming down in Canada and that’s positive for REITs. If you want to go with a momentum type allocation, you’re probably going to go with the residential,” says Weston McComb, portfolio manager and advisor for The McComb Team in Toronto, part of National Bank Financial.

Mr. Needham points to the TD Active Global Real Estate Equity ETF (TGRE) as evidence that a turnaround is afoot, with the fund recently turning positive for the year. Based on private-market valuations of real estate holdings, public REIT ETFs have room to run, he says.

“There’s about a 30-per-cent discount to what private-market funds, including TD’s, are trading at. That gap should narrow.”

Private-markets funds are closed-end pooled funds that don’t trade on an exchange, and they typically hold hard assets such as real estate, private equity, private credit and infrastructure. “We’re seeing some arbitrage happening where people are starting to exit a bit of their private-market holdings where they can, and take advantage of what we would argue is attractive pricing in the public funds today,” says Mr. Needham.

In Canada and the United States, the outlook for commercial real estate remains murkier than residential, even amid rate normalization and a gradual return-to-office trend bringing more workers back to downtown towers and suburban office parks.

“Commercial is in a different dynamic right now,” says Mr. McComb. “Long-term leases are still coming due and being repriced. There is some recovery but it hasn’t stabilized yet. Lower renewal rates are slowing, but until that’s done commercial and office properties are probably going to be challenged.”

That said, the window to establish a position might be opening, he adds. “I’m very much a value investor so that’s a place I’ll be fishing because some [REITs] have gotten very attractively priced.”

In the long term, Canadian REIT ETFs should benefit from a reversion to the mean in domestic commercial real estate. Still, many advisors suggest that investors looking to gain from a recovery should search beyond Canada.

“The Canadian REIT index is only 20 constituents. An ETF that services one particular subsector just wouldn’t be feasible,” says Darren Cooper, senior advisor at Calgary-based Baun & Pate Investment Group, part of Wellington-Altus Private Wealth. “If you’re looking for true diversified exposure, you should be looking at U.S. or global real-estate assets. And those are really best allocated to through some kind of managed fund.”

U.S.-based funds that provide exposure to non-residential real estate there include the Invesco S&P 500 Equal Weight Real Estate ETF (RSPR) and the iShares U.S. REIT Core ETF (USRT).

There are also made-in-Canada solutions that provide non-Canadian exposure, like the TD Active Global Real Estate Equity ETF (TGRE). It has a 64-per-cent weighting to U.S. real estate, and only about 10 per cent to Canada.

“The largest Canadian REITs are very concentrated in domestic holdings,” says Mr. Needham. “The benefits of going global are you get instant diversification, and you tend to get lower volatility. We would argue you end up with better risk-adjusted returns.”

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