Trader’s Narrative

Since some time has passed since my last call on Canadian REITs, I wanted to review it and update my position on the sector.

If you’re new to the blog you probably missed my comment back in early January: Canadian REIT Review. At that time I mentioned that it was irrational for well capitalized companies like the Canadian REITs to be sold off with the rest of risky assets. Remember, not only are these conservatively leveraged, they are diversified and throw off juicy monthly distributions. Of course, a devastating bear market cares little for value. Almost everything was sold indiscriminately as global investors ran like headless chicken to escape further losses.

In early January when I wrote recommending the attractive value evident in Canadian REITs, RioCan REIT, a commercial REIT I highlighted was trading around $14 a unit:

From there it deteriorated further, making a low of $11.50 in March 2009 - along with the vast majority of risky assets. If you were or smart enough to buy at exact bottom, you would be sitting on a 65% gain right now. But if you bought earlier when I wrote about it, it is still a respectable 36% gain. And that’s not even considering the monthly distributions which would pump the total return to 45%.

RioCan, at the March lows, was yielding an astonishing 12%. Of course, because of the pervasive doom and gloom, even the largest and strongest Canadian REIT was suspect. But RioCan has had no trouble in sustaining its distributions due to its top notch management and its heavily subscribed dividend reinvestment plan that allows it to conserve cash by issuing units instead of cash.

In fact, while the US commercial real estate market is seen as the next shoe to drop, Canadian REITs have recovered nicely and are poised for their role as (benevolent) vultures. Sonshine, the head of RioCan raised $150 million, announced a partnership with Cedar Shopping Centers (CDR). As well, the head of RioCan, Sonshine, has hinted of a major upcoming US purchase in the near future.

So all in all, the situation has reversed in all aspects. Now the news is all good and the stock is zooming higher. And as a result, RioCan is now yield just 7.21%. But while things are seemingly rosy, I’m getting ready to leg out of this position. There are a few reasons for that. First, obviously, is the sentiment which has shifted into full sunshine mode.

Second, the rocket ride higher has pushed RioCan to close 26.16% from its 200 day moving average. This is a simple technical barometer which I use to also analyse the general market but it also works for individual stocks. In the past when RioCan has come this far up into thin air territory, it has been unable to sustain its momentum. The last time prices where this far above its long term trend line was back in early 2007, just as RioCan was topping out at $26.

Finally, basic technical analysis reveals that price is now butting its head against the overhead resistance. What was a zone of support has now become a zone of resistance. And while RioCan could technically rise up to $22 a unit, the chances of that are slim. The same chart formation can be seen in almost all of the REITs in Canada. For example, take a look at Allied Properties (AP_un) or Boardwarlk (BEI_un) or Calloway (CWT_un).

Considering everything, putting new capital to work on the long side or continuing to hold here is not very prudent. The probability is that prices will either meander here as they enter resistance or immediately correct. In either case, the ride is over but it was fun and profitable while it lasted.

I wanted to write about this during the holiday season but it being the holidays it got pushed to the new year.

Canadian REITs as a group were pummeled beyond belief during this bear market. Personally I’m surprised to see this because generally speaking they are a solid business model. Not over leveraged, diversified and recession-proof (for the most part).

There is no way that their market valuation should be cut in half - or more! But it goes to the heart of this bear market that even the highest quality securities are being sold off to raise cash, meet margin calls, de-leverage and reduce risk in portfolios.

By now this market dislocation is obvious as Canadian REIT prices have screamed higher in the past few weeks - some rising 25% and others up to 50%. I think they will probably give up some of that increase and take a breather. But considering how extremely oversold they got, they continue to present a very compelling value here.

Here are the 5 largest REITs by capitalization:

• Riocan REIT — (REI.un)
• H&R REIT — (HR.un)
• Boardwalk REIT — (BEI.un)
• Canadian REIT — (REF.un)
• Calloway REIT — (CWT.un)

H&R REIT was under a dark cloud and got taken to the back of the shed in 2008. Their share price fell from a high of $27 in 2007 and a high of $21 in 2008 to just $4.45. Since then doubts about their financial stability have been removed by their announcement of a distribution cut and debenture sale. HR REIT shares have gained almost 100%.

Here’s a chart of Riocan REIT, the largest in Canada. Over the holidays it reached a yield of just over 10%. That’s equivalent to levels which we last saw in early 2001.

At that time, the Bank of Canada interest rate was 5.5%. Right now, the interest rate is 1.5%.

That’s significant to bring into the picture because it shows that 8 years ago, an average investor had alternatives to Riocan REIT which yielded much higher returns than right now.

This just brings home how irrational these valuation levels are for Canadian REITs right now.

Insiders Buying
As you might expect, insiders are not oblivious to this. They have been actively buying shares of their companies even as they have continued to fall.

For example, Calloway Real Estate Investment Trust trustee Mitchell Goldhar bought 37,100 trust units through CWT Investments Ltd at prices ranging from $8.60 to $9.75 each on Dec. 4 through Dec. 10, 2008, bringing these total holdings to 10,889,413 shares.

And Riocan REIT chief financial officer Frederic Waks bought 5,400 trust units at $13.22 each on Dec. 4, 2008, bringing these total holdings to 200,956 shares.

Although you may have missed the extremes, as long as you’re smart about it and don’t chase the price higher, I don’t think you’ve completely missed the buying opportunity here.

There are very few moments in market history when absolutely everything is being sold: stocks, bonds, commodities, REITs, etc. We are going through one of these rare times right now and it can be gut wrenching. Forced liquidation in a bear market can be so brutal, it makes surviving to be able to take advantage of the next bull market a challenging goal.

One of the bastions of stability and what I considered one of the safest investments around, Canadian REITs, have now seen such forceful selling, they look as if they are toxic assets. Take a look at how it left behind the downward trend line and simply dropped off a cliff:

You have to remember these are shopping malls, offices, apartment buildings, manufacturing facilities and warehouses. Basic real estate that is being used day in and day out. And it is being paid for by long term tenants. Sure, there is softening in the Canadian real estate market but it won’t impair what really matters, the income potential of the assets.

In fact, going back I can’t find any time that any of my REIT holdings have ever cut their distributions. While Canadian residential properties did participate in the global real estate bubble, REITs are grounded because they have to meet and exceed their financing costs. So they operate within tight financial confines and although their asset base may fluctuate with the market, their incomes and expenses are both well defined going ahead for many years.

Here is the biggest component of the REIT index, the bellweather Canadian REIT, RioCan:

Right now it is yielding almost 10% - the last time it had this yield was way back in 2001 at a much lower price. This is of course, assuming that the yield is safe and won’t be cut.

The markets are melting, banks are having epileptic seizures, the credit market is frozen solid… and short selling suddenly is illegal, so where are you supposed to hide out? Are there any safe harbors in which to weather the storm?

Something that has been working for me (so far) is Canadian REITs. In almost any crisis situation, it is important to remember that there is always some part of the financial markets which are strong.

Temple REIT (TR.un) is a tiny real estate investment trust which I’ve held for more than a year now:

This beautiful chart is actually just part of the story because on top of the capital gains, Temple REIT has offered a monthly distribution - similar to a dividend but taxed differently.

Before June the distribution was $0.08/unit and afterward it increased to $0.10/unit. So even if Temple REIT had gone sideways, thanks to the distributions, it returns +10%.

That might seem paltry but compared to the carnage that is going on in the rest of the financial markets, I’ll take it.

The Canadian real estate market has been shielded for the most part from the shenanigans in the US. Most of that is because our regulatory structure is different and much more stringent. And as a whole, culturally Canadians are much more conservative. We’re like the Swiss, except we like maple syrup on our crepes, instead of caviar.

Surprisingly, though, you don’t have to look far to find US REITs which look very strong - technically speaking. Take a look at Ventas REIT (VTR), which I mentioned briefly the last time I covered real estate investment trusts:

Sure, the yield is only 4.4% but notice how close it is to its all time high? Plus, I can’t imagine the US Fed or any major central bank in the world embarking on a tightening cycle anytime soon. If anything, we are about to see some fiscal and monetary kick into hyperdrive.

In any case, this is just an idea I’m throwing out. Remember to always perform your own due diligence.

Let’s take a look back at my previous commentary on Canadian REITs’ oversold condition on June 27th, 2007. Yup, it is report card time!

Unlike many other trading bloggers who let previous calls drift into the ether I like to keep myself honest by reviewing past calls and analysis. Both to be transparent and to give myself and others another chance to learn (from my mistakes).

…we could be seeing a major trend change with REITs. But even so, they aren’t going to go straight down. I think this technical oversold picture in the short term is still actionable.

So how did I do?
My thesis was that it was yet another correction within a long term uptrend. I was right about an “actionable” short term oversold condition because we did see REITs bounce into July. However, the index failed to ricochet off its 200 day moving average as it had so many times before. So I was wrong in the sense of not seeing a trend shift taking place right under my nose.

Thinking back, I don’t think I did anything necessarily wrong. I prefer to be proven wrong by price action than trying to simply ‘guess’. I think it is always wiser to continue to do what has worked, until it proves you wrong. As long as you are practicing smart money management you’ll be ahead.

Weinstein’s Stage Analysis
If you’re not familiar with Stan Weinstein, what are you doing still reading this? Go and buy his classic book on technical analysis (on your left). Then you’ll have a great grasp of basic TA and understand what follows.

According to Weinstein, stocks follow 4 stages. From his definition, last summer the Canadian REIT sector had all the indications of Stage 3 - topping. It is now in Stage 4 - decline. Simple to see that in the chart: lower highs and lower lows.

As well, in mid-July 2007, the Canadian REIT index’s 200 day moving average plateaued. No surprise really since the index had been going downhill since late February 2007 (red arrow).

It isn’t just coincidence that since that same point in time, the Canadian REIT index has been trading consistently below its long term moving average. Something that it hasn’t done in years. This definitely denotes a major shift in REITs.

Way before they actually did, I correctly surmised that the Fed was going to have to start cutting rates. But my misstep was in not realizing that there were greater forces at play. So much so that a major campaign of tax cuts has not been able to withstand the tsunami of the credit crisis.

On a positive note, the index seems to have found footing recently along with the rest of the market, lifting off from a double bottom formation. If it continues to rise, its next challenge will be meeting the long term moving average from below as it is hurtling down towards it.

I find myself unable to resist the temptation of picking up some Charter REIT (CRH.un); a tiny real estate investment trust that has a 15% yield. Other than that I’m just going to hang on to my long term holdings.

Lesson learned:
When Sam Zell sells, real estate has peaked.