Canadian Apartment REITs Fall as Home Prices Rise: Why?

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Canada is a hot real estate market as prolonged low interest rates and strong employment have kept home buying active. In fact, home purchases accelerated during the pandemic as the government issued stimulus checks and cut interest rates to near zero. Apartment REITs jumped 40-60% between October 2020 and August 2021 on the back of rising house prices. But in August 2021, the government of Justin Trudeau promised to introduce policy changes to control housing prices, by lowering apartment REIT prices.

Is it a good time to buy apartment REITs? Let’s see.

So many vacant homes, yet Canada faces a housing crisis

According to the Canadian Real Estate Association (CREA), the average house price in Canada leaps 20.8% year over year in February due to a 23.7% increase in new listings. Canada is suffering from a housing crisis due to the lack of affordable housing. This supply crisis has pushed house prices up to 19% above the borrowing capacity of median-income households at the end of 2021.

Some economists accuse speculators of artificially inflating property prices. Speculators buy a house for investment purposes and leave it vacant. Their objective is not to live in the house but to speculate, to buy low and to sell high. Therefore, the government introduced a 1% tax on foreign-owned, vacant or underutilized real estate to curb speculative buying.

Economists give mixed forecast for house prices

Many economists have warned of a housing bubble. Three factors could burst this bubble: rising interest rates, government policies to control property prices and lack of affordability. Any bubble bursts when rising prices dry up liquidity. Capital saving Economist Stephen Brown predicts that house prices in Canada will fall by around 25% if interest rates return to pre-pandemic levels. Oxford Economics warns that if house prices continue to rise, even after interest rates rise, a crash (house prices fall by 40% or more) could be possible.

But some economists expect house prices to continue rising at a slower pace. RBC Economics expects prices to rise 6.2% in 2022, slower than a 17.8% gain in 2021 (based on house price data from RPS). CREA expects the annual average sale price to increase by 14.3% in 2022 and 3.2% in 2023. The basis for this forecast is that there is too much demand in the housing market .

Canadian apartment REITs fall as house prices rise

As house prices rise, apartment REITs are underperforming due to Justin Trudeau’s pledge to change the tax treatment of apartment REITs.

Canadian Apartment Properties REIT (TSX:CAR.UN) and InterRent REIT (TSX:IIP.UN) have fallen 15% and 12%, respectively, since August 2021. They underperformed the Capped S&P/TSX REIT Index, which was virtually unchanged. Both apartment REITs have fallen 4-6% in the past two weeks as Justin Trudeau signed a power-sharing deal with the opposition party. As part of the deal, he pledged to change the tax treatment of apartment REITs.

Currently, Canadian REITs pay little or no corporate tax. They are treated like income trusts because they

  • Hold only “qualifying REIT properties” at any time during a taxation year;
  • Have at least 75% of their portfolios (based on fair market value) in Canada; and
  • Earn at least 75% of the income from rent or mortgage interest from Canadian properties and capital gains from the sale of these properties.

REITs transfer a significant portion of their income to investors in the form of dividends. Dividend income is taxable in the hands of the shareholders and not in the hands of the REIT. Any change in this tax structure could have a significant impact on a REIT’s income and dividend.

Besides the policy changes, the rise in real estate prices will come to an end one day when the bubble bursts. This uncertainty makes apartment REITs more risky. Additionally, apartment REITs face caps on the rent they can charge.

Should you invest in apartment REITs?

Two reasons to buy REITs are to hedge against inflation and to earn dividends. When inflation rises, rents and property prices rise, driving REIT prices. This was the case for apartment REITs before August. Moreover, their dividend yield is less than 2.5% due to rent control.

There are better retail REITs, such as Grocery Slate and Smart Centers REITsoffering a dividend yield of over 6%, as they enjoy high rent.

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