Real estate. (cover story)

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Author: Libin, Kevin

SECTOR

Things are looking so bad for real estate these days, you'd be forgiven for thinking the sector was going to hell in a handbasket. In the malls, merchants are begging for business; all those futuristic office campuses built during the dot-com euphoria now sit empty; companies are reconsidering the wisdom of renting in office towers since Sept. 11; and a severe drop in air travel has hotels suffering. But amidst that cacophony of bad news, you'll not hear much complaining from the real estate gang. "Investors are still favorably disposed to investing in real estate," says Pesach Goldman, an analyst with HSBC Securities in Toronto.

In fact, the TSE real estate index is up almost 10% from the beginning of the year. As bad as things might look on the surface, property owners are doing quite well. "If you want to go into a recession, this is how you want to go in," says Ross Moore, vice-president and director of research for Colliers International in Boston. "Balance sheets are as good as they can be. They're well prepared for this downturn." But, you ask, what about the glut of office space? It's mostly tenants who have downsized or overleased now looking to sublet. "This time it's tenants, not landlords, who are distressed," says Oscar Belaiche, portfolio manager of the Dynamic Diversified Income Trust Fund. "It isn't affecting landlords' cash flow since tenants are still on the hook."

Brookfield Properties Corp. (TSE: BPO) has had more trouble than most thanks to its heavy concentration on Lower Manhattan. "People are questioning how to value Brookfield," says Goldman. "There's no market for their holdings, with not a lot of transactions going on in New York." But even Brookfield stock is down only about 15% from its pre-9/11 high of $31.90. And since most North American cities sat out the '90s boom, with few major construction projects, the inevitable recovery is bound to make real estate firms a fortune.

But prices have held up so well that making a fortune from real estate stocks is something else altogether. With interest rates breaking 50-year lows, investors have been driving up prices in real estate investment trusts, or REITs, because of their high yields. If you'll take healthy cash flow over capital gain potential, some are still paying nice, safe returns. Even with a 25.7% run-up this year, H&R REIT (TSE: HR.U) is yielding almost 9% annually-and with only 15% lease turnover between now and 2006, that isn't going to change much. And even though the hotel business may seem a little scary these days, Royal Host REIT (TSE: RYL.U) has a great niche in its roadside, mid-range hotel business. "They're largely in drive-to destinations rather than fly-to destinations, so there's less impact from Sept. 11," says Belaiche. "And as people are cutting expenses, they're more inclined to stay in a middle-of-the-road hotel rather than a high-end hotel." With a current distribution of 6¢ per unit per month, Royal Host pays close to 13% annually.

As REITs gain favor in the marketplace, it's no wonder that some corporations are turning their business into interest trusts. Last year O&Y Properties Corp. (TSE: OYP) spun off its assets into a REIT. Now TrizecHahn (TSE: TZH) is restructuring its business. Goldman's betting that once that's done, in six or seven months, the switch is bound to put a higher price tag on the stock. "The shares will be trading in New York, and we'll be able to taste that dividend," he says. "Then people will pay more for it." Plus, given all the consolidation going on in the US these days, there's a rumor on Bay Street that Trizec looks good as a takeover target for a bigger American REIT. That's the kind of consolidation property owners like-a lot better than the sort that occurred in the last major slowdown. Provided that things come back soon enough, this should end up being a recession landlords can live with.

YTD return (Dec. 17) 7.6%

GRAPH: Brookfield Properties

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By Kevin Libin