Canadian investors starving for yield in a perpetually low rate environment have been well rewarded by REIT’s over the past two years. But REIT’s haven’t been kind to their shareholders. You can count on one hand the number of Canadian REIT’s that have actually raised their distributions since 2009. Gains have come solely from multiple expansion; the rising tide has lifted all boats. The party may yet continue given that Mr. Carney is still fretting about raising interest rates just a quarter point. With valuations for most REIT’s at record levels and yields ready to fall below 5% we think better opportunities lie elsewhere.
Instead of chasing REIT’s, we think a better alternative is to look at the midstream energy infrastructure companies. These companies are like toll roads, providing pipeline, natural gas gathering and other services to the Canadian energy complex. Like REIT’s, the midstream group offers investors a chance to invest in necessary hard assets that will grow in value over time and benefit from rising inflation. Unlike REIT’s, many of the companies have a good track record of raising dividends each year. Keyera, for example, has raised its dividend nine years in a row, while its peer, Inter Pipeline, has four years of increases. And given their low payout ratios to cash flows, there looks to be more dividend increases in the coming years. Payout ratios average about 70% for the midstreamers, compared to REIT’s which pay out almost 100% of their cash flows. By paying dividends, the midstream group has a huge advantage over REIT’s for taxable accounts. The 6% dividend offered by Pembina Pipeline is worth a lot more to a highly-taxed investor’s cash account, compared to the 5.1% fully taxable distribution offered by Riocan.
Valuations for the midstream group are also much cheaper than the REIT’s. According to the latest research from RBC Capital Markets, the midstreamers are valued at 13 times their expected adjusted cash flows (essentially measures a company’s stock price to its free cash flow per share) for 2012. This metric is also used to value REIT’s which according to RBC are currently valued at 17.4 times for 2012, a 33% premium. The fact that the midstream group is off at least 10% from their recent highs has caught our attention.
While you can’t make an apples to apples comparison with REIT’s given the different business models and risks, we have put this thesis into action. Yesterday we sold all of our client’s holdings in Transglobe Apartment REIT and purchased a large position in Pembina Pipeline.
Disclosure: Baskin Financial clients own shares in Pembina Pipeline and Keyera Corp.