Two years ago, before the late-2008 crash leveled everything in its path, I featured Canadian real estate investment trusts (REIT) in this space. Front and center were the four REITs I continue to hold in the Conservative Holdings: Artis REIT (TSX: AX-U, OTC: ARESF), Canadian Apartment Properties REIT (TSX: CAR-U, OTC: CDPYF), Northern Property REIT (TSX: NPR-U, OTC: NPRUF) and RioCan REIT (TSX: REI-U, OTC: RIOCF).

I also featured several selections not in the Portfolio. Some I considered ultra-safe at the time, including Calloway REIT (TSX: CWT-U, OTC: CWYUF), Canadian REIT (TSX: REF-U, OTC: CRXIF), Cominar REIT (TSX: CUF-U, OTC: CMLEF), H&R REIT (TSX: HR-U, OTC: HRREF), Morguard REIT (TSX: MRT-U, OTC: MGRUF) and Primaris Retail REIT (TSX: PMZ.UN, OTC: PMZFF). And I threw in a few riskier picks I’ve since recommended selling, such as InterRent Properties (TSX: IIP-U, OTC: IIPZF).

My rationale then was simple and manifold. Canada’s property market was never built on leverage to the extent the US market was. Subprime and Alt-A loans were only a tiny percentage of mortgage loans, not bread and butter as it was to so many US banks. Rather, Canadian banks held loans to exacting standards for credit quality, and most were backed by large down payments as well.

I was also bullish on the fact that conservatism extended to Canadian REITs. While their US counterparts were leveraging everything in sight to jack up returns, these companies focused on portfolio quality and controlling debt, expanding earning bases only when opportunities were particularly compelling. They just weren’t taking the risks US REITs were and therefore weren’t exposed to the same level of danger.

Canada’s property market never reached the blow-off levels the US market did following then Federal Reserve Chairman Alan Greenspan’s great re-inflation following the 2001 recession. Rather, it was still recovering from decades of slump when the US market peaked. As a result, prices were not at extremes but were rather rising in the fact of steady and consistent demand growth.

Finally, Canada’s property market was simply behaving a lot better than the US real estate market was in early 2008. Few had any idea then how bad things were going to get in subsequent months. But even then, selling prices for existing homes were coming off at the sharpest rate in decades. And as I pointed out then, US commercial property was softening as well, as businesses pulled in their horns.

In stark contrast, five Canadian provinces had registered double-digit increases in selling prices for existing homes over the preceding 12 months. Emerging energy producer Saskatchewan took the prize with an astronomical 44.5 percent growth rate. Every other province scored solid gains as well except Alberta and Prince Edward Island. And Alberta’s dip was mainly a pause after several years of runaway gains. Meanwhile, every province was projecting higher selling prices over the next 12 months. The Canadian Real Estate Association (CREA)–a clearing house of information on Canadian property markets–was looking for 5.3 percent price growth nationally in 2008, followed by an additional 4.2 percent in 2009.

Of course, those forecasts have proved somewhat optimistic. As we’ve pointed out in Canadian Edge, Canada did experience the shallowest recession of any developed country. The country’s budding trade with Asia did reduce its dependence on the US market just in time for a wide range of commodity and manufactured goods. And Canada’s banks stayed strong even while those in the US went belly up in record numbers.

None of that, however, could prevent property values and selling volumes from taking a hit, just as they did everywhere in the world. Alberta, in particular, has been affected, as falling energy prices have reduced oil and gas producers’ development efforts. That, in turn, has reduced demand for the commercial and residential property that was feverishly constructed in the years leading up to the crash.

In the middle of the last decade, entire homes were transported northward to Fort McMurray, Alberta, the epicenter of oil sands development, to combat a chronic housing shortage. Salaries for unskilled jobs like burger flippers skyrocketed, in large part because few could afford to otherwise live there to service the growing workforce.

Then, falling energy prices triggered a slowdown in spending on oil sands development. The result has been a dramatic drop in demand that’s sent vacancy rates surging and rents plunging.

Some overleveraged Canadian REITs have been driven nearly to bankruptcy by the reversal of fortune. Lanesborough REIT (TSX: LRT-U, OTC: LRTEF), for example, was a major investor in property in Fort McMurray during the boom. It’s now being forced to divest much of its holdings at subpar prices in order to meet its creditors’ demands.

Last month Lanesborough was forced to reverse an earlier move to diversify holdings into Saskatchewan in order to raise CAD3.2 million. And despite a revival of investment in the oil sands, Fort McMurray is still slumping, making odds of a turnaround for the REIT remote indeed.

Happily, that’s a sharp contrast to the experience of most Canadian REITs during this downturn. That includes all four of the selections in the CE Portfolio, each of which has either maintained or increased dividends since the crash. It also includes the other “safeties” recommended in that 2008 article.

In fact, all of my favorites have been able to use the resulting lower property prices to make acquisitions of solid assets at levels that virtually guarantee strong returns. Some, like RioCan, have used superior access to capital markets and low interest rates to raise billions of dollars, which they’ve since used to buy property on the cheap.

Like everything else this side of US Treasury bonds, unit prices of Canadian REITs did take a pounding during the 2008 crash. Even RioCan was taken down briefly under USD10 per unit in early 2009, from a trading range of the low 20s in mid-2008.

That punishment was certainly understandable, given the concerns about the credit market and the ongoing meltdown of US property and US REITs. But since then investors have lost their fear of RioCan and other solid Canadian REITs, and unit prices have been steadily recovering those losses. RioCan itself has hit the low 20s, still below pre-crash levels but definitely headed in the right direction.

Where from Here

In sum, Canadian REITs have weathered some of the worst conditions the North American property market in general has ever faced. Even those who bought on the eve of the crash have maintained their income streams. And while most are still at least slightly underwater from the damages of late 2008, they’ve far outperformed the broad market and are well on their way to making up the rest.

The question is where do they go from here? Are conditions improving enough to resume the cash flow growth of prior years? Will we see a resumption of dividend growth that will push unit prices to new highs? Or is the market still facing a period of prolonged weakness that will ensure yet another retrenchment before there’s genuine improvement?

The answer to these questions more than anything else depends on what happens to the Canadian economy. Currently, most projections call for economic growth in the country to decelerate somewhat from the torrid 6.1 percent rate attained in the first quarter of 2010. But the estimated rates of 3.5 percent for 2010 and 2.9 percent for 2011 are still solid enough to keep the country’s property market healthy. And, if Chinese demand for Canadian commodity products remains robust, they could prove conservative indeed.

The two tables below show the current health of the residential and commercial property markets in Canada’s major cities. “Healthy Market” is focused on residential property, showing the year-over-year percentage change in each city in the price of a single family home, as well as the volume of homes sold. “Recovery in Progress” shows the health of the commercial property market with two pieces of data, the year-over-year change in the number of construction projects started and the change in the number of permits granted for such projects.

Starting with the residential market, all nine cities on the list show an increase in property values over the last 12 months. Not too surprisingly, the biggest gains were posted in cities that have benefited to some degree by the resource boom. Vancouver as a gateway to Asia has also been a hot market, as it’s been for many years.

Even Edmonton and Calgary, however, are showing gains, despite the letdown from prior years’ boom. That’s a very good sign that the slump even here is set to be short and that growth is set to return. And trading volume is picking up as well, a clear sign that houses on the market are turning over.

The barometers I’ve chosen for the commercial property market reflect demand for new buildings and facilities. As the first column shows, construction activity has taken a breather in the past year. Of the dozen cities listed, only the national capital Ottawa (beneficiary of government spending) and Regina have seen greater activity in commercial property construction than they did a year ago. Meanwhile, a half dozen showed a double-digit decline in activity.

The second column has a more hopeful message. Several cities showed a sharp decline in permits filed for new construction. Calgary, in the energy patch, is one that stands out, a result of prior years overbuilding and a resulting glut in office space in particular. Others include Halifax, Quebec and Ottawa, where the dip may be due to less government spending allocated to that purpose.

Most cities, however, are showing solid increases in permits filed. Not all of these projects may be built. But this is a clear sign that markets have tightened enough for construction activity to resume again. And in a country where the developers are as conservative as Canadians are, that’s a pretty strong vote of confidence indeed.

The most positive indications are in western cities like Vancouver and Hamilton in British Columbia and Regina and Saskatoon in Saskatchewan. But there’s also been an upsurge of activity in major cities like Toronto and Montreal. Even Edmonton, also in the heart of the oil patch, has seen an increase in permitting, a strong sign for that region of the country as well.

To be sure, activity hasn’t yet returned to the level prior to the crash. And the drag from the US–still the consumer of more than half of Canada’s exports–is still a factor on many sectors of the economy and regions of the country.

But these are solid signs that the action is moving in the right direction. Moreover, Canadian banks’ credit measures, already the strongest on the planet, are still getting stronger. And with the country’s inflation rate well behaved, mortgage rates remain at extremely low levels as well.

Coupled with low and falling unemployment and stable consumer confidence, that’s a powerful underpinning for Canadian residential property. And that’s reflected in improving fortunes for all property sectors, from apartments and shopping malls to office buildings and industrial properties.

REITs Right and Wrong

Not every Canadian REIT is in good shape to profit from the sector’s improving health. In addition to Laneborough, which no longer pays a distribution, Interrent Properties, which owns apartment buildings, rates a sell on the basis of business weakness and an ongoing inability to cover its distribution with cash flow. Also, a number of REITs in How They Rate coverage have also risen past the price where they would be considered attractive for purchase.

And despite assurances it would do so, the Canadian Finance Ministry still hasn’t passed rules requested by industry to exempt certain business practices from the specified investment flow-through (SIFT) rules released Oct. 31, 2006, and enacted in June 2007. One of these is a rule that qualifying REITs can’t own more than 25 percent of their assets outside of Canada and couldn’t generate more than 25 percent of their revenue from such assets. Others concern profits from property development inside ventures, such as that owned by Northern Property REIT.

To qualify as a REIT, the trust must derive at least 75 percent of its revenue from rent and other specified sources. If the trust holds real estate properties indirectly through a subsidiary trust, this test is arguably not met. Proposed amendments clarify that rent won’t lose its character simply because it’s paid through a subsidiary trust. But again, these have yet to become official.

A REIT must hold 75 percent of its assets in certain qualifying assets, including cash. The amendments expand the definition of cash for this purpose to include amounts on deposit with financial institutions, bankers’ acceptances and other highly liquid, short-term investments.

Currently, nominee corporations must hold title only to property owned by the REIT or by the REIT together with other entities. The proposed amendments expand the rules to permit the nominee corporation to hold legal title to property owned by subsidiaries of the REIT.

The good news is Canadian REITs have largely been able to adapt their accounting to avoid triggering new taxes. Even Northern, for example, will be able to continue paying its current distribution and manage its prospective tax burden by becoming a stapled share, with a dividend-paying equity portion and a high-yielding bond portion. But again, not every REIT will be able to make the needed moves.

The first rule in picking REITs is the same as it is for any company: Buy the business. The single most important number is distribution coverage by distributable cash flow (DCF), which is cash flow less capital costs needed to pay for property maintenance.

Because of the general reliability of revenue from rents, my Canadian Edge Safety Rating System considers distributions paid by any REIT with a payout ratio of 90 percent or less to be very safe. Meanwhile, distribution payout ratios over 110 percent are considered dangerous.

The second most important number is debt, expressed commonly as a percentage of the book value of the REIT’s properties. Again, property is generally financed at least in part with debt, so REITs generally have higher debt ratios than companies in other sectors. Ratios under 60 percent, however, usually indicate financially strong firms with a lot of room to finance more growth. REITs with 80 percent or more should be considered very weak financially.

Structure of debt is perhaps even more important. As I show in this month’s Portfolio Update, Canadian Edge Holdings, including my REITs, have little or no refinancing needs through 2011. That’s the best possible protection against a potential second credit crunch, which I believe is highly unlikely but remains a major fear for many investors.

The safest, however, have also staggered their obligations so no really significant amount comes due in any given year. That’s the best possible protection against having to roll over debt at poor rates, such as those that prevailed in late 2008.

Property quality can be discerned in a variety of ways. The track record of the enterprise in growing assets is important, particularly since it’s the best way to assess the expertise of REITs’ management. Vacancy and their opposite, occupancy rates, are also important measures of strength. Canadian REITs generally have had much lower vacancy rates than US REITs. In fact, only the weakest like Lanesborough have seen occupancy dip below 90 percent. But in general, the higher the occupancy rate, the better.

Rent growth is a primary driver of cash flow. So how a REIT’s current rents compare to market rents is a key determinant of value. Artis REIT, for example, has been able to continue raising rents even in depressed property markets such as Calgary, mainly because it had been charging well below market rents.

I also like REITs to have staggered lease expirations, limiting the amount of property that must be released in any given years. Artis is another good example here. REITs with broader geographic diversification, such as RioCan, or that are focused on niche markets, like Northern Property, are also at an advantage. That’s because a problem in one particular market won’t sink the ship.

The record on REITs that are diversified by sector is decidedly mixed on both sides of the border. Owning, for example, a mix of malls, office buildings and apartments does limit exposure to economic swings. Apartments, for example, tend to be less cyclical than office property. And it allows an otherwise conservative REIT to capitalize on faster growing properties.

But such diversification can also be a distraction, preventing management from really focusing on what it can do best. Consequently, I’ve come to prefer REITs that specialize on a particular type of property, or at least a specific class of customer. That’s true of all four REITs in the CE Portfolio and most of those I continue to rate buy in the How They Rate universe as well.

Finally, there’s no more reliable measure of underlying business strength than the ability to raise distributions. Again, the extraordinary conditions of the past several years have crimped payout growth. And uncertainty regarding 2011 taxation of REITs has only made matters worse.

As Jan. 2011 comes and goes and overall conditions continue to improve, however, there are real signs dividend growth is set to resume, particularly for the lower payout REITs. This month, for example, Northern Property lifted its distribution for the first time in two years, by a solid 3.9 percent.

As I report in Portfolio Update, the gain was backed up by a return to strong cash flow growth, fueled by falling vacancy rates and solid growth in certain markets, including Newfoundland, the Northwest Territories and Nunavut. Those are trends that began several quarters ago for the REIT and are starting to accelerate with improving business conditions. And with the payout ratio just 62.2 percent in the second quarter–based on DCF–there’s a lot of room for more growth.

I look for more REITs to boost their distributions over the next year, starting with stronger and lower payout ratio fare but eventually including even those with higher payout ratios. That’s a major reason I’m bullish on the sector. For now, however, it’s a clear sign of REIT that’s head and shoulders above the competition and suitable enough for even the most conservative accounts, as Northern Property is.

So what REITs stack up on my criteria? Though its payout ratio is somewhat higher than Northern’s, RioCan REIT also looks poised for strong cash flow and, ultimately, distribution growth going forward. Second-quarter earnings were robust, with funds from operations (FFO) per share rising 26 percent. The key is the company’s aggressive acquisitions over the past year–funded by a cash hoard that was unspent for many months–are at last paying off.

That’s a process that will only accelerate in coming quarters, even if the North American economy takes longer to heal. Newly acquired properties in the US have exceptional promise to lift cash flow. Meanwhile, the REIT’s 97 percent occupancy ratio is something the competition can only dream of.

Highlighted in July’s High Yield of the Month, Artis REIT won’t release its second quarter earnings until Aug. 11. But its steady pace of acquisitions (CAD133.4 million completed in July) ensures a return to growth, at least in the second half of 2010. And that’s set to ignite dividend growth again, particularly given the historically low payout ratio.

Finally, rounding out the four Portfolio REITs is Canadian Apartment Properties, which reports its quarterly numbers Aug. 10.

The owner of high-quality residential complexes breezed through the late recession with nary a scratch, holding vacancy rates to effectively nil and enjoying steady rent growth, even while utilizing very low borrowing rates to buy property cheap. We’ll get a better read with next week’s numbers. But this one, too, looks set to start rewarding its loyal unitholders with more cash.

Owning this fantastic four is the best way I know of to cash in on Canada’s continually strengthening property market. To them, I would also add up-and-coming Crombie REIT (TSX: CRR-U), though US investors will have to go to the Toronto market to buy it.

Crombie continues to benefit from its association with conglomerate Empire Company Ltd (TSX: EMP/A, OTC: EMLAF), a new addition to How They Rate coverage. Last month, for example, the parent helped arrange a profitable deal involving ownership of shopping centers anchored by another Empire affiliate, Canadian grocery powerhouse Sobey’s.

The REIT is slated to announce its second quarter results on Aug. 12. I expect another strong quarter marked by solid occupancy rates and modest rent growth. Crombie REIT is a buy up to USD12.

Morguard is an exception to my rule of focusing only on REITs specializing in a particular type of property. Holdings are 34 percent office, 63 percent retail and the rest invested in an array of other properties.

Geographically, it’s most concentrated in Ontario (55.6 percent) but also holds 34.2 percent of its portfolio in the energy-rich provinces of Alberta, British Columbia and Saskatchewan.

Last month, the company expanded its reach in the stable Quebec market, buying an office complex in a Montreal technology park.

The REIT’s record is one of stability, with strong occupancy and steady rent growth a quarterly occurrence. That’s kept the payout ratio and debt levels on the low side as well. Second-quarter results were no exception, with occupancy coming in at 93 percent and the payout ratio at 87.7 percent. That underscores the safety of the 7 percent distribution. Buy Morguard REIT up to USD12.

Finally, I remain a fan of Cominar REIT, the owner of office buildings, industrial facilities and retail shopping centers located entirely in Montreal (46.9 percent), Quebec City (48.5 percent) and Ottawa (3.6 percent). Second quarter operating revenue surged 8.1 percent, triggering a 7.1 percent jump in net operating income. That growth was fueled by the REIT’s continuing string of acquisitions, including an industrial property and a mixed use property in Brossard completed this summer.

Second-quarter distributable income rose 12.7 percent, though it was 9.8 percent lower on a per-share basis due to equity financing. That’s typical for any REIT that’s financing acquisition but the dilution is set to disappear as the new properties boost profitability. Meanwhile, distributions are still solidly covered and debt levels under control. Buy Cominar REIT up to USD20 if you haven’t yet.

Editor’s Note: For additional information on this topic, check out Roger Conrad’s latest report on Top Canadian Income Trusts.