Canadian real estate investment trusts have rallied to the highest levels in five years as rising occupancy and investor demand for yield outweigh concern the Bank of Canada will raise interest rates to cool the market.

The S&P/TSX Capped REIT Index has climbed to within 0.2 percentage point of a March 13 peak of 162.75, the highest level since July 2007, fuelled by dividend yields almost twice the average for the Standard & Poor’s/TSX Composite Index. The gauge has gained 6.3% this year, beating the 0.3% increase in the broader index.

The REIT sector is one of the only places you’ll be able to get a sustainable yield in the Canadian investment landscape

The investors in properties from shopping centers and office buildings to rental apartments have benefited as the 10-year Canadian bond yield fell by more than half, boosting the value of their holdings. The national office vacancy rate fell to 8.2% in the first quarter from 9.3% a year earlier, according to CBRE Group. Apartment vacancy dropped to 2.2% in October from 2.6% a year earlier.

“Fundamentals are very strong in Canada,” Michael Missaghie, a portfolio manager at Sentry Investments, said in an April 16 phone interview. “Both occupancy and rents continue to improve,” said Missaghie, whose firm has $7 billion under management. “The REIT sector is one of the only places you’ll be able to get a sustainable yield in the Canadian investment landscape.”

The REITs have rallied even as Finance Minister Jim Flaherty warned of the risks of record consumer debt and soaring housing prices that some investors say may be inflating a bubble in the condominium markets in Toronto and Vancouver.

Biggest Gainers

Artis Real Estate Investment Trust. which focuses on retail and industrial properties in Western Canada, has surged 17% in 2012, the biggest gain in the Canadian REIT index, while Boardwalk Real Estate Investment Trust. an apartment and residential properties owner, has rallied 16%, the second-biggest increase in the measure. Dundee Real Estate Investment Trust. an owner of office properties in Canada, has jumped 13%.

The REITs have benefited from a drop in the 10-year Canadian bond yield from 4.7% in 2007 to 2.04% April 23. Yields at current levels push capitalization rates lower, boosting net asset value, Jimmy Khing Shan, an analyst at GMP Securities LLC in New York, said in a telephone interview. The cap rate, a measure of investment yield, is a property’s net income divided by purchase price.

“A lot of investors have probably already hedged a 100 basis point rise” in the bond yield, Shan said. “If we get to 3% and we see a further sharp rise in rates, I think we should be a little bit worried about REIT valuation.”

Yield Retreats

The Canadian REIT index had slipped 2.2% from its peak by the end of March after the 10-year Canadian bond yield surged as high as 2.29%. As the yield retreated, the REIT index surged back to 0.2%age point below the March peak.

“With interest rates moving higher, people thought to move away from Canadian REITs so they’d be more exposed to growth in an improving economic environment,” Missaghie said. “When the 10-year bond yield crept lower again, money flowed back in. Now there are a few fundamental factors that are going to stay in place for the rest of the year and keep valuations where they are, if not even higher.”

The Bank of Canada, while keeping its benchmark interest rate at 1%, reiterated on April 17 that the consumer debt burden is among the country’s biggest domestic risks, and higher interest rates “may become appropriate.” Property prices in Toronto and Vancouver almost tripled over the past decade.

Rental Apartments

While these concerns may lead to restrictions on real estate financing, the government’s efforts to curb consumer debt may work in favor of REITs that own rental apartments, Brad Cutsey, an analyst at Dundee Securities, said in a telephone interview.

“It sounds like all policies are geared towards tightening underwriting standards,” said Cutsey. “That makes it harder for first-time homebuyers to purchase. They’ll stay in the rental pool longer.”

Cutsey said units of Transglobe Apartment Real Estate Investment Trust are cheap compared with the industry. The REIT trades at 12.5 times funds from operation, lower than the average of 15.5 times for the 13 stocks in the S&P/TSX Capped REIT Index.

Development Cycle

Canadian office construction is “primed for a development cycle,” Heather Kirk, an analyst at National Bank Financial, said in a telephone interview. She sees Calgary, Toronto and Montreal as major growth areas.

Office property values probably will rise 20% this year in Calgary and about 10% in Toronto and Vancouver, according to CoStar Group Inc. fueled by a boom in the oil and gas industry.

Cutsey said Cominar Real Estate Investment Trust, which owns office properties in the Quebec area, is attractively priced. The REIT trades at 14.4 times FFO.

Retail property is the asset class with the least potential to gain, according to Cutsey. RioCan, which specializes in shopping center investments, trades at 21 times FFO, 35% higher than the index average.

“Retail is more fully priced,” said Kirk, the highest-ranked analyst covering RioCan, according to data compiled by Bloomberg. “There are certainly positive drivers, but with where a lot of stocks are priced right now, you’d probably have to pay up for it more than you would in other sectors.”

 Adding to Earnings

Some Canadian REITs are driving growth through acquisitions, which generally add to earnings and help cash flow growth, Kirk said. Dundee completed the purchase of Whiterock REIT for C$1 billion ($1 billion) on March 6, a move that bolstered its office presence in Toronto. Cominar acquired the 85% it didn’t already own of Canmarc REIT for C$1.5 billion on the same day.

“If you look at what’s happening in terms of internal growth, rents moving up and space being leased out, the market is healthy,” Kirk said. “If the next couple of quarters see solid growth in adjusted funds from operations, we could certainly argue for the stock prices moving higher even on the assumption of stable multiples.”