Michael Missaghie, Senior Portfolio Manager, Sentry Investments
Stance: Go REITs
For investors not well versed with the risks and challenges of property ownership—and contemplating exposure to real estate—REITs are a better choice.
Public Canadian REITs traditionally invest in commercial real estate and rental apartments. Commercial REITs own office, retail and/or industrial assets, leased to tenants for five-to-10-year terms. During periods of economic uncertainty, longer lease terms better protect cash flows and the value of assets.
Residential REITs invest in rental apartments with lease terms of about one year. They have little overlap with the condo markets as they compete in a different rental bracket: $800 to $1,100 per month, as opposed to the condo market’s $1,600 to $2,000. This asset class is generally viewed as defensive because of historically stable occupancy levels, little new supply and CMHC financing.
Public versus private
Direct investment in real estate usually comes with headaches for investors not used to managing assets. Maintenance is a time- and capital-intensive business. With REITs, investors are able to participate in the cash flow and long-term capital appreciation while having properties professionally managed. Management includes capital expenditures (both for maintenance and revenue growth) and tenant needs such as move ins/out, leasing and rent collection.
REITs also provide investors with a share of large, high-
quality assets that would be difficult to acquire directly because of the capital required. Diversified across geography and asset class, REITs also let investors diversify holdings, rather than own just one asset.Historically, REITs have exhibited more short-term volatility than private investments, but over time they more closely reflect the overall net asset value of the properties.
Over longer time horizons, REITs have provided relatively good long-term diversification. Between 1990 and 2012, REITs had a correlation of 0.45 with the S&P 500 over 24-month time periods. Over five-year periods, the correlation drops to approximately 0.10. Correlations have been more consistent with the general markets during periods of uncertainty, such as the financial crisis of 2008/2009, when it was closer to 1.
REITs aren’t designed to deliver outsized returns. They provide income and visible cash flow growth that compounds over time. With more than 60% of total returns historically coming from the monthly income REITs provide, this sector would be most suited for buy-and-hold investors looking for tax-efficient monthly income and moderate cash flow growth.
We focus on companies rather than sectors. We seek consistent cash flow that grows over time, sustainable capital structures, and management teams that effectively deploy capital. I’d suggest Boardwalk and Allied Properties REITs.
Boardwalk is an apartment REIT with the majority of its assets in Alberta. It has a well-aligned management team with a history of delivering strong free cash flow growth.
It is currently trading below NAV with a sustainable payout ratio (70%), and leverage (40%). It’s also in a position to provide future distribution increases as cash flow grows.
Allied Properties operates in the office asset class but eschews larger urban or suburban buildings. Instead, it operates industrial buildings retrofitted to act as office buildings in Canada’s major urban markets. Its capital structure is sound, with a payout ratio (80%) and leverage level (35%) operating well below the industry average.
Internationally, we’ve allocated capital to opportunities in the U.S., Europe, Australia and Asia. The U.S. has the world’s largest public REIT market, with REITs trading at attractive valuations and poised to deliver free cash flow growth buoyed by an economic recovery.
The U.S. also has unique asset classes unavailable in most other geographies—student housing, data centers and cell towers.
In Europe, we’ve identified REITs that can provide above-average free cash flow growth in an economy on the mend. Australia is one of the only developed markets where the central bank continues to decrease benchmark interest rates; its property fundamentals are improving, with many REITs trading below NAV.
We focus on factors that we remember using MAPLe: management, assets, payout ratio and leverage.
We seek management teams that align with investors, which usually means they’re large shareholders of their own companies.
We look for REITs with assets of enduring value. A compelling example is Toronto’s privately owned Eaton Centre. Shoppers continue to flock to the asset despite the bankruptcy of the namesake tenant and ever-changing tenant mix, thus drawing retailers and ensuring continued cash flow.
REITs with sustainable distribution payout ratios and growing free cash flow are good candidates. CREIT, for example, has a strong history of operating at a sustainable payout ratio, thus increasing distribution over the last decade, despite a financial crisis.
We look for REITs with no more than 10% to 15% debt maturing in a particular year.
The REIT sector has experienced some volatility in recent months as investors contemplate the impact of rising rates. But compared to historical norms, we are still in a low-growth, low-interest-rate environment where REITs’ stability, yield and cash flow continue to look attractive.
The REIT market looks poised to deliver returns in the 8% to 12% range going forward. And yield is safer and more valuable than it has ever been. In addition, fundamentals (occupancy and rent) remain sound across all asset classes while commercial real estate supply in Canada remains below average.
New office supply is coming to key markets like Toronto, Vancouver and Calgary. While the majority of these assets have some pre-leasing, we’ll need to monitor the effect the new space has on existing assets, and weigh whether there’s continued demand from tenants.
Over the last three years in Canada, A-, B- and C-class assets have converged in value. This might not continue. A-class assets (more recently constructed or newly renovated assets in urban centers) will likely hold their value, while B- and C-class assets (older suburban and lower-tier urban assets) may see more challenging market conditions.
Finally, we expect larger retail REITs to perform well because of stable consumer and tenant demand, especially from U.S. retailers. The Canadian retail REITs have already done a good job selling their lower quality assets over the last few years, and recycling capital into urban and high-quality suburban assets. REITs like RioCan and First Capital are now involved in mixed-use (retail, office and residential) real estate projects in downtown cores that should be a strong driver of value over the coming years.