How to invest in real estate

During his undergrad days,it was a tug-of-war between law and finance for Corrado Russo, managing director of investments at Timbercreek Asset Management. In the end, the investment world’s pull proved stronger. In the industry for more than 15 years, Russo now manages the Timber-creek Global Real Estate Fund.

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Q: How do you choose investments?

We focus on real estate investments with predictable, growing and transparent cash flow streams. We access this cash by investing:

directly in real estate (approximately 10% private equity);
in mortgages and other real-estate-secured debt (approximately 10% private debt);
globally in publicly traded companies that own investment-grade real estate (approximately 60% public equity); and
in publicly traded debt or hybrid equities (e.g., we have approximately 20% in U.S. REIT preferred shares).

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We like companies that own great properties in attractive markets, have management teams that are good stewards of capital and trade below fair value. If you’re considering the office market, look at underlying job growth. Assess if that location attracts a proper talent pool. In the retail sector, you want to understand wage inflation, consumer confidence and unemployment rates.

On the residential/rental side, you must again look for job growth. For example, we’re currently interested in the southeastern U.S. because a lot of manufacturing plants are moving there.

It’s also more attractive to buy properties in areas that have minimal available land. Such areas are either water-locked (e.g., Sydney, Australia), or fully developed through retail and office nodes. For industrial and commercial real estate, we like Singapore because it’s a gateway to Asian emerging markets. Compared to emerging markets this year, Singapore has higher returns, higher dividends and lower volatility. It also displays more stable economic fundamentals.

Q: How do rising interest rates affect real estate investments?

There’s no direct linear relationship between interest rates and real estate. Real estate cash flows tend to keep pace with inflation. If the general economy and GDP are doing better, there will be a rise in demand and the value of real estate. Landlords will have better pricing power and be able to push inflation costs to renters. In addition, as inflation raises the cost to build new real estate, the value of existing structures goes up as well.

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How do you limit risk?

Portfolio construction: We invest in asset classes, such as private and preferred shares, that are less correlated to common equity. We also invest across different real estate types and in phases of the real estate cycle.

Underwriting: We look at three risks before buying:

1. Real estate quality— location, leasing and capital improvements.

2. Management—acquisitions payments, financial statement accuracy, debt and balance sheet strength.

3. Security—volatility, correlation with other investments, correlation with equity markets and macro variables, and liquidity.

Hedging: If we see abnormal micro or macro risks, we buy puts. In our view, if you short the index, you sacrifice upside. By buying puts against the index, we can collect the spread while protecting the downside. We also hedge our U.S. dollar and euro exposure (roughly two-thirds of the portfolio) back to the Canadian dollar.

If rates don’t go up and there isn’t too much inflation, higher-yielding assets will become more valuable. However, the best compromise is focusing on asset classes and companies (such as real estate) that provide both high current income and growth potential—they’re likely to outperform in either environment.

Q: How do you determine when to buy?

Let’s say you could buy office buildings in New York and they’re trading at 4.5% cap rates. Or, you could buy a U.S. REIT like SL Green or Boston Properties. If a REIT’s trading at a 20% discount to NAV, that implies a cap rate north of 5% (see “The math on cap rates,” this page), and you’re getting a better return. Real estate has a massive private market you can use to judge whether you’re overpaying in the public markets.

Q: What private markets are you most comfortable buying in?

Currently, we’re bullish on multi-family rental units in the southeastern U.S. Given the depressed job growth [there] and persisting weakness in single-family units, the supply is at an all-time low as builders and developers struggle with getting construction debt to build new facilities. We’re seeing some cap rates that are 200 to 300 basis points higher than in Canada. And the cost of debt is still at an all-time low.

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Q: What is the global outlook for real estate?

The highest dividend yields are coming out of Australia, Singapore and Canada. Australia is where the U.S. was three years ago—an economy that’s seen a downtrend, depressed retail sales, a residential market under pressure, and a central bank striving to lower yields to get the economy going.

Australia’s dividend yields pre-2008 were at unsupportable levels. They were paying out more than 100% of their recurring cash flow streams due to substantial gains on the development of new properties. When the financial crisis hit, those gains disappeared. Firms had to cut dividends, and that hurt the overall REIT market. It’s a good out-of-favour market to consider since consumer spending and confidence are improving. Getting in at a low base would mean a small improvement in fundamentals could have a meaningful impact on the overall outlook. In the meantime, you get paid to wait in the form of healthy dividend yields.

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Even Canada is screening well. While the private market continues to be at relatively full value, the REIT market has corrected over the last few months, trading at discounts to the private market. Currently, we like Dundee REIT, with close to 8% yield on stock. Lately, tenants are moving out and not renewing, so it’s trading at a significant discount (10% to 15%) to the private market. But we’re confident the company will be able to fill its vacancies, based on the location and quality of the buildings. Our current portfolio has about 13% weighting in Canada, most of it in public equity, and about 3% in private real estate.

We own few U.S. REITs given that dividend yields are quite low. Most of our U.S. exposure comes from preferred shares. We look for issuers paying high coupons, which are lower duration and provide protection in a rising-rate environment. We own preferred shares of Pebblebrook Hotel Trust and Sunstone Hotel, as the hotel industry will benefit from general economic improvement.

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Q: Has your investment process ever failed?

We look for mispricing, and sometimes we get in or get out too early. For example, last summer, when discussion about tapering heated up, the REIT market showed significant declines. We jumped in and added names after they were down 10% to 12%. However, given the momentum of the market, they declined another 5% to 7% before recovering. Earlier this year, we sold some of those positions as they had fully recovered to original levels and no longer showed discounts. But the market had swung the other way, so they continued to go up. In retrospect, we would have rotated that capital into other value names, not cash.

When the market is driven by momentum concerns, expensive markets can get even more expensive—that’s when we tend to underperform. When cheap markets get cheaper, we might underperform then as well.

To mitigate underperformance, we choose dividend-yielding stocks, such as CFX in Australia or Cache in Singapore.