Faceoff: REITs versus the real thing

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.

Investment strategy

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.

Selection process

We focus on factors that we remember using MAPLe: management, assets, payout ratio and leverage.

Management:

We seek management teams that align with investors, which usually means they’re large shareholders of their own companies.

Assets:

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.

Payout ratio:

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.

Leverage:

We look for REITs with no more than 10% to 15% debt maturing in a particular year.

Future prospects

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.

Catherine Ann Marshall, CFA, Vice-Chair, Toronto CFA Alternative Assets Committee, former research director, CPP Investment Board

Stance: depends on the client

The decision depends on what safety means to the client. If they want to control all decisions that can impact the performance of the investment, then they should invest directly. For instance, investing in a condominium unit gets investors more involved. They make decisions about who to rent it to; what to charge; whether or not to increase the rent; and how to market their unit.

But while there’s more control over performance of the physical investment, the diversification is missing. An intermediate way to get exposure to real estate is to invest in a real estate fund of Canadian direct investments run by qualified investment managers. You’re diversified against the risk of any one market or property type, and the investment team works to minimize the risk of vacancy and borrowing rates.

If clients want well-diversified portfolios of real estate—Canadian or global—they could invest in real estate securities focused on REITs. The only decision they’d need to make is when to buy and when to sell. They will, however, be exposing their investments to the volatility of the securities markets.

Multiple choices

Hard assets:

An investment in hard assets offers two choices: commercial or residential.

Commercial real estate makes more sense for institutional investors. The size of investments can run into millions of dollars.

Residential real estate falls on a carefree-to-complex continuum. A small condo unit is a carefree investment for average investors who know very little about real estate. However, investors must screen tenants because leases protect tenants more than landlords. Those who don’t want that risk could consider using professional managers with experienced leasing teams.

A house is more complex, and best considered by handy investors with the business acumen and capital strength to withstand periods of vacancy. Multi-family units fall a notch higher in complexity; as soon as you exceed six units, you’re verging on commercial.

When supply and demand are in balance, real estate has always proven to be a safe and conservative investment. You could buy an average one-bedroom condo and do well. It’s riskier when there’s a surfeit of supply.

The moment your city’s skyline becomes dotted with cranes, it’s time to become cautious. You could make a good investment even during periods of high supply, but only if the unit offers something above the competition, such as three spacious bedrooms or a large, south-facing terrace.

Equity funds:

Physical assets form a limited part of the overall investable real estate universe. Stocks and real estate products are other viable choices for regular investors.

REITs move in sync with the overall stock market and should be seriously considered by investors who are indifferent to the general variability of the price and concerned only with a monthly distribution. But REITs can easily oscillate between a premium and discount to NAV, and these valuations can change quickly.

Still, once you get past the volatility, REITs have their virtues. Since they’re secured by real estate, they produce stronger income than bonds. The investor is protected against any single property or tenant having a serious impact on the investment’s performance. Professional management also protects investors by managing potentially problematic events.

For instance, when the Bay wanted to sell Zellers to Target, most negotiated successful transitions to Target as a new tenant. But when Target didn’t assume the Zellers lease, REIT managers had to negotiate to protect their organizations from the financial hardship of losing an anchor tenant in their shopping centres.

Private funds:

Another choice for sophisticated investors is private funds. Gradually growing in popularity, they represent a conservative, low-volatility investment as long as they’re well-diversified and don’t engage in risky development activities. They range from funds offered by large investment management companies, such as the Life Insurers, to specialized investment companies with private wealth divisions like Fiera Capital or Connor, Clark & Lunn.

Investments are typically made via a collective investment scheme that pools capital from investors into open-ended funds. The negative aspect is that these investments are illiquid, compared to REITs. You can only sell shares back to the fund, and must follow the fund’s rules around how and when you can sell the units back.

Funds are sold through the broker-dealer network, and typically have a 10-year life span consisting of a two-to-three-year investment period during which properties are acquired, and a holding period during which active asset management is carried out and the properties sold.

A big drawback of these investments is they’re not liquid until the properties are sold. Advisors must review marketing material for the fund’s investment strategy and policy, and look for key words like diversification, low risk and steady income.

Real estate mutual funds:

This option, designed for average investors, invests in securities of Canadian companies involved in the ownership and management of real estate assets.

Outlook

Commercial real estate is anticipated to have a steady outlook, with little capital appreciation and a lot of income production over the next five years. Residential real estate is a big question mark, though. During the low-rate environment of the last five years, many investors ventured into real estate and found it sounder than your typical stocks or bonds. Today’s rising interest rate environment, however, seems to suggest there might be downward pressure on prices.

Kanupriya Vashisht is a Toronto-based financial writer.