We started referring to bad stock market years as Annus Horribilis at the end of 2001. But bad times are a necessary precursor to good ones, and with a bit of luck and planning, we’ll soon see our Annus Mirabilis (year of wonders).
At the beginning of 2003, this is how we summarized our view of the year ahead:
› The bull market of 1982 to 2000 is over;
› Yield on equities will be more important than it has been for over twenty years. Dividends matter;
› While interest rates will eventually rise, expect the deflation fighters to hold off on short-term rate increases until the potential risk of lower prices is over; and
› Housing prices will likely drop as a reaction to the surge over the last few years.
What is as true today as in 2003 is the importance of building cash-flow generating portfolios for your clients, which are sustainable, tax-efficient where possible, and diversified.
What makes this financial crisis unique when compared to other bear markets in equities is that virtually all other asset classes have dropped at the same time. This has meant very little safety in diversification.
Price declines of almost all asset classes have taken down both good and bad investments. So, for awhile, we will focus on REITs, an income-generating asset class that we feel will provide great results for clients with a time horizon of between three and five years (in other words, most of our clients).
Like all investments, Real Estate Investment Trusts (REITs) have experienced large losses in share prices, even though most REITs have been able to continue making distributions. For just that reason, investmentgrade real estate has been a cornerstone for many of our clients and has provided excellent returns—on both capital appreciation and income fronts.
While over long time frames commercial real estate has not outperformed large-cap equities, it has provided returns that are quite close. But more importantly, the income on real estate makes up a much higher proportion of the total return than it does for stocks—less capital gains and more income. In this era of low interest rates, income-producing real estate can be important to insuring consistent cash flow.
Most REITs have very simple capital structures. Investors put up equity that’s used to acquire incomeproducing properties, while using borrowed money (mortgages) to fund part of the purchase price.
Over time, the rental income will pay off the debt, while allowing income distributions to investors. If one assumes rents rise over time more or less in line with inflation, and the mortgage balance is reducing, then both the net cash flow and the equity attributed to investors will increase. So, if all that’s true, why have REIT values in general dropped 60%, exceeding the fall-off for common shares? And why are some REITs cutting distributions if there has been little change in rental income and interest rates are falling?
There are several reasons. For many years, REITs were able to take advantage of very low financing costs. But much of the competition for this cheap money came from the same conduit: Lenders who financed and securitized subprime mortgage debt in the U.S. and Canada.
In early 2007, it wasn’t uncommon to be able to borrow commercial mortgage funds for 100 basis points over Government of Canada bond rates (GOCs), and even less for CMHCinsured mortgages used in multifamily residential properties. Today, those rates are as much as 400 basis points over GOCs. And, many lenders have dropped out of the commercial mortgage market. The remaining lenders are increasing their standards, which means a lower loan-to-value ratio.
Whereas they might once have agreed to lend 70% on a good-quality asset, they may now refuse to go above 55% to 60%. This means less leverage for the borrower and lower returns.
As the price of money got cheaper during the years leading up to 2008, the cap rates used to determine the selling price of a building kept falling—and the lower the cap rate, the more expensive the underlying real estate.
After falling for many years, cap rates are now rising; primarily driven by a tougher economy and the diffi- culty in obtaining traditional mortgage financing. REIT prices have always been more volatile than the actual value of the underlying real estate. In some parts of the business cycle, they trade at prices higher than the value of the real estate they own. Less frequently, they trade below the Net Asset Value (NAV) of that real estate.
For these reasons, one would expect them to trade above the value of the underlying real estate (see “Bargain Basements,” below). As of the end of November 2008, REITs as an asset class were selling at a record 45% less than their NAVs. This has never occurred before. There are legitimate reasons for REITs to have dropped in value over the last two years. In January 2007, they traded more than 11% above the underlying real estate, which was arguably inflated given the low-cost borrowing environment.
Public markets have a tendency to overshoot on both the upside and the downside, which is why clients should look at selected REITs as the least expensive (and least risky) way of increasing exposure to investment-grade real estate and to dramatically boost cash flow from equity-based assets.
So what factors should be considered when selecting REITs? First, there’s sustainability of current cash flow, which is dependent on the terms of the mortgage and other debt within the REIT. If most of the debt is a long-term mortgage that’s not due for many years, the risk of having to refinance a property in this tough lending environment is greatly reduced. It’s also dependent on the quality of the tenants.
Then there’s the type of real estate. Traditional multi-family residential property has proved to be the most resilient in recessions, while hotel REITs are arguably the most vulnerable as people reduce travel. High yields on some REITs are very enticing, but risk of distribution cuts needs to be more carefully examined in this market.
And don’t forget price-to-net-asset value. This can be a moving target since the NAV is a function of cap rates, which may be rising. However, we can measure the current price-to-NAV and compare with other periods to see if we’re in a period of relative value. The greater the discount, the greater the margin of safety.
As 2009 winds along, strong REITs will be able to renew mortgage financing at competitive levels, but will feel pressure on the revenue side as some leases renew at lower rates. In Canada, cap rates for investment-grade real estate are in the 6% to 8% range. The main focus should be on value and cash flow. By pooling REITs, advisors can reduce risk for clients in the same way an ETF would.
When this recession is over, prices will revert back to the traditional premium over underlying real estate. In the meantime, keep looking for good value in hard assets. Some REITs will sell assets to raise much-needed capital, and some of those sales will be at distressed prices, representing an opportunity for investors with time horizons of three-to-five years or longer.