When analyzing an investment, it’s often helpful to do so from multiple perspectives.
With that in mind, we asked Colum McKinley, vice-president, Canadian equities at CIBC Asset Management, and Jeffrey Waldman, head of global fixed income at CIBC Asset Management, to explain how they’d each approach a REIT investment.
Both managers own Toronto-based Dream Office REIT: McKinley as an equity investment and Waldman as a bond.
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Equity metrics for REITs
McKinley, who manages the Renaissance Canadian Core Value Fund, says his overarching goal is “to understand the true long-term earnings power of the business, and the appropriate valuation that the market will apply against that earnings power.”
For REITs specifically, he looks at NAV and funds from operations (typically abbreviated to FFO). Those metrics help him “understand the cash flows that these businesses can generate from the assets they own.” They also help him grasp whether these businesses can “redeploy that capital into the business.”
Dream Office REIT includes Alberta real estate, but McKinley isn’t concerned. He’s looked at the downside scenarios. “[These include] what could happen to rents in Alberta, what could happen to occupancy, and [whether Dream Office has] the balance sheet and financial strength to see themselves through what could be a challenging period in a small part of the business.”
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He also looks at “the sensitivity of their cash flows, because that affects their ability to service the amount of debt that they have.”
His conclusion? “[Dream Office] is trading at a meaningful discount to its NAV, based on the market’s perception of the challenges that exist in the Alberta market.”
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He’s also pleased that “Dream Office has a plan […] to sell existing assets in other markets—markets where some of those assets are trading at a substantial premium to NAV—and generate cash flow that will allow them to sustain their dividend [and] continue to reinvest in their buildings and operations for future growth.”
Fixed-income metrics for REITs
Waldman focuses on a REIT’s debt levels when considering REIT bonds (he’s co-manager of the Renaissance Short-Term Income Fund, an underlying fund in the Renaissance Optimal Portfolios). His favoured metrics include:
- debt to total assets;
- debt to earnings before interest in taxes, depreciation, and amortization (EBITDA);
- interest coverage today and in future; and
- the sensitivity of interest coverage to rate increases.
“In addition to debt, we’re going to look at the profile of the properties of the REIT itself, and the ability to generate cash to service the REIT’s debt,” says Waldman. “So we’ll look at things like occupancy levels, rental renewal rates, the schedule of expiring leases, and property types and locations.”
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He likes Dream Office because “it makes sense from a debt as well as property-profile perspective. The amount of debt that Dream Office has compared to other REITs is quite favourable.” He says the REIT’s current interest coverage is 2.8x and current debt to EBITDA is 8x.
Waldman’s also optimistic about Dream Office’s future prospects. “Earlier this year the CEO, Michael Cooper, announced a two-year plan to create a leaner company.” The plan involves selling $1.2 billion in non-core properties and using the proceeds to reduce debt. “So, going forward we see debt levels improving. This is very positive for bond holders,” says Waldman.
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Like McKinley, he’s also noted Dream Office’s Alberta exposure. The REIT’s occupancy rates overall are “lower than its peers, but that’s due to its exposure to the Calgary office market,” Waldman explains. “Alberta makes up about 26% of Dream Office’s income, and that’s higher than its peers.”
Based on that, one of his credit analysts visited the REIT’s management in Calgary to ask how they’d address the city’s downturn. “He [saw] examples of properties that are being released to new tenants [and] the rental renewal rates that Dream Office is achieving,” Waldman says. The analyst also found the schedule of leases expiring over the next few years to be “very much in line with its peers.”
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So Waldman, like McKinley, is confident about Dream Office. The Alberta exposure is “offset by its exposure to downtown Toronto, which makes up 33% of its income. And that’s performing well.”
What’s more, Dream Office offers “significantly higher yield than other REIT bonds,” Waldman says. “And that makes them attractive, given Dream Office’s plans to reduce leverage over the next two years.”
Why talk to another manager?
“Working with our fixed income team is a collaborative effort,” says McKinley. “That reaps the most benefits for both asset classes.” For instance, meetings with company management will often include representatives from both the equity and fixed-income teams. “Understanding the capital structure of a company gives us an advantage in thinking about that business and its sustainability.”
For his part, Waldman monitors “the relationship between the REIT price in the equity market and its discount to the net asset value of the REIT. We use that to gauge the relative performance of the REIT to its peers in the equity market.”
He asks McKinley’s team “to give us a heads-up [when] a REIT is underperforming in the stock market. A situation like that may force management to be extra sensitive to returning capital to equity holders—and often this takes place to the detriment of bond holders.”
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