Lets assume that low mortgage rates are here to stay for some time. What if one also assumed that there will continue to be a strong appetite for good-quality real estate? Well, if you put those two variables together, it’s not hard to envision an environment with lower cap rates. Lower cap rates drive Net Asset Values (NAV) higher, translating into higher total returns for REIT investors. Combine this with the near insatiable appetite for yield and income by investors and you’ll find that the prospects for REITs look very favorable. This is why we are super excited to present today’s interview with a top ranked portfolio manager, specializing in REITs. You may have seen him dispense his near encyclopedic insight on TV or maybe read his views in the newspaper but today, you’ll be able to find out his reasons for investing in REITs, how REITs perform in inflationary/deflationary environments, what metrics you should look at when evaluating REITs and a couple of his best investment ideas.
Biography: Dennis has been with Sentry Investments since 2005 and has more than a decade of experience in the financial industry. As a member of the equity income portfolio management team, he manages the Sentry Infrastructure and REIT funds. Dennis has been a back-to-back winner of a Brendan Wood International TopGun Award (2009 and 2010); given by the sell-side analyst community to those with the best grasp of the industries in which they invest and the most influence in the Canadian market; one of only 50 managers selected from over 400 individuals nominated. He has an Honours BBA degree from Wilfrid Laurier University, an MBA from the Schulich School of Business at York University and is a Chartered Financial Analyst (CFA).
Q: Don’t you think Canadians have enough exposure to real estate through their home?
A: First off, most people don’t treat their homes as they would an investable asset. I mean if your house price was quoted every second from 9:30 until 4:00 I think that would be one thing but clearly it’s not. Most people look at their home as where they raise their family. They don’t really consider it an investable asset, until, well if at all, until later on, when they’re considering retirement, and at that point they start considering what proceeds they can realize from it and what that would do in terms of their standard of living and so forth. When we talk about real estate exposure, we’re talking about commercial real estate, which runs off the same two macro drivers, that being interest rates and GDP growth. The returns you realize from buying and selling your principle residence are going to be very different from the returns you get from a super-regional mall in Edmonton or Triple A luxury tower in downtown Toronto. So, the two points I would want to make is that most people don’t include their home as an investable asset and that the returns you’re going to realize from investment grade commercial real estate are going to be very different from what you would realize on your principle residence. So I think those are the two things that differentiate investing in REITs as opposed to owning a principle residence.
Q: Given that the Bloomberg Canadian REIT Index has returned something like 25-26% year to date, what is your outlook on Canadian commercial real estate and REITS going forward?
A: Well, we’re not so much concerned with what the returns have been generated year to date. We are more concerned with absolute valuations and then relative valuations. So if I look at absolute valuations Canadian REITs are usually valued on a free cash flow multiple basis so historically they’ve traded around 14 times and right now they are trading at 15 times so they’re not overly cheap as a sector. And then if you’re looking at relative valuations, generally people look at REITs in comparison to utilities or banks for the simple fact that they are generally stable cash flowing assets that offer the same type of return for the risk you are assuming. So on a relative valuation basis REITs aren’t overly cheap either. Idon’t have a spreadsheet open in front of me, I don’t know I can’t tell you off the top of my head where the relative valuations are but I know the last time I checked they weren’t cheap on a relative basis either. So what I would say to investors is that if you are looking at real estate today, you are looking for 8-12% total return, you know, 6-8% from income, and you know anywhere from 2-5% say or 2-4% on appreciation. If there’s a spot in your portfolio for those types of returns with that type of cash flow profile and lower risk parameters than by all means you should consider Canadian REITs. If you’re looking for 30 or 40% you know that window is closed. REITs are no longer you know trading at discount valuations that would imply those types of forward returns.
Q: How are REITs affected in a rising interest rate environment? Can you talk about how REITs are exposed to the long end of yield curve as opposed to the overnight rate that is determined by the Bank of Canada?
A: Sure, I mean you pretty much summarized it there. I mean the short end exposure for REITs really has to do with their lines of credit and most Canadian REITs do not carry large balances on their lines of credit and even if they did the amount they’d have in their mortgage portfolios would dwarf that anyways. So the real exposure there is at the long end of the yield curve for a couple of reasons. The first is obviously debt refinances, as you have mortgages coming up for renewal, are you renewing those mortgages at higher interest rates or lower? Then obviously there’s purchasing assets. All things being equal if you can finance an asset at 4.5% over 5 years as opposed to 5.5 % for 5 years, then generally it should be more accretive and should generate more cash flow growth per unit. Lastly it has to do with discount rates. If you’re going to use a multiple to value of Canadian REITs really what it is – it’s the inverse of a yield. So when we talk about AFFO multiples and I said Canadian REITs were trading at 15 times really what I’m saying is that Canadian REITs are trading at 7 and change free cash flow yield. So as interest rates come lower or go higher you would expect to get more of a cash flow yield or less of a cash flow yield out of Canadian REITs. And since interest rates have come down, yield should also have come down and that should mean multiples expand and Canadian Real Estate values should increase. So when you put all that together and you ask yourself what happens in a rising interest rate environment, well historically rates have gone up when inflation has picked up, and inflation picking up is usually a function of the economy running at very low output gap, meaning that the economy is running at almost full economic capacity, prices are going up, wages are going up. In that type of environment, the demand for commercial real estate increases, occupancies go up, rents goes up, cash flows go up, distributions go up and the real estate itself appreciates in value. REITs do poorly in deflationary environments for the complete reverse of that argument. Companies go bankrupt, they contract, they give back space on lease renewal, and that generally decreases the demand for commercial real estate. Occupancies come down, cash flows come down, and real estate depreciates in value. So historically REITs have done very well in rising interest rate environments when they do poorly is when there’s a recessionary or deflationary outlook or actual deflation or an actual recession taking place.
Q: Just to follow up on that do you see a recessionary or a deflationary environment going forward? Is that something you were considering or not?
A: Well I think you have to look to degrees. I mean if the economy is expanding at 20 basis points a year or you know contracting at 20 basis points a year it really doesn’t make a difference. Bottom line, the economy is very weak and there isn’t a lot of job growth. Now, if we’re talking about going back into the type of recession that we went into in 2008 where you’re talking about economic output contracting at 6%, no we don’t see that happening simply because we think that we’re into a time period here where people and companies are still deleveraging but it’s really moving at a much smoother consistent pace as opposed to 2008 where the credit markets shut almost immediately and companies like Bear Stearns and Lehman Brothers all of sudden found themselves completely insolvent.
I don’t think we’re headed into a period like that. So I don’t think investors have to factor that into their return forecast going forward. Now do I think we’re headed into a period of rampant inflation and unparalled growth? No and No. I think what you have to get used to is the status quo and I think you have to get used to that for another two or maybe even three years, where you’re in an environment of weak or lackluster or sub-par growth. There’s enough sort of structural growth in the economy to keep you know positive growth and to keep the economy expanding but nothing to write home about, nothing to get overly excited about. The government will probably have to pay a larger role in economic growth and expansion than they would be comfortable with and probably for longer than they would anticipate. But at the end of the day the economy will probably continue to expand. And when I say structural growth, let’s keep in mind that people are born every day. So the population of both the United States and Canada is increasing. So while we’re not buying more milk or we’re not buying more potatoes there are more people buying milk and potatoes. So you get natural growth that way. Households are still being formed, people are still graduating from university and getting jobs, people are still making pension plan contributions, RESP contributions, RRSP contributions, IRA contributions. That natural capital formation makes its way into the capital markets, not dollar for dollar but it does make its way into the capital markets and that pushes asset values. We’re seeing that right now. Don’t forget that there is also immigration. So there is natural structural economic growth that’s taking place in North America that should keep us onside.
Q: Changing gears slightly, how do you find and source your investment ideas, Dennis?
A: We don’t use screens. We’re pretty old school in that we just we assemble a list of companies and then we just do a lot of work on them. So when I started in this role 6 years ago I simply took the entire Canadian REITs and REOC universe and tackled them sector by sector. So I believe I started with multi-family and I took all of those companies and one by one I went through all their financials, built out models on each of them, decided whether or not this was an A B or C company, decided how much risk there was involved in investing in them and then I’d find a return hurdle to them. And I did that for – now we’re probably working on 200 companies. That’s what we do and we focus on the riskiness of each investment.
I know when I’m on BNN everyone asks about target prices and what things are worth. We start by identifying how risky something is and we measure that by cash flow volatility, cash flow quality, and cash flow duration. So if you’ve got a triple A office tower 100% leased to Encana (ECA). Let’s use H&R’s Bow as an example, you’ve got a brand new triple A luxury office tower in one of the big 6 markets in Canada, a 20 year lease to Encana. You know, there’s very long duration of the cash flow, good quality is coming from Encana and Cenovus (CVE) and low volatility in that that building is 100% leased for the next 20 years. So that’s something you ascribe a lower risk hurdle to. Now if you’ve got a limited service hotel in Fredericton and there isn’t much differentiating it from the other 8 or 9 limited service hotels, well, that’s short duration cash flow, it’s low quality and you know it’s prone to be much more volatile than even office. So that you’d ascribe a higher risk hurdle to, and when you’re looking at returns out of that type of investment, you’re going to want more return to justify the increased risk you’re assuming. So we’ve done that for about 200 companies. The good part is that most of the heavy lifting is done and you really only need to do that heavy lifting again if somebody changes materially and by that I mean they sell you know a material portion of their business or they acquire a material new business or if there’s an IPO. And so since we’ve identified the risk of most of these companies and we’ve assigned return hurdles to them, it really then just comes down to monitoring them, and buying them when they offer sufficient return for the risk you’re taking on and selling them when they don’t. So we’re pretty old school from that standpoint. I don’t take a lot of shortcuts in terms of screens or anything like that. You know we consult with the analysts on the street who who set target prices and so forth but our discussions more have to do with you know, you’re at 27 on this name and I’m at 24 – what are you using for an NOI (net operating income) margin, what are you assuming for new development, what are you assuming for same property NOI growth, those are the discussions we have as opposed to what do you like or what sector do you think is going to do better, that sort of thing. We have much more in depth and insightful, I think, discussions with analysts around names.
Q: Okay, say you’ve done your research on a company and you like it. Firstly, what is a full position in your portfolio? Secondly, do you scale into your position (for example: maybe take an initial 50% and then wait for your thesis to play out and follow through with the remaining 50%) or do you take a full position right away?
A: I believe in running a concentrated portfolio. I think studies show that the benefits of diversification begin to diminish at 25 names. Just from staying on top of names, really knowing them cold, I don’t think you can carry around more than 40 or 50 names in your head to that degree. So you know, I just think it makes more sense to put money into your 10 best ideas rather than to put money into your 40th or 50th best idea. So, I generally only have between 20 or 30 names in my portfolio at any one time. We have a rule of thumb where we go and see 60% of the value of real estate of anything we own so that requires us to go out and see the real estate, we meet with management, we build our own models. When you do that amount of work you’ve got a very high level of conviction and you don’t go out and buy 50 or 100 basis point weights. When the return you’re being offered justifies the risk you’re taking, we generally step in you know at the 4% level, and if something gets cheaper we’ll take the position as high as, well we’ve been as high as 9% in several names. On average any name in our fund will be somewhere between 4 and say 6%, maybe 6.5 and it really just depends on what the quality and the name is and the return being offered.
Q: What are some of the numbers and metrics that you look at when trying to evaluate a REIT?
A: In Canada we look at AFFO (Adjusted Funds From Operations). We model it out on an absolute basis but target prices are set based on per unit so a multiple of that. We also use Net Asset Values (NAV) so that’s basically a private market valuation, (what you think the portfolio is worth if it were to be privatized?). In Canada we focus on AFFO generally because Canadian REITs tend to pay out all if not even more of the free cash flow they generate. I shouldn’t say that. Most Canadian REITs target somewhere between 90 and 95 but I think the average payout ratio is probably 95 or a little bit higher.
In the United States we tend to focus on Net Asset Value. U.S. REITs tend to have much lower payout ratios and they tend to have much more complex business models so they’ll do more development, they will recycle their portfolio so assets will be sold once they’re 8 years old or once you’ve owned them for 8 years. That generates much more churn and turnover in their portfolios. There you use net asset value because it’s more of a value creation story I guess. But you also use free cash flow just as a sanity check.
In other markets it’s really a function of what real estate provides. In Singapore and Australia it’s more of a cash flow story, in let’s say Hong Kong or China it’s more of a value creation story, so you’ll use NAV or free cash flow metrics depending on which geography.
Q: Now say you’ve bought a company and you’ve done your due diligence, what are some of the red flags in the earnings or the operating results that would perhaps give you pause and make you re-evaluate your initial thesis.
A: The first thing we do is evaluate every company on 4 criteria: management, assets, payout ratio and leverage. So companies that don’t score at least a three out of four we won’t invest in period. So that usually takes care of most of it. Now, for a company to drop from 3 out of 4 or 4 out of 4, something material has to happen. It’s generally not just in quarterly reporting that does that. If a company makes a conscious decision to lever up and they make a number of acquisitions at high leverage then you can notice that trend happening and then you might sit down with management and ask them what their game plan is there. If a company decides that they’re going to enter into a completely new geography or a completely new sector then again, that’s something that you want to re-evaluate. Generally you are keeping track of the trends in your key metrics like net operating income, same property NOI growth, AFFO per unit, occupancy – these are the things that drive value and so you’re staying on top of those and if they do deteriorate then it’s time for a discussion with management.
Q: In an Investor’s Digest of Canada article, entitled ‘Investing in REITs – What you should look for‘ [PDF] that’s posted on the Sentry website, you articulated very clearly how you differentiate between risk and volatility. Do you want to maybe elaborate on that a little bit?
A: Sure. To us stock price volatility is not real risk. If my neighbor’s selling a whole bunch of Allied Properties because he needs to pay for his kid’s education then that might drive the price of Allied down but it doesn’t change the business materially. Conversely if someone comes into millions of dollars of inheritance and decides they are going to put it all into REITs that again doesn’t change the value or quality of the businesses even though their unit prices might pick up. Risk to us is a function of free cash flow. If your free cash flow is shorter duration than another company’s then that adds more risk. If it’s poorer quality – getting 10 dollars a square foot from Walmart is generally better than getting 11 bucks a square foot from Joe’s Pizza. When you are talking about stability, occupancy has a lot to do with that and that is usually a function of location. An office tower in downtown Toronto generally is going to be more full than the same office tower in Halifax or the same office tower in Flin Flon. So we look at those things and that’s how we measure risk. Stock price volatility is just your opportunity to deploy capital, either into the market or out of the market.
Q: You also mentioned in that article that the lack of volatility is also a great indication of mounting risk. Can you elaborate on that a little bit?
A: Once you get into complacency, once the VIX settles down below 20, what you find when those things happen is that it’s usually an indication that everyone has come to a consensus about what’s going to happen. You’ve got to keep in mind that the VIX is a measure of anticipated volatility going forward but you can see it in the current market. So if everybody thinks that REIT unit prices are going up then the VIX actually declines despite the fact that unit prices are going up because there isn’t up and down volatility, it’s all smooth volatility in one direction. Now when people start to get concerned or people take differing opinions, then stocks can be up one day or down another day and that forward volatility starts to pick up and you see it in the direct market in the spot price as well. So when people get complacent and everybody comes to a consensus I get concerned because usually that means the market’s going straight up or at least smoothly up. And at that point, if you’re taking in lots of capital, it becomes more and more difficult to underwrite 12, 15 and 18% returns. So at that point I get concerned. Now those time periods can go on for much longer periods than you would normally anticipate. Like I mean REITs right now are trading at 15 times free cash flow and arguably they should trade at a premium to historical valuations simply because fundamentals are much better than they would normally be. You’ve got high occupancy, record low interest rates and generally a stable environment. Now if we start getting to 16 and 17 times free cash flow multiples, I start getting concerned because those are historically high valuations, especially if the VIX doesn’t pick up or volatility measures don’t pick up. Conversely on the downside, when the VIX is through the roof and unit prices have fallen off their table, as long as the fundamentals in the companies themselves are in good shape, it’s a great time and you feel very good about putting capital to work for the most part.
Q: Dennis, is there anything in terms of topics that may not have been touched on but those that you find relevant to a discussion on REITs? You probably get a lot of questions asked of you in interviews but is there anything that you feel no one asks you or that you think should be put out there but isn’t?
We’ve posted some videos on investing in REITs and the Sentry REIT fund. The ones that are most popular are the ones about rising interest rates which you’ve asked, valuations which you’ve asked, outlook and how we value REITs. Those are the most popular videos. So that gives us pretty good real time data as to what is top of mind for people. So I think you’ve covered the things that people are most interested in right now.
Actually the only thing I would mention is multi-family. There seems to be a push on for multi-family right now and I’m not surprised. Five year mortgage money for CMHC insured properties right now is, I have one REIT telling me 2.75% and I have another company telling me yesterday 2.6%. So if you look at it and put it together, you’ve got apartments which are very stable, non-discretionary spending so the cash flow stream is pretty stable. You’ve got a bid for those assets and there’s very little supply. By bid for the assets I should say Transglobe Apartment REIT has come public, Boardwalk REIT, Northern Property REIT, Cap REIT, and Killam Properties all trade at pretty good premiums to historical valuations. You’ve had the purchase of TimberCreek’s REITs which is predominantly multi-family and you have a number of investors who are interested in the multi-family space. I should mention that ParkBridge Lifestyle Communities was also taken out by bcIMC, so that just adds to the list of people who are interested in multi-family. So that’s one trend that we’ve seen. We tend not to focus on sectors or geographies. Well run companies with good assets with low leverage and low payout ratios will trump any short-term sectoral or geographical advantage. The focus on the multi-family spaces is something current and topical that most people I guess wouldn’t have noticed or asked about.
Q: Since you mentioned the multi-family space, is there a stock that you like particularly in that space that you own? If so, perhaps you can go into a bit of detail about why you like it, the valuation, some risks.
A: I would say in terms of multi-family right now, Killam Properties (KMP:TSX) is probably the cheapest name available. Now the reason I say that is because we’ve recently reduced our CAP rate assumption there and increased our free cash flow multiple when we value Killam and part of that is fallout from the ParkBridge transaction. ParkBridge owns trailer parks, I guess the sector colloquialism for them is manufactured home communities.
The purchase by bcIMC was at a pretty high multiple, a very low CAP rate and if you’ll extrapolate that onto Killam then Killam is probably worth 14 bucks. We don’t do that straight extrapolation but we did you know raise our multiple and lower our CAP-rate assumption such that we think Killam is worth closer to 12 bucks. So trading at 10, it offers 20% appreciation and even if you buy it today you’re still getting a 5.6 % cash yield.
Q: Do you have one more pick?
A: Sure. For a more larger cap commercial name we’d look at H&R REIT right now and the reason we would consider H&R is because cap rates for office buildings are declining and they do have significant option value in the BOW development. So if they were to sell half of that they would probably be selling it at a 5 and change cap rate, whereas it was developed at a 6 and change cap rate. They’ve got some upside optionality there – they will probably sell half of that asset and redeploy the proceeds. Otherwise I mean they’ve given you, I think at the start it was an 18 month schedule for increasing distributions every quarter. So you’ll get a rising cash stream from that name and they have a great portfolio of assets. That’s a name right there where we think it’s probably worth around 23 bucks and it’s still trading just below 21. So there’s some upside potential there in terms of capital appreciation plus you’re getting a rising 4.2% cash yield.