REITs investor favours the U.S. over Canada

Specializing in global real estate, Timbercreek manages approximately $4.5 billion. Its mandates include the closed-end Timbercreek Global Real Estate (TGF.UN) and Timbercreek Four Quadrant Global Real Estate Partners, a private limited partnership.

At last report, as of March 31, Timbercreek Global Real Estate held 43.1% of its assets in the U.S. compared with 23.6% in Canada. Its top holdings included MFA Financial Inc. (MFA), a U.S.-based REIT that manages a portfolio of residential mortgage-backed securities, as well as Toronto-based Dream Global REIT (DRG.UN), an open-end fund that focuses on commercial properties outside Canada.

To a greater extent than in Canada, U.S. REITs cut their dividends during the 2008-2009 financial crisis. Russo says they did so not out of necessity, but to conserve cash flow in the event that they required capital to refinance mortgages. The income streams of most of these REITs were derived from pre-existing leases. So, despite the recession, the REITs’ cash flows were largely unaffected because tenants were already locked in.

In more recent years, with cash flow mostly remaining either steady or rising, payout ratios have become very low. So low, in fact, that in some cases they’ve reached the bare minimum threshold imposed on REITs by U.S. regulations. Russo says he expects earnings growth of 7% to 9% in the near term, which will compel REITs to increase their distributions significantly.

The financial crisis, says Russo, resulted in debt pay-downs that set the stage for favourable conditions for long-term growth in the U.S. REIT market. Initially, the lack of debt financing halted new construction and development, restricting supply. Then, as the economy recovered and corporate balance sheets strengthened, demand for commercial and industrial real estate far outpaced supply. This imbalance between supply and demand will lead to a favourable equilibrium and solid rental growth as vacancies continue to tighten, Russo says.

The REIT market in Canada never collapsed the way it did in the U.S. Consequently, says Russo, the U.S. is coming off of a lower base than Canada, in terms of valuations and rents. For that reason, he believes “the U.S. REIT market will experience above-average growth as it reverts to its longer-term trend line.”

In contrast to the U.S. market, Canada has long-term leases, so revenue growth tends to be flat. Because of the rates being secured in these leases, you will see limited growth opportunities in the Canadian REIT market, Russo says.

Another difference between the Canadian and U.S. real-estate sectors has to do with the ownership structure of real estate. In Canada, the majority of trophy properties, as Russo calls them, are owned by the large pension funds and insurance companies, which tend not to trade. As a result, the public equity markets have limited access to high-quality real estate.

However, in the United States this is not the case. For instance, Russo says publicly traded companies own 50 of the top 100 shopping malls in the country. This allows individual investors, via REITs, to own prime real estate.

Finally, in contrast to Canada, there are an increasing number of merger and acquisition opportunities in the United States. Large pension funds, private equity firms and other institutional investors such as Blackstone Group LP (BX) and Goldman Sachs Group Inc. (GS) are raising large amounts of capital to invest in real estate. However, they’re having difficulties finding high-quality assets. Consequently, they’re buying REITs.

Russo notes that Blackstone Property Partners LP bought Excel Trust Inc. recently, and Washington Prime Group Inc. merged with Glimcher Realty Trust, to name a couple of recent examples. He believes this trend will continue, creating more opportunities for investors in U.S. REITs to profit from M&A activity.