Is real estate investment back on track?

Real estate was at the epicentre of the 2008 financial crisis, Mitchell says, and highly leveraged companies in the real estate sector were hit harder than firms in many other sectors.

“But these [real estate] companies were not mortally wounded, and the sector overcorrected,” says Mitchell. “The recovery since March 2009 has been retracing much of the damage that was done. Now, we’re seeing that the disappointment from growth stocks has encouraged people to look at names that provide some yield. People are saying, ‘We want consistent, stable returns and income, and some knowledge of what we own’.”

Real estate investment trusts (REITs), he adds, have attracted older investors who need income.

Valuations for REITs as a group have rebounded from their lows in March 2009, when they traded at eight times adjusted funds from operations (AFFO), a measure of free cash flow. Today, according to Missaghie, REITs are trading at about 16.5 times AFFO.

But, Mitchell points out: “In June 2007, the multiple was 20 times AFFO. So, we’re nowhere near the peak.” Still, he adds, astute companies can use levers such as the falling cost of capital to generate strong cash flow.

As for risks, Mitchell notes that recessionary fears could pose a challenge, as they have in the past: “That’s our possible headwind. But the reason we’re pretty comfortable right now is that every central bank in the world recognizes that the biggest risk is deflation. And no government can afford higher interest rates. We forecast low interest rates for four to five years.”

From a strategic standpoint, Mitchell and Missaghie have put about 70% of the Sentry fund’s assets under management (AUM) in Canadian firms, 22% in the U.S. and 8% in cash. “We’re not stock-pickers; we’re capital-allocators and invest in businesses,” says Mitchell, adding that he and Missaghie use a style they call MAPLe – management, assets, payout ratio and leverage.

One top holding in the 40-name Sentry fund is Allied Properties REIT, the leading Canadian operator and developer of so-called “Class I space,” former industrial sites in many downtown centres. “We like [Allied Properties] because it is the only consolidator in the field,” says Mitchell. “[The firm’s management] can take their time, buy quality assets and grow the cash flow.”

The unit price of Allied Properties REIT is about $30.30; the units have a 4.3% distribution yield. There is no stated target.

One of the main drivers boosting the real estate sector is that supply of and demand for properties has generally moved back to equilibrium, says Steven Buller, vice president at Boston-based FMR LLC (a.k.a. Fidelity Investments) and lead manager of Fidelity Global Real Estate Fund.

“What kills real estate more than anything is overbuilding,” says Buller. “If you look at the countries with listed real estate stocks – the U.S., Japan, [Britain] or Canada – you don’t see a lot of new buildings. There are exceptions, of course. But you don’t see a lot of new supply, for two main reasons.”

First, notes Buller, rental rates don’t justify new construction. For instance, in the U.S., he says, “we are adding only 0.5% of annual new supply of commercial real estate, which is far below the long-term historical average of 1.8%.

“The second reason,” he continues, “is that construction is dependent on lending – and if there’s one area that banks don’t want to lend to in this risk-averse world, it’s commercial development. While developers can still get financing, they need far more equity to attract lenders than [they did] several years ago.”

Meanwhile, rental rates and occupancy levels are moving up again. “The fundamentals are OK,” says Buller. “But the other key factor is that real estate is an income-generating asset class. We live in a world in which interest rates are historically very low. With this environment, people who need income have looked to real estate to pick up income. In the U.S., for instance, the average REIT dividend yield is 3.4% – and growing. Companies are increasing their dividends in line with their cash flow. On a global basis, the yield is slightly less than 4%.”

Still, Buller says, REIT unit valuations have escalated to the point at which markets such as U.S. and Canada are on the expensive side, although Japan and Europe are on the inexpensive side.

“Over long periods, real estate securities deliver high single-digit returns,” Buller says. “Over several decades, there is nothing that indicates we should deviate from those types of returns. We’re back on track after the global financial crisis.”

A stock-picker who focuses on individual names rather than specific countries, Buller has about 48% of the Fidelity fund’s AUM in U.S. companies, 12% in Japanese firms, 8.5% in Hong Kong companies, 6.5% in British firms and smaller weightings in companies in other countries, such as Canada.

One of the top holdings in the 60-name Fidelity fund is Unibail-Rodamco SE, a Paris-listed operator of shopping malls in France, Spain and northern Europe.

“[This firm] has one of the most dominant regional shopping centre portfolios,” says Buller, “and a strong, tenured management team that does a very good job in repositioning its shopping centres for the changing retail environment.”

Unibail-Rodamco’s shares are trading at about 149.5 euros ($179.20) apiece and have a 5.3% yield. There is no stated target.

Another favourite holding in the Fidelity fund is Ventas Inc., a U.S.-based REIT that invests primarily in housing for seniors. Ventas units are trading at about US$65 ($65) each and yield 3.8%.

Tom Dicker, a portfolio co-manager at Toronto-based GCIC Ltd. and co-manager (along with Oscar Belaiche, vice president at GCIC) of Dynamic Global Real Estate Fund, also notes that falling interest rates have been a major attraction for investors.

“To the extent that real estate is an income-producing asset, and to the extent they are a replacement for bonds,” says Dicker, “as the latter has become more expensive, the relative attractiveness of REITs increases.”

Dicker adds that it doesn’t take much inflation to erode the return on a 10-year government bond yielding 1.5%-1.6%.

“Whereas, with a real estate investment,” Dicker continues, “not only are you getting significantly more than 1.6% but, if you own the right buildings, you will be able to increase rents over time at a rate hopefully greater than or comparable to inflation. You’ll be able to protect yourself against inflation.”

He adds that the better-quality REITs have a distribution yield of about 5.5%.

Still, Dicker concedes, the macroeconomic picture is uncertain: “A number of factors concern me. One is a large-scale banking failure in Europe. That would be negative for real estate because credit spreads would increase, and thus increase the cost of funding. Because of the leverage that REITs rely on, their cost of capital would go up and equity values could be impaired.”

In addition, Dicker cites economic weakness, prompted by worries about the unresolved “fiscal cliff” (which concerns several U.S. fiscal policies that are set to change on Jan. 1, 2013, and could affect the U.S. economy) and the worsening European malaise: “If there is a global slowdown, it could ripple through to Canada – and be negative for REITs.”

Although Dicker does not anticipate this will happen, he’s mindful that some negative impact already is emanating from Europe.

From an investment standpoint, Dicker and Belaiche employ a style they call QUARP – quality at a reasonable price. “We look for best-in-class managements,” says Dicker, “companies that have durable cash flows that can grow over time and [command] reasonable prices.”

Currently about 60% of the Dynamic fund’s AUM is in Canada, 26% is in the U.S., 2% is in countries such as Singapore, and 10% is in cash.

One large holding in the 50-name Dynamic fund is Simon Property Group Inc., the world’s largest real estate company, which owns major shopping malls and factory-outlet malls in the U.S. Simon Property’s stock trades at about US$159 a share and has a 2.57% distribution yield. There is no stated target.IE

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