The out­look is strong for multi-fam­ily res­i­den­tial prop­er­ties, which are ben­e­fit­ing from ris­ing de­mand and short sup­ply

Investment Executive - - FRONT PAGE - BY JADE HEMEON

Per­for­mance of real es­tate mu­tual funds is hold­ing up well.

de­spite a move to higher in­ter­est rates i n both Canada and the U.S., the per­for­mance of mu­tual funds in the real es­tate eq­uity cat­e­gory is hold­ing up well.

In the sec­ond quar­ter of 2018, ended June 30, ac­cord­ing to Morn­ingstar Canada, real es­tate eq­uity funds man­aged an av­er­age gain of 4.2% — bet­ter than the 0.4% de­cline in the in­ter­na­tional eq­uity fund cat­e­gory and the flat per­for­mance of the global fixed­in­come fund cat­e­gory.

Real es­tate eq­uity funds in­vest in real es­tate-based se­cu­ri­ties — pri­mar­ily real es­tate in­vest­ment trusts (REITs), which typ­i­cally pay a gen­er­ous, tax-ad­van­taged distri­bu­tion to share­hold­ers and usu­ally are re­garded as in­come in­vest­ments. But REITs’ val­u­a­tions can be hurt by ris­ing in­ter­est rates if yields be­come less at­trac­tive com­pared with other fixed-in­come al­ter­na­tives in a ris­ing in­ter­est-rate en­vi­ron­ment. REITs also tend to carry mort­gage debt on the prop­er­ties they hold, which can make them vul­ner­a­ble to ris­ing costs if in­ter­est rates rise.

Al­though REITs and real es­tate funds stum­bled when the 10-year U.S. T-bond yield rose to more than 3% last May, that bell­wether bond yield sub­se­quently dropped to 2.85% by mid­sum­mer and REITs have staged a come­back as fears have eased slightly con­cern­ing the pace of ris­ing in­ter­est rates.

Even if in­ter­est rates in both Canada and the U.S. rise a lit­tle more this year and next, they are not the only in­flu­ence on real es­tate in­vest­ments. Prop­erty val­ues and the abil­ity of own­ers to raise rents are af­fected strongly by eco­nomic strength. If in­ter­est rates are a re­flec­tion of a strong econ­omy, they are not nec­es­sar­ily a bad in­di­ca­tor for real es­tate funds, ac­cord­ing to real es­tate fund port­fo­lio man­agers.

“Ear­lier in the year, there was more fear sur­round­ing ris­ing in­ter­est rates or rates ris­ing too quickly, and the fear has dis­si­pated some­what,” says Lee Gold­man, se­nior vice pres­i­dent and port­fo­lio man­ager with Toronto-based Sig­na­ture Global As­set Man­age­ment and port­fo­lio man­ager of First As­set REIT In­come Fund. “The econ­omy is gen­er­ally do­ing well, and that’s good for REITs.”

Fund port­fo­lio man­agers such as Gold­man say the real es­tate out­look is par­tic­u­larly strong for multi-fam­ily res­i­den­tial prop­er­ties, which are ben­e­fit­ing from ris­ing de­mand and short sup­ply for rental apart­ments. These port­fo­lio man­agers also see op­por­tu­nity in in­dus­trial real es­tate that can sup­ply the ware­hous­ing and distri­bu­tion needs of the boom­ing on­line shop­ping busi­ness.

The First As­set fund in­vests across a va­ri­ety of prop­erty types, in­clud­ing res­i­den­tial (30%), re­tail (22%), in­dus­trial (15%), of­fice (10%) and some se­niors’ hous­ing. The fund holds sev­eral sig­nif­i­cant in­vest­ments in REITs that fo­cus on multi-fam­ily res­i­den­tial prop­er­ties, in­clud­ing Cana­dian Apart­ment Prop­er­ties REIT, Pure Multi-Fam­ily REIT and Kil­lam Apart­ment REIT.

“Multi-fam­ily has been strong across the coun­try, but es­pe­cially in On­tario and Bri­tish Columbia,” says Gold­man. “De­mand has in­creased, with lots of mi­gra­tion to On­tario, par­tic­u­larly. The short­age of sup­ply has been go­ing on for years.”

Toronto, for ex­am­ple, has a 1% va­cancy rate, but re­ceives 30%-40% of new i mmi­grants, Gold­man says. In ad­di­tion, sin­gle-fam­ily homes and con­do­mini­ums have been ris­ing in price, squeez­ing out some buy­ers and en­cour­ag­ing more peo­ple to seek rental hous­ing.

In in­dus­trial real es­tate, Gold­man says, much of the avail­able space is on the pe­riph­ery of ma­jor cen­tres, and “there’s been strong ab­sorp­tion with some­what limited new sup­ply.”

The na­tional in­dus­trial va­cancy rate of 4% is the low­est it’s been in 17 years, Gold­man adds.

“Land is ex­pen­sive, and zon­ing can be dif­fi­cult to get,” Gold­man says. “Rents are start­ing to go up, and that’s i mprov­ing the per­for­mance of in­dus­trial REITs.”

In in­dus­trial real es­tate, the First As­set fund holds Dream In­dus­trial REIT, Gran­ite REIT and Sum­mit In­dus­trial In­come REIT — all with most of their prop­er­ties in Canada — as well as WPT In­dus­trial REIT, which is listed in Canada, but has prop­er­ties across the U.S.

A pre­vi­ous top hold­ing, Pure In­dus­trial REIT, was the ob­ject of a takeover bid by New York-based global gi­ant Black­stone Prop­erty Part­ners LP, in Jan­uary. The pur­chase price rep­re­sented a 21% pre­mium to the mar­ket price, Gold­man says, cre­at­ing a juicy pay­day for the fund. The deal closed in May.

On the re­tail side, Gold­man says, there are some good names in Canada, but he is more selec­tive now, as the trend to­ward on­line shop­ping is a head­wind.

The First As­set fund fo­cuses on com­pa­nies with well-lo­cated ur­ban malls host­ing re­tail ten­ants that can thrive in the cur­rent en­vi­ron­ment, such as Win­ners, Cana­dian Tire and Dol­larama stores, as well as banks, gro­cery stores and gyms. Gold­man also likes real es­tate com­pa­nies with mixed-use de­vel­op­ments that com­bine re­tail with res­i­den­tial. Fa­vorite re­tail names in­clude First Cap­i­tal Re­alty Inc. and Crom­bie REIT.

On the of­fice side, the mar­ket is bi­fur­cated, with Toronto and Van­cou­ver en­joy­ing low va­can­cies and ris­ing rents, but Cal­gary and Ed­mon­ton suf­fer­ing high va­cancy rates and a “ten­ant’s rental mar­ket” as the lat­ter pair of cities strug­gle to re­cover from tough times in the en­ergy busi­ness. Gold­man likes Allied Prop­er­ties REIT, which is a niche player spe­cial­iz­ing in trendy “brick and beam” style of­fices con­verted from older build­ings in sev­eral cities across Canada.

“We’re po­si­tion­ing in real es­tate com­pa­nies that can grow at a pace that would off­set any in­ter­est rate in­creases,” Gold­man says.

DEAN ORRICO, PRES­I­DENT and chief in­vest­ment of­fi­cer at Toronto-based Mid­dle­field Cap­i­tal Corp. and port­fo­lio man­ager of Mid­dle­field Real Es­tate Class fund, sug­gests that real es­tate in­vest­ments can be valu­able port­fo­lio sta­bi­liz­ers for in­vestors be­cause of sta­ble cash flow and healthy dis­tri­bu­tions.

Un­like bonds, which pay in­ter­est at a set rate, REITs have the po­ten­tial to in­crease their dis­tri­bu­tions. Dis­tri­bu­tions usu­ally are more gen­er­ous and are tax­ef­fi­cient vs fully tax­able in­ter­est pay­ments on gov­ern­ment bonds.

Roughly 10%-15% of real es­tate ten­ant leases, on av­er­age, are re­newed ev­ery year, Orrico says. With the econ­omy in good shape, leases can be re­newed at higher lev­els and con­trib­ute to in­creas­ing REIT dis­tri­bu­tions.

“Tar­iffs and trade wars could af­fect eco­nomic growth and ac­tiv­ity, but that is not a ma­jor fac­tor to date,” Orrico says. “There is a cer­tain se­cu­rity of cash flow in REITs. Re­cently, peo­ple have been look­ing to l ock i n some of the re­turns they’ve made in growth stocks and are an­chor­ing their port­fo­lios with more de­fen­sive, in­come­ori­ented se­cu­ri­ties such as REITs.”

In con­trast to the First As­set fund, which fo­cuses on Canada, the Mid­dle­field fund holds 50% of its as­sets in Canada, 25% in the U.S. and 25% in Europe.

The Mid­dle­field fund’s largest mar­ket weight­ing is in multi-unit res­i­den­tial real es­tate in Canada and Europe. Ma­jor Cana­dian cities such as Toronto andVan­cou­ver are “hot,” Orrico says, but Ger­many also is ben­e­fit­ing from a favourable sup­ply/de­mand pic­ture.

“There’s a lack of sup­ply and grow­ing de­mand for apart­ments,” Orrico says. “A lot of mil­len­ni­als are happy to rent and walk to work. It’s a life­style de­ci­sion.”

The top hold­ing in the Mid­dle- field fund is In­terRent REIT, which has prop­er­ties in Toronto and sec­ondary cen­tres around south­ern On­tario and in the Ot­tawa re­gion. Other top hold­ings with a res­i­den­tial fo­cus in­clude Deutsche Wohnen SE of Ger­many and Pure Multi-Fam­ily REIT LP, which has prop­er­ties in the U.S. sun­belt.

The Mid­dle­field fund’s ex­po­sure to re­tail-fo­cused REITs is a more mod­est 5% of as­sets.

“Re­tail has been hit par­tic­u­larly hard in the U.S.,” Orrico says. “A lot of malls are an­chored by depart­ment stores at both ends, and on­line shop­ping has hit them hard. The Cana­dian mar­ket is not as ‘over­stored’ as the U.S. is.”

A top hold­ing in the re­tail prop­erty mar­ket is SmartCen­tres REIT, which has a port­fo­lio of des­ti­na­tion malls, value-ori­ented malls and mixed-use de­vel­op­ments that are pro­tected some­what from the on­line shop­ping trend.

Al­though there may be shrink­ing op­por­tu­ni­ties in tra­di­tional re­tail, the in­dus­trial real es­tate mar­ket is flour­ish­ing, Orrico says: “E-com­merce has been a good play for in­dus­trial space. It’s been the yin to the yang of the chal­lenges faced by tra­di­tional re­tail.”

Much like the First As­set fund, the Mid­dle­field fund owned shares in Pure In­dus­trial REIT, but since the Black­stone takeover, the Mid­dle­field fund gained ex­po­sure in the in­dus­trial mar­ket through in­vest­ments in Gran­ite REIT in Canada, Prol­o­gis Inc. in the U.S. and Se­gro PLC in the U.K. and Europe.

An­other key hold­ing i n the Mid­dle­field fund is FirstSer­vice Corp., a Toronto-based firm that doesn’t own prop­erty or act as a land­lord, but i nstead pro­vides prop­erty-man­age­ment ser­vices to the multi-unit res­i­den­tial mar­ket.

“[FirstSer­vice] is an un­be­liev­able growth story,” Orrico says. “A lot of con­do­minium build­ings are out­sourc­ing their prop­erty man­age­ment. FirstSer­vice is the largest player in the busi­ness.”

Un­like bonds, which pay in­ter­est at a set rate, REITs’ dis­tri­bu­tions can in­crease


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