Michael, just to start off, I know you sound quite upbeat on REITs, especially given their recent pullback. But let's start with your view on interest rates, since that's very key. Higher long term rates generally puts downward pressure on REITs. When do you think rates will see another significant bump up?
Hi Darcy - thanks for having me here today. We expect the 10 year US government bond yield to find a new range around 2.5-3% but wouldn’t expect it to go much higher. The US Federal reserve still has certain goals (unemployment of 6.5% and inflation above 2%) that they would like to achieve with their current easing program. Rates that go materially higher than 3% likely would likely hinder their ability to achieve those goals.
So, considering that view, are REITs oversold given the recent pullback as investors got spooked by the sudden rise in US yields?
Global REITs are digesting a new level for interest rates and this uncertainty will likely lead to elevated volatility in the sector. Investors will have a tough time pricing REITs in this type of an environment. Canadian REITs are currently pricing in about a 3-3.25% 10 year bond yield today vs. the actualy bond yield at closer to 2.5%.......
In Canada we are trading at close to a 10% discount to NAV (historically the sector trades at around a 5% premium) and at close to historical free cash flow multiples (15x) but the sector is still delivering above average free cash flow growth of 5%. WIth free cash flow growth expected to stay steady we feel these valuation levels look attractive.
And how do valuations, especially discount to NAVs, appear right now for US and international REITs. And, related to that, where are the best deals right now for REITs: US, Canada or globally?
After this most recent pullback Canada looks relatively attractive when compared to global REIT markets. Most developed country REIT markets are seeing the sector trade closer to NAV rather than at a discount. We evaluate businesses individually and see opportunities in Canada, US, Europe and other markets where free cash flow growth is expected to be above average and high quality REITs are trading at discounts to NAV.
Sounds comforting to all us Canadian REIT investors. Let's open this up to questions now, starting with Emile
Chartwell REIT is a company that has improved greatly over that last 3 years. They have simplified their asset base and improved their balance sheet and payout ratio. They also have room to grow on occupancy and free cash flow growth going forward so its a name we would comfortably own.....
It is an important point that Seniors Housing is an operating business. In evaluating our investment options we always ensure that we are compensated for the extra risk we are taking on in investing in a company like Chartwell vs. a traditional REIT. Chartwell is one of the best operators in the country and for that reason we don't have much of a concern on that front.
Our portfolio is currently tilted towards REITs that have sustainable capital structures that will be able to generate above average free cash flow growth through internal activities such as development/redevelopment, occupancy gains and rental increases....
In Canada one of the names we think offers value here is Boardwalk REIT. Boardwalk is an apartment REIT that has a strong well-aligned management team, should deliver above average free cash flow growth, has a solid balance sheet and low payout ratio. It also is trading below its Net Asset Value today.
That is a great question. I touched on this a bit earlier but in this environment we would be looking towards those REITs that have strong balance sheets without a need to access the capital markets (equity or debt) to fuel its free cash flow growth.....
We think the capital markets are going to be more challanging for the REIT sector going forward than they have been over the last 2-3 years and in that environment external growth opportunities such as acquisitions may slow down or be less accretive to free cash flow.
Healthlease Properties REIT is a recent IPO that had done fairly well until more recently as it has come down with the rest of the sector. Their focus is on skilled nursing and retirement facilities in the United States. The management team is aligned with investors and highly focused on growing the REIT through developments and acquisitions....
The distribution and balance sheet are both sound so we would not be concerned there. Growth may slow as access to the capital markets becomes more difficult but we don't see too much risk in the business that is in place.
This is a very good question as well. The calculation of AFFO (or free cash flow) has been a matter of debate in the sector between analysts, management teams and investors for some time. This is why we build our own models to determine what the value of a business should be independently. When calculating AFFO we usually include any cost that it takes to run the business, including managemnt compensation.
And another question from Jeff:
Thanks for all the questions Jeff. We make sure that we keep a consistent eye on G&A margins and monitor any discrepencies that wouldn't make sense. It's also important to keep in touch with management teams and ask difficult questions to make sure you know what is being included in each line item.
Back to more macro questions now....and this one from Stuart
The sectors that are most sensitive to economic growth (up or down) are those that have the shortest lease terms. Lodging and Apartments REITs would likely be the fastest benificiaries of increasing economic growth. In the Sentry REIT fund we evaluate business prospects individually rather than focusing on sectors but if we see above average free cash flow growth going forward we would consider individual businesses within those sectors.
We don't currently favour any subsectors and our relatively diversified across all asset classes. Our investment philosophy focuses on identifying businesses that have sustainable capital structures, well aligned management teams and assets that have enduring value regardless of the subsector ....
The US real estate market is recovering fairly rapidly and many of the Canadian REITs with assets there are seeing the benefit of this. Our preference is to own US REITs that are listed in the United States as the quality of the assets and access to capital is much stronger than those listed in Canada.
We do consider DRIPs when evaluating a REITs AFFO (Free cash flow) distribution payout ratio. We prefer to see a payout ratio that is well below 100% regardless of how much of the DRIP is utilized by investors. We have not historically utilized the DRIP feature in the Sentry REIT Fund for the REITs that we own.
True North Apartment is also a new IPO. They focus on apartment properties in Canada and were successful at growing their portfolio before the most recent downturn. Apartments are very difficult assets to acquire in Canada as there is very little development and the acquisition market is usually very competitive...
Like any new IPO it may be difficult for them to grow if the capital markets become more challenging. It is a name that will likely provide stable cash flow but you may have to wait to see any further growth through acquisitions until the units recover.
We haven't historically owned any of the Morguard entities as we have found better value elsewhere in the REIT market. In terms of management, we were not able to see eye to eye with MRG management with respect to their acquisition strategy when they came to see us during the IPO roadshow....
Both names are trading at substantial discounts to NAV and MRT has historically traded a wider discount to NAV than most of its peers. I would attribute part of this to a management discount.
Two related questions now concerning Dundee, from jc and Emile
The fee structure in Dundee is different than those REITs that have an internal asset management function. Dundee pays a fee to the external asset manager in order to perform certain functions on behalf of the REIT. This should be a consideration when comparing an investment in any externally managed REITs to those that are internally managed.....
We evaluate managements track record of growing free cash flow vs. their capital allocation decisions to determine whether they have added value, whether internal or external. Dundee has improved the quality of their assets, reduced leverage and grown free cash flow over the past few years so we continue to hold the company.
On DI.UN, another more recent IPO, we are somewhat more cautious. DI owns office assets in Germany and has done a good job of acquiring new assets to reduce its exposure to Deutsche Post. That being said, they are waiting to hear back on lease terminations from Deutsche Post that could kick in next year and that is a risk. They should hear back by August 31.
CAP REIT has done very well at improving its net operating income margins and acquiring assets that been additive to free cash flow over the last three years. Their payout ratio and balance sheet are healthy and you could see another distribution increase soon. We are somewhat concerned with their foray into Ireland and don't really understand the need to do so. We have our eye on any future developments on that front and are hoping this is not the start of a trend.
Just time for this one last question from Rohan
Australia is a sector we have been paying more attention to over the last 2 years. Their central bank is one of the only in developed countries that still has room to lower their overnight lending rate to help boost economic growth. This should help REITs in Australia who are seeing somewhat stagnent fundamentals but improving capital conditions.....
The REITs are also starting to look more attractive vs. other yield options and have finally repaired their balance sheet post the financial crisis. The biggest risk here is a further drop in commodities (hurting job growth and housing) and any drop in GDP growth in China (a large trading partner).
Interesting. That's a REIT sector that's not too familiar to a lot of Canadians.
Well, with that I'm afraid we'll have to wrap things up. But Michael, the floor is all yours for any final comments you may have.
Thanks to everyone who tuned in. Today’s valuations in the sector are reflective of an uncertain interest rate environment but as we settle into a new range for interest rates we think investors will start to see value in the sector. Free cash flow growth remains above average, fundamentals like occupancy and rents are trending in the right direction and yields still look attractive relative to other income options.....
The health of the Canadian REIT sector is something that is consistently overlooked in an environment where the focus is on interest rates. The top ten names in our fund are 95% occupied. Distribution payout ratios in Canada are at less than 90% while in the US we are close to 70%... the lowest levels we have seen historically. Meaning your yield is safer and more valuable. The majority of your return from REITs historically has come from the compounding of monthly/quarterly income making todays investment opportunity even more unique.
Thanks Michael, some great insight today and a solid discussion. Just a reminder to all that we do these investing discussions at 1pm ET on Tuesdays at Inside the Market. We often don't have time for every question, so I'd suggest joining us early in the hour every week to increase the chances of your question being answered....
With that, thank you to all for joining us today. We hope you join us again on future Tuesdays. Bye all.