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Approaching The Opportunities In Real Estate Investment

By: Tom Broughton & Michel Cormier

Investor interest in real estate as an alternative investment class is often triggered by volatility in the economy. But Penreal’s Tom Broughton and Michel Cormier suggest that it is a good investment class regardless the economic conditions.

The past few years have been difficult for most Canadian pension funds. With falling stock markets pushing returns into negative territory, many plans have slipped from healthy surpluses to deficits in just three short years. Moreover, a sluggish economic recovery, volatile corporate earnings, and geo-political risks have forced pension fund managers to lower their long-term return expectations for both stocks and bonds. Pension funds are responding to these diminished prospects by exploring investment alternatives that can enhance returns and reduce overall portfolio risk. Accordingly, most funds are taking a fresh look at the benefits of private real estate investment.

Since the start of the global economic downturn in 2000, private real estate has continued to generate healthy returns, bolstering overall fund results in a challenging investment climate (Figure 1). Real estate returns have also been remarkably stable, despite the volatile economy. For pension fund investors considering an allocation to real estate, the recent success of the asset class raises a number of questions including:

Real Estate Performance – Anomaly Or Intrinsic Strength?

Canadian investors’ interest in real estate has surged since the start of the equities bear market in 2000. However, private real estate has actually been a competitive performer for a number of years, earning an annual return of 11.4 per cent since 1998 and an 8.4 per cent return since 1985. Real estate’s strong results have been driven primarily by its stable income yield, which stems from diversified portfolios of mid- to long-term leases. Since the mid-1990s, real estate has produced higher income yields than stocks or bonds. Real estate yields have remained steady while interest rates have fallen and companies have reduced their dividend payments (Figure 2). In 2002, the income yield on real estate exceeded the yield on bonds by more than 200 basis points and outpaced the dividend yield by more than 600 basis points.

Real estate’s high income yields also offer protection in market downturns, reducing real estate’s risk profile. In the 72 quarters since 1985, real estate returns were negative in only 10 periods, compared to 16 for bonds and 22 for stocks. More recently, real estate returns have been positive in each of the past eight years, which partly reflects the industry’s improved fundamentals that have resulted from the growing involvement of pension funds. Institutional investors, in general, have a low risk tolerance and are much less likely to initiate speculative construction than the large developers that dominated the real estate industry through the end of the 1980s. Canadian real estate lenders have also enforced prudence by demanding larger equity requirements and pre-leasing commitments prior to financing. This increasing discipline is damping out real estate’s once notorious boom/bust cycle.

Another factor that reduces real estate’s risk in a pension fund portfolio is its low correlation with stocks and bonds. Since 1985, real estate returns have been essentially uncorrelated with those of stocks and bonds, allowing portfolios that contain real estate to significantly lower their risk for the same level of returns.

Real estate also offered more diversification benefits than bonds for portfolios consisting largely of stocks. Perhaps more importantly, real estate earned a positive return in 19 of the 22 quarters in which stock returns were negative, and in all 16 of the quarters in which bond returns were negative. Real estate investments also have the ability to protect pension funds against the risks of inflation. Real estate serves as an effective inflation hedge since, like most tangible assets, real estate values tend to rise in periods of unexpected inflation. Higher costs discourage new construction and, as a result, allow rents to rise higher before new, competing buildings are added to the market. These higher rents, in turn, lead to higher real estate values. Inflation protection is also inherent in most Canadian leases which allow increases in operating costs to be passed directly through to tenants. Furthermore, most leases include rent steps or explicit inflation adjustments that drive increases in property cash flows over time. These inflation protection features have led to healthy real returns, which have remained positive in 14 of the past 18 years and have averaged 5.8 per cent since 1985.

Looking Forward – Real Estate’s Prospects In The Near And Mid-Term

The real estate sector has not been immune to the damage caused by the ‘tech wreck’and the global economic downturn as higher vacancy rates have put downward pressure on rents in a number of markets. Nevertheless, Canadian real estate continues to perform significantly better in the current environment than in the recession of the early 1990s and, recently, better than real estate in the United States. The two principal reasons for property market resilience – besides the fact that the Canadian economic downturn has been relatively mild – are the continued absence of significant speculative development and low interest rates.

Development, and particularly speculative development, has been much more restrained in this cycle than in the previous one, reflecting the transparency and discipline that lenders and institutional investors have imposed on the industry. As a result, vacancy rates have remained well below the peaks reached in the early 1990s and are now beginning to stabilize as the development pipeline nears its end in most markets. Lower vacancy rates will allow rents to recover faster once tenant demand picks up.

Lower interest rates have also supported the real estate sector by allowing the owners of troubled properties to re-finance and avoid the distressed sales that otherwise depress overall values. Furthermore, historically low interest rates have encouraged REITs and private investors to capitalize on real estate’s positive leverage and become active buyers, further contributing to the resilience in prices. Although interest rates are expected to rise in Canada over the next 12 to 18 months, leverage (the spread between property income yields and interest rates) is likely to remain positive as the leasing market enters its recovery phase.

Overall, unlevered returns on core real estate should remain in the eight to 10 per cent range over the next year. Stable income yields of seven to nine per cent will continue to represent the largest component of total real estate returns, with capital appreciation limited mostly to high quality, bond-like properties featuring credit tenants and minimal near-term lease rollover.

Nonetheless, real estate returns remain vulnerable to either a double-dip recession or a spike in interest rates. In the event of a double-dip recession, a new round of corporate cost cutting would send more space back to the market, driving vacancy rates higher. The subsequent drop in rental rates would force values lower by, perhaps, three to five per cent, with income yields keeping total returns slightly positive. A rapid, unexpected increase in interest rates would put selling pressure on properties with high debt loads and vacancy problems. This would depress overall values, but may also give well-capitalized institutional investors the chance to buy high-quality properties at opportunistic prices. Both events represent substantial risks that investors must consider in any real estate strategy.

Do Opportunities Remain For New Investors In Real Estate?

Canadian pension funds’ equity investment in real estate grew from $14 billion in 1997 to $31.5 billion in 2002, which is $9 billion more than the combined market capitalization of Canada’s public real estate companies and REITs. This substantial investment by pension funds signifies a vote of confidence in the real estate industry and promotes the stability and transparency that institutional investors demand in an asset class. But it is also a source of concern for pension funds not yet invested in real estate as they question whether opportunities to acquire high-quality properties still exist.

In a current study, Penreal is estimating the size of Canada’s investable real estate universe and the proportions owned by different types of investors. The first stage of the study shows that pension funds control more than 20 per cent of institutional-quality office buildings in Canada’s six largest markets (29 per cent by area). Pension funds also hold 13.2 per cent of the retail properties across Canada (28 per cent by area).

These results confirm the significant role that pension funds play in the real estate market, but a closer analysis also reveals that opportunities still exist for those funds hoping to expand their portfolios. The forerunners in institutional real estate investment in Canada have been the large public funds, which tend to concentrate on trophy assets with values in excess of $50 million. Accordingly, pension funds control almost 50 per cent of Canada’s Class A downtown office space and 54 per cent of its regional shopping centre space, but hold a much smaller proportion of the country’s suburban office buildings and food-anchored retail centres. Moreover, pension funds still own a relatively small percentage of the national industrial and apartment inventories, holding approximately six per cent of the properties in each sector despite their attractive risk/return profiles. Quality properties in the food-anchored retail, industrial, apartment, and suburban office sectors usually trade for $5 to $25 million. This is the ideal transaction size for pooled funds, which are the vehicles that most small and mid-sized pension funds use to implement their real estate strategies.

Over the next 24 months, both financial institutions and the large public pension funds are expected to be net sellers of real estate. Financial institutions, particularly insurance companies, still own significant portfolios of high quality assets that may be sold in anticipation of broader consolidation in the financial services sector. The leading pension funds are becoming more selective in their acquisitions, having already assembled the country’s largest real estate portfolios. In fact, with the recent drop in equity portfolio values, the real estate allocations of several funds have run into the double-digits. As a result, the largest funds have started re-balancing their portfolios to focus on larger core properties or to achieve specific diversification targets. This should give smaller and mid-sized funds an opportunity to acquire properties in the $10 to $40 million range over the next few years.

Approaching The Opportunities In Real Estate Investment

For pension funds that may be considering adding real estate to their asset mix but do not have the internal staff and expertise in the asset class, the easiest route is through the use of an experienced advisor. Pooled funds, both closed-end and open-end, give smaller and mid-sized funds a chance to participate in a diversified group of income-producing properties. For investors with larger mandates, separate accounts are used to build diversified portfolios based on customized investment policies and strategies.

Over the past three years, directly-held Canadian real estate has proven its value in institutional investment portfolios, offering healthy returns and diversification benefits in a volatile economy. Real estate, like all other asset classes, remains exposed to the profound cross currents in the economy and global politics and, therefore, requires a conservative approach to underwriting and defensive management. Nevertheless, the prospect of high singledigit returns, coupled with the lower risk and diversification that result from long-term leases, suggest that real estate will continue to achieve the objectives of institutional investors.

Tom Broughton is senior vice-president and Michel Cormier is a manager at Penreal Capital Management LP, the investment management arm of Bentall Capital LP.

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