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Real Estate Sector Update

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Equity analyst Brad Sturges joins the podcast to discuss the sector he covers, real estate, including:

  • The effects of interest rates and inflation
  • Update on REITs and REIT valuations and total returns beyond income
  • Update on corporate real estate
  • Comments on residential real estate

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Chris Cooksey: Hello and welcome to the Advantaged Investor, a Raymond James Limited podcast, a podcast that provides perspective for Canadian investors who want to remain knowledgeable, informed, and focused on long term success. We are recording this on October 10, 2023. I'm Chris Cooksey from the Raymond James Corporate Communications and Marketing Department, and today we are speaking with Managing Director and Equity Research Analyst Brad Sturges, who's joining the podcast to discuss real estate, including apartments, commercial, and of course, REITs. Welcome back to the Advantaged Investor Brad, I hope you had a great long weekend and enjoyed your turkey or tofurky, whatever your preference is, but coming back on a Tuesday of a long weekend, ready to discuss real estate.

Brad Sturges: Thanks, Chris, for having me. Lots of turkey, lots of stuffing and always excited about talking about the dynamic world of real estate. So thanks, thanks again for having me.

Chris Cooksey: Cool. That's awesome to hear. And obviously, as you mentioned, a lot's going on, so we'll jump right in and let's just start with sort of interest rates and how that's affecting the sector you cover.

Brad Sturges: Yeah, so I guess to give you context, there is a long-term correlation between interest rates and the property yield or the cap rate that you would typically require as an investor, whether you're looking at commercial real estate or investing on the rental side in the residential sector. You know, a rising rate environment typically means you need a higher going in yield or cap rate. And so there is a positive correlation between those two metrics. But from a valuation point of view, there's like an inverse correlation. So, the higher the cap rate, the lower the valuation, when you think about it on a price per door, price per square foot metrics. So you know, there's been a rapid change in interest rates over the last several quarters. You know, that has resulted in lower transaction activity in the market as I think investors are readjusting to a higher cost of capital and there's been a more limited call it pricing discovery in the market.

So, it's tougher to get a gauge necessarily on what we're valuations have fully landed at yet or stabilized at. However, you know, we are expecting cap rates to rise. And we've seen a lot of that movement already. But the key offset to the, the higher yield or cap rate is, is how much rank growth are you getting in a particular market, in a particular asset class. And you know, the better rank growth prospects off at the, the higher cap rate or the higher interest rate. So, we really look at a couple of factors. What's that cap rate or yield spread over your cost of debt? But then what type of rent growth would you assume for that particular property or asset class?

And, and certainly, when you look at Canada, there's a number of strong, healthy markets with good fundamentals where demand and supply are being in favour of the landlord and a lot of positive demand drivers like population growth, job growth and certainly other economic indicators that suggests that fundamentals, I would say, generally speaking, are fairly positive.

Chris Cooksey: And how does inflation affect that? Obviously, we've heard, we've all seen the headlines out there - I was paying this, now I'm paying this, out there. Is inflation a real detriment at this stage or are you waiting to see the effects on that?

Brad Sturges: Well, certainly inflation rates have resulted in higher interest rates are debt costs and to try and slow down that overall inflation rate. You know, when you think about real estate again, there's you're getting inflation protection in those areas of real estate where the demand supply allows you to push through rent growth. So, we are seeing inflation on the rental residential side, the apartment side, where you know, rent growth has been above your historical kind of inflation rate.

We've seen it also in other, in certain parts of the commercial real estate side, particularly when you think about industrial, we're not seeing it as much in office, but again, inflation on a long term basis tends to be positive for real estate because you are inflate inflation protected with rising rents. So you know, certainly if the inflation rates in Canada and globally start to get to target levels that actually might be a good thing in the short run, just given that might ease some of the pressure on the financing cost side and the interest rate side to allow for, I guess, transaction activity to start to occur in the market again, and to have less of that headwind from the financing costs perspective. But I guess short term, it's really about the pace of change. If you have a rapid change in interest rates, that offsets probably the benefits of inflation. But on a long-term basis, inflation tends to be, I think, a positive element for real estate, generally speaking.

Chris Cooksey: Now let's just touch on commercial corporate real estate. Obviously, the office towers are the ones that get the headlines a lot of times, and I know in Toronto, you know, where, downtown is not back to downtown at this stage of the game, and I imagine that's a fairly consistent story. So maybe just touch on some commercial real estate trends.

Brad Sturges: Yeah, I think you hit it on the head there. The office market gets a lot of the headlines, a lot of the attention. it's the most challenging part of commercial real estate when you think about the Canadian market or the Canadian story, and it's not just the slow return to office. We've seen a lot of new supply hit those markets Toronto, Vancouver specifically. In the last few years, so the result has been higher vacancy rates. Companies are only just starting to make decisions around their office usage. With respect to what type of culture do they want? How many days a week you're going to be in the office? How are they going to use that office real estate going forward? There's more availability and flexibility to at least different types of space. So, it's a much more competitive market when you think about the office real estate market. But I think generally speaking, what's being prioritized by office landlord, office tenants, users which impacts the landlords is amenity space is key. You know collaborative meeting spaces, ESG aspects are being considered in terms of choosing space, but there's really ultimately ends up being a flight to quality. So, the newer buildings that are more energy efficient that have more amenity space to attract tenants back into the office. That's generally where you're seeing a relatively more stable conditions, I guess, from a vacancy point of view, where the older, less energy efficient, less amenity package type of building has been much more challenged. So, you're seeing a bifurcation within the office market, and we think those are trends that will continue.

A lot of discussion happens around office conversion to residential, but we think that's actually a really small opportunity. It's very difficult to actually convert. There's not a lot of buildings that are easily convertible into residential because you need specific building attributes for that to work, and the cost really isn't that much cheaper than building new. So, we don't think that's as much of an opportunity, but you will see some selective conversions happening. Calgary tends to be the market where there is some incentives in place. We're seeing a little bit more of that activity. When you put office aside though, and you think about the other types of commercial real estate industrial and, for example grocery anchored retail, the demand drivers of that of those types of commercial real estate tends to be very different and the fundamentals are, it's a very different picture, much more positive when you think about industrial real estate where which benefits from e-commerce demand the manufacturing sector is getting a little bit of a resurgence, with reshoring of manufacturing back into North America post-COVID or changes in inventory strategy.

So you just need more storage in your warehouse for your for your goods because you're using maybe a just in case inventory strategy instead of just in time. So, and again, demand supply from a leasing perspective is very in favour of the landlord right now, which has given much better rent growth really, because it's partly a shipment of goods, whether it's in the industrial segment or even at the physical retail store. And when you're thinking about retail shopping centers, basically the retailers are investing both in the supply chain infrastructure on the back end of the warehouse, but they're also investing in takeaways from COVID that you're seeing more investment in both the physical store and the warehouse. And that's resulting in more demand for retail space and industrial population growth, job growth in the major markets. We've seen acceleration of population growth through foreign immigration in the urban markets. That's certainly a positive trend for both asset classes as well, and we think those fundamentals for industrial and grocery and retail, for example, will continue to be supportive given demand supply dynamics that allow for, for future rent growth.

Chris Cooksey: All right, now let's maybe move on to REITs and, and an update on that sector.

Brad Sturges: Yeah, I would say on the Canadian REIT side, it's generally been a tough or challenging market for the last six or seven quarters, given the rapid rise in in interest rates, certainly the public market tends to be forward looking and there's an expectation that private market values are going to correct by a significant amount and you know, so far we, we've seen more last year, but it's continued on into this year that REITs have sold off and have underperformed the broader TSX and the broader market.

But it's really name or stock specific where you're seeing very large differences in total return performance. We think overall the REIT sector still provides a value component in terms of income in terms of as a investment consideration for many investors we think the clean reads overall are still well positioned to grow their distribution incomes. Over time, particularly benefiting from rent inflation attributes to drive that cash flow growth. You know, we are very focused on certain asset classes and markets where we see the better opportunities, like residential and industrial. Certainly, over a long-time horizon, we think those income returns versus bonds, for example, can be meaningfully outperforming.

But we generally from the research side of things, we take not just an income view, but a total return perspective. And when you're kind of putting together a 6 percent yield in the sector today for what we cover in my coverage universe today on a 65 percent payout ratio, we think there's room for distribution growth. You're getting a 6 percent yield, plus we think the public REITs are trading at, call it, 25 to 30 percent below what we think the private market values of the real estate is today. And so, the combination of that could drive some pretty attractive total returns, as pricing discovery returns to the private market, allows us to better understand what that what those private market values are. Once that happens, we do think that's a catalyst for the sector to move back towards those private market values and see a multiple recovery above and beyond where they're trading today. But in the meantime, if you're thinking about some of the risks and concerns about the economy in 2024, we think the REITs are very defensive place to be in terms of contractual income in place very strong balance sheets, very high quality tenant base, both on the on the commercial side, on the residential side, opportunities for that cash flow growth, and certainly if there's a pivot in the interest rate environment, that could be a key cows for the valuations and see more fun flow back into the sector.

Chris Cooksey: I know one thing we say to investors, like when it comes to dividends during tough markets, is you get paid to wait, you're getting your dividend throughout it. Is that sort of a similar story to this? You're waiting for the value to come back, but you're getting your monthly or quarterly payout from the REITs and so that's why it's a strong consideration for portfolios?

Brad Sturges: Yeah, I would say you're getting generally paid to wait. You know I'd be obviously looking at the sustainability of that income. So, we look very carefully at what the balance sheet metrics are in terms of leverage in terms of the payout ratio their ability to grow cash flows based on the quality of the cash flows that are generating in the asset class, the market, the building type, all that. But generally speaking, we see a number of REITs that are trading what we think is below fair value here today for the real estate and you're getting an attractive call it again, 6 percent yield on average, for what we cover with still ample room to grow that over time, particularly as cash flow growth on a per unit basis is delivered over the next few years. I think that's a good way to summarize, you're getting paid to wait with the potential recovery over the next 12 to 24 months.

Chris Cooksey: All right. Well, residential real estate has been in the news a lot. We're not going to touch on family, single-family homes, but one thing that I noticed is that as condos grew in importance, the building of apartments seemed to stop generally speaking, I know the last apartment I lived was built in the seventies. It seems to be like there's more interest in apartments now, and I don't know if that has to do with the new federal program working with municipalities, but maybe just a comment on apartments in terms of residential real estate.

Brad Sturges: Yeah, I would say the most affordable form of housing is apartments. When you think about where mortgage costs are today versus a rent level a lot of the apartment stock in Canada is 40 to 50 years old. What do the apartment REITs that are publicly listed today, generally they're holding, kind of 40-year-old buildings built in, call it the seventies into the eighties, they're generally kind of old, larger units at a lower price for rent for per square foot in terms of rent and compared to where construction costs are today to drive, or require rents, to drive that construction, you're talking about a rent level of less than 2 square foot for the apartment rates on average, where new construction rents off across the country, could be in the high threes, low fours moving towards five. So, there's a quite a bit of delta gap between an older affordable unit versus what is kind of available on new construction. I think the incentives are starting to shift a little bit on the construction side to try and generate more demand for apartment rental.

As you suggest, there's still lots of condo construction in certain markets. There's condo construction still happening in Toronto, Vancouver but we are seeing an acceleration of construction on the apartment side. We do think the government, the federal government, but also working with both the provincial level and the municipal level, we've seen some positive shifts on a regulatory front that is allowing potentially to see some more construction happen on the apartment side with the move on the GST rebates, plus the expansion of the Canadian Mortgage Bond, and other incentives in terms of waiving development charges or providing lower cost of permanent debt financing upon completion, or even during the construction phase. All these are, are positive elements to try and lower construction costs. You're not requiring as high of a rent to drive that construction decision. You know, the reality is we need to build according to CMHC, three and a half million homes by 2030. And right now, if you just take the current construction pace, we're only going to build less than half of that. We're kind of on pace for 1. 5 million. We need to see an acceleration of construction of all forms, to be quite frank. The most affordable element to address the affordability crisis is going to be apartments. I think it's going to be a key part of it. And we think, today, the apartment sector that's publicly listed on the TSX, that they offer a lot of affordable housing options for Canadians, but they also have various forms of development programs. They have lots of intensification opportunities because of their large urban land bank that, whether they do it on balance sheet themselves, or they bring in partners, or they sell to developers, they are going to be a key component to helping the country address this crisis and we're really encouraged.

I think with the initial steps so far from the government's point of view to try and tackle the supply issue, I think there's still a lot of work ahead on that front. Clearly we think the apartment sector is going to be the most offensive piece of the housing market right now, because demand will likely stay in the apartment sector for more affordable housing relative to the single-family home market. I think that's a little bit more of a challenge, just given where mortgage costs are, but from an apartment point of view given the rank growth that you're seeing, the demand supply dynamics, where vacancy rates are less than 2% in place rents for REITs are 20% more below market, the organic growth prospects for the apartment REIT sectors is quite attractive, if you're thinking about it from an investment point of view.

Chris Cooksey: Awesome. Lots of great information as always, Brad, I hope you'll join us again soon.

Brad Sturges: Yep. Thanks for having me. I appreciate it as always.

Chris Cooksey: Alrighty, reach out to us at Subscribe to The Advantaged Investor on Apple, Spotify, or wherever you get your podcasts. Please contact your advisor with any questions you have. On behalf of Raymond James and The Advantage Investor, thank you for taking the time to listen today. Until next time, stay well.

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