Last week's Vox column on real estate shares provoked a lot of reader response. The drop in value of these investments appears to be a mystery to many investors, given a stable rental market.
Vox asserted that one possible reason for the plunge in the real estate index - about 25 per cent - was that investors and lenders were getting a little more risk averse, and that these little changes in perception, when run through the complicated mathematics of real estate investing, produced big changes in value.
Not everyone agreed. Indeed, Dennis Mitchell, Sentry Select's man on real estate, wrote a long, e-mail debating some of the points in the column. We thought it might be interesting to put his arguments to task:
So what's your beef?Well, for starters, an internal rate of return is not the minimum return that an investor would accept on an investment. An IRR is the discount rate that equates the expected total cash flows of an investment (cash paid and received) to zero. You want the IRR to be a very high number so that there is maximum spread between it and your cost of capital, which is the interest rate on your debt and the cash flow yield on your units. Put simply, if the IRR is greater than your cost of capital, the investment creates value, so higher IRRs are better.
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That's a more technically correct answer, I'll give you that. But before our readers' eyes glaze over, let's call it a hurdle rate for simplicity. What else?
I heard Ric Clark, CEO of Brookfield Properties Inc., speak last week and he confirmed that credit is available but on less favourable terms this year. Higher credit spreads, lower loan-to-value ratios and more restrictive debt covenants mean that Brookfield's cost of capital has increased. In response, they have increased their target IRR for investments by 200 basis points.
So what does that mean for property prices?
Well, in the example you cited last week, the IRR falls from 15.5 per cent to 13.1 per cent. Assuming that Brookfield was interested in it they would still have bought it because it still met their minimum IRR threshold, albeit barely. If another opportunity presented itself with a higher hurdle rate, all things being equal, they would prefer that. Asset values would not necessarily have to decline for value-adding transactions to continue.
What makes you so sure?
Asset pricing is a function of cost of capital and return expectations. Both have increased, but arguably last year's costs of capital were so low that accretive acquisitions were everywhere. Now that costs of capital and IRRs have increased, accretive acquisitions are harder to find and in some cases asset values will decline materially. But I look out the window and the lights are still on in the office towers around me and the tenants are still paying their rents, so it's hard for me to believe that these assets have lost a quarter of their value.
So why is real estate falling?
I think REIT valuations have fallen because investors have linked Canadian REITs to the residential housing market and subprime issues in the US. Canadian REITs and their returns are not directly linked to the U.S. housing market. They own quality commercial real estate, predominantly in Canada, are generally prudently financed and the fundamentals in the Canadian real estate markets are far superior to the situation in the US.
Are Canadian REITs a good buy right now in general?
The Canadian REIT universe is trading at a 15 per cent discount to net asset value and offering forward free cash flow yields of 9 per cent plus. It is tough to find investments in the Canadian market that offer such compelling value from stable, long-term assets. I believe investors purchasing Canadian REITs today and holding for a 5-year period will be very pleased with their total returns over that time period.
Give us your names?
In this market you should focus on REITs that have the ability to generate strong internal cash flow growth. A small cap that we like is Artis REIT which owns office, industrial and retail properties in Western Canada. The strong western economy has fuelled demand for commercial real estate and Artis has leveraged this into impressive internal growth.
A large cap that we favour is First Capital Realty, which is actually a corporation. It owns grocery and drug store-anchored retail plazas in Canada's major markets and growing secondary markets. Its business model includes purchasing land for greenfield development and expansion as well as redevelopment of existing assets. While this strategy entails significant risk, management has a long track record of successfully growing cash flow in this manner and their 52-per-cent ownership stake in the company ensures that they are directly aligned with shareholders.
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