Real estate investment trusts aren't the only small- and mid-cap equities that provide exposure to the property sector, observes Tyler Hewlett, lead manager of BMO Canadian Small Cap Equity. Nor, for the most part, are REITs the best growth opportunities, according to Hewlett, who is vice-president of fundamental equities at BMO Investments Inc. in Toronto.
"Traditionally we have not held a lot of REITs," he says, noting that the fund currently holds only one. "But we've found a lot of operating companies, so non-REITs, within the real estate sector," he says. "Several of our top holdings just happen to be in that sector."
The spinoff of real estate from the financial sector to its own sector on Sept. 1, 2016, made no difference to the BMO team. According to Hewlett, they're not very focused on what the benchmark holds or what their peers hold.
Yet the creation of a separate real-estate sector may be beneficial to investors in order to identify real estate companies. So much of the focus in Canada, especially in the large-cap space, is on banks and insurance companies, says Hewlett. The BMO portfolio has an approximately 12% weighting in real estate, with four of the five stocks invested in the operating area of the industry.
Among the non-REIT positions is FirstService Corp. (FSV), a Toronto-based service provider that operates mostly in the U.S. residential real-estate market. Hewlett notes that FirstService earns profits from two main business segments, one of which is cleaning and consulting services for the real-estate industry. The other main business segment consists of FirstService franchises such as College Pro painters, California Closets and a property-restoration business.
"FirstService has a great management team, and is a good allocator of capital," says Hewlett. As well, "they've grown by over 20% since 1995, about two-thirds of that organically." Hewlett thinks the company can continue to grow organically and through select acquisitions. He says that in the small-cap world, there tends to be a lot of growth through acquisition by consolidating fragmented businesses. FirstService definitely fits that scenario, says Hewlett, noting that last year it expanded into fire-protection services.
BMO Canadian Small Cap Equity's current top holding is Tricon Capital Group Inc. (TCN), a Toronto-based company that manages residential real estate. The company started out as an asset manager for institutional clients, and investing in development projects. After the housing crisis in the U.S. in 2008 and 2009, Tricon saw an opportunity to add value for its institutional clientele by investing in single family homes.
"As they started buying these houses, fixing them up and renting them out," says Hewlett, "they've made very good returns off that. They see it as an area of future growth, so I think now that's about 60% of their overall business." An acquisition earlier this year made Tricon a top-five player in the industry, and it achieved 13% growth in net operating income over the last year. "Those are very strong operating metrics in comparison to the industry," Hewlett adds.
An addition to the fund last year is StorageVault Canada Inc. (SVAUF), one of the largest public self-storage rental companies in Canada. "What we really like about the business is that it's another business with very high cash flow," says Hewlett. StorageVault has the ability to raise prices, and the average customer uses the storage unit for over a year. "Canada is behind the curve on consolidation in this very fragmented market," he says. "I believe it's been the best performing part of the real estate sector in the U.S. for many years now."
Looking ahead, Hewlett thinks the biggest risk to real-estate companies like Tricon, which are focused on U.S. residential real estate, is a downturn in the U.S. housing market. "Yet, most of these companies were around in the last real estate downturn," says Hewlett, "and came out on the other side in pretty good shape. They have managed to grow their businesses very successfully despite that."
Overall, says Hewlett, the "sweet spot" for the best investment opportunities in BMO Canadian Small Cap Equity are companies with between $150 million and $1.5 billion in market capitalization. The average weighted market cap in the portfolio is around $1.2 billion. "The research process begins with the qualitative aspects of the companies, before we even begin to crunch the data on valuation and future growth potential," says Hewlett.
The BMO managers seek companies with growth potential that can be profitable and sustainable for several years. Some holdings in the top 10 and 20 positions, says Hewlett, have been held for a decade or more.
