Real estate investment trusts have come a long way from the cataclysmic days of early 2009, when valuations plunged and they were trading at a cash-flow multiple of eight times their adjusted funds from operations (AFFO). Today, says Dennis Mitchell, REITs are trading at a multiple of 16 times AFFO and represent fair value.
"Going back to 1998, REITs have traded at a historical average of 14 times," says Mitchell, lead manager of the $1.4-billion Sentry REIT and chief investment officer of Toronto-based Sentry Investments. "But look at the peaks and troughs. They traded as low as eight times in March 2009, which they didn't deserve, and up to 20 times in June 2007, when the market overshot on the upside."
The sector has lately had a good run, says Mitchell. "But a lot of that has simply been recovering losses that should not have been realized. Like an elastic band, the sector snapped back. What we have seen since then is an acceleration of cash-flow growth."
Indeed, he argues that the growth of distributions has led the sector to outperform the broader index. "It hasn't just been for the last three years. It's been almost since 1998," says Mitchell. "What it comes down to is that any company that can grow its free cash flow should be worth more year after year. What we've seen in the sector is strong cash flow for the last five quarters, including Q2 2012."
Mitchell uses a stock-picking system that goes by the acronym MAPLe, or management, assets, payout and leverage. That's brought him to RioCan REIT REI.UN, one of the fund's top holdings, which has a relatively high multiple of about 18 times. The key for him is earnings power.
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"RioCan has grown its cash flow significantly. The quality of the asset base has gone up and it has a long track record of compounding capital. It deserves a premium multiple," says Mitchell, who works closely with portfolio manager Michael Missaghie.
Despite being in a slow-growth environment, RioCan has been able to leverage its position, says Mitchell. This has been accomplished through higher rents, favorable debt refinancing, joint ventures and $1 billion in U.S. and Canadian acquisitions. "Put them all together and RioCan has generated tremendous cash-flow growth."
A Toronto native, Mitchell started out as a banker in the late 1990s and soon developed a passion for investing. After graduating in 1998 with a BBA degree from Wilfrid Laurier University, Mitchell worked as a financial advisor at a branch of Bank of Nova Scotia. His career took another turn when he read Buffettology, by Mary Buffett, the former daughter-in-law of Warren Buffett, and one of the first books to explain his value methodology.
"That book changed my life and gave me purpose. I grew up thinking I would play football for a living, but blew out both of my knees. Obviously, I had to find something else."
Mitchell started taking the CFA course and decided to leave the bank, enrolling at York University where he completed an MBA in 2002. Recruited by RBC, Mitchell participated in a leadership program that included asset management and equity research.
Mitchell didn't finish the program, however, because, on the strength of his research on business trusts, he was hired by Sandy McIntyre at Sentry. Although he was initially unhappy when told to cover REITs and infrastructure names, Mitchell grew comfortable with the sectors and was pleased to work at a value-oriented shop.
"I'm a deep-value guy and focus on risk-adjusted returns," says Mitchell, who has worked on the REIT fund since May 2005. In January 2007, he became lead manager. In January 2012, he was promoted to chief investment officer, from deputy investment officer.
Mitchell limits single holdings in the REIT fund to about 5% of the portfolio. Turnover was moderate last year at 54%.
Since June 2010, Mitchell has also managed the $99-million Sentry Infrastructure Series A. The specialty fund returned an annualized 13.4% for the two years ended Aug. 31.
The Morningstar 3-star-rated REIT fund has been in the first or second quartile over almost all periods. However, it had a very difficult year in 2008, plunging 42.7%, mainly because of losses on many smaller companies.
In 2009, though, the fund rebounded and returned 36.6%. Mitchell attributes the recovery to taking concentrated positions in about 16 names.
Looking ahead, Mitchell says the REIT sector is priced to deliver gross annual returns of 8-12%. That's based on a combination of 5% distribution yields, plus an estimated 5% cash-flow growth for next year and most likely over the longer term. The higher-return figure is based a relatively event-free marketplace.
Should interest rates rise, however, Mitchell acknowledges that REITs will underperform. "What concerns us is the operational impact. What does it mean to the ability to refinance debt, for instance?" says Mitchell. "We're more concerned about the cost of capital. That's what drives long-term value. Short-term trading on interest rates going up or down is not a concern."
