Christian Charest: For Morningstar, I'm Christian Charest. We're talking today with Corrado Russo, senior managing director and global head of securities at Timbercreek. The Toronto-based firm specializes in real estate investing and manages a retail mutual fund in Canada, the Timbercreek Global Real Estate Income Fund.
Thanks for being with us today.
Corrado Russo: Thank you.
Charest: So, earlier in January, Timbercreek released its market outlook for global real estate securities, and it's a very optimistic outlook. Can you explain to us why?
Russo: Yeah. I think REITs are setting up to have a great year in 2018. I think there's a few things that line up to make that possible. If we look, first, at the absolute valuations and how attractive they are, they are trading at roughly a 10% discount to NAV or for what the underlying assets would sell for in the private market.
If you look at relative valuations relative to equities, we have all seen what's happened to the equity markets and how they continue to go up. REITs have tremendously underperformed in 2017 by about 1,200 basis points, and that's after underperforming in 2016. And what that's done is, it's left us in a position where if you look at, say, price-to-cash-flow multiples relative to general equities, they are one standard deviation below where they historically have been. The last time we saw that was 2008-2009, which set up REITs to have a multiyear relative valuation outperformance over the long run.
I think if you look at the other things like dividend growth, we are expecting to see strong dividend growth continue, and what we have seen over the last three years to continue into the future. Interest rates, although 2017 was earmarked with the scare in the anticipation of rising rates, and I think that was part of the reason for REITs declining. But as we have seen in the past, a rising rate actually leads to outperformance from REITs, and it's one of the better places that you can be.
Charest: And that's an important factor for a lot of investors who are looking for alternatives for yield. Can you explain to us in a bit more detail why the real estate sector, and REITs in particular, do well in a rising rate environment?
Russo: Yeah. So, first off, if you look at perception of why interest rates are bad, if you look at how you value a piece of real estate, you take the cash flow stream and you divide it by your discount rate. And that discount rate, or cost of capital, is impacted by rising rates. So, if interest rates go up, the value of the real estate must go down. What that fails to include is what happens to the cash flow in a rising rate environment. And what we typically see is a rising rate environment is driven by strong economic growth, potential inflation, low unemployment and generally strong economic activity. Those things are all very good for real estate cash flows.
If unemployment is low, the economy is strong, it means there is more job growth. More job growth means more demand for office buildings and office space. That allows landlords to raise rental prices. If people are working more, consumer confidence is higher. They are spending more money in retail and shopping malls. If they are spending more money, there's more goods moving through industrial warehouses. There's more travel for leisure and corporate activity and hotels. So, generally, what you see in a rising rate environment is that the growth in cash flow offsets the potential impact from a rising rate environment.
Charest: Your retail fund is global in scope. Are there any countries or regions or even sub-sectors within real estate that you favour right now relative to their benchmark weight?
Russo: Yeah, for sure. There are a few. I think I will take that question in terms of countries and sectors together. And the reason I say that is, it's not necessary that we like an entire country, but we like specific sub-sectors within that country. For instance, we think there is an attractive growth opportunity within data centres in the U.S., so technology-oriented U.S. names like data centres or cell towers, for instance.
In Canada, we like REITs that have the ability to grow NAV through this ongoing urbanization trend that we see in Canada. So, as downtowns become more dense, then we have that live-work-play trend that continues. REITs have the ability to use excess land or to densify the buildings they have to create value.
We think European retail is another attractive place that you can put your money in for this year. We have all seen all the headline news with respect to U.S. retail and the potential impact from department store closures and online shopping. While a lot of that sort of fear has hit the European retail sector as well, and it's been painted with the same brush, it's very different than what you see in the U.S. One, it's one-fifth the amount of retail per capita than you see in the U.S., so way under-retailed relative to the U.S. And you get paid strong dividends while you wait for that to materialize, and retail shopping is part of the culture there, rather than in North America or the U.S. where it's about how do I most efficiently and cost-effectively get the goods that I need.
Charest: Corrado, thank you very much for sharing all your insights with us today.
Russo: Great. Thanks for having me.
Charest: For Morningstar, I'm Christian Charest. Thank you for watching.
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