The real estate sector appears to have made a comeback, since the Real Estate Equity category returned 6.09% last year, after returning -21.91% in 2022, due largely to monetary tightening by central banks. However, Maria Benavente, a real estate specialist and co-manager of the gold-medallist 5-star rated $228.1 million Dynamic Global Real Estate Series F, maintains that the way ahead is still challenging although there is value in areas of the real estate market.
“The past two years have been extremely volatile for real estate securities, and so far in 2024, it’s no better,” says Benavente, vice president and portfolio manager on the equity income team at Toronto-based Scotia Global Management. Benavente, who shares duties with Tom Dicker, vice president and senior portfolio manager, joined the firm in 2016 after spending five years on the sell side as an equity research associate. “We have seen volatility come back. The obvious reason for this is interest rates. The fact that we don’t have clarity on what will be the direction of interest rates is leading to a lack of transaction activity on the part of players in the real estate market.”
A look at the so-called direct market, where assets are bought and sold, indicates that transaction volumes have declined 50-60%, depending on the property type and geographic location. “There has been very little price discovery,” says Benavente, referring to transactions that communicate commercial real estate values. “When buyers don’t have certainty around the cost of capital the bid-ask spread for assets remains wide and transaction volumes are depressed.”
Canadian Real Estate Volatility Nothing New
From a fundamentals perspective, Benavente points out, there are no concerns because real estate companies are still operating well. “It’s really all about the macro. So, when we are asked, ‘Is the misery around real estate gone’? I would say that for as long as interest rate volatility remains there will be volatility in the market. Once we have more certainty over the direction of interest rates that is when we will see price discovery and confidence will come back to the sector. We will see out-performance.” What happened towards the end of 2023, she adds, was just that. After being in a period when the market believed in a higher-for-longer interest rate environment, that view created a lot of pressure and negativity around commercial real estate. “That quickly changed when the Federal Reserve signalled cuts in the New Year and made the sector out-perform.”
Year-to-date (Feb. 20) Dynamic Global Real Estate Series F has returned -0.21%, versus -1.15% for the category. Over three-, five- and 10-years, the fund has been a top quartile performer and returned an annualized 3.76%, 3.94% and 7.06%. In contrast, the category has returned an annualized 1.49%, 1.82% and 5.13%.
High Yield Will Bring Investors Back
Overall, Benavente remains upbeat since there are some positive signs. “The portfolios of many companies are now generating very attractive dividend yields. And there’s growth. And they trade below what we think are the values of these platforms in the private market,” says Benavente. “It will lead to a wave of M & A [mergers and acquisitions] in the sector. That’s because there is that arbitrage between private and public markets. Once you start to see that kind of activity and deal flow, you will bring activity back into the sector.”
A good example of that occurred in January when Tricon Residential (TCN), a top holding in the Dynamic fund) was taken private by Blackstone Inc. (BX) at a 30% premium to their last closing price. “More of that is likely to happen and that will bring capital back into the real estate sector. Market conditions now are very good for that M&A story to play out. Availability of debt is still there, and financial market conditions are tighter. But capital is still available for well-capitalized players,” says Benavente. “Some REITs [real estate investment trusts] may have difficulty growing portfolios from here on, so that will lead to more consolidation within the industry. That should be positive for public-listed REIT valuations.”
As for the highly visible signs of empty office towers in major downtown cores, Benavente acknowledges that the sub-sector is still suffering, and she and Dicker have a minuscule 1% exposure there. “As long as we don’t see a recovery on leasing volumes, and vacancy rates remain at all-time highs, we believe it will take some time to work through the excess inventories in the system,” says Benavente, adding that regional banking crisis in the U.S. last year has also hit the office sector in that country. “You are starting to see more defaults and delinquency rates are going up. The laggards that were in trouble have been able to extend and modify their loans with regional banks. That short-term fix is gone. More likely, they may have to foreclose on more properties. There is a lot of stress facing those landlords and fundamentals are not getting better and many have too much debt. We will continue to be under-weight until we see some stabilization in that area.”
The Recession Wild Card
Meanwhile, Benavente is reluctant to comment on the much-predicted recession at home that has yet to materialize, and possibly send tremors through the industry. “There is always a probability of a recession, but it is extremely hard to time it. Most economists have been wrong about it,” observes Benavente. “The probability of a recession is something we always build into our modelling and analyses. But we clearly don’t time when it may happen. We don’t make investment decisions trying to time a recession.”
If there was a recession, it would not be good for real estate because it would impact the sector negatively. “Job growth is very important for the sector. So, under a hard landing scenario, that’s where real estate would be impacted negatively. But I don’t see that happening in the near term,” says Benavente. “I subscribe to the soft landing scenario. But it’s really hard to predict based on a macro forecast. We look at the fundamentals themselves and invest that way.”
A bottom-up investor, Benavente favours companies in the residential and retail sectors, since they account for 26.4% and 18.5% of the portfolio, respectively. There is also 15.8% in industrial, 10.5% in communications and technology, 8.9% in healthcare and 8.1% in self-storage. From a geographic standpoint, Canada accounts for 44.2% of the portfolio, while the U.S. represents 41.3%. There is also 12% in international markets. The fund generates a running yield of 3.9%, before fees.
Top Canadian Real Estate Picks
In searching for holdings, Benavente looks, first of all, for growth in rental income and its direction. “We tend to focus on the long term path of market rent growth and then we narrow the focus on which companies are best positioned to capture that rent growth, with a lower cost structure,” says Benavente. “We look for the property type that is best positioned from a supply-and-demand perspective, which will lead to market rent growth. Then we ask who, in that sector, is best positioned to capture that rent growth, at a better margin,” says Benavente, adding that the team also pays attention to the structure of a firm’s balance sheet and its need for capital. “Real estate is a very capital-intensive business so in times of stress it’s the structure in which the properties are held that can really hurt you. We pay a lot of attention not only to the assets but ask ourselves what kind of structure they are held in and how much floating debt is in that vehicle. We also look at how management is incentivized to drive returns.”
One representative holding in a fund with 60 positions is RioCan Real Estate Investment Trust (RIOCF), which is the largest owner of shopping centres in Canada, as well as a growing apartment division. The retail sector was held in suspicion for a long time because of the fear that so-called brick-and-mortar shopping centres were doomed to fail due to the rise of e-commerce. “We saw capital effectively leave the asset class. Then the pandemic stressed many tenants and you saw some vacancy challenges. If you fast forward three years after the pandemic what has happened in this environment is that retailers have actually realized they want to operate an “omni” channel strategy,” observes Benavente, noting the integration of various marketing channels under one roof.
“Leasing has remained very strong and no capital is chasing the asset class so that supply has been maintained at a minimum. You are now in a perfect market environment where occupancies are at all-time highs and the leasing environment is healthy.”
Firms like RioCan have pricing power, Benavente argues, because they control the best shopping malls, and are benefitting from population growth. “On top of that, you can get a 6% dividend yield, with growing dividends. They just increased the dividend by 3%. RioCan also trades at a 20% discount to net asset value.”
Senior Homes Supported by Demographic Shift
Another favourite is Chartwell Retirement Residences (CWSRF), the largest provider of retirement housing in Canada, which serves about 25,000 seniors. “The pandemic represented a big hit for the whole seniors housing industry and it lost significant occupancy. But if you look at demographic trends you are finally seeing an acceleration of senior population growth. Occupancies are turned round and Chartwell is gaining occupancy quite fast and it is seeing organic growth.”
To boot, the labour market was stressed during the pandemic and many companies had to use so-called agency labour and temporary workers that were significantly more expensive and put pressure on their operating margins. “All those issues are behind and you are in a position where you will be able to drive occupancy and drive margins higher. Chartwell will have one of the best growth rates for the next few years. We believe it’s a very attractive growth story.” Chartwell yields about 5% and the stock trades at a 5% discount to its intrinsic value.
Looking ahead, Benavente argues that if there is consistency of earnings and values start to trough and potentially accelerate again, that will bring investors and capital back into the sector. “Real estate securities represent one of the most under-weighted sectors for mutual fund investors,” admits Benavente. “But if we start to see stabilization of earnings and interest rates, we may see that under-weighting by general investors narrowing, and we may see slow movement back into the sector. That should be a positive for real estate.”
