Active managers eyeing performance disparities across real estate subsectors

After lagging the broad market badly during a money-losing 2020, real estate equities appear to be on track for recovery this year as economies reopen and mass vaccinations ease the ravages of Covid-19. But the pandemic has accelerated property trends that were already under way. This has widened the performance disparities among subsectors, which include office, industrial, retail, apartments and seniors’ housing.

Along with emphasizing property types that they believe will outperform, active managers of real estate equity ETFs are taking advantage of their flexibility to invest outside Canada, citing benefits such as geographic diversification and the availability of specialized property plays that have no Canadian equivalents.

Eleven of the 16 Canadian listings of real estate ETFs are global or North American in scope. The other five, which track Canada-only REIT indexes, are all passively managed. Led by the $1.13-billion iShares S&P/TSX Capped REIT Index ETF, the domestic index ETFs hold two-thirds of the $3-billion total ETF assets in the category.

Lee Goldman, a senior portfolio manager with the Signature Global Asset Management division of Toronto-based CI Investments Inc., manages the $565-million CI First Asset Canadian REIT ETF, the largest actively managed ETF in its peer group. Its 10-year average annual return of 10.3% to Jan. 31 makes it the top performer of the four real estate ETFs with decade-long track records, according to Morningstar Canada.

Goldman cited what he views as the relatively cheap valuations for real estate investment trusts as further evidence of the case for a recovery. On average, Canadian REITs were trading at discounts of approximately 10% to 12% versus net asset value (NAV) in mid-February.

The current NAV discount compares with an average premium of around 2% to 3% historically, Goldman said. “It’s certainly not unprecedented where we’re trading now. But there haven’t been too many times where we’ve traded at a 10% discount to NAV, at least for an extended period of time.”

The risk of rising rates shouldn’t deter investors from this interest-sensitive sector, Goldman said. “Our overall thesis is REITs can do quite well even in a rising rate environment, if rates are going up in an orderly fashion and if they’re going up for the right reasons — basically because the economy’s doing well.”

One of Goldman’s favoured subsectors is multi-family housing. “We think that the apartment names have been unduly beaten up from a market perspective,” he said. The CI ETF’s recent top holding is Canadian Apartment Properties REIT (CAP REIT), Canada’s largest multi-family REIT. It’s one of several apartment REITs in the CI ETF’s top 10 holdings.

Despite concerns about the impact of rising unemployment, Goldman said rent collections for apartment REITs have been “almost completely normal” and vacancy rates have risen only modestly. Rent declines and vacancies have affected mainly privately held condo units in downtown cores, he added, while REITs’ holdings are mostly suburban and more affordable.

“We really don’t think there’s been any long-term impairment to the value of the apartment companies,” said Goldman. “And we think once things open back up, their occupancy will come right back up and market rents will come back as well.”

Among the CI fund’s newer residential holdings is the recent initial public offering of the Flagship Communities REIT. Though based in Toronto and listed on the Toronto Stock Exchange, the manufactured home communities that Flagship operates are all in the U.S.

Management of the Starlight Global Real Estate Fund also favours the apartments subsector, the fund’s largest weighting at 26% of the portfolio. “We’re big proponents of multi-family,” said Michelle Wearing, associate portfolio manager, global real estate, with Toronto-based Starlight Investments Capital LP. This is despite gloomy news of rising residential vacancies in major cities, falling rents and the risk of rent defaults, as well as reduced demand because of lower levels of immigration and student tenants.

“You’ve seen huge negative headlines that rents are down 20% to 30%, and there’s so much vacancy. That’s really not what we’re seeing in the public real estate space,” Wearing said. She noted that CAP REIT has reported rent collections “in the high 90s.” Killam Apartment REIT, another Starlight holding, reported receiving 99.9% of rents for its apartments in 2020.

By contrast, retail properties — particularly enclosed shopping malls that have been forced to shut down — have been hit hard. Retail real estate “has already been challenged for the past few years with a significant oversupply and a lack of demand, given the increase in online shopping,” said Wearing.

Within the retail space, Goldman favours the more defensive REITs whose shopping malls are anchored by grocery stores. Among his recent top 10 holdings is New Glasgow, N.S.-based Crombie REIT, whose anchor tenants include Sobeys supermarkets.

Retail malls’ losses have meant gains for providers of warehouses. “A lot of retailers, especially in North America, were not carrying enough supply within their supply chains,” and needed more industrial warehouses for their inventory, Wearing said. This theme is reflected in Starlight’s holding of San Francisco-based Prologis Inc., which Wearing described as the world’s largest industrial landlord. “That’s really the best way that we see to play the industrial space and the need for more space.”

Having a broad geographic mandate enables the Starlight fund to hold specialized real estate companies such as Boston-based American Tower Corp., which owns cellular towers, and Redwood City, Calif.-based Equinix Inc., the world’s largest provider of data centres. By investing outside Canada, Wearing said, “there’s a broad range of different sectors and niche asset classes that you can participate in, which over the past couple of years have generated higher returns than traditional office or retail.”

The office subsector is probably the industry’s biggest question mark, Goldman said, though rent collections aren’t a significant issue. What is uncertain is the pandemic’s longer-term impact on the demand for office space.

“I don’t think anyone really knows yet,” Goldman said. “I think the consensus is that there will definitely be more flexibility and perhaps a hybrid model going forward, in terms of people wanting to work a couple of days a week from home.”

The other subsector that has fared poorly is seniors’ housing, not because of rent collection but because of rising vacancy rates. Lockdowns have halted showings and prevented new people from moving in. “We’re still believers in the long-term value of seniors’ housing,” said Goldman. “But results will probably be a bit soft in the next couple of quarters at least.”

Sharing that view is Barry Morrison at Toronto-based Purpose Investments Inc., who manages the Purpose Real Estate Income Fund. “We believe office and health-care REITs will remain stressed on an earnings basis,” Morrison said in a February market commentary.

Morrison, whose fund invests in Canada and the U.S., expects continued strong earnings from providers of data centres and telecommunications towers. “These are the sectors that have thrived during the Covid lockdown.”