Real returns

(May 2006) Traditional asset allocation typically divides a client’s portfolio between stocks, bonds and cash, with some fine-tuning around allocations of global versus Canadian, small cap versus large cap, and growth versus value stocks.

Most advisors design their recommended portfolios around this approach for both funds and securities. What we tend to overlook is the opportunity to earn strong, reliable returns from commercial or multi-family residential real estate. That’s a mistake because investment-grade real estate should form a significant part of an investor’s overall portfolio. The focus should be on commercial real estate and not housing. Historically, this asset class has been limited to high-net-worth individuals and institutions, but the emergence of real estate investment trusts (REITs) during the past 15 years has changed that. Many REITs have done quite well over the last five or more years because of low interest rates, a strong overall economy, reduced vacancy rates and a desire by investors to acquire assets that provide relatively high cash yields, as well as options for portfolio diversity.

We’ve done a great deal for our clients over the past decade to create investment vehicles that allow them to participate in both commercial real estate and mortgage pools. Outside of REITs, there are not a lot of liquid real estate funds available to investors. Globe HySales reports only 11 real estate funds with a five-year track record and only three that have been around 10 years or longer. The Globe Peer Real Estate Index (made up of those funds) has averaged returns of 8.41% for 10 years and 10.52% for the five years ending in December of 2005. Interestingly, the 10-year results for the real estate index are almost the same as the returns for the Globe Peer Canadian Equity Index (9.27% yearly) but with less than half of the volatility. The Globe Peer Real Estate Index has a 10-year standard deviation of 6.15%, versus a 14.27% standard deviation for the Canadian Equity index.

A visit to the National Association of Real Estate Investment Trusts website (www.nareit.com) will provide you with data that shows overall returns in publicly traded real estate investment vehicles averaged 10% annually between 1971 and 2006. And they did this while offering relatively low levels of volatility. Let’s look at the investment vehicles we use for real estate. We do not use funds but we have acquired REITs for our own pooled fund. These include real estate limited partnerships (LPs), and mortgage investment corporations (MICs).

Both are exempt products issued with offering memorandums and designed for accredited investors. The MICs we offer have a minimum initial investment of $25,000 and the real estate partnerships require $100,000. These minimums are not based on compliance, but cost considerations. For clients who do not meet the British Columbia requirements for accredited investors, the minimums are $150,000. An accredited investor is defined as an individual whose net income before taxes exceeds $200,000, or $300,000 when combined with a spouse, in each of the two most recent years and who reasonably expects to exceed that net income in the current year. Rules are similar in other provinces, but discuss these products with compliance before proceeding to offer them to clients.

Currently all our MICs are RRSP- and pension-eligible, and we use them primarily in registered accounts since their entire return is interest income. They’re also ideally suited for donor-advised accounts.

The key features of MICs we use are as follows:

• They traditionally lend money for construction financing (usually as second mortgages). This makes them a higher-risk investment, although pooling the mortgages significantly reduces risk. Further, many newer MICs have developed lower-risk first-mortgage pools and other types of loans that provide greater diversification (with lower returns to reflect the reduced risk). One MIC we’ve used since 1996 invests in second mortgages and has produced an average net return after fees of 10.8% per year, with the lowest annual return being 5.6% in 2002.
• We work with two external managers who have created a number of mortgage pools with varying degrees of risk and return (see table below).
• We acquire units in those pools — one of the pools was designed exclusively for us and the other three are open to outside investors.
• The shares are priced at a fixed redemption rate (often $1 or $10). Interest is credited monthly or quarterly and can be reinvested automatically or distributed.
• Fees on these MICs are similar to F-class mutual fund shares at about 1% to 1.25%. The manager often has a hurdle rate, essentially a yield related to government bonds and the risk of the pool. If the net return is above that rate, then the manager can earn a percentage (often as high as 25%). For example, say you’ve invested in a first mortgage pool with a hurdle rate equal to a five-year Canadian government bond (assume that rate is 4%), plus 200 basis points (2%). That makes the hurdle rate 6%. If the manager earned 10%, then he or she would earn an additional fee of 1%, that’s 25% of 4% (which equals the 6% hurdle rate, subtracted from the 10% gross return). In many cases, if they fall below the hurdle rate their base management fee drops, in some cases by as much as half.
• Most MIC managers put a lot of their own capital in these pools and also are dependent on both relative and absolute performance for part of their compensation.

We also periodically offered specific syndicated mortgages from the MIC managers that clients would participate in directly. These are typically limited to minimum investments of $100,000. They offer both higher yields and risk and are therefore recommended for very sophisticated clients who have experience in this type of real estate lending. Typical current returns range between 12% and 20%, net of fees, and in most cases, the loans are for fewer than two years.

It can be argued that mortgage pools aren’t a true real estate investment any more than corporate bonds are an equity investment. These mortgage pools often provide higher returns relative to corporate bonds that have a similar risk level, but they also provide less liquidity. One advantage of mortgages is they’re secured by a specific asset that can be foreclosed upon in the event of default.

In February 2000, we put together our first real estate limited partnership with an outside partner who managed the project for our investors. Since then, we’ve acquired seven more commercial assets. Recently, we created a new limited partnership that has acquired two assets within one partnership and also manages a portfolio of mortgages with our MIC advisors.

We don’t consider commercial real estate to be a superior asset to a value-based equity portfolio, but it is complementary and often non-correlated.

While we’ve acquired a total of eight different assets over six years, we have also sold four of them because we were offered excellent prices. A client who bought an interest in each asset would have realized a net compound rate of return since February 2000, of 26% per year. Obviously this result was far in excess of what we’d hoped for and unlikely to repeat — another reason we sold some of the assets. However, we do look for buildings we can structure that meet the following criteria:

• Valued between $10 million and $40 million.
• Minimum client investment of $100,000 per LP (the largest single investment has been $1 million).
• Up to now we’ve focused on retail shopping centres and mini storage facilities but we would look at other assets, especially medical and dental buildings.
• Net income after all expenses (cap rate) between 7% and 8% in an interest environment where we can lock in mortgage rates for roughly 2% less. Our last project had a cap rate of 7.5% and a 10-year mortgage rate of 5.4%.
• Leverage between 65% and 70%, which allows us to earn a 7% to 8% cash return on invested equity and amortize the mortgage. This adds an additional annual return of between 3% and 4% of the original equity. We further project that over time rents will rise at 1% to 2% per year (lower than the anticipated inflation rate). Overall that gives us a net long-term Internal Rate of Return, after costs, of between 10% and 13%. While returns over the last few years were much higher, close to 25%, it’s always better to temper client expectations by telling them to expect 6%.
• We have partners who work with us to find the right assets, manage the properties and upgrade the quality of tenants (and by extension the income). We invest alongside our clients in every project.
• We have not considered individual housing, condos or multi-family residential because in virtually every case we’ve examined, the cap rates are below the cost of financing. This means we’d have to count on price appreciation to earn a return and we prefer to rely on cash flow.

Commercial real estate will go through performance cycles just like any other market. We view the assets we’re now acquiring as long-term holds. If cap rates rise and prices fall, then we’re well protected on our current buildings because we’ve locked in the financing. The key is the spread between cap rates and borrowing rates. We will not acquire an asset if the difference falls short of at least 2%.

We just created a new LP which has already acquired two buildings and several mortgages. From now on this partnership will acquire all future real estate assets for our investors (think of this as a type of private REIT). The pooling helps us reduce operational and legal costs, increase diversification, and allows for a limited form of liquidity as annual redemptions. (With our original LPs, liquidity was realized when an asset was sold.)

Real estate and mortgage pools are effective asset classes. Client needs differ, but overall there should be no difficulty placing between 20% and 40% of a portfolio in these types of assets. If you are considering offering such investments, you’ll have to be licensed to provide exempt offerings based on the requirements of your province of residence. If you aren’t licensed, you’ll need to work with individuals or firms that are and can provide the expertise you and your clients will need.

MORTGAGE INVESTMENT CORPORATIONS These instruments allow diversification of real estate holdings in registered and donor-advised accounts.
Type of MIC	Bancorp Select Income	Bancorp One	Harvard MIC	Bancorp Two
Types of mortgages held	First mortgages on income-producing properties with a maximum loan to value (LTV) of 75%	First mortgages on land being developed for various construction objectives, with a typical LTV of 70%	Second mortgages on income-producing properties, with an LTV up to 85%	Second mortgages (mezzanine financing) on development projects
Anticipated returns in current interest environment	5% – 6%	7.5% – 8%	8% – 9%	10% – 12%
Source: Nicola Financial Group, 2006

This article originally appeared in Advisor’s Edge. John Nicola, CFP, CLU, Ch.F.C., is chairman of Nicola Wealth Management, a Vancouver-based firm.advisorsedge@rmpublishing.com

(05/05/06)