PARTICIPANTS
Tom Dicker
Guest Host, Vice President & Portfolio Manager
Maria Benavente
Vice President & Portfolio Manager
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Tom Dicker: Welcome to another edition of On the Money. I'm your host, Tom Dicker. I'm here with Vice President and Portfolio Manager Maria Benavente to talk about real estate. Maria is my partner on the Dynamic Global Real Estate Fund, the Dynamic Real Estate & Infrastructure Income Fund, and covering real estate for the Dynamic Equity Income Team generally. She's one of my favorite people to talk to about REITs and real estate investing.
Thank you, Maria, for joining me. I wanted to start today's discussion by going back. It's not obvious to me that someone who graduates high school in Ecuador ends up covering Canadian real estate in Toronto. Can you take me back? How did you come to Canada? How did you choose finance? How did you choose real estate investing as a career?
Maria Benavente: It's an interesting question that you pose. Obviously, coming from a country like Peru and Ecuador where there has been a lot of volatility and stability from a political standpoint and from an economic standpoint, there was always this need to create wealth to find stability and independence in my life. That naturally, and my interest to understand businesses and strategy, led me to a path to study finance. When I was in college, I decided to apply to Canada because Canada has this wonderful immigration program that really allows you to stay in the country from a permanent resident perspective and work here. I decided with my parents that we were going to pursue a better life in North America.
When I was in university, I had the fortune to be a part of a portfolio management program where I was able to invest in different GICS and get an exposure to different sectors and one of them was real estate. For me, it just clicked immediately that this need that I had for wealth creation and stability, you can really find it in real estate in a reliable and stable manner.
Tom: Remind me, didn't you have one of the best real estate analysts in Canada as your mentor when you were at Concordia?
Maria: Yes, you're absolutely right. When I was in school, they would actually pair us with mentors. I had the fortune of being paired with Heather Kirk, which was one of the best sell-side analysts in Canadian REIT space, and that's how I started my career in the sell-side research.
Tom: She hired you?
Maria: Yes, for National Bank Financial doing real estate investments in Canada. That's when my career started in real estate, and for the past 15 years, that's what I've done. Specializing in Canada real estate at the start of my career and then moving on to global when I joined Dynamic 7 years ago.
Tom: Canadian REITs are down 5% and a bunch more from their peak in February and they've underperformed the TSX so far this year. Can we get right into it? Why have Canadian REITs underperformed?
Maria: That sector has had a very challenging 18 months. This started in February of 2022 and the negative outflows out of the sector have just continued year to date. If you really drill down to what has happened, it is really mostly about interest rates. You can't have the 10-year do what it's done and not have a significant derate in the multiples and cap rate expansion in the space. If you see generally the fundamental side of things and operation-wise, we really haven't seen any material deterioration in fundamentals or a slow-down real estate deceleration or anything breaking down from an operating perspective.
Real estate has really done what it's supposed to do in inflationary environments, which is grow market rents at inflation or above. That's really what we've seen, same property NOI growth, which is essentially revenue minus cost, has continued to grow. In the US, it was on average 10% last quarter, in Canada, it was about 5% to 6%, so it's very solid growth. However, interest rates are creating pressure from higher refinancing costs and a transaction market that essentially has seen growth of activity.
If you go and see year-over-year transaction volumes in the actual, that is the physical assets trading and changing hands buying and selling, that's down 60%. That creates an environment where there's really not a lot of price discovery and for REITs just to trade without much inflow into the sector because you're just not seeing the typical M&A and IPOs and things that drive flows into the sector.
Tom: I want to touch a little bit more on the 60% reduction in transaction volume that we've seen so far this year. What is the reason that people aren't even really willing to trade properties?
Maria: A lot of the transaction activity or those peak volumes that we saw in 2021 was driven by private equity that was flush with cash and they were levered buyers. They were buying essentially with very cheap debt and financing was readily available, there was a lot of credit out there extended, and they were able to buy these properties and earn returns and they were trying to make the money that they have raised from institutions, they were trying to put it to work really fast. That has all unwound it as they are facing redemptions like you've seen out there in the media.
Blackstone continues for their non-traded REIT, continues to see redemption. Now that's slowing, which may be a positive but you're still seeing redemptions out there from private funds. Then you add to that the fact that obviously lending environment has tightened but certainly, lending standards are a lot tighter, and the cost of debt is much greater. Levered buyers have essentially disappeared from the market. That is creating a lot of a reduction in transaction volumes and deals that happen out there are really very selective and in its vast majority, they have some type of structure where the buyer is assuming a low-rate mortgage on the asset, and with concessions, they can make it work.
That is what is in the market today and what we're seeing, and that just feeds into the public market where we just are seeing constant outflows and not a lot of appeal from a generalist investor, which is a big like the marginal buyer of REITs, it's not really there. What you have is a market where it's essentially rededicated in specialists like you and I just trying to trade in and out of names that is creating widespread and a lot of bifurcation between performance of the different property types in the sector.
Tom: That'd be quite different from say, that period from 2010 to 2021 where there was generally a lot of money flowing into real estate both on the public market side, we were seeing funds flow into our funds and into the passive ETFs, but also private equity was seeing really big inflows. Then the third part of that was pensions were increasing their allocations to real estate. That seems to have paused at least so far this year. Do you think that that's mainly a function of interest rates that things have gone on pause? It sounds like the property fundamentals are still relatively stable, so is it that institutions are over-allocated? How do you think about that pause?
Maria: I think it's mainly interest rates. I think it's mainly the uncertainty that creates where our rates are going to stabilize, and we just haven't gotten a clear picture of that. It was interesting because Bank of America Merrill Lynch published a fund management survey not too long ago, I think last week, that showed that net positioning, which means the percentage of fund managers that are underweight real estate, it's at record net negative positions, which makes the majority of them are underweight. That is the same positioning that we saw in 2008.
That tells you how bearish the sentiment is from the asset class, and I think it is mainly driven by that uncertainty around interest rates. If you see valuations and where they are today, for the US REITs, they're trading about 20% discount to their net asset values, which is essentially a proxy to where private values are, and in Canada 20%-25%, which we haven't really seen since the bottom of COVID. There is certainly a lot of fear out there from the asset class. I think until we don't see at least some stabilization in rates or a clear indication that perhaps the tightening cycle is close to done, that will be the catalyst for the sector.
Tom: Sentiment is clearly very negative, and I would definitely second the idea that with positioning being very bearish, it creates a much bigger opportunity. When you look at valuations where they are right now, what do you think is being priced in? I know that that's a big generalization and it's going to be different from one stock to another or one REIT to another in Canada versus the US, but broadly, how do you think about what's being priced into the real estate market?
Maria: There's certainly more of a recession discounted in real estate than other securities out there. I think people are already looking ahead and forecasting a material deceleration in employment, the consumer weakening in the case of retail. Canadian retail real estate has never been better in terms of occupancy at record levels. 98% for many of these REITs, they're actually getting mark-to-market on rents.
Tom: What does that mean?
Maria: When they do a new lease, the increase that they're getting versus the in-place rent, it's in some cases over 20% whenever there's not a contractual or a fixed contractual rent increase. The portfolio is under-rented relative to the market and that just adds to a lot of visible growth, yet the stocks are down 10%-15% after a challenging year in 2022. You have some of these REITs with visible growth at record low vacancy rates trading at 11, 12 times. I think there is a lot of pessimism priced in out there. People are expecting the consumer to weaken, jobs to weaken. That's not happening in other areas like tech where there's more bullish sentiment out there.
Tom: Is the story in Canada fairly similar in the US?
Maria: It is. In terms of retail, I would say that we again are seeing record low levels of vacancy rates in the majority of the shopping centers, not so much in malls. Malls remains a challenged asset class, but the power centers, the shopping centers, those remain very attractive. The Wall Street Journal had an article, I think one or two days ago, talking about the net store count being positive. That is dramatically different to what it was in COVID and during those last couple of years, so you are seeing momentum.
You're seeing strength from a lot and it's like the demand is broad-based, so it's not really related to one group. You're seeing strength among different groups of retailers that want a physical store and physical space to operate in. That's obviously creating positive market rent growth in the states as well. It is a very interesting environment in retail where retailers have actually become stronger, and the centers are also in much better position.
Anecdotally, another thing that has happened that has been positive for this space is, as we all know, Bed Bath & Beyond went bankrupt and that would have traditionally been a very negative thing for this space. However, there has been excellent demand for those boxes where a lot of retailers have just essentially bought those stores out of bankruptcy and have created essentially no downtime for these REITs, so again, there again visible growth, and the stocks are not acting like it.
Tom: I want to talk a bit about apartments. The general consensus in Canada has been immigration is a good thing. That discussion seems to be changing after the massive surge in immigration that we had last year, I think it was over a million people, and it's now being blamed for things like housing inflation and inflation even more broadly than just housing. Can you talk about the debate around immigration in Canada right now and how does that impact Canadian REITs?
Maria: Obviously, I'm an immigrant myself, so it's a very easy thing for me to understand and see the positive things that immigration does for the country. We have an aging population. One in five people are closer to retirement than there are entering the workforce. We have low fertility rates, record low, I think 1.4. I think it is a very easy thing to see why we need immigration in this country from a productivity perspective.
That said, while I think the immigration policy has been the right one, the housing policy that came a companion to that immigration policy was not the right one. I think that the federal government has obviously not focused as much on bringing the right level of housing supply that the country needs to provide affordable housing for all of this immigration that is joining the country.
I think that's where we see the negative media headlines out there, especially going into an election, and obviously, there is a lot being done and being saved by governments, whether it's the municipal government, the federal government, provincial government, in terms of how to fix this affordability crisis. I think that a lot more has to be done in terms of collaboration between different parties and different stakeholders to get to the root cause and not only take reactionary measures like putting additional rent controls and things that really will not work.
We have different case studies across the globe in terms of like if you go to Europe and Germany and see how those markets have operated under rent control, they're having the same housing crisis and the same housing issues that we are in Canada. If you go and see in the US, the Sunbelt markets, unregulated markets, they just develop. With development, you self-regulate the market and they don't have an affordability issue a big as we have it in Canada. I think there is different ways and different policies that can be put forth in order to change what we're currently facing.
Obviously, with almost no supply coming into the market and with supply being extremely tough to bring and to get accomplished for many reasons, again, in terms of development charges, obviously cost of financing today is a bigger issue, and availability of labor, that benefits the incumbent landlords who have the mid-market product that everyone wants. We are continuing to see positive market rent growth and these apartment lenders are benefit from this very attractive fundamental and market environment.
Tom: Who do you mean by mid-market landlords?
Maria: The mid-market landlords would be like the publicly listed REITs. Think about CAPREIT, Minto, InterRent, they are the ones who own the type of inventory.
Tom: Can you talk a bit about how immigration has set Canada apart from other G7 or other developed markets in terms of growth for even the other sectors like industrial, retail, and so on?
Maria: Essentially demographics is the bloodline of real estate, and if you go see and you rank Canada against the US even, or the European countries, the population growth is much greater than other developed economies. That's obviously creating a very attractive demand profile for real estate. Again, we spoke just now about apartments, but if you go and see Canadian retail, which I've mentioned, and storage, if you think about population and demographic growth and housing and mobility of the population, that drives demand for storage as well and industrial in terms of consumption, more population means increased consumption. It is definitely a very positive thing for the Canadian economy and the Canadian real estate market.
Tom: It's been almost six months now since Silicon Valley Bank and a few other banks imploded back in March. Since then, commercial real estate has been a bit of a four-letter word. That's obviously gotten a bit worse recently with the recent move up in 10-year yields. What has been the impact so far in the US or in Canada, or elsewhere, and are there winners and losers so far from the Silicon Valley mini crisis we had?
Maria: You're absolutely right in terms of how much negativity this event has brought into the sector and the future of the asset class. There's no questions about it that it has certainly reduced availability of credit out there. However, I think the challenges are more specific to certain property types and I wouldn't paint everything with the same brush that lending has become tighter for the asset class as a whole, but rather the challenges that were happening going into the crisis were already exacerbated.
If you think about office, they were already in a downturn, they were already having pressures even before the US regional banks crisis. I think those issues just became more prevalent in terms of office is not only having an operational crisis, but it is also having a refinancing crisis. Office was certainly one of the losers from that event.
Tom: Is it possible that the worst is over? What's your latest view on office?
Maria: It's very uncertain still what will happen with office. I think every day you and I have conversations about this, we try to peg where the bottom is for REITs. The reality is that it's probably still too uncertain. I think there are certain positive or at least things that are not getting worse. Leasing is starting to stabilize at certain level, materially lower than it was pre-pandemic, but at least stabilizing. There has been a couple of trades out there highly structured and with some concessions given by the sellers but some transactions in the direct market that is properties trading hands have happened.
SL Green, which is a landlord in the US, sold a large property in Park Avenue in New York at about $2 billion in valuation. The headline cap rate was about mid-force cap rate. Obviously, like everything today in today's environment, you have to take that cap rate with a grain of salt because there was some debt that was assumed at a low-interest rate, and that it was a highly structured deal. The fact that that transaction closed, and it got done and it's such a big debt-like number, I think it really brought that question back to the sector. Are things getting better?
I think there's a little bit of green shoots happening in the office, but it's still too early to tell. I think a lot of employers are trying to unsuccessfully bring people back into the office. I think the mandates are changing and Labor Day is going to be one of those dates that will define again, yet again, whether employees comply or not. We're even seeing the tech firms that were notoriously saying that work-from-home works forever changing tune and saying--
Tom: Even Zoom themselves.
Maria: Yes, so I think there is a change in tone that could be positive for the sector, but again, too early to tell. What I would say is that while we are perhaps not as negative, we're also not positive on the asset class. If we're going to invest and we're going to add to exposure, we're still going to choose to do it with the lower leverage balance sheet names, the names that are perhaps not as much traditional office, but more niche place like think about lab space and things that are just not as exposed to the economy and to the work-from-home.
Tom: An area that we like with really stable fundamentals has performed even worse, and you know where I'm going to go with this. Cell phone towers have performed even worse than office so far. How is that possible?
Maria: I think it's obviously been a surprise for us to see how weak the towers have been. If I had to explain it, I think it was a couple of things that went against the towers. First of all, towers are usually viewed a recession trade. They have highly contracted cash flows that really shine in a recessionary environment. The fact that we haven't really seen a recession yet, or at least not a hard landing, has obviously been a negative for the towers in terms of fund flow because more cyclically levered names have seen more of the demands. Think about hotels, office even.
The other thing that I think has worked and I think I'll explain because this was a double pain for them was interest rates. Again, given that towers have a highly contracted visible revenue stream, and model, it tends to be more sensitive to interest rates. You add to that the fact that their largest tenants are the telcos and are the mobile network operators, think T-Mobile, AT&T, and Verizon. They took a lot of debt to fund the first phase of their 5G deployment infrastructure build.
When rates went up, that hurt their tenants. It was not only painful for American Tower and Crown Castle's discount rate as to value their cash flow, but it was also painful for their tenants that had to cut back on their spend and therefore spend less in terms of leasing and servicing of the towers. I think that we're going through a digestion period where growth was very elevated post-COVID and just normalizing as the mobile network operators are more capital constrained.
Now, that doesn't mean that growth has fallen off the cliff the way that the stocks would make it look. Some of these stocks are down 50% from peak and that has not happened, their cash flows have not gone down in any way by that much. I think if you look at the contracted revenue for American Tower, they're still set to grow at 5% over the next five years from an organic tenant billing perspective. I think there's a lot of fear and there's a lot of pessimism priced into the stocks, and for us investors that are willing to make bets at this point, we believe that this is a great time to be opportunistic in towers.
Tom: It wouldn't be an investment discussion if we didn't talk about artificial intelligence, the hot, hot trend this year. What areas of real estate are affected by AI?
Maria: AI is pretty much the number one theme out there being talked I think for every sector and people are constantly trying to figure out how is that going to change the way we operate and it's no different in real estate. I will talk about AI in two buckets, how it affects from an operation perspective, and what property types actually benefit directly from AI.
From an operation perspective, I think REITs are still very early innings in terms of trying to figure out the technology and the applications of AI and how that can help them from an operation perspective. Whether it is enhanced leasing or the revenue management systems, cut costs among other things. I think it's still pretty early to tell what the real application is from an operating perspective.
Now from a direct impact on demand, from an asset, obviously, data centers are the main beneficiaries, and you have seen that theme played out this year where data centers have been one of the best performers in real estate this year in the US because we don't have data centers in Canada other than one REIT that had a portfolio that they recently monetized at a very attractive cap rate.
Whether I think that the market has it right or not in terms of the growth of AI and how big of that opportunity it is, I'm not sure. I think we're all trying to still figure out the size and the scope of it, but what we have definitely seen is in the near term, we have seen a material boost, or a material jump in leasing activity for data center REITs. I think a lot of people are trying to build and have access to power and just secure their infrastructure.
I think it may be a little bit about how Amazon took as many logistic spaces as they could during COVID because they just thought e-commerce will continue growing and now, they're building into that infrastructure. I think the same thing is happening with data center today where all of these AI companies are trying to secure their real estate. That's why you're seeing the big spike in listing activity that is being very favorable from a development perspective and for all of these data center companies. It's to be determined how big that opportunity is, but obviously, it's benefiting the data centers most.
Tom: Maria, I want to thank you so much for this discussion today. I learned a ton. I hope everyone else did as well. It's been great to have you here.
Maria: Thanks, Tom, for having me.
Tom: Thank you for joining us.
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