On the Money with Dynamic Funds

PARTICIPANTS

Tom Dicker
Vice President & Portfolio Manager

Maria Benavente
Vice President & Portfolio Manager

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Tom Dicker: You're listening to On the Money, a podcast from Dynamic Funds. I'm your host, Tom Dicker, and I'm here to discuss real estate with Maria Benavente, Vice President and Portfolio Manager at Dynamic Funds. Maria and I have been partners in the real estate sector for over eight years here at Dynamic. Today we're going to get Maria's updated thoughts on the real estate sector and why we've launched a new real estate ETF, which is called the Dynamic Active Real Estate ETF, and the ticker is DXRE on the TSX, and why we're doing so right now. Maria, let's get right into it. Why are we launching a real estate ETF right now?

Maria Benavente: Why now? I think it's like a great question because it really allows me to frame the opportunity that exists in real estate today. Real estate has been, without an exaggeration, perhaps one of the most hated asset classes in the broader market for the past 24 months. I think we need to frame how hated is real estate. If you go and look at what the US REIT index has done from a flow perspective, we have been in net redemptions or net outflows for the past 24 months of over $40 billion has been pulled out of real estate equities in the US. That is significant. What that has done is it has created a big repricing of the real estate securities.

A lot of the mutual funds out there, a lot of the general equity mutual fund managers, which is really the ones who drive the marginal price of real estate securities, have either had no real estate exposure today or are significantly underweight. There's a lot of negativity out there. The negative stock prices have also driven a lot of the negative narrative. If you go and open The Wall Street Journal, The Financial Times, and you go and see the headlines around real estate, there have been really negative, and that all drives the narrative. There's an opportunity today in our view to be a contrarian investor and to take advantage of the dislocation that still exists in real estate securities in the listed market. The listed real estate securities are trading at significant discounts to the broader market and also to their private estimated market values.

If you go and take an average of US REITs or Canadian REITs or even globally, this trade an average between 10 to 20% discounts to their private estimated values. We think that is significant and something that we would expect that over time will narrow. With all this focus on the negativity and the macro and what interest rates have done to REITs, and I don't want to be dismissive that higher interest rates have, of course have a negative impact in the growth of real estate securities, but we have forgotten to look at what these properties have actually done and what they have done in an inflationary period.

If we really go down and break down the real estate sector, there has been property types that have been able to grow at inflation and above, especially those that have had structural tailwinds. There has actually been growth in real estate. Obviously, decelerating growth as companies have a more challenged cost of capital and as they have to refinance at higher rates, but it has still been positive. More importantly, if we really want to look and take a forward view on real estate, we think that things are starting to look better. We're certainly going to discuss a lot of that. Where are the green shoots and the opportunities in real estate as we go through this podcast. Really, we see this dislocation, this valuation, this kind of opportunity to invest in real estate today. We see ahead of that rate of change from a growth perspective, from what we think is an acceleration in growth that you can see out 2025, 2026.

Tom: We have seen some negative headlines about, say, the residential developers in Canada having a lot of trouble. Why is that? Why are they having trouble right now? How does that affect, say, the Canadian REIT landscape?

Maria: Like I said, higher interest rates have negative impacts in real estate. Not all real estate is the same and you have to be selective in the market. If we think where the risks have been and where the challenges have been, it's really about those companies that have excess development or excess debt. Let's focus on the development and where the challenges have been there. I think developers in general have been hit by multiple things, not just higher interest rates. Even before COVID and even before interest took this big down move, construction costs were already accelerating. That has already started to put some pressure on developers not knowing what would be their construction cost budget and ever-changing zoning laws and ever-changing supply issues, supply constraints. COVID made that situation even more difficult for developers to really be able to budget properly.

Construction costs have pretty much gone up anywhere from 10 to 15% over the last two to three years and have put a lot of pressure on what we would call the economics of development. Developers needed a lot higher market rent growths. They needed higher price per square foot to make the profitability to compensate for the risks. They started to push and underwrite higher rent growth, underwrite higher price per square foot. I think that at some point affordability was not considered. To make matters worse, developers then were faced with higher interest rates.

A lot of those development companies, especially if you're smaller and not well capitalized, you were using a lot of construction loans, you were using a lot of floating rate debt and using a lot of leverage. When we saw the big change in the move in interest rates, the developers now had two issues. They had to deal with higher construction costs and higher cost of capital. That really became an issue for them. The economics really just didn't work. That's really what we've seen in the US. Like, if we talk about the US a little bit, the issues got compounded by a tightening financial conditions. When you saw the regional bank crisis, like the banks have really pulled back construction loans.

You had also an issue where you cannot access capital. You were being required to put a lot more equity. That really stressed development. When you're reading a lot of the negative headlines around in the media and a lot of like the challenges in real estate, it has really been about development, one, and obviously about office where we can talk and discuss a little bit more. That's where the really the risk has been concentrated for real estate. What is the silver lining of all of this?

In a lot of asset classes, in a lot of property types out there in the real estate sector, we're starting to see a big drop in building permits and starts because developers have just retreated, have gone out of the market, and they cannot develop in the same way or at the same pace that they were doing it a couple of years ago. Why is that a silver lining for real estate? Lower supply leads eventually to higher market rents.

We're still dealing a little bit from the oversupply and the excess from a couple of years ago. If you can look out again to 2025, 2026, the outlook for property types like US multifamily, US industrial, Canadian multifamily, it looks a lot better now that housing starts in general have started to trend at lower. Again, when we're starting to see the green shoots of what higher interest rates have done for the industry, this would be one of them.

Tom: Where else are you seeing opportunities right now? One of the sectors we're seeing in the headlines on the positive side has been data centers. We've seen a lot of excitement around artificial intelligence lately and the build out of data centers. People starting to talk about not enough availability of power. Can you talk a little bit about what's going on in data centers in the age of AI?

Maria: Certainly data centers is a very interesting sector because in a way, AI has really changed the course of the property type, especially for the wholesale data center business. We'll talk a little bit about what wholesale data center business means. Prior to the AI demand boom, data centers that were effectively servicing the large hyperscalers, which effectively means you were just creating a box and just leasing a wholesale, like big chunks of space to the cloud providers like AWS or Amazon, Azure, which is owned by Microsoft, you were just giving them space in like large chunks. They had the pricing power and the industry had become a little bit overbuilt.

That really has changed and it has changed rapidly because we have seen this big change on the demand side. That has been really an eight quarter story with the significant growth and the significant big increase in leasing activity really coming in the last three to two quarters. If you go and see perhaps one of the largest data centers, Digital Realty, their last bookings, which is like the leasing stack, they were up 40% higher than their long term average. You've seen really a big, significant move up. If you believe that level of significant increases in bookings will continue, then you have a market where the demand profile has significantly shifted.

At the same time, power constraints and power scarcity has really made bringing supply a lot tougher. You're speaking about a market where the landlord has gained pricing power back. Before, the hyperscalers had the power. Now, because of constraint availability and the difficulty to bring supply into the market, now landlords have the upper hand. If you continue to see investments in the way we have seen so far, this market can continue to grow market rents and we will see positive improving ROIs. I think it has really changed.

You do have to be selective. This is a property type where being selective matters because there's high obsolescence. If you think about how quick technology is changing and how quick different GPUs and power consumption changes, you really need to always just be investing in the data center to be the product that the hyperscalers that the enterprises want. You do have to be selective and be invested in the companies that have the access to capital and that have the balance sheet to be able to invest in their data centers to redevelop and really adapt to the quick and the changes that exist in the marketplace.

Tom: Can you talk a little bit about what are maybe some of the bigger picture trends taking place in industrial real estate? Are you seeing that as an opportunity or is there still more risk and are you staying away?

Maria: Industrial has obviously been a property subsector that has been loved for a long time. A lot of pension funds were under allocated industrial and really moved capital and deployed a lot of capital over the last couple of years to industrial because industrial was seeing all of this positive tailwinds from a demand perspective. What that happened is like anything good, sometimes it gets overbuilt. We are seeing right now we're going through a record high wave of supply at a time where demand is normalizing because you obviously saw a lot of 3PLs and a lot of companies like Amazon taking a lot of space for future growth. They're slowly growing into that.

Demand has normalized and supply is very high. You're starting to see a pickup in vacancy and that rate of change, obviously the market never views negative rate of change positively. I think that's what the stocks have sold off. Industrial as a long-term story remains a positive one. Once we have moved through that short-term, near-term supply issues, we should see market rent growth reaccelerating and stabilizing.

Real estate businesses and real estate operators are constantly trying to find, "What is the best use of my land today? What is the best use on my property? Can I change the use for me to earn higher profits or higher profitability?" A lot of the industrial companies have gotten smart about that. Now that we're seeing this AI boom and this very significant demand for data centers, well, you can change. A lot of these sites have access to power. Some of them like, if you look at Segro, which is a warehousing REIT in the UK, they have assets in the most important data center node in London. They know that they can make a significant higher profit. They can change the use for me to earn higher profits or higher profit from data center development than they can about from industrial. What many of these companies have done is they just change the land use and they are looking to monetize some of that land.

I think that's a very interesting thing that the industrial REITs are doing. I'm not suggesting that this is going to be a big part of their business, but it's at the incremental. Another way they can drive value.

Tom: Another big picture of long term trend that we've talked about is demographics. There are two big demographic trends taking place right now in Canada. Obviously, we have a big influx of immigrants, which seems to have peaked. It is now receding a bit. That's traditionally been a tailwind for apartments. We've seen some changes to the temporary residents, foreign students. Is the demographic story in Canada still intact as far as immigration and apartments?

Maria: I think the policy error from a temporary immigrant and that level of intakes that we took in Canada, it has created significant stress in the housing market. I think it will take much longer to relieve the pressure. I think it will require a significant change in immigration to change the path in terms of the housing or for these apartment REITs. If we look at what has happened really before this big jump in immigration, and that was running at about two units of new immigration per housing start. In the past year, it has run at about five times new immigrants per unit of housing built.

If we had a housing crisis before, that, well, you just put the system in a tremendous amount of stress. I think to correct and to really change the course of the Canadian housing market, you will need more drastic immigration policies. However, it is very tough to do that at a time where we need more construction workers, where we need more nurses, where we need really immigration, given our aging population. I think in the near term, this reduction in temporary residents at the margin will create some relief. It won't change the deep crisis that we're going through. The government now is trying to do some to encourage some supply.

Again, I think that the challenge from a housing starts perspective, it's not as easy to solve because we just don't have construction capacity to bring a significant move in starts. Interest rates are still too costly. It is still very difficult for a lot of developers to make the economics work. Third, it's just you're not bringing the product that is much needed into the market, which is kind of that affordable mid-market product. If you go and look at what has been developed over the last few years, has really been about condos and a lot of one bedroom apartments and at the higher price point of the market.

Guess where the challenges are right now? Even though we have a housing crisis, we're actually seeing softness in the rental market for one bedroom apartments. It's because we have overbuilt a product that is too expensive and too unaffordable for a lot of our population. I think more work needs to be doing in the housing side. I mean, the government is trying to bring affordable product by changing the CMHC product and some of that will get built. Again, until we don't add labor to the labor pool and until interest rates doesn't make a lot of this affordable or economical to build, we may still be in this shortage of housing for the near term, which is a good thing for the apartment REITs that we own in Canada because they are providers of affordable mid-market housing.

Tom: The other major tailwind from a demographic perspective has been the aging population. I want to talk a little bit about seniors housing. I'm looking at the seniors housing situation in Canada. What I see is population growing at about 4% over the next decade, which is pretty dramatic growth. I see very little new supply being built in seniors housing right now because we've had a few years of higher interest rates and all the things that you had talked about earlier in the podcast. As I see it, I think the next housing crisis is actually going to be in seniors housing. What do you think of that? Is that an opportunity? Is that a risk? Are you invested in the sector? How do we think about seniors housing in Canada?

Maria: I think we have been talking about this 80+ population cohort, the big acceleration in growth happening for a long time. The business kept getting oversupplied ahead of this big move. What COVID did to the industry was it made a lot of operators realize that actually operating seniors housing is a lot more complicated and challenging that one may think. It's an operating business. There's a lot of parts that you have to manage, especially labor that can be very tough when you're labor constrained. Not all operators can make it, especially in a stress environment.

COVID effectively, what it did was that it removed a lot of bad operators from the market, and it resulted in a lot of property closures and a lot of obsolescence in a way being taken out. Now we are actually timing the market where we need more supply and there's just not enough capital formation. I think what we will continue to see is occupancies growing and that will continue to give pricing power to the landlords. By the way, this is true here in Canada, as it is true in the US and globally or in developed countries. I think that is a big positive for the sector. We're entering a multi-year growth story.

At the same time, the operators that survive, which in, large part are in the listed market, have gotten a lot more sophisticated, when it comes to operations. They're using a lot more data to know where to develop, to know how to manage these assets. They have changed the way they manage labor to be more efficient and targeted to be better able to manage labor when it's needed. They're offering better programs. They have economies of scale, so they can do better in terms of food offerings, program offerings.

I think that the operators that have remained in the market are a lot stronger and can operate much more efficiently. You're going to see occupancy growth and you're going to see margin expansion, which is something that we haven't seen in seniors for a very long time. I really am excited about the prospects of seniors going forward, acknowledging that it still remains a very challenging operating business, tough to operate in, and that should improve and that should be to the benefits of those that do it well.

In addition, I think in the capital markets, the stocks have performed well. They have a cost of capital advantage, whether it is Welltower, Chartwell, and they can go in offense. They can go and do external growth, which they haven't been able to do in a long time, especially the ones in Canada. Now that they have a cost of capital advantage and a lot of debt is coming to term and refinancing is needed by a lot of the developers that develop a lot of the facilities over the last few years, they can be there to do large transformative acquisitions. We've actually seen whether it is Welltower, Ventas, or Chartwell, do large portfolio transactions recently and adding those assets into the platform, again, enhances economies of scale and can allow them to provide better services to their residents at the end of the day.

Tom: Why would you like to see a real estate company like a healthcare company go out and buy assets? When is that good and when is that bad?

Maria:One of the good things about real estate, I think, when you have the cost of capital is that you can buy these assets accretively and tie them into your platform and run them a lot more efficiently. I think a lot of smaller operators or those that do not have scale, struggle getting that operating leverage. Therefore, either the marketing is not as good or the way they manage labor is not as good. Therefore, it's a negative for both the tenants and the assets, or they underspent in terms of CapEx and bringing the assets to where they need to be.

I think if these operators and these larger REITs have a cost of capital advantage and want to acquire this on an accretive basis, that is, where their cost of capital is lower than the cap rate they're paying for those assets, they can bring it into their platform and drive synergies. Then they can really drive growth.

Tom: Can we talk a little bit about Canadian REITs broadly now? They've underperformed global peers this year. Why is that? Is that an opportunity? What do you think it's going to take for Canada to outperform again?

Maria: I think Canada is struggling to be relevant in the global context. The sector is like today, less than 3% of the global real estate benchmark. I think in a way they're being underweight just because there's not really a reason to be in Canada. Before we had obviously that big population growth story and Canada was doing quite well, but now with the economy being very house independent and the consumer perhaps being more stretched than in the US and with the US market being a lot deeper and having a lot more exposure to this alternative types of investments, I think there's a lot less reasons for a lot of that international capital to come into Canada. The international capital tends to be the marginal buyer that will drive the price.

In addition, I think the government has honestly not really helped and I don't want to get too political. I'm going to try to stick to the competitiveness of Canada from a global perspective. The government has made a disservice in terms of the last couple of years trying to target the REIT structure when it came to residential. Now the most recent changes in the capital tax gains, it just creates more uncertainty from a global buyer perspective to know what your return can be in Canada from a long-term perspective. I think that has really not helped the sector.

In terms of, do we view it as an opportunity? Yes, because there's still very attractive, healthy fundamentals in Canada. I understand from a global perspective how an international investor wouldn't want to perhaps invest capital today. I think over the long-term capital, Canada will remain competitive and will have very competitive growth returns. The valuations today are really cheap. You have the largest retail platform trading below 10 times on an earnings multiple basis. That's one of the cheapest we've seen it in a while despite improving fundamentals. I think there's an opportunity. I think we're going to require large transactions, a large portfolio to transact in the market for that disconnect and that discount to really narrow. I think M&A can really be a catalyst for the sector and we're hopeful that that can happen.

Tom: It wouldn't be a real estate podcast in the post-COVID era if we didn't talk about office real estate. How's your opinion evolved on the office down cycle? Has it played out? Where do you think we're at now? Do you like it yet?

Maria: There is still a lot of hate for office out there. The challenges are probably going to persist. I think when I was speaking about, not all real estate is the same and most sectors are okay. The sectors that aren't, the first one would be office. There has been structural challenges and it is not only about how bad the cash flows have been and how capital intensive the sector has been, but it's also on the fact that not a lot of people want to provide financing, whether it is from banking or even private credit at this point, want to provide financing to this asset class which makes it even more challenging for those landlords to operate. We actually just had a New York based office read in our office today.

One of the comments that they made, which was quite interesting is that, even the leasing, even if you're a tenant and want to lease, it has all become about capital structure. Think about the little leasing that is happening out there in the market. If I'm a tenant, now they're asking the landlords, "Hey, even if you have a great asset, what I want to know is, what is your capital structure position? Are you still going to be here over the next 12 to 24 months? Because I only want to lease this if you're still going to be my landlord, and if you have the capital to invest in the fit-out of the space, because if I'm going to lease from you, I want you to dish out some capital and share the burden of fitting out my space."

I think like there's going to be more bifurcation even within office about the have and the have-nots. If you are an office REIT that have invested in your assets and you have good product, that competitive pricing, and you have a good balance sheet to help the tenant with fit outs, you're going to be an ultimate winner. If you don't have a good capital structure and you don't have a good asset, then you're probably going to default. We're starting to see that in the public markets and in the private markets where we're seeing incremental levels of default. In the public markets, what I would close with is a lot of that distress is priced in. Is there an opportunity? We would say, "You know what? It's something that we're incrementally looking at." I think you definitely have to be careful with where you put capital still. We're going to do it very cautiously. We're going to be adding to places we think things have stabilized to potentially improved.

Tom: Another subject that we haven't talked about yet, and maybe it's a great place to finish is, how are you thinking about interest rates? Obviously, they've got a huge effect on real estate valuations, sometimes cash flows, real estate companies' cash flows. Will cuts to interest rates by central banks help the sector in Canada and the US? Could that be a catalyst for the sector as the year goes on?

Maria: I think it would definitely help, but I think people are putting too much attention to interest rates, and understandably so. I think you can't fully rely on interest rates to solve all issues in real estate. There are some issues that will take much longer to be fixed than just rate cuts. I think in real estate today, you really need to be selective because we had a good long cycle where pretty much you really just had to own real estate assets and you made money. That really was a macro trade. Now you really, it's the time to own real estate by being more selective, focusing on what do you own, the market, the property type that you own, and not only the property type now, but really how is the company structured to succeed?

Be the ones, own the acquirers because it accrues to shareholders because you can buy that accretively and then just drive synergies and drive operating efficiencies and scale benefits. You want to be with those who have the right balance sheet to do that, to do those strategic changes, to drive that change and to drive that growth in accelerating growth. I think rate cuts, it's wonderful and it will be good for real estate, but it won't solve everything.

Tom: I want to close it there. Thank you so much for sharing your insights today. That was a really great discussion. For those who are interested, the ETF is called Dynamic Active Real Estate ETF. The ticker is DXRE, it's listed on the TSX. Thanks everyone for listening and good luck in the markets.

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