Finding Global Real Estate Opportunities
Real estate has been a profitable venture for investors since the start of the millennium. Now, however, the best opportunities can be found outside of domestic markets. Darren Spencer, Russell Investments’ director of alternative investments, looks at how real estate can be used to help meet investment goals in an interview with Benefits and Pensions Monitor.
Benefits and Pensions Monitor: What is the opportunity today in real estate for Canadian institutional investors?
Darren Spencer: Real estate is an important part of what Canadian institutional investing does. If you look at the data from PIAC (the Pension Investment Association of Canada), across its membership, the average allocation is 10 per cent so it is clearly an important part of portfolios. Typically when you look at Canadian institutional investment portfolios, those real estate programs are heavily biased towards Canada and that is to be expected. It is an important part of what they do. They typically have significant allocations to Canada. However, you need to put that into context. Some of the work that we have done shows that Canadian real estate returns have been really, literally, off the charts. If you invested in Canadian bonds between January 2000 and June 2014, a dollar invested would have given you $2.40. That is a good return. A dollar invested in Canadian equities would have returned $2.51. A dollar invested in Canadian real estate would have returned $4.38. So real estate has outperformed Canadian bonds and equities by a margin of 74 to 82 per cent respectively. It has been fantastic. It is what I would call the golden age of real estate investing.
Hopefully, this sets the stage, but what we are seeing now is that the fundamental drivers in real estate are shifting. If you look at the supply side of the equation, you are seeing, for example, more construction of office space in places like Vancouver, BC; Calgary, AB; and Toronto, ON. Supply is going up, but vacancy rates are also creeping up.
The other thing is just valuation. Is Canadian real estate over-valued? When you look at the overall picture, you can see that the fundamental drivers in real estate are starting to turn.
BPM: And this is not good news for Canadian institutional investors?
Spencer: It is not good news if your portfolios are biased towards Canadian real estate because the other factor I have not touched on is the impact of the oil sector. Around a quarter of Canadian business investment comes from that sector. If falling oil prices become a permanent feature, then that is clearly bad. Canada is actually one of the higher cost producers of oil in the world with the break-even price around $75 to $90 a barrel. At the start of 2015, crude oil traded at below $50. This gives you another pause for concern. All of this is impacting the psych of investors. You are starting to see Canadian investors diversifying their real estate holdings outside of Canada into the U.S., Europe, and Asia Pacific. We have seen several examples of large Canadian investors doing that.
BPM: The really large plans, like the CPPIB, have been going outside of Canada for some time. We have also seen OMERS setting up an office in London and others are getting more active. Are medium- and small-sized plans starting to look outside Canada as well?
Spencer: As we work with our clients and travel around Canada meeting with smaller and medium sized institutions, there is a high level of interest in demand for diversifying real estate because at the end of the day, risk is one of the key variables that investors can manage in terms of achieving their desired outcomes. I would argue that diversifying away from Canadian real estate is an important risk to manage.
BPM: The Canadian plans that are looking abroad, are they ahead of institutional investors elsewhere in the world, for example, ahead of the U.S. and Europe?
Spencer: I would say the answer is yes because they are savvy enough to understand that the domestic market has done exceptionally well and there are fundamental reasons why they should diversify into other countries.
The other trend that we have seen, and this is maybe not surprising, is that our Australian clients are starting to invest outside of the Australian market for many of the same reasons that Canada’s investors are. Their economy is very much driven by commodities as well and they also have made allocations to real estate which are heavily biased towards Australian assets. They are also looking to invest globally, particularly taking advantage of some of the European de-leveraging story, which we think is a real opportunity. It has a long way to go and is a significant opportunity for investors to buy attractive assets at discounts to intrinsic value.
BPM: Is there going to be an impact if interest rates go up?
Spencer: The key point around rising interest rates is not rising interest rates purely. What you have to think about what is the path. What I mean by that is do interest rates go up and normalize over a period of time or is there some shock which causes interest rates to rise very rapidly. These can have quite different outcomes. I would suggest that with respect to a more normalized environment, that is going to be good for real estate because, obviously, the economy is doing well, businesses are expanding, and they need office space.
Whereas if you have more of a sudden or unexpected increase in interest rates, that could impact real estate values negatively. To take that one step further, one of the key areas of opportunity that we see is being able to buy asset at discounts to intrinsic value or below replacement cost, particularly in Europe.
Along with this is recapitalization. Real estate assets acquired at peak pricing in the 2005 to 2008 cycle have not recovered. If you are an owner of those real estate assets, you have likely deferred maintenance. You now need to recapitalize these assets, but you do not necessarily have the cash or you may just not want to deal with this asset anymore. There is basically $380 billion of real estate coming due over the next few years. Investors may need to think about this as they may be buying good quality assets with bad capital structures.
BPM: Are we going to start seeing private equity outfits entering the real estate sphere?
Spencer: Certainly, those are the two main ways to play real estate. You can do that in the listed format. You can do it in a private structure. Core real estate tends to be more liquid. As you move into some of the more opportunistic or non-core real estate strategies, then you are definitely looking into private equity style fund structures and being able to really take advantage of some of these themes that I talked about, buying assets at discounts and recapitalizing assets.
BPM: What other considerations are there in terms of investing in real estate?
Spencer: It starts with having a global perspective because real estate is truly a global business.
Still, investors must recognize that real estate cycles exist. They are important. They have existed for hundreds of years and understanding them really matters. That particularly applies as we help our clients create real estate portfolios. Where are we in the real estate cycle as we develop our preferred portfolio positioning? One of the strategies that we want to be pursuing is buying assets below replacement cost. It is also getting recapitalization and accessing some of the higher growth economies.
BPM: Do we see many investors looking for real estate more as an income stream to replace returns in their fixed income portfolios?
Spencer: This is exactly the case, particularly for investors in North America where fixed income returns are very low and are not likely to improve any time. For example, with core real estate, history shows 75 per cent of the return is from an income stream and that is average. If you can clip a five per cent coupon from very high quality assets, which are in the major cities with high quality tenants, then that is a pretty attractive proposition in the total portfolio context. If you think about retail investors, and even institutional investors who invest in global real estate securities, the yields on those assets are also higher than what you get in typical equity market dividends and/or fixed income. So that is a key part of the total portfolio construction framework and the reason why investors hold real estate, because it does throw a nice dividend yield relative to other assets.
BPM: What would you say are the prime markets out there right now?
Spencer: It depends on what strategy you are playing. For core private real estate, there are places like New York, San Francisco, and London where you are seeing a lot of the money flow. Outside of that, I think what you are also seeing are opportunities in some of the secondary markets, the smaller cities, where prices are still below peak value. Savvy investors could come in and purchase those assets at quite good valuations, maybe repurpose and then reposition them to feed the demand for core real estate.
BPM: What are some of the possible looming storm clouds?
Spencer: I always go back to the fact real estate is driven by three main fundamentals – supply, rental growth and vacancy rates. That is basically a valuation. If you think about valuations in Canada, they are very high. You have deteriorating fundamentals. That is one of the reasons people are looking elsewhere.
It is a different story in the United States because the U.S. economy is doing quite well. It is not, obviously, as dependent on oil as much as Canada. The U.S. economy is looking very strong, but there are also important considerations on the supply side.
Basically, you have seen very limited new supply in the U.S. since the crisis. From the fundamental supply and demand picture, vacancy rates are declining. That is a key point. Real estate in the U.S. is probably a good place to be right now because you have solid fundamentals, a growing economy, strong demand for these assets, and, depending on which sector of the real estate market you are playing, compelling opportunities.
BPM: Are we seeing much building activity in the U.S.?
Spencer: Relative to history, the supply picture has been quite good. There is just not a lot of new construction. There has been one sector where there has been a bit more construction – multi-family dwellings, such as apartment buildings. That is because following the financial crisis, people did not want to have the headache of owning a home. We have seen more construction to meet the demand there.
On the flip side, one of the strategies that our clients have been able to take advantage of is actually more on the other side of the equation. We have seen even distressed prices for land since the housing crisis as new home starts have been very much below peak levels. That offers an opportunity because over time this will moderate, particularly now that the U.S. economy is getting on its own feet. Given the demographic trends, the big home builders will need a supply of land to build new homes. One of the strategies we have been able to execute for our clients is buying these tracks of land at very discounted prices – 20, 30 cents relative to the dollar compared to where they were priced before the crisis – and then aggregating these so they in a position to sell those homes to the home buyer. That has been a very profitable strategy.