In an environment where global equity markets are reaching all-time highs and fixed income faces increasing interest rate hikes, we believe real estate offers an attractive source of alternative yield with growth potential that is expected to exceed inflation. These characteristics coupled with the diversification benefits that real estate offers makes Canadian and global real estate investment trusts (REITs) attractive assets this year.
With the recent Bank of Canada interest rate hike to 1.25 per cent – the highest since 2009 – REIT investors may be concerned about the impact it could have on REITs. Contrary to conventional beliefs, today’s upward trend in interest rates is actually a good sign for REITs. Why? Rising rates typically means the economy is experiencing growth, which means more jobs, higher consumer spending, more leisure travel to hotels and greater demand for commercial real estate space all of which leads to higher revenue and greater cash flow growth, helping to partially offset the rise in borrowing costs. As a result, we continue to find compelling opportunities in REITs and believe that the sector offers investors numerous benefits, including a steady stream of reliable income with inflation protection.
One of the most compelling REIT opportunities in Canada lies in office and retail assets concentrated in densely populated cities. Currently, Toronto, Montreal, Vancouver and Calgary, are experiencing a wave of gentrification driven by people’s desire to live, work and play in the same place. This has spurred a large amount of real estate development that is driving the land values higher than many thought possible. A number of REITs in Canada are capitalizing on this trend by rezoning urban properties in order to increase the density permitted on the site. Not only are REITs creating outsized net asset value (NAV) growth through building an additional structure on an existing property, but they are also increasing the value of the existing property by creating a mixed-use asset where each use –retail, residential and office – virtuously supports each other.
Looking beyond Canada, we believe that Canadian small cap underfollowed REITs that own assets internationally, either in Europe or in the U.S., are fundamentally mispriced. We believe valuations are more attractive on a relative basis as niche-oriented property types tend to produce an above average return at NAV due to having a higher going-in yield coupled with lower financing, general and administrative costs and capital expenditure costs. We believe this group of REITs is poised to deliver better than average total returns for investors in 2018.
Four REITs that could outperform this year:
Allied REIT: In many of Canada’s largest cities, urbanization continues to be a major trend. Allied is in the middle of this urbanization. We believe that Allied’s position should lead to stronger land values for the residual and excess land they hold, as well as outsized growth in NAV as it expands by utilizing excess land to build new developments.
Digital Realty: In the U.S., Digital Realty effectively stores data for companies like Amazon, Facebook and other large technology companies and we believe this REIT is going to benefit from the continued growth and demand for more centres. In terms of valuations, the company is trading at strong levels not fully reflective of the growth expected in 2018. The shortage of data storage supply could potentially lead to outsized growth in cash flow, making Digital Realty particular attractive to investors.
Merlin Properties: In Spain we are closely following REITs involved in office logistics and retail. Office rents in Spain – in some of the major markets like Barcelona – are slowly returning to more normalized levels from a very low base. Spain was hit hard in the 2008 crisis but the recovery has materialized. Merlin has the potential and the assets in the right locations to benefit from growth in rents over the long term.
Wereldhave: In the Netherlands, we are seeing opportunity across the retail sector. Wereldhave is a REIT with assets in a number of markets including France, Italy and the Netherlands. Wereldhave is a retailer, which continues to be a strong investment type in Europe. European retail comprises approximately one-fifth of the amount of retail per capita as the U.S. This is a compelling opportunity as it means there's a more equilibrium without the potential risks currently seen in the U.S. Additionally, Wereldhave’s stock price and valuations are priced at deep discounts.