Good question. There's nothing fundamental going on that would justify that kind of spread. When I talked to my colleagues in the U.S., one guy said they were looking through the trough to 2012. Another guy said it's all a leap of faith. Either way, it spells overvaluation and we sold our U.S. REIT positions in May. U.S. REIT multiples need to decline to 16 times before they are fairly valued, which means U.S. REIT share prices have to fall by another 5 [to]10 per cent before I'm all that interested again.
Are the market fundamentals really so different?
Definitely, our financing model has survived because we didn't rely so much on commercial securitization to fund real estate mortgages (residential or commercial). We used it a little here, but it wasn't the main source of capital, like it was in the U.S. In the U.S., it was the dominant source of debt financing and few financial institutions retained any of these mortgages on their own balance sheet. When the securitization market went away, U.S. REITs saw their cost of capital rise dramatically and at just the time they needed access to cheap capital. They were forced to forge new relationships with new lenders at a time when credit spreads were blowing out. Right to this day, there is very little lending going on in the U.S. right now. In the U.S., lending is now pretty much limited to government programs or entities, with little bank lending taking place. That is not the case here. We've always been balance sheet lenders and most REITs already have strong relationships with the group of lenders in this country.
The other fundamental difference is occupancy. The U.S. is much more competitive than Canada is and as a result, margins are much thinner. When a downturn like we are currently experiencing happens, there is less room for U.S. companies to manoeuvre and as a result, there are many more bankruptcies. In Canada, we have one national grocer and several regional players, making competition in that sector relatively benign. Compare that to U.S. grocers where there are several large regional competitors in each market and you see the potential for bankruptcies and reduced occupancy.
Are things that much better in Canada?
We're not an island, but absolutely, things are better. People ask me all the time, what happens when vacancy falls to 60 per cent? Are you kidding me? Look at the tenants and you tell me which ones are going out of business. If occupancy at RioCan falls to 50 per cent, you'll have a tough time finding fresh produce and a hell of a time filling out your prescriptions because that means Loblaws and Shoppers Drug Mart are out of business. Good luck getting coffee too, cause that means Tim Hortons must be gone too.
What numbers should investors pay attention to when trying to pick a REIT?
When we're trying to gauge the riskiness of an investment we look at the cash flow stream - I don't care about stock price volatility, real risk is the risk of permanent loss of capital. We value REITs based on their free cash flow as measured by AFFO so we measure their risk as a function of the riskiness of their AFFO.
We measure this riskiness as a function of the quality, duration and stability of the cash flow we're getting. Stability is best represented by occupancy and how volatile it is over a business cycle. Quality refers to the tenants that underlie that occupancy. If you have a whole bunch of mom and pop companies in your property that's generally poor-quality cash flow. Large, national tenants and/or government tenants are generally better-quality cash flow. Finally, duration is a function of the term of the leases. Longer-term leases are generally preferred since that provides greater visibility on cash flow over a longer time period.