Brad Sturges, the Real Estate and REITs analyst from Industrial Alliance Securities, discussed his stock recommendations with The Globe and Mail, highlighting three REITs – his growth, value and income top picks. Below are excerpts from our conversation.
Before we discuss your recommendations, can you comment on the rising interest rates environment and the implications for the real estate sector?
Short-term borrowing rates have risen but the longer-term rates have really not risen substantially and so the yield curve has flattened… A flat yield curve can still indicate, at least from the bond market perspective, that there is uncertainty around the longer-term economic outlook. Therefore, Canadian REITs, given the contractual defensive nature of the cash flows, still should be an attractive place for investors.
Given where the longer-term underlying benchmark yields are, and where borrowing costs are for Canadian REITs, we believe there is still some ability for Canadian REITs refinance and replace maturing debt at either similar or slightly lower interest rates, which still could be a modest positive, on average, from a cash flow growth perspective.
Depending on what type of asset class the REIT owns within the direct property market, the investment demand from institutional and private equity investors in the direct Canadian property market remains fairly robust in certain property sectors, which could help underpin the low capitalization rate environment that we see in Canada that may also continue to support current net asset values.
What sectors are you seeing as having demand?
The real estate asset classes in favour right now are the multi-family or apartment sector, particularly in Ontario; the industrial property sector; and seniors housing.
It's also important to look at it from a geographical perspective as well, with Toronto and Vancouver having benefited from strong investment demand in the direct property market, which we think can continue in 2018. There also have been improvements in Montreal and in Ottawa recently. Although Calgary and Edmonton have been challenging given the weaker economic growth prospects in the last couple of years due to the low energy price environment, it seems like Alberta has stabilized in some property sectors and could be positioned for a longer-term recovery.
InterRent REIT is your growth recommendation. You have a target price of $10.75.
InterRent is a stock that could continue to generate above average price appreciation driven by strong NAV [net asset value] per unit and AFFO [adjusted funds from operations] per unit growth. We believe InterRent could continue to be one of the top performing Canadian real estate entities on the TSX over the next 12 months. It had a very strong total return performance in 2017, and I think it's still positioned for another year of solid performance.
It's really two main factors that may drive strong investment returns and strong potential for growth in InterRent's units.
One, InterRent has 100 per cent Canadian apartment exposure ... 80 per cent of its portfolio is essentially in Ontario, 20 per cent in Quebec and, within that segmentation, 80 per cent are InterRent's apartment suites are located in urban market or primary markets, and the remaining 20 per cent is more secondary-market focused.
When you look at the underlying fundamentals in Ontario, there is, what we believe, a shortage of affordable housing options in the province, and given that, we continue to see strong leasing demand in the Ontario apartment sector that benefits from a lack of affordable options plus population growth within the province, particularly in the GTA [Greater Toronto Area]. We think there is still an imbalance between demand and supply in the province, which should continue to be positive for market rental rate growth. What we have been seeing over the last several months is market rent growth accelerating in Ontario in the apartment sector. So from an underlying fundamental perspective, we think InterRent is very well positioned due in part to its geographic concentration.
Secondly, InterRent has a very strong track record of creating value through implementing value-add strategies. InterRent typically focuses on acquiring and owning properties that are very well located and in growing property markets where management can implement active management strategies such as repositioning assets through capital improvements if required, and drive robust improvements in rental income over a three to four-year period.
The REIT has completed a process over the last couple of years that included selling some of the assets InterRent had recently stabilized in smaller secondary markets and redeploying and reinvesting that capital into growing urban markets. We think InterRent is again in the earlier stages of repositioning these newly acquired urban assets. We think there is quite a bit of long-term potential or upside to drive rental income growth and that should translate into pretty strong NAV per unit growth over the next few years.
Will they continue to divest in the secondary markets and invest in urban markets?
They are pretty much through that capital recycling program. InterRent may still have a little bit more dispositions in secondary markets, but that is not going to be the main focus going forward. I think more importantly, InterRent will start to focus on potential to extract land value through its existing portfolio by intensifying existing land sites. We think they have a number of very attractive land sites in Ottawa, for example, and in the GTA that we could see InterRent begin to implement a little bit more of a formal development program over the next few years, which could even further add additional growth to the story.
What are those land sites that you are referring to?
They are income-producing now, but could be low-rise apartment buildings existing today or it could be underutilized land that could be zoned or rezoned for mid-to-high rise units, which could add more density to the existing sites.
An attractive feature of this REIT is its steady distribution growth and its conservative payout ratio. However, the yield is quite low. Could we see a meaningful increase in the distribution announced?
As long as there is a significant growth opportunity within either their existing portfolio or external to the portfolio then the intention by the REIT is to maintain a lower payout ratio, to retain cash to fund some of these internal redevelopment opportunities. InterRent would increase the payout ratio, and increase the distribution, if that growth opportunity became a little bit more limited. It's more strategic in nature that the REIT has a lower payout ratio. InterRent has a very successful track record in implementing annual distribution increases. It is a little bit lower yield today, but that's also partly a reflection of the fact that Canadian apartment properties are trading at very low yields or cap rates in the direct property market as well.
The REIT trades at a premium valuation.
Our view is that the REIT's NAV per unit growth could be above average. We have a $9.50 NAV today, and we view that NAV to be unstabilized, with about 45 per cent of InterRent's apartment portfolio in Ontario and Quebec going through various phases of repositioning. InterRent may be putting more capital to work now or the capital spend is complete and now the REIT is in the process of trying to stabilize the property's rental income stream, which may take a few years to implement. From our view, that gives quite a bit of torque to the upside on the NAV per unit. We do think that both the AFFO and the NAV per unit will grow from the levels we have currently estimated today, and therefore, there is still good upside to InterRent's unit price at current levels.
What is the downside risk?
I would suggest that given that InterRent has more of a value-add, redevelopment strategy, the REIT typically has a little bit higher percentage of variable debt and shorter-term mortgages that it utilizes until assets stabilize. In this environment, a little bit higher shorter-term rates could constrain some of that cash flow growth forecasted, but we still feel that the top line revenue growth for InterRent, particularly the monthly rent growth, will continue to be greater than any further upward pressure on shorter-term borrowing rates.
What are the catalysts?
Quarterly earnings will continue to be positive catalyst for the REIT, and the potential for new development projects or joint venture partnerships, either within its existing portfolio or for new sites outside of InterRent's portfolio that adds or augments the potential pipeline of development growth for InterRent could be announced over the next 12 months and that would be a positive catalyst.
Last year, Milestone Apartments REIT was acquired; is InterRent or any of the REITs that we are discussing today potential takeout targets?
I would suggest Pure Multi-Family REIT, which is now a fully internalized REIT, with no large controlling unitholder. We think Pure Multi has a very high quality portfolio that would potentially attract strategic investors. Therefore, we believe, there is potential for M&A here if the valuation gap doesn't narrow.
Any additional thoughts before we move on?
We did downgrade InterRent from a 'strong buy' to a 'buy' for valuation reasons. But that being said, we think it's still a very attractive name from a growth perspective… not just in 2018, but looking out over the next few years.
Your next recommendation is Pure Multi-Family REIT LP that offers investors U.S. exposure.
Pure Multi is our best value idea right now. It still trades at a reasonably sized discount to net asset value when most of the Canadian REIT sector trades much closer to net asset value…It does also trade at a price-to-AFFO multiple discount to the peers. So from a valuation perspective, we believe the current value is quite attractive.
What we like about Pure Multi is the high quality aspect of its U.S. apartment portfolio. The average age is about 10 years. Pure Multi is in very attractive growing markets in the U.S. Sunbelt like Dallas and Phoenix. These markets are benefiting from strong population and job growth, which is creating more leasing demand in the apartment sector. With improving occupancy levels in these markets expected over the next 12 to 24 months, we certainly believe that these markets will continue to support above average rental rate growth as a result of the strong underlying fundamentals.
Pure Multi achieved several important strategic initiatives in 2017. They internalized their property management team. Pure Multi successfully completed a couple of equity raises that were deployed into new property acquisitions, which helped diversify and grow its U.S. apartment portfolio. Pure Multi been able to achieve the lease-up [occupancy stabililization] of certain non-stabilized assets that have been recently acquired. These initiatives may support the potential for a recovery in Pure Multi's AFFO per unit, which we believe could be a very positive catalyst for the stock going into 2018.
I would say the second catalyst for the stock is it is a TSX Venture Exchange-listed stock and we do expect the REIT to list on the TSX in 2018 as well so that should also be positive.
Pure Multi has reported financial results shy of expectations. When do you expect to see a recovery in FFO per unit?
I think it's as early as their Q4 (fourth quarter) 2017 you will start to see some recovery there.
As I mentioned, Pure Multi completed the internalization of property management on Sept. 30, which would have been a full drag in Q3. Essentially, what was happening is they were paying an external party manager a property-management fee while also incurring G&A (general and administrative) costs to build the internalized platform and essentially you're doubling your G&A costs for the property management platform. That goes away as of Q4 so you will see accretion from a cash flow perspective as early as Q4.
Pure Multi raised equity capital on June 30 of last year and that was only partly deployed in Q3. Pure Multi did fully deploy that capital in mid-Q4 so the removal of a temporary drag from the June equity raise will also support a higher AFFO per unit.
Pure Multi also had other operating challenges that are more based on what's happening in the underlying market in Texas, where there has been a little bit of new supply. Pure Multi dealt with some storms like Hurricane Harvey that increased non-recurring repairs and maintenance costs during the last quarter or two. We expect that when you strip away some of the non-reccurring noise from that perspective, it would also suggest a higher AFFO per unit. The new supply issue is something that the market is working through right now. We view that by the second half of 2018, when it looks like that construction pipeline starts to dry up, the U.S. Sunbelt apartment market would be better positioned for improved occupancy, with less incentives being offered to prospective tenants, and thus, some stronger rent growth prospects probably in the second half of 2018.
Can you tell me what your target price is and how you arrive at it?
It is US$7.50 [based on] 17.5 times 2018 FFO. It's trading at [around] 14.5 times so we expect that there could be about three turns in the multiple, right now.
The payout ratio is above 100 per cent in 2017, but that does not concern you because you are expecting to see a recovery in 2018.
We are estimating Pure Multi's AFFO payout ratio to be in the low 90s for 2018 and as we talked about we are forecasting about strong recovery in the AFFO per unit. I think the CAGR (compound annual growth rate) over the next couple of years for Pure Multi's AFFO per unit could be close to 20 per cent.
The REIT has had frequent equity offerings, which for some investors may be a concern given it dilutes existing unitholders. Any thoughts on the frequency of equity financings that we have seen?
Well the frequency of Pure Multi's last two deals were very close together last year but recall Milestone was in the process of being acquired by Starwood and that left Pure Multi as the only TSX-listed REIT essentially that had exposure to the U.S. Sunbelt apartment market. So we think that while investors are generally more cautious about REITs that frequently issue, we view Pure Multi's capital raises to more opportunistic given the increased demand for the stock following the Milestone transaction.
That being said, now, if you look into this year, we only would expect Pure Multi to raise capital if it makes sense to do so. But, we wouldn't expect them to be raising capital at these trading levels. Pure Multi is still trading well below its last issue price and its stock would need to experience a better recovery in the unit price before coming back to market because, as you said, management doesn't want to be diluting their unitholder base. At this stage, if the price were to remain at these levels, it's unlikely to see Pure Multi come back to the market and raise more equity.
The Canadian dollar has been rallying relative to the U.S. dollar, are there currency risks that investors should be aware of?
Yes. They earn 100 per cent of their revenues in U.S. dollars. There are two tickers, there's the RUF.u, which trades in U.S. dollars. There's the RUF.un, which trades in Canadian dollars. Either way, there is still FX [foreign exchange] risk. Pure Multi distributes in U.S. dollars, and you can accept that monthly distribution in Canadian dollars or U.S. dollars. The REIT itself doesn't need to worry about currency from a cash flow perspective because it's earning U.S. dollars and it's paying out in U.S. dollars. Pure Multi's unitholders have to the make the decision regarding that potential currency risk.
Is there anything else you want to add on Pure Multi before we move on?
Pure Multi is now a fully internalized REIT, with no large controlling unitholder. We think it has a very high quality portfolio that would potentially attract strategic investors and so as we discussed before, there is potential for M&A if Pure Multi's valuation gap doesn't narrow.
Your income recommendation is Nexus REIT. Tell me what your investment thesis is?
Nexus REIT is a small-cap diversified commercial REIT focused on the Canadian market. Its biggest exposure is in Quebec and Alberta at this stage. It's a newly formed entity through the merger of two micro-cap REITs called Edgefront REIT, which was a 100 per cent industrial property with a bigger weighting to Western Canada and Nobel REIT, which was a diversified commercial REIT across all commercial asset classes of industrial, retail and office. The newly combined entity now is fully internalized, both its asset and property management function. Nexus has done a very good job of structuring this REIT and positioning it to grow: one, from the internal management structure. Two, from a financial leverage and an AFFO payout ratio, which is lower than some of their small cap commercial REIT peers. This could allow Nexus to achieve a better cost of capital in order to grow. The cash flow is viewed to be fairly stable with a high occupancy level and contractual rent growth embedded in a portion of the leases.
We think Nexus is well positioned to grow both internally and externally. Second, Nexus has essentially two strategic partners, RFA Capital, and TriWest, which combine to have an effective 36 per cent interest in the REIT. We do think these partners could provide access to capital for Nexus as well as an acquisition pipeline over time that could be fairly sizeable. We think that, if executed, Nexus could re-rate on a higher multiple as liquidity improves for the stock and the size and scale of the REIT's platform increases closer to some of the larger cap commercial REITs in Canada.
What are the drivers to lift the unit price to your target price of $2.30?
We see two or three positive catalysts potentially for the stock. It is a Venture-listed stock. We do believe that they will consider moving to the TSX this year and expect an announcement there soon. Two, Nexus has a redevelopment property in Montreal, on Stanley Street, which if successfully leased up and stabilized, should be positive for AFFO per unit. Three, we do expect Nexus to be active from an acquisition point of view in the next 12 months, even if without access to the capital markets. We do expect Nexus to pursue acquisitions and be able to fund these transactions through issuing class B units to potential vendors. We wouldn't expect Nexus to issue at less than $2.10 per unit, which is what the REIT's last issue price was.
Nexus trades at a discount to its net asset value and trades at a pretty low multiple at a discount to the larger cap peers. From an income perspective, you're getting an attractive 7.9 per cent yield, and we have the payout ratio estimated around 80 per cent today, which we think is quite attractive.
From a valuation perspective, the REIT is attractive?
We have our net asset value at $2.15 a unit, and at [around] $2.07 it's about a 4 per cent discount. It trades at slightly over 10 times price-to-AFFO for 2018. We are using a 10 times 2018 FFO multiple to get to our $2.30 price target. On an FFO basis, it trades at about 8.5 times, so that's a multiple turn of about 1.5.
If they do announced acquisitions, there would be room for further multiple expansion?
We think over time. We are not baking in further acquisitions into our numbers so we think there is room for the AFFO per unit to grow beyond our numbers if they are successful in executing their acquisition strategy. Over time, given improved liquidity in the stock, we do think that there is room for multiple expansion.
On the third quarter earnings call back in November, the co-CEO Kelly Hanczyk mentioned that he sees a 'number of attractive' acquisition opportunities and that, 'If all goes well, we hope to close additional deals in February.'
We think they are reviewing opportunities now. Whether it's in Q1 or sometime later in 2018, we would expect there could be some positive announcements on that front within 2018 that we think can be positive for the stock, If the stock price improves to a point where Nexus can come back to the public markets, we believe that Nexus would opportunistically consider that option to help improve the float and the liquidity in its stock as well as diversify its portfolio by growing the size and scale of the REIT.
The yield is quite attractive at over 7 per cent, as you mentioned. The distribution has been maintained at its current level for several years. Do you believe the distribution is just going to be maintained or could investors expect a distribution increase?
As the payout ratio continues to grind lower into the lower 70-per-cent range, we think there could be a potential opportunity for Nexus to consider a distribution increase with successful growth in its AFFO per unit.
Cash flows are very stable. You are forecasting FFO per unit of 22 cents in 2017 and 23 cents in 2018. This REIT is your recommendation for investors seeking income.
I think you're getting an above-average yield with Nexus at a little bit less than 8 per cent. The average yield in Canada right now for Canadian-listed REITs and REOCs [real estate operating companies] is about 5.7 so there is a couple hundred basis points of extra yield with Nexus. Given the high occupancy levels and the average lease term, Nexus generates stable income and so the underlying cash flow yield, or AFFO yield, is more like 10 per cent, which we view to be quite attractive.
Are you concerned with their exposure to retail properties?
No, Nexus' anchor space for the majority of its retail assets have longer-term leases in place with good credit quality tenants. At this stage, we are not concerned about it.
We think if you are looking at retail property as a whole, there's a little bit of misunderstanding in the Canadian landscape for Canadian REITs. Most of the larger tenants within most of the Canadian retail REITs are non-discretionary, in some cases grocery-anchored or staples-oriented type tenants. There are not a lot of fashion tenants. It's not a lot of big-box type formats. It's more open air, strip-anchored retail, which is also longer-term leased so we think the valuations for retail REITs generally look fairly attractive right now.
Any closing thoughts?
We think Nexus is a very well positioned REIT with very strong sponsors behind it. We see some good positive catalysts and if you're looking for an up and coming small-cap REIT that has been structured, we think the right way, then this is a stock to take look at for a little bit of extra income in the Canadian REIT space.
Jennifer Dowty, CFA, Globe Investor's in-house equities analyst, writes exclusively for our subscribers at Inside the Market.
Jennifer Dowty