Multi-residential property, 65 Boulevard Fournier, Gatineau, QC
Skyline Apartment REIT.

Soaring interest rates have slammed all types of securities, with real estate equities hit harder than most. Last year, index ETFs investing in REITs plunged more than 20% globally and more than 17% in Canada, and returns are down about 6% through the first nine months of this year.

“Real estate tends to have more leverage in its capital structure than a typical business,” said Dennis Mitchell, CEO and chief investment officer of Toronto-based Starlight Capital. “And so I think investors tend to overly penalize real estate investments during periods of high or rising interest rates.”

Actively managed and investing in the U.S. and Canada, the $95-million Starlight Global Real Estate Fund’s ETF series lost 22.3% last year, after surging 29.5% in 2021. Through Sept. 30, it’s down 3.9%.

When interest rates were low, real estate equities saw significant expansion of the multiples at which they trade. That trend reversed as interest rates spiked last year, Mitchell said, “so as a result, the multiples that real estate and other equities traded at contracted sharply.”

Mitchell’s strategy to return to robust returns for the mutual fund and its ETF series is based on bottom-up stock selection and in-house research, including operating models that it maintains on 96 different REITs. “Whether it’s residential, cell towers, data centres or industrial real estate, we’re looking for companies that generate strong cash-flow growth,” he said.

Starlight has managed to avoid REITs that have slashed their distribution payouts.  Even during the 2022 downturn, the Starlight portfolio had 31 distribution increases, and the average increase was 12.7%, Mitchell said. To date this year, the portfolio holdings have had 15 increases, averaging 13%.

Among the industry’s more attractive subsectors is multi-family residential real estate, particularly in Canada. Immigration-led population growth is increasing housing demand amid insufficient new supply.

Residential is the largest subsector currently in the $532-million CI Canadian REIT ETF, at about 31% of the portfolio. The ETF is down 4.5% for the year to Sept. 30. The rental marketplace is very tight right now in Canada, with the national vacancy rate less than 2%, said Lee Goldman, senior vice-president and portfolio manager with Toronto-based CI Global Asset Management.

Residential rents are going up rapidly, said Goldman, whose Canadian REIT holdings include residential landlords Boardwalk, Canadian Apartment Properties, InterRent, Killam Apartment and Minto Apartment. He doesn’t expect to see much of an increase in the very low vacancy rate: “It’s a good long-term demographic story, a good supply-demand story in terms of being an apartment owner right now.”

Another area of strength is industrial REITs, Goldman said. The Canadian market was already healthy before the Covid pandemic. The increase in online shopping has bolstered demand for logistics and warehousing space — as well as the rents they’re able to command.

Though vacancies for industrial property have increased slightly, Goldman said it’s still “an incredibly low 2.1% across the country” — and even lower in Toronto and Vancouver. He added that average annual industrial rents nationally have risen to $16.35 per square foot, up about 20% year over year.

For both the Starlight ETF and the $82-million CI Global REIT Private Pool, which has an ETF series, the top global holding is San Francisco-based Prologis Inc. The global leader in logistics real estate, Prologis owns more than one billion square feet in properties in 19 countries and reported record operating earnings in the second quarter of 2023.

Every year about 2.5% of global GDP flows through Prologis warehouses, said Mitchell. “They are a very strong operator. They’ve got a dominant portfolio that allows them to provide warehouse and logistics real estate to large multinational companies.”

Another common global holding for CI and Starlight is Boston-based American Tower Corp., a multinational provider of wireless and broadcast communications infrastructure. The company is a global play on population growth and the continuing increase in data creation and access.

“You’re seeing a demand for more and more cell towers,” Mitchell said, “and you’re seeing pricing power increasingly emerge for the existing cell tower owners and operators.”

Another specialty play that Mitchell likes is New York-based VICI Properties Inc., which owns gaming and entertainment properties primarily in Las Vegas, but also elsewhere in the U.S. and in Canada. He said VICI simply owns the real estate and collects rents, with no exposure to the underlying operations.

“During the pandemic, while the casino hotels were shut down, VICI continued to collect 100% of their rent,” Mitchell said.

Back on the home front, CI’s Goldman also favours shopping centres that are anchored by necessity retailers such as grocery stores or pharmacies. He cites modestly rising rents and low vacancy rates for REITs like Choice Properties, Crombie, First Capital and Riocan, which hold mostly these types of properties.

“One of the pluses for this type of retail is there’s been really no new supply at all over the past number of years,” Goldman said. “So if tenants are looking to expand, or new tenants are coming into the market, there’s very limited space.”

A subsector that continues to be out of favour is office buildings, due to the shift toward work-at-home and hybrid working models. The vacancy rate across Canada is now 17%–18%, Goldman said.

Toronto, once one of the strongest office markets in North America, has seen its vacancy rate swell to 14%, up from a pre-Covid 2%, “an unbelievable increase over the last three years,” he said.

REITs in Canada, the U.S. and elsewhere are generally trading at steep discounts of about 20% relative to the net asset values of the underlying properties, Goldman said. This is at the low end of historical ranges. “It looks pretty compelling to be at this kind of discount. Forward-looking returns are quite strong.”

Looking ahead, Mitchell expects distribution yields of 4%–5% for REITs as an asset class, and earnings growth of about 8%. And assuming central banks start cutting interest rates at some point next year, he said, there could also be some expansion of price-earnings multiples to provide a further boost.

“You’re looking at low teens in terms of a total return,” he said.