In the current global economic environment, real estate investors face a high degree of uncertainty.
In a March report, Toronto-based DBRS Morningstar Inc. forecast that the pandemic’s impact on real estate would vary by subsector, with hotels and recreational properties more vulnerable to the effects of Covid-19 than e-commerce, warehouse and long-term care properties.
More recent reports have highlighted weaknesses in recreational real estate, to which consumers and tourists have been slow to return, as well as uncertainty tied to commercial real estate, such as office buildings.
Real estate investment trusts, which typically enjoy reliable income streams via lease agreements, were hit just as hard as broader equities markets were when the pandemic took hold. The FTSE EPRA Nareit global real estate index series dropped by almost 30% year-to-date by mid-March. As of Sept. 1, MSCI’s U.S. REIT index was down by almost 17% year-to-date.
“It’s been a very dynamic year,” says Colin Lynch, vice president and director of global real estate investments with Toronto-based TD Asset Management Inc.
Lynch manages TD Greystone Global Real Estate Fund LP, which launched in February.
The TD fund is available to institutional investors in Canada and had total assets under management (AUM) of $117 million as of June 30. Lynch says TD hopes to make the fund “available to retail investors in the future, although that will be subject to obtaining regulatory approval.”
Before the pandemic, Lynch and his team focused on “the impending end of the economic cycle and [the] real estate cycle.” Capital expenditures, he notes, were decreasing in most real estate asset classes, with the exception of retail properties. But the potential for a significant decline in economic growth, in the U.S. in particular, led Lynch to “defensively position” his portfolio.
Slightly more than half (53%) of the TD fund was invested in the U.S. as of June 30, with the remainder split between Asia/Pacific and Europe. Over the long term, Lynch’s team intends to allocate 40% to the U.S. and 30% to both Asia/Pacific and Europe, with a goal of having the entire portfolio focus on income-producing properties that have growing asset values.
At the end of June, the TD fund’s highest allocation was to office properties (31%), followed closely by industrial (28%) and retail (23%). The long-term targets for those asset classes are 35%, 20% and 25%, respectively.
With regard to office space, Lynch points to a long-standing trend of more people moving to and working within cities in Europe, Asia and the U.S. However, he also acknowledges that the pandemic has led to questions about how people will choose to live and work in the years to come.
“There’s no consensus in the industry right now regarding the future of the office,” Lynch says. “But I believe that offices that are well-located and connected to transit, as well as attractive and environmentally best-in-class, will perform better and retain value better.”
Based on current trends and research throughout the past year, Lynch says he has “a very constructive view on necessity-based retail in Europe, such as in Germany. We actually made an investment in Germany grocery assets in March.”
The TD fund also made investments in the logistics and industrial spaces in Australia. “Those areas have performed pretty well in the pandemic environment,” Lynch explains, due to “strong long-term fundamentals.” As of June 30, both Melbourne and Sydney were among the TD fund’s top 10 city exposures.
Lynch predicts real estate income “will be moderately lower” for the rest of the year and heading into 2021. However, he adds, rent collection rates in the retail space “steadily increased month-over-month from March to [mid-August]” despite the devastating economic effects of the pandemic.
“From a capital perspective, in terms of appreciation and depreciation, 2021 will be a very interesting year,” Lynch says. “We may see depreciation at the start and more appreciation at the end, but guesses are loose at this point.”
Jeff Olin, CEO and Co-founder of Toronto-based Vision Capital Corp., says the majority of what’s unfolding in the real estate space is tied to “the acceleration of trends that were already in place” prior to the pandemic, such as increasing e-commerce and declining demand for office space.
“E-commerce sales as a growing percentage of total retail sales has been very detrimental to mall and retail [properties],” Olin says. “There were already long-term secular reductions in demand” for office space in cities like Toronto and Montreal, where the square footage per employee has consistently fallen in recent years.
While Olin acknowledges the need to accommodate physical distancing in offices will partially offset declining demand, he still has a negative view on office space demand, particularly because the CEOs of many large companies have said they don’t plan to have employees return to the office when the pandemic ends.
Olin’s firm offers Vision Capital Opportunity funds, which are value-driven alternative funds for accredited investors. The funds had AUM of $630 million as of July 31.
The Vision funds take both short and long positions in stocks based on assessments of real estate supply and demand alongside analysis of interest rate movements and regional trends. Olin and his team have the ability to short-sell names they believe are overvalued and invest in names they believe are undervalued.
“The ability to be short on a relative or absolute value basis is significant,” Olin says. “In January, we remembered [the SARS outbreak] when we started getting news feeds about something called ‘coronavirus.’ All things travel-related were hit with SARS, so in January we shorted [Virginia-based] Hilton Hotels & Resorts.” (The listed company is Hilton Worldwide Holdings Inc. [NYSE: HLT].)
Olin adds that Vision also took short positions in other global hotel chains at that time.
Combined top allocations by net exposure in the Vision funds as of July 31 were multi-family (42%), single-family rental (38.9%) and industrial (16.8%) properties. At that time, the funds held short positions in hotels (-2.5%), office space (-3.1%) and net lease properties (-3.5%).
Regionally, the Vision funds’ exposures were tilted toward the U.S. and global, at 66%, with 34% allocated to Canada as of July 31.
The pandemic has presented challenges in assessing investments, Olin concedes. He prefers to visit real estate sites and meet with management teams in person, but the majority of buys now take place following video-conferences.
When Covid-19 took hold, there was “indiscriminate selling in markets,” Olin says — which presented a buying opportunity for the Vision funds.
“This environment has allowed us to get investments in sectors that we’ve loved for years but [we felt] were too expensive,” Olin says. These sectors include real estate tied to e-commerce as well as single-family rental homes, the latter of which are mainly located in the U.S. Sun Belt, where supply and demand metrics “have received a boost.”