IN THIS ISSUE: In today’s volatile investment climate, it’s important to find ways to mitigate exposure to the intense ups and downs of the market. One proven strategy is investing in income-producing assets, such as real estate, to provide stabilizing cash flow. This edition of Tactics explores why investment grade real estate should be an important piece of your portfolio puzzle.
There is probably no need for us to get as emotionally involved with real estate as Scarlett O’Hara’s father, but it has, over the centuries, been perceived by individuals and investors alike to be special — perhaps because it is “real” estate. In this newsletter, we explore where the investment cousin of housing (commercial real estate) fits into your portfolio. Standard asset allocation typically divides a portfolio between stocks, bonds and cash. Additional fine tuning would involve looking at Global vs. Canadian, small cap. vs. large cap., and growth vs. value.
Standard asset allocation typically divides a portfolio between stocks, bonds and cash. Additional fine tuning would involve looking at Global vs. Canadian, small cap. vs. large cap., and growth vs. value.
Traditionally, most advisors design their recommended portfolios around this approach for both funds and securities. Many clients have earned strong reliable returns from commercial or multi-family residential real estate, but most investment firms do not offer this option.
It is my belief that investment grade real estate should form a significant part of an investor’s overall portfolio. In 2003, the Economist magazine reported that commercial real estate worldwide had an estimated value of about $15 trillion (US) vs. a total of about $65 trillion for stocks, government and corporate bonds, and real estate (not including housing). In other words: almost 25%.
Here we are focusing on commercial real estate and not homes. Historically, this asset class has been limited to high net worth individuals and institutions. Over the last fifteen years or so, a number of real estate investment trusts have been created. Most have done quite well over the last five to six years because of a number of factors, including lower interest rates, an overall strong economy, reduced vacancy rates, and a desire by investors to acquire assets that provide a relatively high cash yield.
So where does real estate fit into an investment portfolio? In this article, I would like to focus on what we have done to create investment vehicles that allow you to participate in both commercial real estate and mortgage pools.
Outside of publicly traded REITs, there aren’t many liquid real estate funds available to investors. Globe Hysales (an investment tool used by advisors that analyzes the performance of mutual funds) reports only 11 real estate funds with a five-year track record and 3 with ten years or more. The Globe Peer Real Estate Index (made up of these funds) has averaged returns of 8.41% for ten years and 10.52% for five years (December 2005). Interestingly, the ten-year results are almost the same as the returns for the Globe Peer Canadian Equity Index (9.27% per year), but with less than half of the volatility (tenyear standard deviation of 6.15% vs. 14.27%).
In 2005, The Journal of Portfolio Management presented a detailed article on real estate and how it reduces overall portfolio volatility and increases cash flow simultaneously. You can also go to www.nareit.com (National Association of Real Estate Investment Trusts) and retrieve data showing that overall returns in publicly traded real estate vehicles from 1971-2006 averaged just over 10% per year with the same low levels of volatility as shown in the Globe Hysales analysis.
We currently offer our clients two investment vehicles for real estate:
- Mortgage Investment Corporations (MIC)
- Real estate limited partnerships
In both cases, these are exempt products issued with offering memorandums and designed for sophisticated investors. For the MICs we offer, we recommend a minimum initial investment of $25,000 and the real estate partnerships $100,000. For those among you who do not meet the BC requirements for accredited investors, the real estate LP minimums are $150,000.
Currently, all of our MICs are RRSP and pension eligible and we use them primarily in registered accounts, since their entire return is interest income. They are also ideally suited for donor advised accounts.
The key features of the MICs we use are as follows:
- MICs have traditionally lent money for construction financing (usually as second mortgages), this makes them a higher risk investment (although the pooling of mortgages reduces that risk significantly). However, many newer MICs have developed lowerrisk first mortgage pools and other types of loans that provide greater diversification with lower returns to reflect the lower risk. The MIC we have used the longest (since 1996) invests in second mortgages and has had an average net return after fees of 10.8% per year, with the lowest annual return being 5.6% in 2002.
- We work with two external managers who have created a number of mortgage pools with varying degrees of risk and return (see table below).
- We acquire units in their pools (one of the pools was designed exclusively for us and the other three are open to outside investors). Interest is credited monthly or quarterly and can be reinvested automatically or distributed.
- The manager often has a hurdle rate (a yield related to Government bonds and the risk of the pool). If the net return is over that rate, then the manager can earn a percentage (as much as 25%). Here is an example: assume you have invested in a First Mortgage pool with a hurdle rate of 5 Year Government of Canada Bonds plus 200 bps. Assume that the 5 year rate is currently 4%, so the hurdle rate would be 6%. If the manager earned 10%, then they would earn an additional fee of 25% multiplied by the rate earned (10%) minus the hurdle rate (6%). In this case, the result would be 1% (25% x [10% – 6%]). Should they fall below the hurdle rate, their base management fee drops (in some cases by as much as 50%).
- The MIC managers invest their own capital in these pools and derive part of their compensation based upon performance.
A look at our various MIC investments
From time to time we also are offered specific syndicated mortgages that we make available to our clients to participate in directly. Offering both higher yield and risk, these are typically limited to minimum investments of $100,000 and are therefore recommended only for very sophisticated clients who have experience in this type of real estate lending. Typical returns for these loans would be between 12% and 20% and, in most cases, are for less than two years.
One advantage that mortgage pools enjoy over other securities is the strong underlying security of the investment. Investments are secured by way of first or second mortgages on the real property being financed. Therefore, in the event that a borrower defaults on his/her payments, the MIC can foreclose and take possession of the real estate in order to be paid what they are owed. Conversely, investors in corporate bonds are typically secured only by a general claim to the company assets.
In February of 2000 we put together our first real estate limited partnership with an outside partner who managed the project for our investors. Since that time, we have acquired seven more commercial assets. Recently, we created a new limited partnership for the purpose of acquiring a portfolio of revenue producing real estate and mortgates for clients. In the space we have, I’ll outline the key features of these LPs and why they have been successful.
We do not consider commercial real estate a superior asset to a value based equity portfolio, but it is complementary and often non-correlated. While we have acquired a total of eight different assets over six years, we have also sold four of them because the price we were offered was more than we would have been willing to pay. As a result of this, a client who bought an interest in each asset would have realized a net compound rate of return since February 2000 of 26% annually.
Obviously this result was far in excess of what we hoped for, and is very unlikely to repeat itself (another reason for selling some of our assets). However, we do look for buildings that we can structure as follows:
- Primarily income-producing commercial real estate in Western Canada.
- Stability of income derived through mix of tenants, tenancies, and strength of the covenants.
- Strong locations within the local market supported by appropriate market demographics and regional economy.
- Attractive financing terms with non-recourse to investors.
- We are looking for the net income after all expenses (cap. rate) to be between 7% and 8% in an interest environment where we can lock in mortgage rates at 2% less than that. Our last project had a cap. rate of 7.5% and a ten-year mortgage rate of 5.4%.
- With modest leverage (typically 65% to 70%), we can earn a 7-8% cash return on invested equity and amortize the mortgage. This adds an additional return of between 3-4% per year of the original equity. We further project that over time rents will rise at 1-2% per year (less than anticipated inflation). Overall, that gives us a net long-term return after costs of between 10-13%. While the last few years were much higher than that, the future will be a more difficult market in which to earn returns.
- We have partners who work with us to find the right assets, manage the properties, and upgrade the quality of tenants (and the income). We all invest alongside our clients in every project.
- We have not considered individual housing, condos, or multifamily residential, because in virtually every case we have looked at, the cap. rates are below the cost of financing. This means that in order to get a return, one has to primarily count on price appreciation. We prefer to rely on cash flow to make most of our returns.
- Up until now we have focused on retail shopping centres and mini storage facilities, but we are reviewing other assets.
Commercial real estate is a market and, as such, it will go through cycles of performance as other asset classes do. For us, the assets we are acquiring now are meant to be long-term holds. If cap. rates rise and prices fall, then we feel we are well protected on our current buildings, because we have locked-in financing. The key is the spread between cap. rates and borrowing rates. We will not acquire an asset if the difference is not at least 2%. In November of 2005, The Nicola Crosby group created the SPIRE Real Estate Limited Partnership. SPIRE (Strategic Partnership for Investment Real Estate) differs from a single purpose LP in that it:
- Holds multiple properties.
- Includes syndicated mortgages.
- Allows investors to increase/decrease their involvement over time.
- Provides access to a professionally managed, diversified real estate portfolio.
- Operates with lower operational costs and fees as a whole than one based on each project if held seperately
Personally, I have found real estate and mortgage pools to be an effective asset class. Each of our clients’ needs is different, but in general terms I would have no difficulty in seeing between 20% and 40% of our typical client’s portfolio in these types of assets.
Good portfolio design comes from diversified asset classes. In our opinion, the overall portfolio should have more than 50% of its total return coming from income (rents, dividends, interest etc.). Cash flow matters. Income-producing real estate and mortgages offer a reliable income source, and a good balance with equities and other asset classes to provide a truly diversified portfolio.
Gone with the Wind ended with Scarlett O Hara saying “….I’ll deal with this tomorrow. After all, tomorrow is another day.” That might work well in getting Rhett back, but for making good asset allocation decisions, tomorrow may be too late.