Andrew Moffs, senior vice president and portfolio manager, Vision Capital

FOCUS: Real estate stocks 

MARKET OUTLOOK:

The extraordinary monetary policy response from central banks throughout 2022 has started to show signs of its objective, with the multi-decade high inflation levels starting to taper off. However, these events have pushed economies into deceleration territory. The impact of these policies last year, and market uncertainty, continue to increase the likelihood of a recession in developed markets in 2023.

In the first six months of last year, the speed and scale of the monetary policy change contributed to publicly-traded REITs having the worst stock market performance ever. This was a result of sharp sell-offs in the stock market that created dislocations where publicly-traded REITs became more correlated to the broad equity market, instead of the private market. This caused publicly-traded real estate securities to trade at a significant discount to the underlying net asset values, creating an opportunity to buy real estate cheaper in the stock market than in the property market.

In the early days of 2023, structural inefficiencies in private real estate are starting to emerge. Where publicly-traded real estate securities are marked-to-market daily, non-traded REITs and direct property investments rely on lagging, backward-looking appraisals to value their respective holdings, creating a timing mismatch between the property market and its publicly-listed counterparts.

As well, in periods of market stress, a high number of redemption requests on these non-traded REITs is often met with restrictions on redemptions levied by the fund managers, creating non-favourable illiquidity. This liquidity issue highlights the benefit of publicly traded real estate securities.

Last year saw a significant slowdown in mergers and acquisition activity and private placement vehicles. However, select institutional investors continued to find opportunities due to the large discount to NAV that has emerged in the public markets. This was highlighted by a joint venture between Singapore’s sovereign wealth fund GIC and Dream Industrial REIT which announced an agreement to acquire Summit Industrial Income REIT on Nov. 7, 2022. The further anticipation in the recovery of the credit market in 2023 bodes well for further mergers and acquisition activity, which additionally can provide favourable returns for REIT investors.

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TOP PICKS:

First Capital REIT (FCR.UN TSX)

First Capital REIT owns interests in over 22 million square feet of retail real estate located in Canada’s major urban centres. More than 85 per cent of the portfolio is leased to tenants providing essential goods and services and the portfolio has over 24 million square feet of future development potential. Vision believes this is the highest quality and best-located grocery and pharmacy-store-anchored portfolio globally.

At First Capital’s Annual General Meeting (“AGM”) on June 21, 2022 the REIT’s former chairman and chief executive officer, Dori Segal, posed two pointed questions to First Capital’s management team and board of trustees. Vision believes one objective of this questioning was to disseminate publicly, Mr. Segal’s ownership, dissatisfaction, and potential activism. Notwithstanding the importance of this event, no real estate research analyst has published a note informing their clients of this.

Over the five years leading up to the disclosure of Segal’s potential activism at the REIT’s AGM, (June 21, 2017 – June 21, 2022), the units of First Capital had been the worst-performing Canadian shopping centre REIT with a total return of -13 per cent versus +35 per cent for the REIT’s peers. This is in contrast to the five years prior to the hiring of the current CEO on Feb. 16, 2015, when the units of First Capital were one of the best-performing grocery-anchored shopping centre REITs with a total return of +94 per cent versus +59 per cent for the REIT’s peers.

The supply and demand backdrop for grocery-anchored shopping centers is increasingly favourable in the current economic environment with minimal new supply and a high degree of recession resistance. Over 85 per cent of First Capital’s tenants are necessity-based retailers which offer essential goods and services. In a recessionary environment these tenants, and as a result First Capital’s properties, will outperform peers more exposed to discretionary retailers.

First Capital is well positioned for strong unit price outperformance. This is because supply and demand fundamentals continue to be favourable at a time of increased activism. The REIT is trading approximately 29 per cent below comparable private market values (the most discounted valuation in the Canadian shopping center REIT space).

Sun Communities (SUI NYSE)

Sun Communities owns and operates approximately 117,400 manufactured housing sites, 63,200 recreational vehicle sites and 46,100 marina wet slips and dry storage spaces, all are located in 39 U.S. states, Puerto Rico, Ontario and the U.K. The REIT focuses on high-quality properties that tend to be clustered in popular coastal and vacation destinations. Its largest markets are Florida, Michigan, the U.K., California and Texas.

The manufactured housing communities (“MHC”) sector has several uniquely positive characteristics. Namely its resilient demand and high barriers to entry have resulted in the publicly-listed U.S. sector, on average, never having a negative year of same-property net operating income growth. The sector also benefits from lower capital expenditures relative to other asset classes as it is largely a land lease business. The marinas business similarly has compelling supply-demand dynamics, with 12 million registered boats in the U.S. versus an estimated supply of between 0.9-1 million wet slips. As a result, approximately 85 per cent of Sun’s marinas have a waitlist.

With uncertainty in the economic environment over the year, Sun is well-positioned to capture continued rental growth. To this point, the REIT is currently in the process of distributing 2023 rental rate increases to its tenants. This is expected, on average, to range from 6.3 per cent year-over-year for its MHC business to as high as 7.8 per cent year-over-year for its annual RV segment, at the midpoint of its guidance. Importantly, these levels for represent an acceleration in growth that Sun is achieving, unlike other sectors where growth may be moderating this year.

Sun’s shares are an attractive investment opportunity as they trade at an approximate 12% discount to NAV in a sector with positive supply-demand fundamentals and defensive and growing cash flows.

American Homes 4 Rent (AMH NYSE)

American Homes 4 Rent (AMH) owns nearly 58,000 single-family rental homes across 21 states in the U.S., with most of its NOI coming from high-growth Sun Belt markets. AMH is well-positioned to benefit from the strong outlook for single-family home rental (“SFR”) operating fundamentals, in addition to being uniquely positioned among the publicly-traded SFR operators with an internal development program.

SFR is currently benefitting from a favourable supply-demand imbalance that should bode well for the sector over the long term. Population growth of the 35-44-year-old age group, the primary cohort requiring housing, is projected to grow at twice the rate of broader population growth over the next five years. This should result in strong demand for both homes to purchase and homes to rent. At the same time, the production of new single-family homes remains well short of historical levels, both on an absolute basis as well as the amount required based on current demographics. In addition to these factors, it is currently more affordable to rent than to own a home. It is estimated that the median monthly payments between owning versus renting a home have widened to approximately US$1,200 per month, or approximately 60 per cent greater to own than rent. As such, this demand for rental housing should currently provide SFR operators with higher retention rates as well as pricing power.

Amongst the publicly-traded SFR companies, AMH is uniquely positioned with its extensive development pipeline of more than 15,000 lots owned and optioned, which provides for years of built-in or internally-generated earnings growth. In addition, management believes there is the potential for development yields to increase by as much as 100 bps, to the seven per cent range, due to lower construction costs, as the cost of building materials has begun to ease because of the slowdown in homebuilding. As a result, the combination of increasing deliveries at higher yields should aid in the REIT’s earnings growth for 2023.

With AMH trading at an estimated 17 per cent discount to the underlying value of its homes and a more stable source of earnings growth than peers with its focus on its development pipeline, the REIT is an attractive investment opportunity.