The best-performing asset class in many portfolios last year was commercial real estate. That was certainly the case for Nicola Wealth Management Ltd. and other firms that use these types of investment strategies.
Upon hearing this, some investors may wonder, “How could that possibly be the case when real estate investment trusts (REITs) seem to have been the worst-performing asset class of 2022?” It appears to be a paradox, but it provides a lesson that investment vehicles can matter as much as the asset classes themselves.
To that end, many Canadians only diversify by utilizing publicly traded stocks and fixed-income instruments, whereas we believe that commercial real estate can be an important additional asset class for the right investors.
In this area, Nicola Wealth primarily invests in real estate through the use of limited partnerships (RELPs), where we directly own, develop, and manage properties. Investors also have the option to buy shares in REITs, either directly or indirectly through exchange-traded funds (ETFs). There are differences between RELPs and REITs, such as liquidity, valuation, and investment philosophy. In 2022, the most significant difference was price.
The characteristic of REITs to quickly reprice based on sentiment, due to their publicly traded nature, was very evident in 2022. This isn’t uncommon. In times of uncertainty, REIT share prices will often deviate from the actual market prices of the underlying property they hold (the net asset value or NAV). This means they can trade above or below the intrinsic value of the pool of real estate itself.
Let’s draw a point of distinction here between price and NAV. Price is what one pays to buy a REIT or a RELP today. The NAV is the assessed value of the underlying holdings.
As mentioned, the price of a REIT may be heavily influenced by investor sentiment and can decouple from the NAV. By contrast, the price of RELPs is typically almost the same as the NAV; it will usually lag the NAV only by the RELP’s frequency of a full valuation.
REIT price vs. NAV
For REITs, the NAV is the book price, which is the assumed value of all the real estate assets minus any debts and obligations.
A price/book ratio of one would mean that the trading price of the REIT exactly reflects the current NAV. Less than one suggests the REIT is either undervalued or that investors expect its price to decline. Greater than one suggests the REIT is either overvalued or that it might be expected to grow in price. Theoretically, a REIT should trade at a price that is a slight premium above its NAV considering the benefit of its high liquidity versus physical ownership of real estate.
For example, one of Canada’s largest REITs, Canadian Apartment Rentals REIT, traded at a premium in 2018 and 2019 when markets were more stable. When the pandemic emerged and roiled investors, the REIT’s price dropped too. Then in 2021, as markets boomed, it began trading at a premium again.
Enter 2022 and its very high inflation, sky-rocketing interest rates, and the rare double-decline in stocks and bonds. Canadian Apartment Rentals REIT had one of its most significant valuation falls in recent memory as investors quickly speculated that the future of commercial real estate would become challenging.
Why buy REITs?
Through this example, it becomes evident that REITs can be considerably influenced by investor sentiment, just like public markets. Some might argue this defeats the point of having commercial real estate in a portfolio. However, long-term investors who utilize REITs might point to the real rate of return as a counterpoint, relative to public stocks.
In all, what does this tell us? First, there is a relatively strong long-term case for investing in commercial real estate, depending on the investor. Second, publicly traded investments can be subject to rapid speculation based on fear and greed (note that I am not using those terms as pejoratives, fear/greed indexes are long-used means of summarizing prevailing investor sentiment using a variety of qualitative data). Third, it reinforces why some choose to own real estate through the RELP structure, believing that the investment price and NAV will be closer to real market rates.
REIT vs. RELP pricing
A natural question may follow the points above: Perhaps REITs declined too quickly, but won’t all commercial real estate eventually follow? In my opinion, the short answer would be “no.”
The inference of the question is that the RELP’s use of a different valuation structure means it will be slower to “catch up” with REITs. While no one can predict the future, there are plenty of reasons for us to believe this won’t be the case.
For instance, RELPs may use many active strategies to hedge downside risk. They don’t usually buy commercial real estate as a monolithic asset class. They don’t focus solely on collecting rents.
Instead, my experience is that RELPs mainly seek diverse, targeted strategies that will perform well in both existing market environments and in the future.
One interesting point about REITs is that the pricing mechanism can occasionally shift too far to the negative, potentially positioning REITs attractively for the future. Essentially, if a REIT is well-capitalized and is producing steady cash flow, it can be an opportune time for entry when a REIT’s price is well under its NAV (and one even we have considered on occasion).
That said, our preferred long-term approach remains to recommend the RELP structure for potential return maximization and volatility reduction in a diversified portfolio. Our analysis of the two investment vehicles has historically demonstrated higher downside protection for RELPs over REITs, potentially leading to greater long-term returns.
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In all, investing in commercial real estate can be a helpful addition to many investors’ portfolios, so long as it is approached strategically. One should understand how the characteristics of RELPs and REITs align with an investor’s profile (including their risk tolerance) and how these investments fit into the overall investment plan.
Chris Warner, FCSI, CIM, CFP, PFP, is a wealth adviser at Nicola Wealth Management Ltd.