Navigating the third leg of REIT valuations: the view from Echelon
For the relatively new two-person team of real estate investment analysts at Echelon Wealth Partners, the third leg in the valuation of the issuers they cover has arrived, a time characterized by a larger focus on interest rates.
And, according to Frederic Blondeau and Stephane Boire — both of whom arrived at the firm late last year from the former Dundee Securities — in that third leg, an issuer’s risk management strategy is the top priority when they assess the merits of the companies they cover.
That heightened priority has arisen because of concerns about actual — and projected — interest rate increases by the central bank. In Canada’s case, there have been two rate hikes: the first in July and the second in September when they were raised by 25 basis points. Most economists expect the Bank of Canada, along with its U.S. counterpart, is not done with rate hikes for 2018.
“Rates will always be the biggest risk factor for interest sensitive sectors, including REITs,” Blondeau said on Tuesday. “Rates are now more volatile so a bigger focus is required on risk management.”
The renewed focus has occurred following two other legs: the first from 2012 to August 2016, when rate hikes were not a concern.
“We felt rates had more leeway on the downside,” said Blondeau. “As a result, we didn’t feel that REITs were at risk from a pure macro standpoint,” he said, adding that two-thirds of the issuers he covered were, at that time, rated as buys.
But in the summer of 2016, the second leg got underway, helped by the “positive” push from the creation of a new separate real estate index (previously part of the financial services index) and the feeling that rates would continue to stay low. “But I thought the REITs were fully valued, which meant there was little upside.”
That environment meant the two analysts largely abandoned a ”top-down” approach — which favored a buy and hold strategy — and opted more for a bottom-up approach that focused on stock picking.
“After that, I got lucky,” said the Montreal-based Blondeau, when referring to the effects of the election of Donald Trump, including the “Trump tantrum,” which had a positive effect on interest rates.”
But in the middle of 2017, Blondeau said his team readjusted its strategy, because the “Trump trade” was faltering. As a result, the team opted to “not to be too cautious.” Accordingly, it upped the rating on half a dozen of the 20 REITs or real estate operating companies that it covers. Now two-thirds of that universe is rated a buy.
“We are more open to be more reactive in our ratings. We will be more dynamic (given) that rates are becoming more volatile,” Blondeau said, noting that “quality” will now assume a greater importance.
As for particular sectors, those REITs whose business is in apartments or industrial properties will be favoured, while those that focus on office and retail will be avoided. “Retail in particular should continue to perform relatively poorly in this environment,” he wrote this week.
InterRent is the firm’s top pick. Others with a buy rating include: Pure Multi-Family; Northview Apartment; Northwest Healthcare, Killam Apartment and Morguard North American Residential.
But with many issuers set to report their financial results in the next six weeks, Blondeau may make some changes. “We will have precise questions in terms of operations and new supply in each of the sectors,” he said. “You will have to be more active to generate alpha (or outperformance) because of the expectation the market will produce lower returns.”