This week the Ontario government announced the Fair Housing Plan, a 16-point program that included a number of supply and demand measures, all designed to curb some of the excesses of the housing market. As expected reaction has been mixed with some arguing that it will create even more distortions; others argue that the changes represent a common sense proposal designed to make housing more affordable. Lost in those divergent views are the opinions of the professional money manager, those charged with investing client money in public real estate securities.
One such manager is Joshua Varghese, the lead Portfolio Manager of Signature Real Estate Pool and assists with the portfolio management of Signature High Income Fund and Signature Diversified Yield Fund, three funds managed by CI Investments Inc.
Signature Real Estate Pool and Signature High Income Fund each invest in Interrent REIT.
Here are the views of Varghese:
I’ve spent many years analyzing and investing in large real estate companies. In real estate securities investing, the biggest differentiating factor for successfully performing real estate companies over time tends to be the quality of the management team and the capital allocation decisions they make. These management teams are able to “compound capital” at a superior risk-adjusted rate, meaning that they create significantly more wealth for their shareholders over a long period of time. In fact, many of these companies have provided their investors significantly higher long-term returns than those same investors would have earned in the Canadian (and more specifically, Toronto) housing markets.
One of the biggest lessons I’ve learned from observing these management teams comes from how they make their investment decisions. They have a tendency to take rather conservative approaches to investing, meaning that they rarely overpay for expected growth, and they provide themselves strong “margins of safety” should their investment thesis not play out. This strategy serves as a compelling framework for any property investor to follow, and the basic message is simple: invest rationally.
While largely helpful, part of the Ontario government’s Fair Housing Plan will now limit property investors’ abilities to invest rationally.
To understand this, one needs to first understand how money is often made in real estate investing. Investment returns often come primarily from two things 1) income earned and 2) property price appreciation. Income is the amount that one earns on a property after collecting rent and paying property level expenses. The income earned divided by the total price paid is the yield, or in real estate terms, the cap rate. Property price appreciation is simply the growth in value of the property over time. If you were to buy a property at a 5% yield, with the potential for income to grow at a rate of 2% per year, then you can expect an annual unlevered return of around 7%. If you are really optimistic you might expect out-sized rental growth, so perhaps your expectation is that rents increase by 4% per year, taking your annual return to 9%. However if you are wrong, and rents only increase (as they often do) in line with inflation, then you still can earn a good return, since the income yield was there. If rents or property values decrease, you can still be relatively well protected with the income generated. In this case, growth is a bonus, not a requirement.
However what if the yield is not there? What if your earned rent is not enough to cover your current and long-term expenses? Let’s say your yield is 2%. If that is the case, you will require annual growth of 5% to earn your return of 7%. In an asset class where growth over the long term is typically closer to inflation, this is a leap of faith in something beyond your control. It will significantly depend on your expertise and ability to make accurate predictions on property pricing. If rents decline, there is a significant chance you don’t earn anything close to what you need, and a good chance you lose money. Add leverage (e.g. mortgage debt) to the equation and these losses can get significantly magnified. In this case, growth is an absolute requirement, and not a bonus. The smart real estate investors I’ve observed tend to not make a habit of making these investments unless they have developed a significant edge in understanding growth potential.
Back to the Toronto market.
A recent example of a condo I analyzed showed me that the initial yield on the property was around 2.5%. Add to that realistic long-term maintenance capital expenditures, plus the costs of interest and principal payments and that equates to negative monthly cash flow for a prospective buyer. In this situation, the only way to earn a decent return on one’s equity investment is to experience outsized growth (i.e. growth significantly above inflation) in value. It may happen, it may not, and it is entirely out of the investor’s control. If for some reason, growth is negative and the property price declines by a total of 10% over 5 years (that’s a 2% annual decline) then assuming one has paid a 20% down payment, an investor could see an annual return on their investment of negative 15%, due to the effects of leverage. Long-term successful institutional property investors tend to not make investments with this type of risk/reward profile.
On the other hand, what types of return does an institutional investor get on an apartment investment? In 2016 Interrent REIT, a successful Ontario Apartment REIT purchased a three-building apartment complex in Ottawa for a reported 5.3% yield. While the management team indicated that it is really excited about the growth prospects of the area, they paid a price that does not require outsized growth to make a decent return. This is a risk/reward profile that is extremely difficult for a condo buyer in Toronto to find.
Rental levels in Toronto have been growing strongly. They have finally reached a point where a sophisticated, risk-averse institutional investor is willing to take on the development risk of building a property because rent levels (or their yield on development) is attractive enough to give a reasonable risk adjusted return. There are currently pending apartment developments in Toronto that expect to yield 5.5%-7%. However the ability to be able to increase rents on the property adds significant upside to potential returns.
Institutional apartment development has come at a very important time in Toronto’s housing market. My belief is that individuals should consider renting (instead of owning) and using the money they save from down payments and housing costs to invest into more rationally priced investments. This view is highlighted in Alex Avery’s recent book “The Wealthy Renter”. Individual residential property ownership over time can produce good returns, but relative to other investment alternatives those returns are not as strong as many people think. And at a time where home price levels, debt levels, and price-to-income levels are at all time highs; my opinion is that individuals should seriously consider renting now more than ever. Institutional apartment development is in my mind a good way to create properly managed rental options for Torontonians. Institutional apartment supply transfers the risk of home prices to a more sophisticated owner, the apartment building builder (or owner).
But new rent controls could very likely cause a pause for many apartment developers. The upside potential to their investment returns was just seriously cut off, and building an apartment becomes a less rational investment than it was before the measure was announced. If they start to pull back their developments, then we could very well see a further ramp-up in condo developments. Note the risk transfer here: in a condo development, the builder bears the risk for the period it takes to develop the project (let’s say 2 years). After that, the long-term holder is the individual buyer of the condo unit. So the risk gets transferred very quickly from the sophisticated, experienced developer, to the less sophisticated individual homebuyer. Contrasting this with apartment development, the developer often ends up being the long-term owner of the building. So the risk stays in the most sophisticated investor’s hands.
The measures announced by the Ontario government seems to be predicated on the assumption that Canadians need to own their homes; with an approximate 70% home ownership rate in Canada, this view would seem to be supported. However with home ownership rates around 50% in Germany, and below that in Switzerland, is that a view that needs to be reconsidered? Are we really better off owning our homes vs. renting and investing our money elsewhere? It appears not. In my opinion the goal should be less about home ownership affordability and more about creating more long-term affordable options for living space in Canada, with a focus on creating more rental options. While rent control may cause a relief on rental rates, is a sure way to limit the development of more long-term living options.