Nicola Wealth has consistently included real estate within its recommended asset allocation strategy for numerous years. Over the past two decades, we've closely monitored the Canadian publicly traded Real Estate Investment Trust (REIT) market. One intriguing aspect has been the varying ways in which private and public markets assess the value of real estate investments. Sometimes, publicly traded real estate vehicles seem overpriced compared to private market valuations, while at other times, public markets appear undervalued in relation to private markets. These discrepancies can arise due to a multitude of factors, such as shifts in monetary policy, global pandemics, financial crises, or even distortions caused by accessible funds and a vigorous merger and acquisition environment.
The prices of publicly traded REITs can exhibit volatility; however, they eventually gravitate toward the intrinsic value of the assets. This tendency leads to a pull back toward the Net Asset Value (NAV) as publicly traded REITs mean-revert and trade close to their NAV.
Illustrated in the graph below is the historical pattern of publicly traded REITs trading either well above or below NAV estimates. Instances of significant discounts to NAV estimates have historically yielded average forward twelve-month returns of approximately +25% for the iShares S&P/TSX Capped REIT Index. Currently, we consider the publicly traded REIT market attractive, appreciating the investment opportunities within specific real estate sectors, although not all.
The present disparity between public and private market valuations stems from the rapid surge in bond yields. The escalation in bond yields during this tightening cycle has exerted pressure on sectors favoured by investors for their yield, such as telecom, pipelines, and REITs—all experiencing valuation declines. Over the long run, there is an anticipated convergence between publicly traded REIT prices and their underlying NAVs. An essential catalyst for achieving this lies in the stabilization of interest rates, marked by the halting of central banks' rate hikes and the initiation of discussions about potential rate cuts. Challenges like high inflation, concerns about the banking sector, economic deceleration, and elevated interest rates are complex issues to address that require patience. Nevertheless, we find current valuations appealing, noting that the ability to achieve investment returns in this area correlates directly with the depth of discount at which investments are acquired in relation to NAV.
Source: Nicola Wealth Public Assets team
As interest rates stabilize, we believe the market will gain a clearer perspective on the cost of capital, enabling a more precise assessment of future real estate values. This, in turn, will help alleviate the uncertainty surrounding REIT share prices.
Our approach to selecting publicly traded REITs leans towards a targeted strategy as opposed to passive ETF investing. Passive ETFs tend to be market-cap weighted – in other words, passive ETFs will heavily weight REITs according to their relative total market capitalization rather than weighting REITs that show strong growth in income and asset value. Asset values appear to be holding up in sectors where growth in income generated is strong enough to offset modest cap rate expansion. For instance, the residential REIT sector remains sturdy due to heightened housing demand and ongoing affordability concerns, elevated industrial demand prevails with restricted new supply, while the retail sector sustains strong leasing momentum despite macroeconomic uncertainties. On the other hand, office fundamentals are likely to encounter near-term pressure.
We believe public market valuations appear attractive, and any substantial downward pressure could create opportunities for REIT acquisition, especially for investors seeking income solutions.
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. All investments contain risk and may gain or lose value. Please speak to your Nicola Wealth advisor for advice based on your unique circumstances. Nicola Wealth Management Ltd. (Nicola Wealth) is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required securities commissions.
