The importance of fund composition in achieving strong risk-adjusted returns is a critical aspect of investing, and real estate is no exception.
Investors who choose to hold publicly traded stocks and bonds are usually aware that each of these asset classes has many sectors and attributes that impact both risk and return. In the case of stocks, for example, small-caps and emerging markets are expected to generate higher long-term returns but with notably higher volatility. Even within large-caps, the risk-return profile can vary between growth and value stocks.
Similar differences can be found in fixed income assets. High-yield bonds and distressed debt generally pay much higher interest than government or highly rated commercial bonds. Traditional mortgages on homes normally offer lower yields than mezzanine debt used in construction financing.
Within investment cycles, there are times when the returns generated from higher-risk assets are worth the added risk they present. However, there are also environments where the additional risk is too great and expected higher returns do not materialize. When creating any stock or fixed income portfolio, fund composition is essential. With regards to real estate, this has been especially true over the last few years.
Why is fund composition essential to overall performance?
In the words of Stephen Schwarzman, CEO and Founder of Blackstone Group, "You can't paint commercial real estate with one brush." In other words, not all real estate funds are created equally. His words resonate, especially in our current environment. In May 2020, shortly after the onset of COVID-19, we wrote an article titled “Real Estate’s Next Challenge – Fund Composition.” We stated that it was important to bulletproof your portfolio in preparation for the next economic event. That "next economic event" arrived much earlier than anticipated in the form of higher interest rates. The Nicola Wealth Real Estate (NWRE) team was fully prepared for this challenge.
The rising interest rate environment that has accrued since February 2022, with nine successive rate increases from the Bank of Canada, has put real estate in the spotlight. Debt is directly correlated with capitalization rates, and there is increased scrutiny on property valuations for private assets and funds. Fund composition can have a material impact on how property values are affected. Property valuations for the various asset classes are impacted based on several factors.
Firstly, market demand for leasing can be impacted by supply in any particular market. If a market has a low vacancy rate, there is a high probability of securing tenants at higher rental rates and with quick lease-up time. Another factor is the demand from investors to acquire specific assets that are impacted by the amount of capital required to maintain the assets. For example, high-rise office buildings typically command large tenant inducements and leasing fees, requiring large capital outlays. This can have a negative effect on the property value compared to asset types that are less capital intensive, making those investments more attractive and resulting in premium pricing. This is why fund composition matters, specifically market selection and asset types/allocation. Not to be overlooked are people. An experienced team with a hands-on approach can also determine outcomes.
In terms of market selection, too much exposure to one market could limit the upside and prove costly with limited liquidity if the economic drivers of that specific market deteriorate. Some fund managers purposely elect to focus on one specific market due to bench strength, fund size, or resources within the team. This can be beneficial when drivers for that market are strong but could also end up being punitive when those drivers deteriorate. Conversely, some fund managers feel it is essential to have a diversified strategy in markets to limit the downside. For example, the NWRE team completes a comprehensive analysis of each market we invest in to ensure strong demographics where we can succeed and employ our cluster strategy. Given the size of our portfolio, we have purposely elected to concentrate on selected major markets along with some strong secondary markets to provide a diversified and balanced approach. We aim for our target markets to possess features such as strong economic drivers for job growth, established universities, strong labour markets, a favourable tax environment, and low overall vacancy rates for the desired asset types.
Equally important is asset selection and allocation. In Q2 2020, at the onset of the pandemic, we witnessed firsthand how different assets performed during a stressed environment. This information reinforced that the NWRE team was on the right path with asset selection and allocation, as our real estate portfolios comprised strong-performing assets. The strongest performing assets within the Nicola Wealth real estate portfolios included multi-family rental apartments, small and mid-bay industrial, self-storage, industrial outside storage (IOS) sites, seniors living, flex industrial/office and single-story/low-rise office. These assets typically require low capital outlay both to retain existing tenants as well as attract new tenancies. We also favour these assets as they offer an attractive opportunity for rental growth, which is very important in this environment to help counterbalance any rise in cap rates.
The NWRE team has purposely steered away from high capital-intensive assets such as high-rise offices, certain types of retail, and hotels. This does not mean we will not consider these assets in the future, as we remain flexible and actively monitor trends. Fund composition is critical to building a well-diversified portfolio to ensure there is not too much exposure to one asset type and promotes a healthy balance of reliable and consistent cash flow. The NWRE team closely monitors market trends and performance for each asset type to make any necessary adjustments to limit overexposure to any one category. For example, the asset composition from 10 years ago for the Nicola Canadian Real Estate LP and the Nicola U.S. Real Estate LP, looks much different today and could very well look different again in 10 years' time should market conditions warrant further adjustments. We look for good deal velocity from leasing demand and acquisitions. The strong pace for both leasing and buyer demand reaffirms that cash flow is maintained, and values will hold firm for the quality assets.
How has this strategy translated into results?
When we look at the results over the previous year for the Nicola Canadian Real Estate Limited Partnership (NCRE LP), the biggest contributors to the 2022 returns were our industrial and self-storage assets. Our industrial assets, particularly in Toronto and the GTA, performed well despite rising cap rates due to the ongoing upward pressure on rental rates resulting in higher valuations. Yields for self-storage assets performed above expectation as the net income growth was significant due to our experienced in-house leasing and asset management teams moving rents to market after years of stagnant growth.
Industrial – Build to Own: 880 Avonhead Road, Mississauga, ON
Advanced Self Storage - Squamish
For the Nicola U.S. Real Estate Limited Partnership (NUSRE LP), the primary driver behind the double-digit returns for 2022 was the performance of our multi-family portfolio, which despite cap rate expansion, appreciated in value due to the level of net income growth. Our industrial distribution and flex assets also experienced similar rental growth contributing to the overall performance. The limited office assets we own in markets such as Denver, Houston, and Chicago did experience decreases in value, but they represent a very small allocation (less than 2%) within the NUSRE LP.
Multi-Family Rental – Build to Own: The Rex, 33689 King Road, Abbotsford, B.C.
The NWRE team reports to Morgan Stanley Capital International Inc. (MSCI) for portfolio benchmarking purposes for the NCRE LP and NUSRE LP. MSCI is a leading provider of global indices and benchmark-related products and services to investors worldwide. This is a measurement commonly used in the real estate sector to help benchmark at the asset level.
NCRE LP ranked 6th out of 47 funds (total return) in Q1 2023, reporting to the MSCI Canada Index (which excludes Super-Regional and Regional Shopping Centres).
NUSRE LP ranked 1st out of 38 funds (USD total return) in Q1 2023, reporting to the MSCI/PREA U.S. AFOE Quarterly Property Fund Index. PREA (Pension Real Estate Association) is a non-profit trade association for the global institutional real estate investment industry. AFOE (All Open-end Funds Property Level Index) applies to direct property only.
Interestingly, the NUSRE LP has ranked first in income growth in every quarter since March 2020, thanks in large part to our multi-family portfolio. In addition to the strength of the multi-family assets, we also outperformed the MSCI benchmark for industrial, retail, and other (development), only underperforming in the office sector.
Why do some investors prefer private real estate funds?
With publicly-traded REITs, investors may prefer liquidity, but they also knowingly sign up for volatility. Private real estate funds, however, typically attract patient, sophisticated investors who don’t require liquidity but subscribe to a long-term investment approach without volatility. The stability of reliable cash flow coupled with the opportunity for income growth stemming from a well-diversified portfolio is appealing to this type of investor. These features further underscore why fund composition matters. Cash flow certainly may vary depending on asset type and market selection. If done properly, each individual asset within the fund should have attractive liquidity if exposed to the market for disposition. The danger in disposing of prime assets is the challenge of replacing these properties at a future date at an attractive price.
Watch for Part 2 of this series, where we explore property valuations and strategic advantages.
The Nicola Wealth Real Estate (NWRE) team is headquartered in Vancouver and is comprised of an experienced & diversified team of 65 specialists with a broad range of experience in different sectors of real estate. The NWRE team manages the three open-ended evergreen real estate limited partnerships for Nicola Wealth and their clients. The funds include the Nicola Canadian Real Estate Limited Partnership (NCRE LP), Nicola U.S. Real Estate Limited Partnership (NUSRE LP) and the Nicola Value Add Real Estate Limited Partnership (NVARE LP).
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. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may 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. This is not a sales solicitation. This investment is intended for tax residents of Canada who are accredited investors. Please read the relevant documentation for additional details and important disclosure information, including terms of redemption and limited liquidity. For a complete listing of Nicola Wealth Real Estate portfolios, please visit https://realestate.nicolawealth.com.
