In Part 2 of this series, we delve into property valuations of private real estate investments, comparing the performance of Nicola Wealth Real Estate (NWRE) limited partnerships (LPs) with REITs and identifying areas of additional value. Additionally, we explore various strategies for real estate investors to position themselves in this dynamic environment. Lastly, we provide a brief outlook, outlining how the NWRE team plans to navigate the upcoming months.
Why are property valuations under the microscope?
Recently, there has been scrutiny of valuations for private real estate. This is understandable given that publicly traded REITs are trading well below their Net Asset Value (NAV). However, if you asked CEOs of REITs, most would agree that the REITs are not representative of the true market value. REITs are not prepared to sell their prime assets in this current environment just to achieve liquidity. The primary reason for this is they would be challenged to replace these prime assets in the future.
Lack of confidence in the public markets is caused by emotional behaviour that creates volatility. Rising interest rates play a significant role in market sentiment as some (but not all) of the REITs typically use floating debt which has caught many off-guard. This is not the case for NWRE LPs as most of our debt is locked in long-term at attractive rates.
The common question we are asked relates directly to our valuation process. It is important to note that the main industry players all use appraisers. NWRE, public REITs, pension funds, and institutional owners use professional appraisal firms and methodologies.
Every asset (excluding those under construction) in the Nicola Canadian Real Estate Limited Partnership (NCRE LP) and Nicola U.S. Real Estate Limited Partnership (NUSRE LP) is appraised on a quarterly basis. This process is utilized to help establish a Net Asset Value (NAV) every month to ensure fairness to our investors. This includes one full narrative report and three quarterly updates.
No internal valuations are completed for our income-producing properties. The third-party appraisals are reviewed by the NWRE team starting with the asset management and leasing teams who undertake a thorough analysis to ensure all assumptions, market comparables, and appraisal methodologies are correct. The independent third-party appraiser has the final say on valuation.
Value lies in the team behind the fund
Not only are real estate funds created differently, but so are the real estate teams that run their respective portfolios. This is where we believe the NWRE team has a big advantage. We believe the “noise” in the media about the “imminent demise of commercial real estate” is overstated. Peeling back the layers of these articles, one will find that the majority relates to downtown high-rise offices, an asset type that we do not hold in our portfolios. Hotels and enclosed malls have also received negative press, for obvious reasons coming out of the pandemic, neither of which we own.
We attribute the performance of our real estate limited partnerships to the strength of our in-house NWRE team comprised of 65+ people, with a wide range of expertise, actively managing the real estate LPs. Headquartered in Vancouver, the team includes the following areas of specialization: acquisitions/dispositions, active asset management, leasing, mortgage debt, the development team for build-to-core and finance/accounting.
Once a property is acquired or developed, the hard work begins, starting with active asset management. We employ a "hands-on" approach with a high level of collaboration across various departments to ensure the best possible outcome for each and every asset. This, in turn, aims to deliver strong performance for the funds and, ultimately, solid returns for the investors.
Selecting the right markets and asset types will go a long way in ensuring high occupancy levels are maintained. This lays the foundation for reliable cash flow and healthy annual income growth. Our focus is on achieving high occupancy rates, rental growth, and securing quality covenant tenants. Our team strategically works on leasing outcomes that can enhance the valuation and set the stage for the debt team to refinance the asset on improved terms in the future.
Why is build-to-own a good strategy?
Build-to-own is a popular strategy for many sophisticated real estate groups in both publicly traded REITs and private real estate funds. If done properly, a build-to-own strategy can result in attractive development yields, and one can be rewarded for the risk. Selecting the right location and asset type positions the property for potential success for a timely lease-up and stabilization upon project completion.
Multi-Family Rental - Build to Own: The James, 345 Quebec Street, Victoria, B.C.
The NWRE team has an experienced in-house development team to execute this strategy and create value for our investors. Our team specializes in various types of developments, such as multi-family rental apartments, industrial distribution, self-storage, and creative office products. Focusing on new product development helps minimize capital expenditures in the foreseeable future and, more importantly, generates risk-adjusted leveraged returns for our investors.
Industrial - Build to Own: 601-607 Milner, Toronto, ON
Why is mortgage debt critical to fund performance?
One of the many challenges for publicly-traded REITs and certain private funds is their reliance on floating debt. Everyone was spoiled in the low-interest rate environment over the past 10 years. Using floating debt was a popular strategy used by many fund managers to help provide enhanced returns. However, many have been caught off guard in this rising interest rate environment which has led to negative impacts on returns and further distress from higher redemption requests.
The NWRE team has an experienced three-person in-house debt team that manages our entire $9.5B portfolio including acquisitions, construction, land loans, and takeout financing. This has led to some favourable outcomes for our LPs. The NWRE debt team adopted an aggressive approach in late 2021 to lock in debt and renew early on the anticipation of rising interest rates with the overall goal of de-risking our portfolios.
Both income portfolios boast low debt coverage ratio (NCRE LP @ 43% & NUSRE LP @ 48% as of June 2023) meaning that the LPs are not overleveraged. Moreover, our two income portfolios have minimal exposure to floating rate mortgages as a large portion of the portfolio is locked in at favourable rates (by today’s standards) for terms ranging from 5 to 10 years. NCRE LP has 71% fixed with only 29% floating. Whereas NUSRE LP has 91% fixed and 9% floating. Overall, there is minimal exposure to floating rate mortgages.
Why does governance provide good oversight and accountability?
Smaller fund managers/owners may not have proper oversight on decision-making, but governance is vital to provide proper belts and suspenders for the larger fund managers/owners where the stakes may be much higher. The NWRE team operates with a strong level of oversight starting with the NWRE Investment Committee that is comprised of four independent members, each having extensive real estate experience. Every acquisition and disposition must receive unanimous approval prior to proceeding which promotes healthy discussion and accountability. In addition to the Investment Committee, the NWRE team reports to the firm’s Investment Review Board, Board of Directors, and the Senior Leadership team. Overall, there is strong governance for the Nicola Wealth’s Real Estate LPs.
Where do we go from here?
Since February 2022, the Bank of Canada has raised the overnight lending rate nine times, increasing it from 0.25% to 4.75%. This rapid increase hasn't been witnessed since the early 1980s. In the early 2000s, the real estate markets benefited from access to relatively cheap money, abundant capital, and, most importantly, positive leverage of 200-300 basis points. However, these favourable conditions have now quickly disappeared, leading to differences in how lenders view various asset types and markets.
Challenging assets have seen significant declines in their valuations and, more worryingly, have become very difficult to finance. On the other hand, in-demand assets have experienced only moderate valuation impacts, but access to debt remains relatively strong. The main challenge now is that there is little to no positive leverage available in the current environment.
There is a flight to quality by lenders in terms of asset types, target markets, and borrowers. The overflowing market of capital experienced in 2021 and early 2022 has dissolved and is not expected to improve until 2024. In this stressed environment, there is also a flight to quality for investors on where to invest. Healthy and strong portfolios are well positioned to prosper in this challenging environment and can take advantage of those who may be forced to liquidate their quality assets.
In closing, we believe the NWRE team is in a strong position to benefit from this environment. We understand the importance of a well-diversified portfolio comprised of the desired assets in the preferred markets that have the prospect of maintaining and growing revenue. At this time, many players are on the sidelines reassessing their portfolios with high debt and redemption requests thereby creating a golden opportunity for funds such as the NWRE LPs which are well capitalized and designed for resiliency.
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 LP (NCRE LP), Nicola U.S. Real Estate LP (NUSRE LP) and the Nicola Value Add Real Estate LP (NVARE LP).
