Real estate investment trusts or REITs have been generating some interesting returns on both sides of the 49th parallel over the past three years. The MSCI US REIT Index, which represents approximately 85% of the U.S. REIT universe, was up 9% in 2011, after rising 28% in 2010 and 29% in 2009.
North of the border, temperatures may be colder but the Canadian REIT market is not—the S&P/TSX REIT Index returned 22% in 2011 after gaining 23% in 2010 and a whopping 55% in 2009.
REITs have existed in the U.S. since the 1960s and in Canada since ‘90s. They are companies (configured as trusts) that own and usually manage income-producing real estate property (including, soon, the Empire State Building, the owners of which have just announced plans to form a REIT as part of a proposed $1 billion IPO). Because they must distribute virtually all of their net taxable earnings to shareholders, REITs can reduce or eliminate corporate tax. Today, there are about 35 REITs in Canada and 100 in the United States.
Investing in REITs is something Andrew Moffs and Rod Hinze know a little something about. Both manage real estate hedge funds—Hinze in Dallas Texas, Moffs in Toronto, Ontario—and both focus largely on REITs.
Hinze, the founder of KeyPoint Capital, manages the $37 million KeyPoint Real Estate Opportunity Hedge Fund, an opportunistic fund launched in 2009 that returned an impressive 15.6% in 2011 and was up approximately 3.6% in January 2012.
Moffs works for SRE Securities, the Canadian arm of the Greenwich, Conn.-based Starwood Real Estate Securities, managing their fledgling Canadian vehicle, the Longwood fund. Launched in 2010 with local seed capital, the fund had returned 4.32% as of November 2011 and 10.51% since inception. It currently manages just under $5 million, and Moffs is now ready to make his case to outside investors.
Hinze, whose resume includes positions at both Bear Stearns (in mergers and acquisitions) and Goldman Sachs says it was during his time at the latter that he conceived of the plan for his own fund:
“Over at Goldman,” he told FINalternatives recently, "I was in the real estate private equity group (Whitehall) and that’s really where I came up with the idea for this fund, to have a more liquid way to invest in real estate and to be able to hedge my positions and go directionally short.”
Moffs has also focused on real estate investments for much of his career, which began at Salomon Smith Barney in 2000, and has included stints at ABP Investments US in New York and Waterfall Investments in Toronto, as well as time as a co-portfolio manager of a market neutral hedge fund called, appropriately, Neutral. He worked for SRE in Connecticut from 2004 to 2006, before returning in 2008 to launch the company’s Canadian arm.
The strategy for the Longwood fund, he says, is similar to that of the U.S. parent company: it’s a long/short vehicle focused on publicly traded real estate securities. Where Hinze confines himself to the U.S. market, the Longwood fund has roughly 50% exposure to Canadian securities, 45% to U.S. securities, and 5% to international securities. Moffs, whose fund focuses on commercial real estate, estimates the market capitalization of his investible universe at roughly $800 billion.
And what a varied universe it is: REITs include industrial warehouses, offices, malls, shopping centers, rental apartments, healthcare properties and some “sub-sectors,” as Hinze calls them, including datacenters, cell phone towers and timberland.
In addition to equity REITs, there are mortgage REITs, which Moffs says represent “a small portion” of what he does.
Beyond REITs, Moffs also looks at home builders and companies that own a lot of real estate. Such companies, he says, are valued by the market for their earnings, whereas Moffs considers what such a firm would be worth “if it simply sold off all its real estate or found a way to capitalize on the value of its real estate.”
Hinze says most hotels are not REITs, and he’s open to investing in hotels as well as certain non-REIT healthcare properties, movie theaters, prisons, home builders and building suppliers. “It’s a broad universe and I try to get involved in anything that either has real estate value or touches real estate.”
Moffs’ aim, as an investor, is to “capture that arbitrage between real estate trading on Wall Street versus Main Street” and he describes SRE Canada as “agnostic” in terms of “the vehicles in which real estate trades.”
Choosing a REIT or company to invest in, for both fund managers, involves some serious number crunching. Moffs looks at each potential investment to try to determine the “private market value” of its assets.
“We look at their income and we assign some sort of capitalization rate—which is basically the inverse of the multiple—and we then add other assets they have and deduct their liabilities and come up with the net asset value for each company…We have a good sense of where each of these publicly traded companies [is] trading relative to [its] net asset value, whether there’s a premium or a discount, and then…we try to ascertain why there’s a premium or a discount.”
Hinze also has his formulas. On the long side, he looks for “secular growth markets” within his universe. Once he’s identified such a market, he says, “I drill down into asset levels, cashflows, if I can, and then put a value on those cashflows, roll it up into an overall evaluation and take out any liabilities including debt or any kind of tax liabilities and then come up with an equity value per share and if that value is dramatically lower than where I think fair value is, I’ll take a long position.”
On the short side, Hinze says, he brings to bear the knowledge he acquired during his time at Goldman Sachs:
“At Goldman I learned about the leverage assumptions you can put on a piece of property or a portfolio of properties—at Goldman we would put leverage on the property, leverage on the portfolio, then leverage on the fund, and as long as your cost of debt is less than the yield on the properties, you can really juice the return on the equity by layering as much debt as possible, and when that goes against you, you can lose a lot of money very quickly.
“And so…on the short side particularly, I look for REITS and other operating companies that use a lot of leverage on their portfolio and in particular leverage that’s cross-collateralized with multiple properties, so if one goes down they can all go down together. That’s what really helped me generate positive returns on the short side, even in an up market.”
Hinze also looks for what he terms “broken business models.”
“[L]ast year I did well shorting a REIT that had a lot of exposure to Borders books. That, to me, was a business model that was broken and so, as I drilled down into the portfolio, I really came away understanding that the properties were not covering the debt…and the overall portfolio was not covering the dividend payout ratio. So, this company ended up cutting their dividend by about 25% and then the stock fell with it.”
But while number-crunching is an important part of the process, Moffs says “a lot” of his information comes from monthly meetings with managers and property tours.
“What’s nice about real estate compared to, perhaps, some other sectors,” says Moffs, “is that you can actually go to the property [in] Midtown Manhattan, you tour all a specific REIT’s properties with the property manager and get a sense for the way the buildings are managed, where there might be some tenants rolling their leases and moving out, and you get a good sense of, is the cash-flow sustainable or not, or if there’s an opportunity, perhaps, to even lift rents.”
At any given time, Moffs’ Longwood fund will hold between 40 and 60 positions (on the day we spoke, it held 43 positions—26 long and 17 short). Hinze, similarly, says his fund averages between 30 and 50 positions.
Both Moffs and Hinze are confident real estate markets on both sides of the border will continue to throw up opportunities.
“I think real estate will perform well as long as the economy can just sort of chug along at a low growth rate,” said Hinze. “Interest rates will remain low and that’s a great environment for real estate, but there are a lot of headwinds out there in terms of employment growth and these macro issues, in terms of sovereign debt issues, they can disrupt the credit market and anytime you have a disruption in the credit market that will hurt real estate, because they’re so levered to the credit markets. And so, I’m picking my spots…I’ve been market neutral all year and plan on keeping my net exposure pretty low and just sort of picking my points when the opportunities arise.”
Up north, things are looking, if anything, even brighter. Says Moffs:
“The real estate market in Canada is doing quite well, it’s pretty much thriving, and a lot of that is a confluence of two things. One is that the Canadian economy has weathered the storm quite well; any jobs lost from 2008 have been recovered and more. And Canada has just been generally regarded as a safe haven…
“The other thing of course, is that we’re in a low-interest rate world. So as soon as rates are really low, it’s quite easy for these companies to access capital and property owners are able to refinance their mortgages, issue unsecured bonds and [attract] capital to grow their companies and perhaps buy other assets, pursue M&A and be able to grow their cash-flow."
Moreover, Moffs says the Canadian REIT market has been growing and should continue to do so, as large capital flows, both foreign and domestic, have “provided some of the larger-cap REITS with access to capital and given them the means with which to grow.
“…[Y]ou’re seeing, for example, the largest Canadian REIT, a company called RioCan,…they own shopping centers and they’ve expanded into the United States because they’ve grown so large in Canada…that they said, ‘We have this attractive cost of capital and it’s becoming expensive to buy properties in Canada because of how well the property market is doing, let’s dip our toes into the United States.’ And the strategy is working nicely. So yes, in this environment, it’s a great opportunity for a lot of the Canadian companies to grow.