MASTERCLASS: Real Estate - July 2019

Real assets encompass a range of investment options that offer diverse benefits. Incorporating alternative investments into a portfolio can protect investors against volatility and downside risk. In this Masterclass, 3 experts discuss why real estate has become such an important element of an investor's portfolio.

  • Hatem Zarrouk, Regional Vice President of Sales at National Bank Investments
  • Kim Inglis, Financial Advisor and Associate Portfolio Manager at Raymond James
  • Dennis Mitchell, Chief Executive Officer and Chief Investment Officer at Starlight Capital.

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  • 50 mins 29 secs

Clare O'Hara: Real assets encompass a range of investment options that offer diverse benefits. Incorporating alternative investments into a portfolio can protect investors against volatility and downside risk. Specifically, real estate securities, tend to march to their own market beat as they did in 2018 when they bucked the prevailing downward trend in the Canadian stock market. While the S&P TSX composite index fell almost nine percent on the year, the unglamorous real estate sector gained about six percent, second only to the healthcare sector.

Clare O'Hara: Joining us today to discuss real assets with a focus on real estate are Hatem Zarrouk, regional vice president of sales at National Bank Investments, Kim Inglis, financial advisor and associate portfolio manager at Raymond James and Dennis Mitchell, chief executive officer and chief investment officer at Starlight Capital.

Clare O'Hara: I'm Clare O'Hara with the Globe and Mail and this is Asset TV's real estate masterclass. And I'm just going to dive right into it. Hatem, I just want to start off with you and maybe you can give us some perspective, why has real estate become such an important element of an investor's portfolio?

Hatem Zarrouk: Thanks for the question. Thanks for having me today. Real estate actually gained popularity over the last, let's say, decade. Started with the streusel investors, endowments foundations. When you look at their asset allocations they caught on earlier and they have a healthy allocation within their portfolios and mainly a growth at risk mitigation and more importantly generating income. And when you look at the mass affluent investor, today with the way the markets are behaving, if you limit yourself to just Canadian equities, global equities and fixed income, you are actually leaving return on the table. So, real assets become an interesting structure, interesting asset class. It can provide that income, the growth in mitigating risk as well.

Clare O'Hara: Right. And Dennis, is that your feeling as well?

Dennis Mitchell: Yeah, but I'll challenge the assumption that real estate has become popular. Real estate has always been an essential component of a diversified investors portfolio. If we go back five, 600 years, we talked about landed gentry, you know, one of the only sources of wealth for people was their holdings, lands and titles. Fast forward to today, the real challenge for investors to get real estate exposure is liquidity and their ability to amass enough capital to take advantage of the real estate opportunities. So, I think the recent popularity has come about through the rise of the REIT structure globally. So, you've got over 35 countries now that have REIT or REIT like legislation that allows for the ownership of investment grade commercial real estate through a liquid publicly traded or private vehicle that mass affluent investors can access. So, it's really a function of real estate always being a vital component of a diversified portfolio, but more recently more investors being able to access it in an efficient manner.

Clare O'Hara: So, Kim, as the only advisor on the panel, are these some of your thoughts when you're trying to incorporate this into your client's portfolios?

Kim Inglis: Definitely. I would echo actually both thoughts here. I would definitely say one of the main reasons it's perhaps become more popular, although I would also argue that it's always been popular, is largely due to people chasing yield. There are so many baby boomers that are retiring and they just, they need income and they're having a hard time getting it anywhere else. So, you're seeing a lot of, uh, yield capital going out of traditional fixed income and into, your more high-yield sectors and real estate being one of them. And then I would also argue that for a lot of people, people are very comfortable with real estate, but a lot of people recognize that their principal residence, while yes, it is an investment, it's also more of a consumption good. You know, they're not generating any cash flow from it. They're having a lot more outlays are in terms of mortgage taxes, that sort of thing. So, in order to actually get real estate investment and properly diversify, they're having to go more the REIT route.

Clare O'Hara: So, Hatem, just coming back to you in a rising interest rate environment, does the way in which advisors are using real estate and whether it's ETFs or REITs, does that change?

Hatem Zarrouk: It's a million-dollar question actually. Yeah. What can we use in rising interest rates? So, when you look at the real estate, let's take an example of, uh, you know, you buying a house for instance, right? When interest rates going up, that means that the economy's doing well and it means that valuations are going up. It means that the value of your, let's say your house, is going up as well. So, it's you're participating in that growth. The other ways as well, when interest rates are going down, meaning that there is a little bit, probably a risk of recession, what happened to my real estate? It comes down to value and it comes down to the quality of the investment of the house that you own. Is it in a good location? Is it in a high demand? Or does it not? Same thing applies to the whole sector itself as well. So, we look at it from an asset management standpoint is it is a great tool as an asset allocator to client's portfolios, but quality remains of course, that is the decider of whether you want to own it in rising interest rates or in a decreasing interest rates.

Clare O'Hara: Dennis, what are your thoughts on that?

Dennis Mitchell: Well, I find that a lot of investors, whether they be advisors or whether they be retail investors or professional investors like myself, invest along a lot of rules of thumb. And so, real estate is looked at as interest rate sensitive. And so, when interest rates are going up, I've got to sell my real estate. We actually did some research that actually proves that you should be doing the exact opposite. We went back 10, 15, 20 years and we looked at when either the Bank of Canada or the Federal Reserve had been hiking interest rates more than once per year. So not 2015 or 16 where you had one rate hike in December, but years like 2004 where you get five and six rate hikes. What we found is that in the United States, six out of the eight years, US REITs had actually provided positive returns when the Fed was hiking rates and five out of the eight years they'd actually outperformed the S&P 500 and in Canada, the analysis was even simpler. For the seven years going back to 2000, when the Bank of Canada had been hiking interest rates, Canadian REITs had outperformed the TSX every year and deliver positive returns every year, including 2018 for that matter, where Canadian REITs up six percent and TSX down 9%.

Dennis Mitchell: So what we find is that when interest rates are rising, as Hatem pointed out, the economy is doing better. Interest rates are probably rising because inflation is picking up. But that means the demand for goods and services in that economy is picking up, including commercial real estate. And on the downside, well, we actually, you can manage real estate portfolios the same way you manage a fixed income portfolio. So, if interest rates are going up, you probably want to shorten your duration, reduce your interest rate exposure. So, you'd want to invest in real estate sectors that have got shorter lease durations, things like hotels or things like on multifamily. On the converse side, when interest rates are falling, you probably want to extend your lease duration. So, then you'd be looking at things that are a little more defensive with a longer lease term, increase your interest rate exposure in that case. So, we look at real estate as almost the perfect investment. You've got consistent, stable income, you've got the ability for capital appreciation and you've got less volatility than generally your alternatives like publicly traded equities.

Clare O'Hara: Right. So, thinking about that rising interest rate environment, what are the conversations like that you're having with clients?

Kim Inglis: Well a lot of people are asking, you know, are rates going to be going up? What's, you know, what's the situation there? How's that going to impact the portfolios? But ultimately it doesn't look like anything is going up anytime soon in any kind of significant manner particularly given the narrative that came out from the US the other week. So, it's looking more like it's going to be lower for longer type of situation and in which case, I read the same report that Dennis had seen that ultimately shows that any kind of rate increases, at least over recent history has not really had much of an impact on REITs. If anything, it's been positive for them. So, I would tend to err on that side of things.

Clare O'Hara: Right.

Dennis Mitchell: One thing I would just add to that, the reason you have a diversified portfolio is because you don't have perfect information, right? You simply don't know. When you talk about lower for longer, I've been hearing that for a lot longer than I thought I would. So, I mean, I think you can change that to lower for much longer. And so, because we don't have perfect information, you've got that diversified portfolio such that if things don't work out the way you'd anticipated, you still have exposure to sectors that will perform well in the environment that does in fact transpire. So, real estate should always be a strategic allocation for investors given that we don't have perfect information.

Clare O'Hara: Right. So, it sounds like it could be a similar approach if the dreaded R word comes into play. So, you know, there's a lot of, people talking about the recession lights are flashing orange and does this change how advisors, and I'll stick with you for a second there, Kim, on the advisor side of things, you know, does that change any ways of how you're using REITs or ETFs?

Kim Inglis: Well, you know, in many respects, REITs are basically a sector of many sectors. There's residential, industrial, commercial, senior care homes, you name it. So that means that there's lots of opportunity to go, if there's a recession, certain areas are going to be do better than others. There are still areas that you can access to maintain that real estate exposure but not be as impacted by it.

Clare O'Hara: Right. And Dennis, when we're talking about the dreaded R word, you know, what are your thoughts on that?

Dennis Mitchell: Well, I know this may be hard to believe, but, when it comes to whether it's a recession or an economic boom, we still generally invest the same way, which is we're looking for great businesses that have the ability to grow their cash flows and compound their value. So, whether you're headed into a recession or economic boom, generally the same businesses run by strong operators that have got well located real estate that's going to be, you know, in demand by tenants. They're going to do well in either one of those environments. And quite honestly, we're not interested in investing in businesses that can't absorb a hundred-basis point interest rate increase or can't absorb a 200-basis point uptick in unemployment. So, we generally don't change the way we look at it. We're cognizant of recession indicators, but certainly we pay more attention to our businesses and how they are specifically performing.

Clare O'Hara: So, Hatem, are you on side with Dennis on that or does your team take a different approach?

Hatem Zarrouk: Yeah, I mean 100%. I'll bring it down to portfolio construction. Right? So, we believe that when you build portfolio, you need to have a core hold and we believe that infrastructure should be part of that core holding. So regardless of what the market is doing, that core holding will help you either grow your wealth or protect your wealth. Obviously, the market is going to do what markets do. Markets go up, markets go down. It's part as part of the game and we believe that you can use some satellite holdings to mitigate to kind of minimize the risk. But it comes down to what's the gut feeling of the client and the investor? Are they nervous? If they're nervous, then they work with an advisor to build a portfolio that can mitigate that feeling because it's more emotion. When it comes to the academics, we truly believe that same thing as Dennis said is when you solid secure companies and they are consistent, they will eventually perform and allow you to achieve what you're trying to achieve within your client portfolios. So clearly, we don't pay too much attention to recession. It's a distraction. We believe that a real asset or infrastructure should be a part of a client's core, portfolios.

Clare O'Hara: So Dennis, jumping over to you, can you give us a bit of information around the key factors that you're looking at in the real estate market and maybe some other factors that go into the drivers of price?

Dennis Mitchell: Sure. So, we're obviously paying attention to interest rates, but it's a function of the cost of capital. You know, for these businesses to continue to grow, they generally have to acquire real estate or they have to invest in that real estate. So, we pay a lot of attention to where interest rates are, but also just liquidity. So, one of the companies that we own just successfully raised $450 million dollars for an unsecured venture and they recently had their credit rating upgraded. And so, this was investment grade credit so it's less than 2% yield for seven-year money. That is very, very attractive and allows them to deploy that capital into a creative acquisitions or to reinvest it into the portfolio to drive expansion, to improve the quality of the facilities, and eventually drive rent growth and appreciation of the value of that real estate.

Dennis Mitchell: So we pay attention to interest rates, but not necessarily the way that people look at. Then we pay attention to the tenants. Right? At the end of the day, you're renting out boxes to operating businesses. So, we pay attention to the quality of the tenants. We pay attention to the trends in the tenants. Who's moving out? Who's moving in? To the extent that we see the quality of the tenant base continually rising, we know that going forward the cash flow is more secure, more stable, and so we're willing to underrate it at higher and higher multiples because it's that much more valuable. So those are some of the things that we pay attention to. The other things like occupancy and sort of geographic distribution, those are things that are obvious that everyone's paying attention to. But some of the unique things that we pay specific attention to are sort of interest rates and liquidity and the access to that capital and then the trends in the tenant roster.

Clare O'Hara: So, Hatem, would you agree that those are unique or are those universal factors? Do you look at different things?

Hatem Zarrouk: Yes and I can add to that as well to what Dennis said, is predictability of the cash flow as well because that is a big element of infrastructure, especially when you're dealing in private infrastructure. The other thing too is the demand because, I mean if you Google the stuff, you'll find interesting sensitivity to infrastructure. But as Dennis said the stats, when you look at it, it's actually the opposite. Real estate has done extremely well in a rising interest rates. Why? Because the demand was there. There was more demand than extra supply and there was more demand for real estate and that drives the price up. So, there are things that we have to be cognizant about, things that we have to look at, and it comes down to security selection. Are you owning solid business is what it comes down to it? As Warren Buffett said, whether you're buying socks or you're buying stocks, it comes down to paying less for greater value and that's what we believe in.

Clare O'Hara: Right. So, Kim, listening to those factors, you know, what are your thoughts on those from the advisor standpoint?

Kim Inglis: I would definitely agree that a lot of that is what you want to look for and keep in the back in your mind and analyze when you're looking at the portfolios. I'll add to that a couple of other points that are interesting right now that I'm keeping an eye on. One would be debt rolls, for instance. 2019 is the first time that we're seeing increased rates on debt rolls which means that the people that did their low-cost financing's five years ago are now coming due and I saw a report that said it was an estimated eight billion debt maturities this year and they're all rolling at around 3.7% which is obviously significantly higher than people would have done that five years ago.

Kim Inglis: So you have to assess the ability for people to be able to carry that. Then there's another interesting thing that's been going on the western side of things, is that a lot of western REITs have been following oil prices down but on the flip side, as oil prices recover, you haven't seen a proportionate increase in price with the REITs. So, it's kind of an interesting trend going on, so those are some other things that I'm watching as well.

Clare O'Hara: Great. So, Dennis, you know, where we are in a mature economy right now, so why real estate investments for the moment?

Dennis Mitchell: Well, whether you're mature or whether you know your merging your emerging economy, real estate as a vital component of any diversified portfolio, quite honestly. I mentioned before that I thought real estate was the perfect investment. When you look at the components of any return out of any equity, there's only three of them. There's the yield that the security provides, there's the growth that the operating business generates and then there's the multiple that it trades at in the market. And so, when you look at real estate, it's got very consistent, stable cash flow growth, which lends itself to a consistent long-term multiple, so less volatility so sort of reducing the volatility of a portfolio when you add them, there's a consistent stable contractual income stream that people can bank on and then the growth again is very consistent and stable.

Dennis Mitchell: If you're looking at a mature economy that's going to grow at sort of 4% nominal, you know, 2% due to productivity and population growth and another 2% due to inflation, you multiply that by one and a half and you get 6% internal growth long-term out of real estate. So, you put all those components together, it's a very consistent, stable return that is both income and appreciation and most investors are looking for that. They may chase after shiny things when technology gets hot or when bitcoin or marijuana becomes popular, but at the end of the day, people are going to retire on that stable compound that they can generate year after year after year and real estate is a perfect that provides just that.

Clare O'Hara: So, Hatem, do you agree with those thoughts?

Hatem Zarrouk: 100%. I can add to it too. I use the example of one of the companies that our managers are looking at. Let's say you to predict the water consumption in the UK over the next 12 months. It's easier to predict versus predicting, let's say, buying cell phones or iPhones over the next 12 months. It's really difficult to do. The predictability is there. If the trend is there and if the demand is there, it's clearly an interesting asset class to consider. The way we look at infrastructure, there is what we call the economic infrastructure, but there is the social infrastructure which is more technology, healthcare sectors. And these are things that people always need. People always will tend to spend money on even if they're in a recession environment. Even if they leave their jobs, still need their phones, they still need their bed, they go to the hospital. So, there is, there is that predictability of the expense that kind of hedge against what happened in the marketplace.

Clare O'Hara: Right. And so, Kim, when you're talking to clients, is that coming up? The mature economy factors?

Kim Inglis: Not so much. When I'm talking to clients most of my clients are looking for risk management and so from that perspective, real estate is a perfect fit for that. Even down to the fact that REITs, for instance, real estate provides good diversification. I don't know too many people that can go out and purchase individually condo towers and office buildings and industrial spaces on their own. So, the real estate, the REITs, provide a good way of getting that diversification uncorrelated to the equity markets generally. Obviously, it's helping to provide some income there. Interestingly within the income side of things, I read a report recently that talked about over a 30-year period, 80% of the returns generated in US REITs regenerated from their cash flow. So that's ultimately adding total return, total return leads to lower volatility. So, it all really boils down to risk management.

Clare O'Hara: So Dennis, at the end of 2018 the global real estate universe was outperforming global equities by more than 700 basis points. Is that a trend that you think will continue and why?

Dennis Mitchell: Sure. I mean we've done analysis that shows that global real estate is outperformed both global equities and global fixed income from the end of 2002 through to the end of March of this year by several hundred basis points. So, at that point, we don't think it's a trend. We think it's the nature of the asset class. It just provides more stable, consistent cash flows that then allow it to trade at a higher multiple and consistent growth thrown in. You take all three components, we would expect that to continue going forward. When you look at any economy, real estate makes up a big chunk of any economy, whether it be an emerging economy, a mature economy. Most economic activity takes place in some form of commercial real estate. We're in an office tower now. I came over from my own office tower, literally, we own it. If you're going shopping in malls or even if you go shopping online from your cell phone to the cell tower to the data center to the distribution facility, almost all economic activity takes place in some form of commercial real estate. So, it should be no surprise that over the long term, commercial real estate does outperform global equities and global fixed income.

Clare O'Hara: Right. So, Hatem, I see you nodding your head and your thoughts on that?

Hatem Zarrouk: Yeah. I'm probably going to repeat myself, but it's an asset class that's appealing to the mass affluent. They know it. They understand it. They live it every day and there is demand for it. It's driven by that demand. It is an attractive asset class that investors are looking for it. And, as I said earlier, if the endowment foundations and pension plan are using it, so why don't the individual investor use it? That's what's driving it. We think there is a master class that is going to continue to perform the way it does right now and it did.

Clare O'Hara: So Kim, how much do you think real estate, the asset class is going to continue to be attractive for clients and how much of that also is going to have to, for your role, educate the clients to be putting their money into that too?

Kim Inglis: Well, education is always a key piece. You want your clients to understand what they're investing in. So, I would say that's ongoing, whether that's real estate or anything for that matter. In terms of real estate as a sector, again, there's pockets of opportunity within real estate and I would echo the commercial real estate as being one that has strong demand and looks like that's not ending anytime soon. We'll use Toronto as an example because that's where we are right now, but right now we're seeing vacancies less than 3% on a year over year basis. Rents are up over 12% and part of the reason for that are the trends that are going on. You're seeing large companies that had previously moved out to the suburbs coming back into the city. Microsoft importance in this tower, coming back into the city because they're chasing the talent, they're chasing the employees and the employees that they're wanting to attract, don't want to live in the suburbs. They want a condo in downtown Toronto. So, you're seeing a complete lack of supply. There's no big blocks on the market right now. Any new supply that's coming in is pre-leasing extremely well. So, there's a lot of opportunity there. No supply, higher rents, higher prices.

Dennis Mitchell: If I can just add to that. One of the great advantages of Starlight Capital is that we are owned by a direct real estate investment firm, Starlight Investments. We get firsthand knowledge of what our institutional clients are actually looking to buy. And for the last several years, there's been an insatiable demand for multi residential assets and industrial assets. All of the headwinds that retail assets are facing in terms of people shifting to online purchasing, that just creates more of a demand for distribution and fulfillment centers closer and closer to these population centers. And so, we've seen billions and billions of dollars of global capital flood into industrial assets globally. Then on the multi-residential side, speaking specifically about Toronto where we have vacancies of less than 3%, whether it's new graduates, whether it's immigrants coming to this country, a lot of them end up in the GTA area and that creates tremendous demand for multi-residential accommodation. So those two asset classes in particular, I've seen tremendous demand and being owned by a direct real estate investors, one of those opportunities where you get to see that firsthand.

Clare O'Hara: Great and just to jump back for a second on the client side of things because we're comparing to global equities. Are they coming to you and talking to you about real estate, like opportunities? We hear a lot from the institutional clients knowing, but do retail investors actually come and say, you know, I want to have x percent of real estate in my portfolio or do you have to actually present it to them to say, Hey, this is an opportunity?

Kim Inglis: I would not say any clients are coming to me with specific sectors that they want to access or specific companies. They're looking more goal oriented. They're looking to achieve a certain income in retirement or they're looking to buy another home or what have you. So, I find most people come to me with some kind of goal that they want to achieve and then it's building the portfolio that's going to get them there as opposed to them coming to me with specific ideas.

Clare O'Hara: So Kim, as part of a diversified portfolio, what role does or can real estate play?

Kim Inglis: Well that depends on the client and what their goals and what have you. I mean the long and the short of it is if I were to generalize, I would say that in riskier portfolios, clients looking for higher risk, real estate could be more of a bond proxy and then for those that are more income focused, looking to supplement their retirement or what have you, real estate can act as a compliment to other income producing assets, equities, in there.

Clare O'Hara: Dennis, do you have any additional thoughts on how it can be implemented into a diversified portfolio?

Dennis Mitchell: Yeah, I would absolutely echo Kim sentiments, both just now and earlier when you talked about real estate sort of being a sub sector of sub sectors. For clients who are more risk oriented or I would say more growth oriented, there are sectors within real estate like data centers or cell towers that are really driven by global macro factors, like social media, big data, E-commerce. So, these are sectors that have got the ability to grow and compound at sort of mid-teens going forward. That's probably more attractive for someone who's looking for more long-term growth. Whereas if you've got more conservative clients in your book of business who are looking for stable income and consistent sort of appreciation, you know, multi residential assets, there's an insatiable demand for them. They provide sort of basic shelter needs for a big portion of the population and they provide that consistent income and yield. So, I would argue that no matter what type of investor you have in your book of business, there's always a sub sector of real estate that's probably appropriate for them and probably why you should have a strategic allocation to real estate.

Clare O'Hara: Hatem, do you agree with that?

Hatem Zarrouk: Yes. I mean I think Dennis alluded to earlier, which is it's a balancing between income and yield. I mean, the mandate that we run at NBI, National Bank Investments, is we run a barbell strategies between yield and growth because you don't want to sacrifice one fee for the other depending on the client's needs. But more importantly you want to take advantage of trends. You want to look at the global economy and see what trend is actually benefiting from the very a real estate or infrastructure. It's a balancing act and that's where it comes down to depending on what the client's needs, if they need growth or they need income or they need both, it's a perfect marriage between both of them.

Clare O'Hara: Is there ever a percentage that you know, of advisers come to you and say, how much should I have this? And then they want a number. Is it going to differ per client? Is there a suggested number of how much should be in there?

Hatem Zarrouk: I mean if you look at the institutional endowment and foundation model, they have an average of 20% allocation within their model when it comes to infrastructure. But to take a step back here, when you're dealing with the retail investor, the risk tolerance is different, the objectives are different, what they trying to achieve is different and their familiarity and savinus for the market is completely different and that's when I think the asset allocation model can differ from one client to another.

Clare O'Hara: Right. Kim, do you typically have a percentage in mind of maybe you don't want to go too much into it or is it really client by client?

Kim Inglis: It's really client by client. No single client is the same. So, it really, you know, they're all completely different with what they want to achieve with their portfolios so it's kind of not, not one size fits.

Clare O'Hara: So, Hatem, just to jump back to you now, what are the inherent risks to including real estate? And what are the strategies one can use to mitigate those risks?

Hatem Zarrouk: I mean, when you're dealing with the investing period, there is risks. I mean the volatility, markets, emotions. There is market risk, there is industry risks that comes with being an investor. How to mitigate them, it's sounds, probably cliché, asset allocation, a proper asset allocation, proper security, a security selection and manager selection. Obviously, I mean in Dennis' world probably security selection is very important. I mean, you manage money, you try to go out and find the right type of companies that can deliver what you're trying to achieve. On my side or on Kim's side where she can do both, but again, on manager selection, which manager can I select? Can I go active? Can I go passive? So, there's a lot of combination that varies from one client to another. But clearly diversification is the best way to diversify the risk away and minimize it.

Clare O'Hara: Kim, are you utilizing that approach when you're looking at your client's portfolios?

Kim Inglis: Yes, with real estate, if we're talking about rates, for instance, rates in and of themselves are diversified. To purchase one REIT and you're generally getting exposure to a number of different properties. I however, prefer to go more of the managed route, either using something more passive and ETF or using a mutual fund manager for instance, for that purpose because I find that in the sector it can move a fair bit that there's pockets of opportunity in many different areas and that you need someone that's got more of an active touch to be moving in and out where the opportunities are. And you are seeing a lot more product in both worlds, in the ETF world and the fund world, coming out with more active solutions there. So, there's a lot more opportunity to fit that into your portfolios.

Clare O'Hara: Dennis, what are your thoughts when we're talking about risk?

Dennis Mitchell: Yeah, so I think if you're looking at it from an investor's point of view, most investors look at risk as the potential for them to underperform, right? Not save enough or not compound enough or to run out of money in retirement. So, when you look at real estate through that lens, I think the risk that a lot of investors are concerned about is not so much the downside because real estate tends to cushion on the downside by virtue of the income, contractual nature of it and again, as I said before, you can look through sort of the tenant roster and get pretty comfortable with the sustainability of the cash flows. So, it really shifts to the upside, right? In real estate because you tend to have longer term contracts, real estate isn't able to reprice as quickly to the upside depending on the lease duration.

Dennis Mitchell: I mean if you have hotels, you have a one night lease duration, you're going to be able to reprice. But if you're talking about office or retail or even industrial assets, there are three, five, 10, 12 year leases, you don't reprice the cash flows as quickly and so investors feel like they can get better returns elsewhere, things that are more economically sensitive. And so that's why you often see a lot of people selling their interest rate sensitives when interest rates are picking up. They're concerned that real estate is going to lag and so it's always a surprise to them when they find out that real estate actually outperforms in those types of environments. So, I think that's the number one risk, is that people sell a great investment because they're misinformed in terms of the risks and exposures they're actually exposed to when it's actually a fantastic time to be allocating capital to that sector.

Clare O'Hara: So, Dennis, just to stick with you for the next question. In this day and age, we can't ignore geopolitics as well as politics and it does seem as though we're very interconnected on all levels. Can you give me your general economic outlook for the real estate market?

Dennis Mitchell: If we're talking about Canada, real estate starts with growth. Is the economy growing? Where is it growing? Where are jobs being created? Because if you look at any economy, wherever jobs are being created, people migrate to there, to the extent that they can, which creates more demand for the real estate in that location. So actually, probably a great example is the United States. You know, Detroit has gone in one different definable direction. You know, 50, 60 years ago if you were building a car in the United States you were doing so in Detroit and the city was booming, people were moving there, the value of the real estate was increasing both commercial and residential.

Dennis Mitchell: Well today, if you're building a car in the United States, you're building it in Mississippi or Alabama or South Carolina. And so, you've seen the population migrate away from Detroit and of course the real estate in that city has gone down in value dramatically, whereas the real estate in sort of those sunshine states that are now the beneficiaries of those manufacturing plants have gone up. As car manufacturers have located their built plants there, people have migrated there because that's where the jobs are.

Dennis Mitchell: So when I look at the economy, I'm really looking for what pockets of the economy are doing well, that are going to be creating jobs because then I know the real estate and that in that part of the country will appreciate and value as there's more demand for it. And you know, we're in the heart of downtown Toronto right now. This is one of the most economically diverse cities in all of North America, if you will, not just Canada. And so, there's always something, whether it's finance or whether it's the auto sector or whether it is the healthcare sector, there's always something in Toronto that is creating jobs and growing and so you often see a lot of migration into this city. So, Toronto, Vancouver, Montreal, Calgary, Edmonton, the Ottawa whole region, these are all areas that we want to concentrate our investments in, in this country because that's where the long-term growth is, the long-term population growth, and as a result, that's where the real estate is most valuable.

Clare O'Hara: Do you only focus on North America or have you looked globally?

Dennis Mitchell: That would make my job so much easier. But we are truly global investors and so globally we're always looking for those supply demand imbalances. Situations where you have a lot of people going into an area where there isn't enough commercial or residential real estate to satisfy the demand because then what you get is rent growth, you get capital appreciation in the value of that real estate. And inevitably you do get new supply as developers step in and start to meet that demand. But for a period of a year or five or ten years, you have a supply demand imbalance that leads to abnormal returns and hopefully award-winning performance for us.

Clare O'Hara: So outside of North America, which countries or are you seeing most opportunities coming from?

Dennis Mitchell: Well now you're asking for all of my secrets.

Clare O'Hara: Listen up Hatem.

Dennis Mitchell: It really does depend on the sector and it depends on the country. You know, if you're in Asia, from an infrastructure standpoint, a lot of those countries are emerging. They're tied to China's growth and so they're really building a lot of the essential infrastructure. So, there you're looking at multi-residential, you're looking at some industrial. If you look at more developed economies where sort of the pressing concern is how much data can I fit into one phone or how many apps can I download and use simultaneously, there you're looking at things like cell tower REITs, you're looking at data center REITs, where those are emerging sectors that again have the ability to grow at a higher rate. And then you look at different countries that are experiencing in migration.

Dennis Mitchell: So a few years ago, famously Germany took in over a million Syrian refugees. That exacerbated and already existing supply demand and balance on the multi residential side of things that is slowly correcting itself. So, it really does depend on the geography, the sector and quite honestly the time the team has to analyze all of these opportunities. But fortunately for us it's a labor of love. We're really passionate about this work and so makes it easy to commit all these resources and time to this.

Clare O'Hara: Right. So, Hatem, thinking of the economic outlook, where do you see things going for the real estate market?

Hatem Zarrouk: It's a sector that traditionally existed forever. We can tell its recession proof. It might go through a little bit of volatility, but eventually it's something that people relate to. It's easier to talk to people about real estate and infrastructure. They relate to the user every day. They own houses. They use the 407 here in Canada. They to go to airports. So, it's truly an asset class as intimate to your mass affluent. The way we look at it is the future, especially now where it's really tough to get healed, let's say in the fixed income space. It's challenging to build portfolios for our clients. From a compliance standpoint, from a regulator standpoint, we need to have that income generating within client's portfolios and that brings the real estate space, the asset class in high demand and that's good for this space.

Hatem Zarrouk: Just to add something in the geopolitical aspects of it too, because it does play a big part in investing in real estate and infrastructure because a geopolitical risk creates uncertainty and uncertainty is not good for business, not good for investing. So being cognizant of it and being and cautious of the risks, whether you're looking at countries, you're looking at regions, as a manager or as a selected security, what are the premiums that I need to get paid in order for me to invest in that specific firm or that specific country. That's one of the things that our manager does, they go across the globe, trying to find those opportunities being obviously self-aware of the geopolitical risks that's happening in the world.

Clare O'Hara: Are there certain regions that you're steering clear of?

Hatem Zarrouk: Not really. I think we look at the globe as a big set and we kind of tap into where the opportunity is. So, we have a presence in emerging markets, we have presence in Europe, we have presence in North America. We look at different sets of geographies and where the opportunity presents itself. And that's the ability of having an active management approach where the manager can actually even travel and go in and kind of evaluate the environment, the company, talk to the people, talk to the actual employees, to get a feel of how are they actually managing their business.

Dennis Mitchell: Can I, can I address that question? We have a couple of rules of thumb, all portfolio managers do. One of my rules of thumb is that I don't send clients’ money anywhere that I'm not willing to go physically myself. So, there are some geographies where you just don't feel comfortable or safe. And as a result, it may simply be that there isn't sufficient separation between the political infrastructure and say the judicial infrastructure where property rights are not necessarily respected, where corruption is rampant. So, we don't want to send capital there. In terms of emerging markets, what we found is that it's actually more efficient to invest in companies that are domiciled in developing markets, that are pushing into emerging markets for their growth. So, to go completely outside of real estate.

Dennis Mitchell: If you looked at a company like Nestle, Nestle has long had the Nestle model where they want to grow at sort of five to 6% every year, but if you took a look at that growth and where it's come from, it's really one to 2% in developed markets and six to 10% in developing markets. And so really if you're investing in those types of businesses, you get developed market volatility with emerging market growth. We look at it and we say Chinese people may want to eat a more western diet with more protein. They may want to wear Levi's and go to Disney theme parks, but you can do a lot of brain damage trying to figure out which Chinese consumer staples or discretionary businesses are going to succeed. Or you can buy Nestle, you can buy real Daimler Benz, you can buy Disney, you can buy Apple because all of those are consumer oriented businesses that are pushing into emerging markets, specifically China for their growth.

Dennis Mitchell: And on the real estate side of things, there are wonderful businesses domiciled in Singapore and Australia or even the United States that are pushing into EM like Mexico or South America or into China for their growth. And so, we think the combination of developed market domicile and emerging market growth potential is a more efficient way to get that exposure.

Clare O'Hara: So Kim, I'm going to give you a sort of the final thoughts on the economic outlook. Where do you see things heading from the advisor perspective?

Kim Inglis: Well, from the advisor perspective, because I prefer a more managed solution for thought space, I'm looking at things more broadly. All of the analyst reports that I've read for the year are calling for, in the Canadian REIT space, at any rate, total returns of between 10 to 20%. Through the end of May, the spaces up 14%. So, there's the question there is, has most of the run for the year happened? That's probably the question a lot of people have mind for the market in general. So, I wouldn't be terribly surprised to see anyone taking some money off the table a little bit in a sector or perhaps seeing a little bit of a pause in the price action.

Kim Inglis: Actually, interestingly my company, Raymond James, they earlier this month they moved to the sector from overweight down to neutral. They're still positive on the space, but just more of a neutral over the time being over the near term. I mean the macro picture, the macro backdrop for things is definitely very accommodative for real estate long-term, but perhaps over the near term here we see a little bit of a pause.

Clare O'Hara: Great. And in terms of just geographic locations that are talking about it as an advisor, do you typically stick with the Canadian real estate space or have you been looking at investments in other areas?

Kim Inglis: With my portfolios in general, I prefer to stick with portfolios that are more global in nature and that would certainly apply with the real estate as well. You need to be able to go where the opportunities are and not be too biased to your own home country.

Clare O'Hara: So Kim, you make a good point about the outlook of returns and if you're hearing that the first half of the year has been very positive, and I'll throw the question to Dennis and Hatem, what are your outlooks on the returns? You know, has it sort of peaked already, you know, six months into the year?

Dennis Mitchell: Sure. Great question. I agree with Kim. If you look at sort of analysts’ expectations for returns for the year, we seem to be about 50% through the year, but we've achieved 75% of the expected return for the year. So that would lead you to believe that returns have been front end loaded and leads to questions about what types of returns we can expect for the rest of the year. I would actually expect that the rest of the year is going to be characterized with a lot of sort of churning, sort of consolidation, troughing and plateauing, false starts. A lot of that, you know, I can give you a ton of economic data as to why PMIs and interest rate increases and sort of stimulus measures, but really it comes back to, we think the second half of the year isn't going to be as robust as the first half of the year.

Dennis Mitchell: So then what can you do? When you look at sort of, again, those three buckets of return. If you can't expect much, tremendous growth, if you can't expect multiples to expand, then you come back to what kind of yields and income can you get out of the securities that you own right now. And if you look at Canadian REITs yielding 5% and change, I think that's a healthy place to rotate into, sort of ride through some of the volatility we may see in the second half of the year.

Clare O'Hara: Hatem, your thoughts on it?

Hatem Zarrouk: We tend to agree the same obviously with my two co-panelists in terms of return. I think we had a great run so far. We're expecting to have the numbers by this time of the year, but clearly yes, as we dive into throughout the year, I think the numbers that got quoted today is within what we believe.

Clare O'Hara: So I just want to throw a question out for an advisor that maybe hasn't really paid a lot of attention or hasn't really dipped their toes into this asset class, you know, where can they start? And I'll start with you, Kim, because you did mention analyst reports. So how did you start out in integrating this into your portfolios?

Kim Inglis: Well, I mean really you should be, as an advisor, you should be reading a whole host of different analysts’ reports and ones that are not just from your company, but sourcing a number of ones on the street so that you can get a broad range of views and then form your thesis from there. Advisors can also, I mean every advisor has a different way of doing things. If they're not looking at purchasing, for instance, real estate, via rates outright, they can look at it, through ETFs, as one option or funds.

Kim Inglis: Using the ETFs as an example, there's a whole host of them out there and it really depends on how you want to access a space. Traditionally when they came out, it was mostly ETF providers providing an index and they might differentiate themselves through either being cap weighted or equal weighted, maybe differentiated by geography, but now there's a lot of interesting product that's looking at things like net asset value per share and they're looking at a price dislocation between the pricing of the unit versus the value of the actual real estate and seeing if there's something to capitalize on that end.

Kim Inglis: So there's a lot of interesting areas and it's starting to do your research, talking to your research department at your firm, talking to the different providers and finding out what is the best fit for your clients.

Clare O'Hara: Right. So, Hatem, Kim brings up a good point that ETFs, you know, now there's, there used to be only a few of them and now we have over, I think it's over 700 and a lot of that we are seeing more real estate ones, but when we're talking about product for advisors, you know, where can they go? What can they be looking at in this sector?

Hatem Zarrouk: Clearly, I mean, obviously the analysts list. Morningstar is a great, great tool to kind of narrow it down. I mean, the space itself is still in its infancy when it comes on for the mutual fund side of it and that's due to liquidity because earlier I mentioned that the endowment foundation had the lag and they were investing in the space way before the retail investor for the simple reason because the restrictions that the institutional investor has, it completely different from the retail investor. And the biggest restriction for the retail investor when you're buying a mutual fund is liquidity. With the infrastructure space is always, there's that fine balance between liquid and liquid assets and is my money stuck? When can I get my money out.

Hatem Zarrouk: But I think the industry is getting better and there is a lot of products that had been developed, whether on the active or the passive side. It comes down to comfort, it comes down to what you're trying to achieve. We believe at NBI that you need to have a healthy combination of our field and growth because obviously for client portfolios that they're trying to achieve multiple goals, you can obviously use that mandate to get you to what you're trying to achieve and we believe in security selection as well.

Clare O'Hara: So Dennis just final thoughts over on your end there, an advisor just starting out or are looking to get into an asset class, you know, where, where can they go?

Dennis Mitchell: Sure. Whether it's an advisor or do it yourself investor, I think two of the best places to start our REALPAC and NAREIT. If you go to either website, NAREIT is the US version, REALPAC is the Canadian version. These are the industry groups that provide education, that provide access and analysis, research, historical data and so both websites are tremendous resources for learning about the North American, actually the global real estate market for you. Then if you really want to expand your horizons, you can go over to EPRA and APREA which are the European and Asian versions of have NAREIT and REALPAC but those are two valuable sources of information both on returns. What is a REIT? The tax structure and a lot of investors think that, uh, they can value these things using a PE multiple or an EV/EBITDA multiple and these are common sort of broader diversified equity valuation metrics that really don't apply to real estate.

Dennis Mitchell: So going to either website will give you information on what is funds from operation? How has net asset value calculated? What is the adjusted and adjusted funds from operations? In Canada we say debt, in the US they tend to refer to it as leverage. In Europe, it's gearing, right? So, understanding the lingo and the terminology and which valuation metrics are important, these are two websites that are tremendous resources for any investor to sort of get them up the curve on how the sector works and how it should be looked at.

Clare O'Hara: Well, thank you to everyone for joining me today on the panel on real estate. Lots of interesting points here. And I'm Clara O'Hara with the Global Mail and this has been Asset TV's real estate masterclass.