We’re still near the beginning of a long runway of outperformance by REITs.
That’s according to Dean Orrico, CEO of Middlefield Group and portfolio manager of Middlefield Canadian Income Fund.
Under Orrico’s stewardship, Middlefield has focused on publicly listed REITs, which the industry vet said have behaved differently from the private real estate market over the past few years.
“With the increase in rates, they’ve sold off and are now trading at significant discounts to private real estate, especially as investors moved into term deposits and money-market funds over the past two years,” he said in an interview with Green Street News.
Now, with interest rates just starting to come down, Orrico thinks REITs represent “maybe the best value he’s seen in the last decade,” as cash reenters the market in search of competitive yields no longer available in cash-like alternative deposit accounts.
Green Street News talked with Orrico about the company’s Canadian real estate strategy, opportunities in commercial real estate and how he’s preparing for 2025.
How does your Canadian real estate strategy fit into your overall strategy?
Firstly, as an asset manager with a particular focus on income investing, REITs are a core component of our portfolio strategies since I believe REITs are among the best income vehicles in the market. Their revenue streams are contractual, grow over time and, in many cases, are highly tax-efficient.
With respect to how we invest in real estate, we follow where the population is growing and look at general economic and business trends that inform which real estate asset classes have the best long-term fundamentals – i.e., supply-and-demand dynamics.
There are four sectors I really like in Canada.
We got ahead of the growth in industrial real estate some seven or eight years ago. In fact, we actually launched a fund dedicated to industrial real estate that generated great returns. We knew that e-commerce was a growing phenomenon, and then we got a massive boost during the pandemic a few years after we launched that fund.
The demand for industrial properties includes tenants in the logistics and distribution businesses. Really catering to e-commerce activity – to me, this was a very powerful trend we got right.
“We follow where the population is growing and look at general economic and business trends that inform which real estate asset classes have the best long-term fundamentals”
For the last year or so, as rates have gone up, it’s been pencils down for new development activity, with the amount of new industrial properties under construction in the GTA at less than 1% of the current inventory. So as demand continues to grow, rents are going to go higher.
In multifamily, it’s less pronounced, but those re-leasing spreads are still pretty significant. In some cases, on turnover, they’re 15% to 25%. And I distinguish between turnover versus renewal, because in provinces like Ontario and British Columbia, you’ve got rent control.
For any building built before November 2018 in Ontario, if the existing tenant stays in that unit year after year, that lease can only go up 2.5% to 3%. But as soon as that tenant leaves that unit – i.e., it turns over – rent can be marked up to market, and in many cases, the market is 25% to 40% higher than the lease that was in place.
As a result, I believe rental revenue will continue to climb in the high-single-digit/low-double-digit range for many years due to the significant housing shortage in this country.
Similarly, with respect to retail, there have been very few new grocery-anchored shopping centres in the past 10 years. In fact, the last Walmart-anchored shopping centre was built over 15 years ago. If anything, the retail REITs, like SmartCentres and RioCan [REIT], are taking all that excess land surrounding a Walmart-anchored centre and building multifamily apartments and condominiums.
Choice Properties REIT, whose major tenant is Loblaws, which is Canada’s largest grocer, has done an excellent job driving rents and maximizing the potential of its excess land in both the retail and industrial property sectors.
Even though e-commerce is growing, there’s still demand for grocery-anchored retail, and rental rates are going up. Virtually every major grocer in Canada is looking for more physical space to service in-person shopping and to facilitate e-commerce fulfilment.
And then there is seniors housing. It was probably the most hit of any real estate sector during the pandemic. Costs were up, and you couldn’t refill empty beds because of restrictions on movement during the pandemic.
But that’s all changed over the past 18 to 24 months. Occupancy is steadily going higher, and labour-agency costs are going down because you don’t need all the additional staff that was required during the pandemic.
So that’s informing our continued investment in the retirement and long-term care sector. I think the fundamentals there are very good, with the unit prices for major players like Chartwell [Retirement Residences] and Sienna [Senior Living] up over 25% year to date.
Do you see opportunities anywhere else?
I’m still wary about office. Yes, office assets are trading below what they’re worth, but the sentiment continues to be so negative, and at least in the near term, I’m hard-pressed to think that you will see any major re-rating higher in the office sector.
Outside Canada, we like areas like data centres. I think that business is going to continue to grow, and it’s now got a massive boost from AI and the need for more data storage, because AI requires so much more computing capacity.
We play the data centres primarily in the U.S. where there are a number of REITs well positioned to take advantage of the growth in data storage. Cell towers are also very attractive because they’re leasing space to telcos who are servicing the continued growth in data creation.
Will all the ‘pencils down’ from the past few years create a shortage in any particular asset class?
I think you’re starting to see that now. There are very clear supply constraints and an insufficient number of completions in the retail, industrial, multifamily and seniors housing [sectors]. People have talked about the condo market being really soft in places like Toronto, and this is due to continued high construction costs, development charges and borrowing costs.
So, if I’m a developer, I’m not going to reduce condo prices – as long as I have the financial staying power, I’ll wait for buyers who are prepared to pay the price I need to make an appropriate return on the project.
As a buyer, I can only pay a higher price if I can get a mortgage at a cost and amount which meets the down payment I can afford.
“Outside Canada, we like areas like data centres. I think that business is going to continue to grow, and it’s now got a massive boost from AI and the need for more data storage, because AI requires so much more computing capacity “
How do you view the bumps the industry has faced recently in the historical context of your 25 year-plus career?
When I look back over the last 25 years, I’d say we had a major hiccup during the global financial crisis in ’08 and ’09, and then we had another one during the pandemic. But the reality is, in that ’08-’09 crisis, you saw most Canadian REITs actually skate through fairly well, and the pandemic was just a very short-term blip.
More recently, the move in interest rates has had a more profound impact because rates have increased so significantly and have stayed high since 2022. The benefit we’ve got in Canada, unlike the U.S., is two things.
One, you’ve got full recourse lending in Canada versus non-recourse in the U.S. For example, assume I own an office building and I’ve got a major Canadian bank as my lender. If the value of this office building goes down while the cost of the mortgage has gone up, the bank not only has recourse against the asset, it can also go after my other assets for any amount they weren’t able to recover from selling the office building.
Secondly, Canadian lenders, whether they are banks or lifecos, have a greater tendency to work with borrowers versus their U.S. counterparts.
This provides the Canadian real estate market with much more stability, but it also tends to limit your upside as well. More specifically, asset prices get hit a lot harder in the U.S. during market downturns, but they tend to recover more when markets recover. So Canada operates in a more-narrow band of valuations versus say the U.S. market, which sees lower lows and then higher highs.
So, while the Canadian market can be more stable, it is also witnessing a significant level of growth in the current environment. By virtue of, one, our population being concentrated in a handful of cities; two, Canada possessing an educated workforce; three, having population growth which has far surpassed any other G-7 country – Canada is actually experiencing quite a bit of growth, and real estate’s going to benefit.
These factors have been in place for a number of years, and due to higher rates and construction costs, there’s been very little development activity. As a result, these are the best supply/demand dynamics we’ve seen in many, many years.
How are you preparing for 2025?
I’ve been preparing for 2025 for the last year and a half because there’s been a saying in real estate: “survive to 25” – and the view is that rates will eventually start coming back down, and that’s what you’re starting to see.
If I’m a real estate owner and if I’ve got a bunch of assets with short-term borrowings – and you’ve seen that spike in interest costs in the last 24 months – that’ll start coming down, but your cost of borrowing will still be higher than the rates you were paying in 2020 or 2021.
“These are the best supply/demand dynamics we’ve seen in many, many years”
From our perspective, we are more focused on the higher-quality assets. As a result, I haven’t had one of my REITs experience any major issues. They all run relatively conservative balance sheets with high liquidity.
So, while virtually all REIT prices have sold off with the increase in interest rates and the corresponding withdrawal of capital from the REIT sector, their businesses have continued to grow and their balance sheets have improved with a reduction in short-term borrowing.
Bottom line, I think we’re only in the very early innings in the recovery in REITs. You can see how excited I am because their time is coming.
