The REIT stuff: Creating alpha with small and midcaps

Matt Buchanan

Livewire Markets

Inflation, inflation, inflation. We knew it was coming, of course, but now that it's here it's like it's never going away - and it is, along with rising rates, putting its handbrake hand on returns across the board.

Not so fast. There are some asset classes that far from slowing down actually accelerate in an inflationary environment. Real estate for example.

As the New York-based David Kruth, Regional Adviser, APN Real Estate Securities, says in the second of our three interviews: 

"Real estate is a hard asset class, inflation-protected, on a relative basis would look better than most asset classes. 

we continue to see really strong inflationary protection in our leases because we're getting somewhere between 70 to 80% of inflation pass-through in rents, so we're maintaining that rent growth.

"And the public REITs today have never had stronger balance sheets and better business models than they've had in the history of the REIT industry, going back to the 1990s."

You can hear more from David by watching the video below in which he also discusses:

  • The primary drivers of returns for global REITs
  • The prospect of dispersion in performance between unlisted and listed property funds
  • Why now is a good time to be a portfolio manager
  • What keeps him up at night  

This transcript has been edited for clarity and length

What has been the primary driver of returns for REITs

Well, hard assets, inflation protection, and mispricing. There was a while during the pandemic when they were trading at quite discounts to net asset value, more from fear and more from just a lack of clarity in the markets.

We focus on the public market, of course, but we look through to the private market and we continue to see really strong inflationary protection in our leases because we're getting somewhere between 70 to 80% of inflation pass-through in rents, so we're maintaining that rent growth. 

And we're seeing, of course, in the sectors I mentioned before, strong underlying demands, so rents are going up. So we're going to have a positive cash flow in our companies, in our real estate for the next several years, which I think is very inflationary protective.

And there's one added piece. The private equity space and real estate, which I first worked in way back when I started, now has $400 billion of what we call dry powder, unutilized or uninvested capital, and most pension funds around the world continue to add an allocation to real estate. 

So 90% of real estate gets allocated in the private market, 10% goes to the public market, give or take. So where do you think the capital's going to be going? Into the market, which pushes firms' prices up for the best real estate sectors. We take that into consideration in our investing.

Will rising rates and inflation act as a handbrake on future returns?

I don't have a full idea of what could happen with stagflation or something that gets really out of hand, but real estate is a hard asset class, inflation-protected, on a relative basis would look better than most asset classes. 

The reason why we're seeing some technology stocks get hit so badly so far in 2022 is as the discount rate goes up, what are you discounting if there's no earnings or no cash flows? 

Those stocks get hit pretty hard, not the Apples and the Googles, but others. 

So real estate, because you have that inflationary protection, there's been some adjustment in pricing, but we continue to think that on a relative basis, you're in a good spot with the dividend plus growth.

Will we see a dispersion in performance between listed and unlisted property funds?

It really depends on the market cap, the size of the company, and how it's being run. We'll use the United States as an example. The best rates in the US trade at or above private market value because they have excellent management, low gearing, tight balance sheets, growth potential, internally and development. 

They do development on their own for the benefit of the shareholders. They're internally managed, so best-in-class companies. Day trade, generally at or above, if you will, maybe, NAV. However, there are smaller cap companies that may have more entrenched management, a bit too much leverage, or they're sort of under the radar screen by many other investors.

Those tend to trade at discounts for one reason or another, be it structural or other. We like to play in that sandbox because we believe that with the capital and the market, they are open game in the safari. 
And we've seen several opportunities already where companies have been taken private by the big private equity names that everyone knows. And we believe that that will continue. 

So we have our eyes and ears open and investing, not only in the best-in-class companies but companies with good assets where we think there is a catalyst to get to the fair value, which sometimes can be between 30 and 50% discounts.

Is it still a good time to be an active portfolio manager in a time when passive ETFs are rising rapidly?

I would say that today, being an active portfolio manager is a very good thing to be, mainly because the ETF and global REITs has 250 companies in it and it's biased toward the large-cap names, which tend to be more fully valued. 

We love those companies, but at the same time, we like to play in the sandbox of the smaller midcap companies, where they might be more opportunistic in value. It requires you to actually really open the hood and get into the engine to understand it. And a lot of active managers don't really do that.

They try and look at the benchmark and say, we have to be looking at the big names. We tend to think that there's more value and opportunity in those small and midcap names. 

So we play there. For example, one of our names might be three to four per cent of our portfolio, being a small to midcap name. And that's a billion-dollar name. It's not a tiny company. It might be 20 or 30 basis points of the index. 

So our ability to create alpha, if you will, by owning small and midcap value names in good sectors is - we think we're in the sweet spot.

What keeps you up at night?

Just about everything. Geopolitical, inflation, tenant risk, pretty much everything. 

But I have to say that I've been in this game a long time. I'm not a spring chicken, right? I've been in it for 30 odd years. And I've seen cycles that you wouldn't believe from the late 80s to the early 2000s, to the GFC, to COVID. 

And each time, real estate comes out, generally speaking, pretty good. Sectors change, companies change, where you want to be positioned changes. That's our job to figure that out. 

And the public REITs today have never had stronger balance sheets and better business models than they've had in the history of the REIT industry, going back to the 1990s.

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Matt Buchanan
Content Director
Livewire Markets

Matt Buchanan is a former Head of Content at Livewire Markets. Matt is an avid investor and a big fan of the Livewire community, which he first joined in 2017.

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