Financial Post Magazine: Where Investors Looking for Cash Flow and Capital Preservation can turn
Real estate is one sector that should be considered as a key part of a diversified portfolio
Arthur Salzer, Special to Financial Post
Jun 24, 2022
REITs are a tax-effective way of generating cash flow compared to bonds. PHOTO BY KEVIN KING/WINNIPEG SUN/POSTMEDIA NETWORK FILES
There is a large group of investors and borrowers who have never experienced inflation of the kind we are experiencing, with “official” numbers hitting 40-year highs of 8.6% in the United States and 7.7% in Canada. From a generational perspective, this time is indeed different.
We’ve seen significant declines of 50% or more in new economy stocks such as Netflix Inc and Shopify Inc. as these companies don’t tend to have dividends or stock buybacks. In other words, they are long-duration assets. Bonds have not been spared either, with global bond indexes down 15% since January 2021 and investors suffering trillions of dollars of losses as a result. This slump poses a particular threat to investors who have favoured the security of bonds to provide an income stream from their portfolio.
Central banks, especially the United States Federal Reserve, despite being behind the curve, are beginning to take the inflation threat seriously, with, for example, Fed chair Jerome Powell becoming hawkish and warning of multiple 50-basis-point hikes this year. If monetary conditions become too tight, we could see a repeat of the stagflation of the 1970s. This means low or even negative economic growth, rising unemployment and above-average inflation. During the 1970s, stock markets suffered some of their worst multi-year bear markets in history.
For investors who desire a portfolio that generates cash flow, yet still retains the possibility of capital preservation, where do they go? One sector that should be considered as a key part of a diversified portfolio is real estate. Many investors get exposure to this sector through real estate investment trusts (REITs), which hold portfolios of properties that can either be diversified across sectors such as commercial, industrial or multi-family, or focused on just one of these sectors.
REITs are popular because they provide a regular distribution that is a combination of return of capital and the net business income from rents. In general, REITs are a tax-effective way of generating cash flow compared to bonds. The challenge investors face with many REITs is that they trade on stock markets, so they are vulnerable to selloffs when markets decline. A solution to this volatility can be found by investing in private REITs or potentially through limited partnerships.
As with all investments, the devil is in the details. A high-quality management is especially critical with private investments, since there is limited regulatory oversight and, as such, private REITs are only suitable for accredited investors. An investor can lose a lot of capital very quickly with an inexperienced management team or, worse, a fraudulent one.
“Location, location, location” was a saying I learned from my real estate teacher in Orillia, Ont., where I took my coursework during the summer of 1988. This is especially relevant today as cap rates for multi-family dwellings in Canada are less than 3%. Ceteris paribus: it would take an investor 33.33 years to have their capital returned when buying real estate at a 3% cap rate. Similarly, an investor who buys at a 5% cap rate only waits 20 years. While 5% or higher cap-rate opportunities aren’t available in Canada, they are found in the high-growth/low-tax southern markets such as Florida, Texas, Arizona and Tennessee.
Interest-rate risk is also a concern, because cap rates increase when rates increase, and, therefore, the economic value of real estate declines. A sophisticated and experienced management team, such as a family office that can access and invest with best-in-class real estate managers from anywhere in the world, can offset these risks.
The best managers have already hedged a fund’s interest-rate risk by locking into mortgages of 10-year terms or more. A poor manager will still have significant exposure to variable-rate or short-term mortgages (which, admittedly, has been a winning strategy for 30 years). However, the rollover will be very costly as interest rates are now climbing, which will reduce that fund’s cash flow. In addition, to offset cap-rate expansion, it’s important for the properties to be in free markets that don’t have rent controls, thereby allowing rents to increase in a timely fashion.
It’s possible we are seeing peak inflation numbers, but it’s likely we saw a secular low in spring 2020 and inflation, as opposed to deflation, is something everyone will experience for many years to come. FPM
The original article featured in the Financial Post Magazine.