RELPs, REITs give commercial real estate exposure, but are different

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Chris Warner: Commercial real estate can be an important additional asset class for the right investors

Published on March 15, 2023 • 5 minutes read

Commercial and residential buildings in Vancouver. Commercial and residential buildings in Vancouver. Photo by James MacDonald/Bloomberg

The best performing asset class in many portfolios over the past year has been commercial real estate. This was certainly the case with Nicola Wealth Management Ltd. and other companies using these types of investment strategies.

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Some investors may wonder upon hearing this, “How could that possibly be the case when real estate investment trusts (REITs) appeared to be the worst-performing asset class of 2022?” It seems like a paradox, but it is teaches us that investment vehicles can be just as important as the asset classes themselves.

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To that end, many Canadians are diversifying only through the use of publicly traded equities and fixed income instruments, while we believe commercial real estate can be an important additional asset class for the right investors.

Within this space, Nicola Wealth invests primarily in real estate through the use of Limited Partnerships (RELPs), where we own, develop and manage real estate directly. Investors also have the option to buy shares in REITs, either directly or indirectly through Exchange Traded Funds (ETFs). There are differences between RELPs and REITs, such as: B. Liquidity, valuation and investment philosophy. In 2022, the most significant difference was price.

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The trait of REITs to reprice quickly based on sentiment due to their publicly traded nature was very evident in 2022. This is not uncommon. During uncertain times, REIT stock prices often deviate from the actual market prices of the underlying property (the net asset value, or NAV). This means they can trade above or below the intrinsic value of the property pool itself.

Let’s differentiate between price and NAV here. Price is what you pay today to buy a REIT or RELP. The NAV is the estimated value of the underlying stocks.

As previously mentioned, a REIT’s price can be heavily influenced by investor sentiment and can decouple from the NAV. In contrast, RELPs are usually priced close to NAV; it will usually only lag behind the NAV by the number of times the RELP is fully assessed.

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REIT price vs. NAV

For REITs, the NAV is the book price, i.e. the assumed value of the entire property minus any debts and obligations.

A price-to-book ratio of one would mean that the REIT’s trading price accurately reflects its current NAV. Less than one suggests the REIT is either undervalued or investors are expecting the price to fall. Greater than one indicates that the REIT is either overvalued or that the price is likely to rise. In theory, a REIT should trade at a slight premium above its NAV, given the advantage of its high liquidity over physically owning real estate.

For example, one of Canada’s largest REITs, Canadian Apartment Rentals REIT, traded at a premium in 2018 and 2019 when markets were more stable. As the pandemic emerged and rattled investors, the REIT’s price fell as well. Then in 2021, when markets were booming, it started trading at a premium again.

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Enter 2022 and its very high inflation, skyrocketing interest rates and rare double decline in stocks and bonds. Canadian Apartment Rentals REIT experienced one of the most significant valuation declines in recent memory, as investors were quick to speculate that the future of commercial real estate was going to be challenging.

Why Buy REITs?

This example shows that REITs, like public markets, can be significantly affected by investor sentiment. Some might argue that this defeats the purpose of commercial real estate in a portfolio. However, long-term investors using REITs might point to the real yield as a counterpoint compared to public stocks.

All in all, what does that tell us? First, depending on the investor, there are relatively strong long-term arguments for investing in commercial real estate. Second, publicly traded assets can be subject to quick speculation due to fear and greed (note I’m not using these terms pejoratively, fear/greed indices have long been used to summarize prevailing investor sentiment using a variety of qualitative data). Third, this reinforces why some choose to own property through the RELP structure, believing that the investment price and NAV will be closer to real market rates.

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REIT vs. RELP pricing

An obvious question may follow the points above: perhaps REITs have fallen too quickly, but won’t all commercial real estate eventually follow? In my opinion, the short answer would be no.

The implication of the question is that RELP’s use of a different valuation structure means it will be slower to “catch up” to REITs. Although nobody can predict the future, there are many reasons for us to believe that this will not be the case.

For example, RELPs can use many active strategies to hedge downside risk. They typically don’t buy commercial real estate as a monolithic asset class. They don’t just focus on collecting rent.

Instead, my experience is that RELPs mainly look for diverse, targeted strategies that work well both in existing market environments and in the future.

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An interesting point about REITs is that the pricing mechanism can occasionally shift too far negative, potentially positioning REITs attractively going forward. Essentially, when a REIT is well capitalized and producing a steady cash flow, it can be a good time to buy when a REIT’s price is well below its NAV (and one that we’ve even considered on occasion).

However, our preferred long-term approach remains to recommend the RELP structure for potential return maximization and volatility reduction in a diversified portfolio. Our analysis of the two investment vehicles has historically shown greater downside protection for RELPs versus REITs, potentially leading to higher long-term returns.

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All in all, investing in commercial real estate can be a sensible addition to the portfolio for many investors, provided it is approached strategically. One should understand how the characteristics of RELPs and REITs fit an investor’s profile (including their risk tolerance) and how these investments fit into the overall investment plan.

Chris Warner, FCSI, CIM, CFP, PFP, is a Wealth Advisor at Nicola Wealth Management Ltd.

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