Navigating the complicated relationship between interest rates, real estate

The complicated relationship between real estate and interest rates makes it important to know the role different types of properties play in a portfolio and to use public real estate for liquidity to keep a focus on core property, said Derek Warren, vice-president at Lincluden Investment Management.

Speaking during a session at the 2018 Defined Benefit Investment Forum in Toronto on Dec. 10, he said one reason many investors are flocking to real estate in recent years is that when using the Canadian 10-year bond over 30 years there’s been a continuous tailwind of lower interest rates, making it harder to find yield, which has pushed investors into the asset class because they want to get a spread over the risk-free rate.

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He noted real estate will be affected by rising interest rates, so it’s important for a pension plan to be cautious and understand the different real estate it owns, as well as the role it plays in the portfolio. For example, it’s important to understand a property’s debt-to-gross book value, the weighted average term to maturity on debt and the weighted average interest rate, said Warren.

“I would argue that considering where we are in the interest rate cycle, you want to take the hit now and go as long as possible: 10, 15-year debt and then lock in the rates that we have now.”

As well, if a pension plan is using floating debt, it’s time to lock it in, he said.

In addition to this, it’s important to consider the cash flow and the weighted average lease term of the tenants, said Warren, explaining investors tend to worry so much about the building and debt, and forget tenants, who write the cheques, are really important. In a rising rate environment, it’s also important to understand that’s likely to be accompanied by inflation, which will affect capital expenditure costs and maintenance costs, he noted.

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But it’s not all about prices.

Property prices adjust slowly, but this doesn’t mean investors must sell, said Warren. “You don’t have to take the price that’s being offered in the market. If you’re happy with your portfolio and what’s it’s doing, just ride through and collect the income.”

But liquidity adjusts quickly, he cautioned “There may be a collapse in liquidity, which will affect the value.”

An example of this is secondary retail in Canada, so retail properties in small towns. Currently, this isn’t worth very much because supply is high and there’s little liquidity, said Warren. “Because no one’s taking the lower price, everyone thinks it’s still worth more. So it’s a bit of a dichotomy that we have to be conscious of.”

To deal with this lack of liquidity, Warren suggested investors can use publicly traded real estate. “If we start to see that there’s a bit of a problem in our portfolio, we can always augment that using the public markets to maintain our yield, increase our liquidity — yes, with some volatility. However, on the fringe, we can still gain what we need for our portfolio and de-risk it using the public markets.”

Read more articles from the 2018 Defined Benefit Investment Forum