Counsel Views – Episode 1: Michael Kitt

Stu Morrow:

Hello. My name is Stu Morrow, Vice President and Head of Investments at RBC PH&N Investment Counsel. Thank you for tuning into the inaugural session of Counsel Views, an audio recording series where we aim to keep you, our valued RBC PH&N Investment Counsel clients, updated on what is happening across global markets, while adhering as always to a long-term perspective.

Counsel View audio recordings will feature guest speakers from time to time, where we will discuss and debate various topics related to global markets, the economy, and investment process.

Please feel free to reach out to your investment counsellor with any questions or comments related to what is discussed in these audio recordings.

And with that, our first session of Counsel Views will be a timely discussion on Canadian commercial real estate. Over the last few months, we’ve all been grappling with some form of disruption in our daily lives as a result of the COVID pandemic. For some of us, that disruption has meant we are no longer—we are working from home. As a result, millions of people are no longer commuting to and from the office or spending as much time within downtown cores as they used to. Retail shops and restaurants have likewise been disrupted as well.

Will all of this have a lasting impact on Canadian commercial real estate? Or could this just be a short-term disruption that provides a great opportunity for investors?

To help us get a handle on these issues, I’m happy to welcome our guest, Michael Kitt. Michael is Head, Private Markets and Real Estate Equity Investments at RBC Global Asset Management. Michael brings more than 25 years of direct real estate investment experience to the role.

Prior to joining RBC, he was CFO, Executive Vice President, Finance and Strategy for Oxford Properties, the Ontario Municipal Employees Retirement System wholly owned real estate investment entity. He also held senior positions at Cadillac Fairview Corporation, in Ontario Teachers’ Pension Plan board, all related to commercial real estate investing in Canada, the United States, and Europe. He has also served as a trustee for two public REITS, Invest REIT and Choice REIT.

Morning, Michael. Welcome to Counsel Views. Very excited to have you join me today.

Michael Kitt:

Hi, Stu, and thank you, as always, for having me. It’s always fun to have a chat with you.

Stu Morrow:

Indeed. Indeed. So obviously, a lot to talk about. Perhaps, maybe we could start by having you explain to our listeners, in your own words, what you do for investors? And what the focus of your investment mandate is?

Michael Kitt:

I’ve always been a believer in the principles of portfolio construction. It started almost out of university. One of my first jobs was with Ontario Teachers’ and really building their real estate program within their entire portfolio and quickly came to understand the importance with allocation and as a key contributor to driving the long-term returns.

And we’ve all read the articles; I know you’re a believer that asset allocation can drive somewhere in the neighbourhood of 90% of performance. And this includes private mortgage asset classes, and it was really important theme with Teachers’. It carried on to OMERS. And at OMERS, the 10 years I spent there, I was part of the asset allocation process at the fund level. And their dedication to private asset classes, specifically real estate was very significant. They targeted 50–50—50% publics, 50% privates. And of that 50% privates, 15% to 20% real estate, and the rest infrastructure and private equity.

And so you dug into why, and the reasons are low correlations. Real estate had such a low correlation to Canadian equities and Canadian bonds, specifically, and so it really added a nice diversification element to a portfolio that had low volatility.

Actually, the real estate, as an asset class—so I’m talking about core institutional quality real estate, unleveraged, the volatility of real estate’s been similar to bonds over time and it has a high income component. And many investors appreciate this. Fifty to sixty percent of the total return comes from income. And then there’s a little bit of inflation protection built in as well because, often, rents or escalations are tied to inflation increases.

So all of that contributed to making real estate a very important component of a pension fund’s portfolio, and. And so, they didn’t have an access problem because they built departments to invest in real estate. But individuals did have an access problem. They couldn’t go out and hire a real estate team to invest to real estate directly, and, you know, it’s time-intensive, and it’s tough to find deals. And the deals tend to be very large. An office building can cost $0.5 billion.

And so that was really the mission, and RBC GAM charged us with it. And we wanted to solve it, which was creating an access point for individuals to basically get into the institutional real estate investment process and with complete alignment and focus around quality and with all the governance and discipline that RBC brings to the table. So that bottom line was the—the mission was to give investors the opportunity to construct the best long-term portfolio possible. And that was—part of that was giving them an access point into direct core institutional quality real estate.

Stu Morrow:

That access is an interesting one. So if you could, some people may be confused or have questions about, you know, REITs as a structure of the real estate investment corps versus investment trust versus core real assets. You’re talking about core real assets, institutional assets.

Can you just briefly kind of contrast those two so it’s sort of clearer?

Michael Kitt:

Yeah. Sure. Absolutely. At the pension fund, we invested in a REIT, and we invested in core real estate and really treated those as two different asset classes, two very different investment strategies.

When you look at a REIT, you look at a number of key differences versus the underlying core real estate; the way a REIT is capitalized. They are in the equity markets. So in down markets, they really do—they’re associated with the moves in and out of the market, the emotional swings that can force decisions. And it’s also often difficult to borrow during these times.

And so a REIT’s balance sheet can be impacted significantly in down markets, and many REITs have development programs and these larger development programs have a very different return profile than underlying core real estate. And they’re quite often more leveraged to—REITs overall have approximately 3 times the leverage our core real estate fund has today. So that leverage, obviously, can swing returns one way or another.

And they have a very big management effect, actually. REITs are a company with G&A and fee revenues and so you can quite often see a company’s stock value moving or changing due to a management effect. You’re buying a company, not an asset.

And if you do look at REITs and you go down their asset list, when you get down to the bottom third or half there, they are lower quality assets, often in tertiary markets versus an institutional core portfolio. They would tend to have top-to-bottom high quality. And so it’s interesting, when you look at the volatility that REITs have versus what the underlying real estate actually has, REITs are about 6 to 8 times more volatile versus the underlying real estate.

And it’s kind of played out this year, you know. I would say, overall, the real estate values are down, call it 3 to 4% on average, and that’s taking a cross section of institutional quality real estate. And REITs are down about 20 to 25%, on average, and so I think that’s playing out in this down market, where you’re going to see that kind of volatility.

And it doesn’t make it a bad investment. It just makes it a very different type of investment. You’re not buying the underlying real estate. You’re actually buying a company, and that’s why pension funds treat them like stocks.

Stu Morrow:

That’s great. No. It’s good to get that difference in people’s heads.

So when we’re thinking about your Canadian core real estate strategy, and talking about institutional quality assets, core real assets, commercial, one of the things I mentioned in the introduction was, of course, both you and I are experiencing it right now, where we’re working from home.

When you’re thinking about your fund, and you’re thinking about these work-from-home arrangements, how should we be thinking, as investors, about a permanency behind that? So what impact did that have on Canadian commercial real estate, of course, but your fund? And where do you see, you know, the risks? And any opportunities as well?

Michael Kitt:

You know, work from home is not a new trend or idea. It became a key part of corporate real estate strategies, probably 10 years ago, as technology allowed it really to happen efficiently and effectively. And I think back, actually, to one of the last buildings that I had developed when I was at Oxford Properties, and that was 88 Queen’s Quay for the Royal Bank. You know, roughly 1 million-square-foot building and the bank was taking over half of it.

And at that time, we were working with them in developing the building and ultimately looking at the way they were going to fit it out. And they were in the middle of competing for talent with tech firms and the holding onto accounting firms and—and even if with accounting firms, they wanted to optimize their use of space. And they started targeting, roughly, two employees per every desk and they were designing lockers and booking systems for spaces and quiet areas and lunch areas, and.

Goal was all about increasing productivity and employee engagement but, at the same time really focused on space efficiencies and usage because real estate is a cost for a corporation. So they were very focused on that as well. And that 10-year experience has proven out; um, it’s worked. And the bank’s model going forward has really been about replicating this build-out strategy, really over the past five years.

And along the way, though, even though they’ve been increasing efficiency and their ratio today is about 1.8 employees per every desk that they have across their entire portfolio, even though they’ve been increasing density, they’ve been needing more space. Why? Common areas, the amenities to compete, even just the growth of their business has really driven an increasing need for real estate.

And so when you look at real estate and the role of office space in the future, uh, and this work-from-home trend specifically, it’s really important to understand it isn’t a trend. It is a key part of a corporate real estate strategy, really driven by employees wanting that flexibility about where to work.

And the bank has taken numerous surveys over the past six months, and there’ve been many fundamental, large surveys done about what employees want. And it’s very, very clear that the extraordinarily high percentage of the employees do not want to just work from home. They want to work from anywhere. They want to carry their computer and plug in. Whether it’s at the office or at home or at their cottage or at a coffee shop, they want that control and flexibility of their lives.

And what the Company wants is them to be productive, them to be engaged, and really to drive the growth of the business. And so I think both sides are really saying that the office is going to exist like it was before.

And Scott Foster, who is the Global Head of Corporate Real Estate at RBC, I was listening to him last week. And some of the key takeaways is—and he works with a—I think it’s a collection of 25 of the largest global occupiers in office real estate. And they’ve gotten together, through COVID, just to try to understand the impact.

And again, every one of them has said that they’re not going to overreact and potentially harm their business. So no one is stepping back and declaring that the office model isn’t important. They really have reaffirmed that their strategy, pre-COVID, is going to step back in, post-COVID; that there isn’t going to be a significant change to their long-term real estate strategy.

They see their long-term strategy as actually being very relevant, post-COVID, and it includes a work-from-home/work-from-anywhere element. And anecdotally, we’ve seen that in our portfolio. Amazon. We have Amazon as a tenant in our portfolio, and they’ve confirmed the same thing to us. They’ve taken, in fact, five more floors in Vancouver just recently, and they have a downtown core office strategy that is about collaboration, culture, training, and really that breeds employee loyalty.

And it’s almost like thinking about creating a university type of setting. The way university students work, where they free flow between university campus settings, but then also home, and then also coffee shops. And Google, Amazon, Telus, and even Shopify—who, by the way, was the most vocal about stepping back from office and then only a month ago, exercised an option to take another 80,000 square feet at The Well in Toronto. And so, I think all of these tech companies, importantly, ’cause they are important drivers of demand in the future—know that the office and work from anywhere and growth in their productivity all coexist.

So what you’re going to see in the office market, you know, very likely is, in the short term, demand’s going to pause. I mean, everyone is taking this moment in time to reflect on their business and think about employee health. And so no one’s making big moves today.

Rents are going to hold in better buildings. You’ve seen that through Q2. We’re seeing it in our portfolio that those buildings with high occupancies are owned by strong landlords, and really rents are holding firm and occupancies are holding firm. But the world has definitely paused.

Midterm, office demand is going to resume, when the economy recovers and the new social routines have become a habit. And so you’re going to see that demand resumption come in, midterm. And long term, you listen to these large corporate occupiers, their strategies aren’t changing. And so office planning’s going to continue to be driven by productivity and growth, and work from anywhere is going to be a key part of that.

Stu Morrow:

That’s great. That’s great colour, Michael, for the office space.

If you think about the portfolio, um, you know, maybe, perhaps touch some other industries or sectors where you’ve seen some opportunity. So in office, where short term, midterm pause, long term, still very positive. Anything in the short term where you’re—you’re sort of seeing opportunities? And maybe where you might position the portfolio, maybe differently than you would have in a pre-COVID world?

Michael Kitt:

Yeah. I’ll start with some thoughts and observations there because I think it’s important to keep perspective here.

Cap rates, which is a vernacular in the real estate industry for the year one income yield, so those are about 5% today, overall. And I’m just using a, you know, a spot average. Often, those are compared to 10-year government interest rates, and that spread is something that people monitor for buy or sell signals. And historically, they’ve ranged in the neighbourhood of 300, 350 basis points over long-term Canada’s. So cap rates versus Government’s.

Today, they’re historically wide. Those spreads are actually through the great—where they gapped out in the great financial crisis. So if you’re of the view that we’re going to be lower for longer on the interest rate side, and that seems to be a consensus view today, that rates are going to hang around where they are, it’s a pretty compelling buy signal because the gap between cap rates and long-term government’s is at an historical wide. So that’s number one.

Number two, um, in my experience and, you know, I’ve fortunately or unfortunately had to live through cycles like this—it’s always a better strategy to focus on quality and lower risk. Tenants are going to tend to move or consolidate in quality locations. There’s a, you know, “flight to quality”. Lenders and buyers are more focused on quality asset. Lenders are more comfortable lending on them. So you have capital flowing into quality. You have tenants flowing into quality. From an investment perspective, those are two key reasons why you want to keep focusing on quality and keep that discipline.

I’d be very wary of this element today. There is a cost pressure, just because of the supply chain impact and labour inefficiencies. It’s just taking more time to build buildings, and I do worry, short term, about the impact of the efficiencies of the construction, um, project world. And time can kill development projects, so there’s extra risk in the development sector.

And I think, if you want to search for a bottom, you want to use that kind of strategy, I’d really look at assets that are adaptable because that’s another beautiful thing about real estate, is what you buy today doesn’t mean it’s stuck in a use, um, that’s restricted forever. Often, you can change use quite easily in the real estate world, and if you have good managers and, you know, are creative, you can turn coal into diamonds, so to speak.

So with all of those themes, if you look at a grocery-anchored plaza, for example, and retail has had a blanket thrown over it as being one of the hardest hit sectors due to this crisis, and restaurants and fashion really hit hard. But if you step back and look at, maybe there are retail sectors within that overall blanket that haven’t been quite as hit hard [financially], but yet their [businesses] are down.

I look at grocery-anchored plazas in really strong locations, and they’re actually holding up really well. And if any real estate asset is adaptable, that’s at the top of the list. You’ve got big parking lots that you can build on. You’ve got single-use buildings that you can easily convert to other uses. Quite often, these well-located plazas, you can build residential. They work for storage. They work for a data centre. They work for distribution. They work for a medical office, medical uses. They work for education and even social municipal uses like a library or even a rink.

So if you can buy a great neighbourhood plaza with a grocery store and a demand driver, I think your short-term downside is limited. And then, you’ve got potential upside around all these converting to other uses. And so, you know, if there’s a diamond in the rough, so to speak, that’s been pulled down in this crisis, that’s definitely one that I’d look to.

Stu Morrow:

That’s great. That’s great colour. You know, one of the things that we talk about with—obviously as part of the investment process at RBC PH&N Investment Counsel is portfolio diversification. Can you spend a minute on, or just, you know, some time, talking about your fund and diversification, as it relates to, you know, sectors? Or geographies? Building types, that sort of thing, to sort of give our listeners a sense of how you’re thinking about portfolio construction and diversification when it comes to your fund?

Michael Kitt:

Yeah. I’ve been part of a lot of work over a long period of time around developing an efficient portfolio and running correlations and return, and understanding return of volatility within the portfolio, specifically even within a real estate portfolio. And the concepts are so basic, so important, yet it’s so easy to ignore or forget sometimes. It takes discipline to stay diversified. And, you know, I often think about a dog chasing a car. You know, that never seems to end well when you start to chase gains, or you chase after headlines.

And I look a little bit at data centers and self-storage. Those are two areas that are, you know, quite hot right now. You know, data centers for the obvious reason that everyone’s using an extraordinary amount of data through this time. And self-storage seems to be, you know, another in getting the benefit of a halo effect, and. And not to say that, again, those two investment classes within the real estate world don’t have merit. But they tend to be in average locations and data’s driven by technology, and very specific-use. Self-storage, you have kind of weaker covenants and short-term leases.

And so, I mean, it did—chasing trends never seems to end well. And that’s why, when we look at asset allocation—we talked about it, actually, right at the start—that from a top-down perspective, when the institutions build their portfolio, they think about public markets. They think about private markets. And within those private markets, they think about real estate. And then you drop down into the real estate level, you want to keep diversification again at the forefront at that level.

And so we really think about it from two perspectives. At the asset or portfolio level, we’ve got specific sector targets and bands. We’ve got geographic targets and bands. We’ve got single-asset limits. We’ve got asset and tenant quality filters. You know, all of that comes together with a view of maintaining discipline and creating a strong, diverse cash flow stream.

And if you step back, we have exposure to 1,000 commercial tenants. But think about that in the context of the S&P 500. That means we have exposure to 2 times as many businesses because we can access public and private businesses within our real estate portfolio. Add to that, 2,000 residential tenants in our portfolio. And add to that, we aren’t exposed to 1,000 different tenants and their equity balance sheet or what their companies are worth. We’re up their balance sheet. We’ve signed long-term, fixed-rate contracts with those tenants. And so we’re almost moved up into a debenture position within those 1,000 companies.

And so when you look at the number of tenants, you look at the fact that there’s residential included, and you think of the fact that we have contractual obligations from those tenants, that’s why the real estate sector has such low volatility. And that’s why it’s such a strong diversifier. And that’s why it isn’t really correlated with equity or fixed income risk because it really is a different animal.

Stu Morrow:

Those are all great points. I really liked the point around disciplined portfolio, uh, construction. Investing can be simple and easy but, you know, we tend to, you know, be our worst enemies at times. But clearly, to be disciplined and talk about portfolio diversification the way you do, um, you certainly get the feeling that, you know, headwinds are not—there are still risks, but there is certainly opportunities within your sector.

So one of the things, Michael, just to kind of close it off, I’ll always ask guests, you know, obviously besides my great content that I put out, but is there anything out there that you’re sort of listening to and reading that, you know, perhaps, our listeners may want to tap into? Or just sort of get a sense of how you spend your time reading and—or listening? Obviously, this is a new medium. It’s audio and video cast. So anything you can share with our listeners would be great.

Michael Kitt:

We’re subject to so much negative news. And, you know, it’s driven by, it seems, human nature, and it’s driven by interest, and. And so the channels will feed our need for sensational stories and that’s driven by—often by negative headlines.

And I read a book recently that was suggested by Dan Chornous. And for everyone’s benefit, Dan’s my boss and, you know, one of the most thoughtful, intelligent CIOs, out there. We’re very fortunate to have him at RBC GAM. And the book was Factfulness. So Factfulness by Hans Rosling. And it really paints a positive perspective of the world today. You know, the top of the book—and I’m just looking at it—the headline is Bill Gates has called it the—one of the most important books he’s ever read.

And what it does is just paint a more positive perspective, long term, all fact-based about we’re actually living in a much more positive world today than, I think, the headlines would lead you to believe. And he also gives you a few different things to think about. And I think, they aren’t just rules to live by, but they’re kind of neat rules to invest by.

And the three that he points out are:

• Always compare numbers, so don’t just look at the absolute number and be wowed by the headline. That’s a headline issue. Compare the numbers and so, see where you were, and where you are, and think about where you’re going. So always compare numbers.
• Number two, always divide by something, was another rule he had. So it’s often the rate of change or the rate per person that matters because, again, you can get the law of large numbers can start to dominate attention.
• And then the third one is one that we’ve all heard before, but it’s worth reminding, is the 80/20 rule, is when you’re investing, focus on that 20 percent that is going to drive 80% of the result. But make sure you get the bigger picture right and don’t get as caught up in the detail.

And so, you know, that book is one of those books in life where you can keep opening it up to a page and reminding yourself of a really interesting point and actually feeling positive along the way. So I bought a couple copies and sent one to—one to my very good friends for their birthday and it’s a really neat, neat read. It’s one of those books you’ll just keep coming back to.

Stu Morrow:

Yep. That’s a great recommendation. I’ve read that too, also from the recommendation of Dan Chornous as well. And I found myself, throughout the crisis, reading that over again. So a great, great, great recommendation, great book.

And with that, Michael, on behalf of RBC PH&N Investment Counsel clients, thanks for taking the time to speak with us today, share your thoughts on the outlook for Canadian commercial real estate.

Hope that you remain well and the family’s well, in good health, and enjoy the rest of the summer break. And we’d love to have you back at some point, and your schedule permitting, of course. But with that, hope you take care.

Michael Kitt:

All right. Well, thank you, Stu, and thank you, everyone. Good luck, and stay safe.