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REOCs winning property investment battle

berman@globeandmail.com

There are said to be at least a half dozen real estate investment trust initial public offerings getting ready to hit Canadian markets, and the managers at top-performing real estate hedge fund Vision Capital aren't very keen on what is coming.

It's not that Vision's principals are not bullish on real estate - they are. They just don't like much of what is on offer as investment bankers hunt about for companies to take public, feeding a market that swallows new REIT IPOs like a contestant at the Coney Island hot dog eating contest scarfs tube steaks.

On a global basis, real estate equity sales are the second-busiest sector of all, trailing only energy and electricity generation. Last year, real estate accounted for more than a 10th of all new equity sold in Canada. Much of the buying comes as investors demand yield, which real estate investment trusts provide.

"There is so much crap coming to market," said Jeffrey Olin, one half of the team of co-portfolio managers at Toronto-based Vision, citing what he calls "stupid structures."

What are yield-blinded REIT buyers overlooking? As one example, investors have not been all that picky about such issues as external management structures, which in bad cases can siphon too much shareholder money to management companies.

Taking it a step further, there is a good argument that yield is exactly the last thing an investor who is really interested in buying property stocks should be looking for. More on that later.

First, here are some details on why Mr. Olin and his partner in portfolio management at Vision, Frank Mayer, are worth listening to. Vision's two inaugural funds, set up in the summer of 2008, have both handed investors returns of better than 20 per cent a year. Climbing values for commercial properties have provided a rising tide, certainly, but the funds have handily outperformed indexes of Canadian real estate stocks.

Generally, Mr. Olin and Mr. Mayer are optimistic about real estate. They are not overly concerned that real estate stocks are overpriced, even given the stellar runs.

"Supply and demand fundamentals are the best we've seen in years," Mr. Olin said, pointing to single digit vacancy rates "in virtually every property type." What's more, the excess cash yield from properties over government bonds is relatively wide by historical standards.

So what is Vision buying? Over the years, Mr. Olin and Mr. Mayer have often gravitated to real estate operating companies (known by the shorthand REOCs). These are the companies that have shunned the REIT structure, which requires a company to pay out the bulk of its cash flow, and instead tend to retain their cash flow. If they pay a dividend at all, it is usually small. Instead, they keep most of their cash to reinvest.

They are the poor cousins of the real estate business when it comes to investor attention. The lack of yield is a turn off for some buyers. Analysts don't tend to cover real estate offering companies as much, perhaps because they rarely issue stock to generate investment banking business for the firms that employ the analysts.

In a rough market for real estate, should we hit one, there are lots of reasons to like REOCs over REITS. (To be sure, these are broad generalizations, as there are good and bad in each category.)

REITs often fetch premiums to their net asset values. REOCs can be found at a discount. That provides a little cushion.

REOCs don't need as much access to capital markets because they retain their cash flow. They can use that money that comes in from rents to fund purchases of properties or redevelopments in tumultuous markets when opportunities arise.

REOCs are often more active developers than REITs, many of which are asset gatherers. In other words, REOCs are good at creating value out of their existing portfolios.

Even in a bull market, there are inefficiencies that can be found.

Vision's team points to Morguard Corp. and Morguard REIT. Morguard Corp. pays a tiny dividend, offering a yield of 0.5 per cent, and is only covered by two analysts. Morguard REIT is covered by five analysts and offers a 5.2-per-cent distribution yield.

Which would you rather own? In this case, the answer has clearly been Morguard Corp. It has provided a total return of 45 per cent in the past 12 months, double the REIT.

Similarly, they have long preferred Mainstreet Equity Inc. as a way to play apartments, rather than the bigger and more well-known Boardwalk REIT. Once again, the REIT was the laggard.

"The REITs were a sucker bet," Mr. Mayer says.

© 2007 The Globe and Mail. All rights reserved.

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