It took only a small interest rate rise in mid-2013 to take the shine of the REIT sector.
When the U.S. Federal Reserve takes its thumb off the scale for real and lets interest rates find their natural level, things could get really, really interesting for the real estate industry.
That prospect of rising rates is not just something Shant Poladian thinks about, it is treated as a near certainty that he uses to determine the financial structure of his REIT as well as its deal-making activity.
Poladian, CEO of FAM Real Estate Investment Trust (F.UN-T), has no crystal ball to say exactly when rates will start marching back up, but he expects it to get ugly fast when that day comes.
“I think the next couple of years are going to be very difficult for the REIT industry. They are going to be battling a lot of headwinds with rising long-term interest rates. It is going to be tough and the balance sheet is going to be the real differentiating factor between those that can move the ball forward and those that are going to struggle.”
It’s in the numbers
Just like a doomsday prepper’s commitment can be measured by the amount of guns, ammo and food packed away for dark times, FAM’s preparedness can be seen in its balance sheet. Just before the holidays, the Toronto-based REIT announced that it had purchased a 30,268 square foot office building in Winnipeg, for $4.0 million (1700 Ellice Avenue) and sold a 106,108 square foot retail property, in Humboldt, Sask., for $1.85 million, before closing costs.
Typically, when an outfit sells one property and buys another, more expensive one, debt usually goes up. Not in this case. In fact, the REIT’s liquidity rose from $12 million to $17 million, and cut its leverage ratio by 100 bps to approximately 52.5%. FAM was able to boost its liquidity position by paying for acquisitions using equity, rather than debt.
For FAM, liquidity is its equivalent of guns and ammo.
“If interest rates are rising and it does create a number of number of opportunities, we want to have money to move quickly,” said Poladian, who comes at the real estate industry with a different perspective due to his background as an equity analyst.
That $17-million cash hoard could be added to with injections from its largest unitholder, Huntington Capital Corp., as well as other large institutions shareholders which own about 30% of the REIT. “Our ability to access capital for the right opportunities is definitely there.”
The REIT chief executive is already seeing signs of a change in the environment.
“In the larger REITs, it is not that evident that the current market is having a major impact – sure they are not that happy that their stock prices are done. But if you look at the smaller REITs and their ability to raise money and some of the REITs that don’t exist anymore and were taken over – C2C which was taken out though it was a corp, not a REIT – and now you have Partners REIT which has gone through its own challenges.
“You are starting to see some real challenges in the small world,” he said.
FAM REIT is small by anyone’s standards, with about $100 million in market cap, and it is acting the way other small guys should emulate, added Poladian.
“You need to do what we are doing. We are building for a much more difficult tomorrow, but we are doing it all today.”
That uber-cautious approach to its balance sheet will show up in FAM’s acquisitions as well, said the CEO.
“We have had to raise our hurdle rates for new investments. So that little property we bought, 1700 Ellice, if you look at at it in terms of what the going in return is, it is quite a lot higher than the other two deals we did and we did it without putting any debt on the asset.”
That equity-instead-of-debt approach makes the Ellice Avenue property immediately accretive to FAM as well as improving its liquidity position.
The Ellice property was paid for with the sale of 466,094 class B LP units at $8.58 per unit. The class B LP units are economically equivalent to, and exchangeable on a one- for-one basis for, FAM REIT trust units.
“You want to buy properties than can generate you a higher total return than your weighted average cost of capital,” he added. “That way even though you might not like the price that you issue equity at, you are more than offsetting it by the return on new investment.”
The approach does “not necessarily” mean a slower pace of acquisitions for FAM, but that is really dependent on how much pain real estate players feel in the next cycle of the market.
“I think over the next few years there will be a number of transformational events that will come, but they won’t be compared to 2009 to 2012 where there was a steady flow of acquisition opportunities that made sense. Right now I think it will be much more sporadic,” Poladian said.
In other words, he is preparing for a market characterized by motivated sellers with a shallow pool of potential buyers. When those deals come up is anyone’s guess. It just will not be as fast and furious as the post-crisis high times the industry enjoyed so recently.
“Those opportunities will definitely show up, but compared to say the pie-eating contest of 2009 to 2012, that is definitely over,” Poladian concluded.