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Canadian investors wanting to generate portfolio income have long turned to residential real estate as a source of stable returns. While net property rental income has not always exceeded yields from fixed-income instruments, over the past decade, this shortfall was usually more than compensated for by capital appreciation. However, times can change.
This month we look at one of the more fundamental portfolio decisions that many investors face – bonds versus residential real estate. And, having run a few numbers, we argue that a portfolio allocation to corporate credit offers higher income, with considerably less potential downside, than even a well-executed program of residential real estate investing in one of Canada’s largest cities.
On the bond side of the equation, we consider a selection of North American corporate bonds (see Table 1) with yields at February 28 of approximately 8%, all of which are holdings of this Fund. For real estate, we consider the midpoint of multi-family apartment “cap rates”1 in Canada’s three largest cities: Toronto, Montreal and Vancouver.
As of Dec. 31, 2022, according to property brokers Cushman & Wakefield, multi-unit residential property paid its owners between 2.5% and 5.5% in the largest Canadian cities. So as a starting point, the bonds pay approximately twice as much income as the midpoint of a residential real estate market.
It is one thing to earn a coupon, but quite another to ensure that the coupon is generated from an asset that is well supported by fundamental value. For the corporate bonds, we considered the current level of valuation coverage – that is, the degree to which the estimated value of the issuing company exceeds the total amount of debt at or above the level of our bond.
We also considered the coverage in three circumstances: based on the current market prices; based on long-term average enterprise value multiples; and based on decade-low enterprise value multiples. We observe that, even valuing these issuers based on a 10-year minimum enterprise value to sales multiple, the 8% notes are more than two times covered by the value of the issuing companies.
The downside protection argument for the real estate investment in the current market environment is far less certain. First, investors in real estate such as houses or condominiums typically are not sitting in the senior capital position. Capital priority, in fact, is often surrendered to a bank that may have funded a first mortgage. So, any diminished value of the property is a direct mark-to-market hit to the investor.
A second concern for real estate investors is the very low level of cap rates (or rental yields) relative to history. One recent study noted that real estate cap rates in Toronto, Montreal, and Vancouver were all at least 1.5% below their longer-term average as measured by the spread of cap rates over Canada 10-year bonds.2 If one were to apply a 1.5% higher cap rate to the midpoint of the Toronto-Montreal-Vancouver current cap rate, the impact on underlying real estate value would impact values by more than 25%.
Of course, markets are not completely uniform, and there may be some attractive property deals even in the current environment. But given the choice of real estate and bonds in this context, we prefer bonds due to their higher income generation and capital exposure, which we deem to be far less risky.
Geoff Castle is Portfolio Manager of the Pender Corporate Bond Fund at PenderFund Capital Management. Excerpted from the Pender Fixed Income Manager’s Commentary, February 2023. Used with permission.
Notes
1. A cap rate is simply the net rental yield after property specific costs, divided by the capital price of purchasing a property.
2. Colliers Canada Cap Rate Report Q3 2022
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