Unlocking Canadian Residential Real Estate as an Asset [podcast]

Investor Mindset Podcast, Let's talk residential real estate investing - Episode 1

Learn more about Canadian SFR as an asset class opportunity, learn more about focusing on Ontario’s secondary markets as an investment strategy, and why Konfidis is on a mission to champion Canadian tenants.

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In This Episode We Cover:

• Formation of Single-Family Rental (SFR) Opportunity in the US

• Professionalizing SFR investments using technology

• Similar SFR Opportunities in Canada, specifically Ontario

• Supply constraints in Single-Family Rental homes

• Novel risk and return profile in real estate investing

• Challenges for tenants in today’s residential real estate landscape

The video version of this episode can be found here. View all Investor Mindset show episodes here.

Full transcript:

John Asher: Hello and welcome to Episode One of the Investor Mindset. And today we're lucky to have Shael Soberano as we talk about unlocking the Canadian residential real estate market as an asset class. Thanks for joining us today Shael. Shael is Konfidis’ Chief Investment Officer, we're very lucky to have him. And Shael, for the people who are watching, again, it's kind of a very exciting time, but if you wouldn't mind giving people a little bit of a background for who you are, your story, and I guess I should have introduced myself as well. I'm John Asher, President of Konfidis, but I'm much more interested in your history.

Shael Soberano: Thanks, John. Yeah, my pleasure. So I've had great opportunities in my career over the last 13 years in institutional asset management, with the focus primarily on real estate. I started my career at a hedge fund that invested exclusively in real estate securities founded by two pioneers and helped build the REIT (real estate investment trust), a real estate investment trust sector in Canada that it moved to the buy-side and launched their own fund, when they were quite small and nimble, I joined about six months after they launched, and spent about nine and a half years with them, building what is now one of the most successful Canadian hedge funds with that exclusive focus on the real estate sector. First half of my tenure, there was primarily on the operations compliance and asset management business with some involvement in the analysis of the underlying positions, finished my CFA (Chartered Financial Analyst) designation, but halfway through my tenure there and then transitioned fully over to the investment side of the business. I was the vice president and senior analyst. I became a registered Portfolio Manager with the OSC (Ontario Securities Commission) at the fund and I was responsible for following primarily residential real estate stocks, multifamily, seniors housing, land developments, and I've heard of this new industry in 2011/2012, called SFR, single-family rental that was emerging in the U.S., and I know we're going to talk about that. After leaving the hedge fund, I helped establish a single-family office with a real estate focus, as well as other asset classes, private equity, venture capitals, and hedge fund style investing. And of interest, taking what I learned at the hedge fund, and seeing the opportunities in residential real estate, found that it was very challenging as now a principal investor for a family office to gain exposure for the family, to single-family homes in a Canadian context where we have more comfort in our backyard, and then was lucky enough to join the Konfidis team at the end of 2020. I'm the chief investment officer responsible for all aspects of the business that are investor-facing and related to underlying investment analysis.

John Asher: So it's kind of interesting because you've really had kind of a ringside seat to the front row, sort of vision of what's been going on in the U.S. And if you wouldn't mind kind of telling us a little bit more about how the asset class sort of emerged in the U.S.

Shael Soberano: Yeah, I like to joke that really, investors wouldn't listen to the single-family rental story when I first heard it and was exposed to it. I joke that I would attend these luncheons because there's one particular investment bank on Bay Street that puts on the best lunches, so I would attend. And I'm happy I did, because it was really me as the only institutional investor in the room in a lot of investment advisors, listening to what hadn't been considered an investable property type in the world of real estate in the U.S. And fast forward now, 10 plus years, and it's by far the most sought after property type in the U.S. and really globally. And what I would note that is especially interesting is that it's all been driven by tech and data innovation. The idea of management was very challenged, efficiency of management, prior to significant tech innovation. And that's something I think is an opportunity in Canada that I know we're going to come back to. What's also important to note is that these players in the U.S. and a very broad now investment community into single-family rental, have created an immense amount of quality rental homes for Americans. And what that is open there's always been a bit of a chicken and egg and we can come back to in the Canadian context but there wasn't high quality availability of rental supply in detached single-family homes. And now that that's been provided, you're seeing a very strong preference for tenants that want to rent single-family homes, quite different to the American dream of owning a home than folks think about. It's maybe a generation or two, dated now and it's thinking, there are large cohort that prefer renting.

John Asher: So we're going to come back to that because I think that's a really kind of important point, but if we think about and I stepped back, you know, I think a lot of people would always say, “Listen, just because it's happening in the U.S., it's not going to happen in Canada.” However, when we talk to a lot of people, we often hear the saying of “Whatever happens in the U.S. eventually will happen in Canada as well.” So I'll ask you the question of, you know, fine, this is happening in the U.S., do you really think this is going to actually come to Canada?

Shael Soberano: That's a great question. And the reality is that it's already happening in Canada, it has been happening for a long time. A lot of headlines. I'm sure the viewers have seen about how investors have been dominating 20% plus of the acquisitions of homes in Canada, challenging to define that looking at investors or owners that have multiple mortgages has really become the proxy to determine who's an investor versus who's a family owner-occupier of a home. But those investors historically have used very dated tools, and have had challenges with management. So this idea of professionalizing single-family rental, I think is a massive opportunity in Canada that investors need to be paying attention to. And if we look at the U.S., and there's a lot of exciting headlines, very strong rent growth, very strong home price appreciation, a lot of that's been driven by the Sun Belt region. Texas as a great example of a state that's seen a lot of investment from the private sector into single-family homes and SFR specifically, there's a really great thesis around the demand for rental homes in that part of the world. Low cost tax jurisdiction, driving a lot of job creation, so very compelling demand side of the picture. If I look to Ontario, where we focus fundamentally on the supply and demand fundamentals, we see a similar demand side of the equation. Canada has recorded immigration reform of a thousand last year and targeted increased growth this year. Demographically, there's a very large cohort of millennials that are starting to form families getting married later in life. They are looking for larger format housing. This has been accelerated by trends in working from home through the pandemic, and we're seeing increasing indications that a hybrid model is the most likely solution over the next many years. What's a little bit different than the Sun Belt as an analogue for what we can pay attention to in Canada is the supply side is very different. There is a significant lack of new supply, and new headlines are really uncovering, that is what's driving housing unaffordability. And it's my job to dive into the details of those supply demand fundamentals, to understand the future, the marginal supply, the marginal demand that will drive future pricing of homes in future pricing of rental rates. So on the supply side to discuss a few specifics, there's very little availability of land, Greenbelt in Ontario and really focusing Ontario's discussion, seeing secondary markets in Ontario is really the core focus and the core opportunity to participate in home price appreciation, but also to enter the investment but sufficient amount of yield through net rental income. So you have very little availability of land, your skyrocketing construction costs that are making it more expensive to deliver new housing. And it's becoming very challenging, from a timeline’s and cost perspective, to create zone and service land for home development, and that's you know, unfortunately, working policymakers have come up short. And there's been this massive mismatch that's been driving home price appreciation that we don't see changing with a federal immigration policy, really an open-door immigration policy that's very positive for this country. Canada is probably a massive pandemic winner, but even before so, it's one of the best places in the world to live and to start a family for many around the world. So we only see that increasing and then on a provincial or municipal level, you have significant restriction on the ability to build new supply. And that's a combination that unfortunately for affordability looks like it's going to continue for some time.

John Asher: So let's talk a little bit more about demand and supply. In demand, I think you don't have to go too far, to see houses and multiple offers every single city and subsidy and tertiary community in Ontario, so clearly the demands there and there's some long term dimensions. So let’s talk about supply. You talked about it really quickly there. What is being built. Right. So if we've got strong demand for larger format housing, but what is being built, like, you know, are we seeing single-family homes being built or are we seeing condos? Which is it?

Shael Soberano: You're seeing diminishing new supply when it comes to the traditional suburban sprawl that suburban subdivision development, many of those multi-generational developers have turned their attention from suburban single-family style residential development to urban condos. You're starting to see a little bit of more urban high-rise, rental built for rent, but relatively small compared to total housing, new availability, new inventory coming online. So it's a great question because there is a mismatch. So yes, immigration, those are coming to Canada, over two-thirds are coming to Ontario. The majority of those are coming to urban centers, but many are going to the secondary markets and even those that come into the urban centers, there's a ripple effect of push those that are currently out to the secondary market and pricing is a big factor of that. So you have a demand being pushed down to the secondary markets, whether it is still affordability from an ownership purchase price perspective, as well as a rental perspective compared to the downtown cores. And the supply is not meeting that demand, there is that mismatch of supply and demand there.

John Asher: Let’s take a step back. Let's think a little bit more fundamentally, you know, I think a lot of investors will look at this asset class and they'll think you know, it's interesting, but there are other sort of alternative asset classes as well as office commercial are sort of mixed use. So can you talk to us just a little bit around just the general risk and return profile that an investor should have when they're thinking about investing in residential real estate?

Shael Soberano: Absolutely. And investment in the single-family residential, non-apartment buildings brings a very novel risk profile that is of interest to many investors. So we'll start with the risk profile and talk about the return potential. From a risk perspective, liquidity is key. Single-family homes and residential real estate is the most liquid asset class, real estate asset class in the world. What's incredibly compelling about single-family homes, is the disposition optionality, which is what many of the American investors talk about, if you buy an office building or have an investment in an office building, or shopping plaza, if you want to sell that asset? Those that are available to buy them are really financial acquires. Single-family homes, quite different, where, yes, you can sell to another investor, but you always have the ability to sell to a family that's looking for somewhere to live. So you have that optionality, it's quite differentiated from all other real estate property types. Real estate is generally known for being a very strong inflation hedge, which is especially important in today's environment where that's the primary concern for many investors is what happens to my purchasing power, what happens to the value of my portfolio in an inflationary environment? Real Estate broadly, is known for being a very strong hedge. Single-family rental in particular, is probably among the most efficient inflation hedges within a broader real estate market. So if you think about a 20-year office lease, with contracted rents, in perhaps step ups in those rents, but contracted at the time of the commencement of the lease, there's very little inflation protection built into your cash flows over time. It's more bonded like. Single-family rental, and we'll come back to how rent controls impact is, but they have rental rates that adjust typically on an annual basis. Typical residential lease is one year with month to month thereafter, and even within rent controls in an Ontario environment. There's the ability to increase rents per government guidelines increases on an annual basis. So there's that protection, that if inflation is going up, your operating expenses are going up, you have the ability to offset that with rents. Real estate is often thought of as a development opportunity when many look at real estate opportunities, and when you're assessing different investment opportunities, understanding the risks across those alternatives is quite important. The concept of development brings a whole new set of risks when it comes to execution, then an income-producing piece of real estate does not. Most importantly, unlike commercial real estate, where your cash flows are typically corporate credit, leases with corporations or our non-individual entities. In residential real estate your tendency is very high credit quality with individuals that ultimately need a place to live. As we've seen the last few years, you might not need a place on Bay Street to go to an office building. You might not need a place in a mall to be able to sell product. People need a place to live and that's very important. And very quickly on multifamily apartments because multifamily apartments do benefit from much of what I just spoke to, less so on that disposition optionality. But if we look at multifamily apartment investments in Ontario, first of all the ability for an individual investor to acquire an apartment building is very challenging, given the cost of one unit of an apartment building. And in this country, multifamily apartments are at all-time highs in terms of pricing and valuation, all-time lows in terms of cap rates which is the inverse of an earnings multiple. And because of rent controls, which I know we're going to come back to, there's significant deferred Capex (capital expenditure) within these buildings, which is you can be very large check sizes to abate that which is quite different than single-family rental, where you have new stock being created frequently.

John Asher: Let's shift a little bit here. I know there's been a lot of discussions that goes on, whether it be through social media or opinion pieces, and it's all around the, “Is this a good thing for tenants or is this a bad thing for tenants and the story of the investor?” And, you know, my personal view is this is really kind of like an ecosystem. There has to be a balance between making sure that there is rental stock, but then also making sure it's good for the tenants as well. I'd really like to get your thoughts on, “Is this a good thing for tenants or just what makes it different?”

Shael Soberano: Yeah, absolutely. And I think I can also come back to the second part of your previous question around the return side that gets exciting in single-family rental. But the idea of tenants and investor acquisition of single-family homes very sensitive topic in Canada, rightfully so, a sensitive topic. But we need to look at the facts. And there was a great article in The Globe and Mail a couple of days ago. I want to just read a quote from it. Relating to the Minister of Housing that was providing some insight in the profile into what has become a really sensationalized matter on investors participating in the housing market, and the article quotes, “Over the past three decades, individual investors have provided the majority of Canada's new rental homes. They helped fill a shortfall in rental properties when the supply of homes that were specifically built to rent started to decline in the 1990s.” So yes, it is a sensitive subject and Tenant Protection is incredibly important. But the issue that's been driving a lot of the concerns have been around a lack of supply. So if you are a tenant, or you prefer to be a tenant, or you're a newcomer to Canada, that can't qualify for a mortgage today, or if you're self-employed can't qualify for a mortgage today, and either you must or you prefer to rent. There are limited options. You can look at multifamily apartment buildings, many of which were built 50 to 70 years ago, you can look at renting condo units from individual investors that have their own set of issues that come with that. But when it comes to families that want to live in secondary markets that want larger format housing, it's very challenging what's available to them today. And to give a quick primer in Ontario about how rent controls work here, once a residential lease is signed between a landlord and a tenant, typically that one-year lease with a rolling monthly thereafter. The landlord is only allowed to increase annual grants per guideline increases, typically ranging between one and a half to two and a half percent over the last dozen years or so. There's also what's called vacancy decontrol. So if a tenant leaves, that landlord can rent that unit at any price that the market can garner. So the rent control is to the tenant, not to the rental unit, unlike some cities in the U.S. as an example. So unfortunately, what that creates is no great solution here but it's important to highlight the ripple effect or the negative consequences that have emerged. The first is the lack of new supply as the Minister of Housing noted, has been virtually no housing for rental for tenancy built since the 1990s, and that's really a function of rent controls. But what this also does is create a misalignment for landlords to service tenants. If the market on average, rents are increasing by six, eight percent and you've had a tenant for five plus years, there's a very reasonable chance that the rent that tenant is paying might be 20% to 40% below what you could get if that tenant or that family left. And if a tenant calls you to fix a leaky faucet or fix a toilet in the middle of the night, the alignment is not great to be able to provide quality service and that's something that really needs to be addressed. And a group like Konfidis are really striving to support tenants in that capacity, which you know, John, you're going to be touching on so we can talk about this issue all afternoon and I promise we won't. But to come back to your previous question on single-family rental in Canada or in Ontario Secondary markets as a focus. The supply and demand imbalance is what really provides a compelling investment opportunity. And the other very noteworthy aspect of investing in single-family rental, as we mentioned, people need somewhere to live. There are many investors that you, John, and I have spoken to. If you're very comfortable with their investment portfolio today, planning for their future, planning for their family's future, and feel comfortable that they might have young children, they can support those young children in today's dollars to have a down payment on a house. But they're concerned that if their wealth continues to increase at five, six percent a year. Their income, maybe two or three percent a year, and the housing market over the last 15 years in Ontario was about 10% unlevered a year. They might not be able to support their children that same way in 15, 20 years from now. So there's this added benefit of investing in the housing market today through single-family rental or for buying an investment property yourself. In this idea of tracking the market or locking in your purchasing power that many folks that I speak to get quite excited about. The other subject that I think's worth touching on which also catches a lot of the headlines are how interest rates may impact housing prices. And I would start by saying that pricing anything whether it be any sort of a widget housing goal is driven by some marginal supply and demand, interest rates impact more so demand if mortgage payments always being equal, or more expensive, perhaps less can buy a home. But at the end of the day, supply and demand fundamentals that drive interest rates and if interest rates are going up, really what's important to assess is why interest rates are going up. So if we have an inflationary environment, it's the current concern. We've talked about real estate and residential real estate being a very strong inflation hedge. You also have construction costs going up, so if inflation is increasing, it becomes more expensive to buy materials, more expensive to get crews to be building homes. So if you have new primary homes becoming more expensive, you would expect existing homes or resale homes to track in a similar fashion which is what we've seen historically. But with that said, one should anticipate a knee-jerk reaction in the housing market. That's to be expected. But there's so much pent-up demand. It's such a lack of supply that we would expect that to be materialized or come to an equilibrium quite quickly and I would point to 2008, 2009 in peak to trough drawdown and home prices in Ontario. It's about 8% unlevered in Toronto, it was less than 4% in secondary markets outside of Toronto and Ottawa. So, something that we can track really closely and think that in an inflationary environment, residential real estate is probably one of the best places to hide, for lack of a better term.

John Asher: Well, it's interesting, you know, and I'm glad you brought up 2008, 2009 I think a lot of people will also remember. You know, interest rates in the 1980s where we hit double-digit kind of interest rates, 2008, 2009, I remember personally trying to get out of some commercial investments that we were involved with at the time, and there was absolutely no market. And of course, I still remember 2017 with the introduction of double interest rate tests, and again, like all these kind of measures, were things that happened to try and cool off the housing market, 2017 being very deliberate kind of policies to try and cool off the market. And the answer was, it's temporary, like it literally was temporary. In 2018, sales volumes did decline, but the demand was still there and actually feel like demand is like it's a good thing. It is a good thing. We got people who want to come to Ontario, they want to work and live and I really feel like that's a positive thing. And I think you know, my last question to you would be, what would you like to see? What would you like to, if you had a message directly for municipal, provincial or federal governments? What would you like to see them doing to help with the housing issues that we have today?

Shael Soberano: Yeah, so that's a good one. It’s a tough one. Probably doesn't make sense to get too political here.

John Asher: Sure.

Shael Soberano: So what I would say is to focus on the fundamentals. You know, this is an economics 101 problem that needs to be addressed in terms of creating new supply, demand-side changes policies will not impact the underlying issue and that seems to have changed in headlines and political narratives, which is welcomed and exciting to see as someone who's involved in this industry.

John Asher: Great. Shael, thank you very much. It's always great talking to you. If I could kind of give a final thought. I think this is interesting. We've hit a lot of different topics here. When it comes to investing in residential real estate, we do believe in looking at fundamental supply and demand notes, what is happening in the marketplace, we are inevitably in a wonderful community where people want to be here. Households coming together who are looking for larger format housing, and I don't think that anything that has gone on with the pandemic is really redefining what people want but actually accelerating trends that were already happening with work from home and we're seeing that happen every day in the impact for demand in secondary and tertiary communities. It's a very complicated time we did touch on you know, a lot of the topics that have been happening around - is this good for the tenants. And I really do thank you Shael for being here. At any time. If you have any further questions, you can always reach out to us we're available at hello@konfidis.com, and thank you very much for joining us.

Shael Soberano: Thank you.

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Shael Soberano Bio:

Shael Soberano, CFA, is the Chief Investment Officer at Konfidis Inc.

Shael is also a Principal of the Sharno Group of Companies, including as a Partner of Sharno Group Inc., a privately owned independent principal investment firm, and as Principal of Sharno Capital Corporation, a registered Exempt Market Dealer and PM with the OSC.

Previously, Shael was Vice President, Senior Analyst at Vision Capital, a leading Canadian Hedge Fund manager focused on publicly traded real estate related securities. Shael first joined Vision Capital as an Analyst in 2009, shortly after its inception, became Vice President, Senior Analyst in 2014, and was registered as an Advising Representative with the Ontario Securities Commission in 2017. With a wide range of roles spanning both business development and investment management, Shael’s contributions were integral in growing Vision Capital’s assets under management and contributed to its award-winning risk-adjusted performance over his tenure. At Vision Capital, Shael was responsible for hands-on analysis and diligence of the U.S. Single-Family REIT sector from its infancy.

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