This month’s market commentary focuses on the real estate investments managed by Trez Capital (Trez). Trez has managed assets on behalf of WealthCo investors since 2014. We posed a few questions to Dave Makarchuk, Chief Investment Officer for WealthCo followed by a few to Sandra Ferenz, Managing Director, Portfolio Manager & Product Strategy with Trez.
Q: Dave, can you describe the mandates Trez manages with WealthCo?
Trez manages a variety of mandates within the WealthCo Alternative Income Fund and the Alternative Growth Fund. Our holdings within Alternative Income are primarily commercial and residential mortgage investments providing regular distributions to unitholders. Our holdings within Alternative Growth are primarily real estate equity investments across the US. Distributions from the Alternative Growth holdings are less frequent and typically reflect proceeds from the sale of particular projects.
Q: Dave, why is Trez a good fit for WealthCo and its investors?
Trez has an established track record managing and extracting value from real estate investments both with respect to short-term mortgage investments and growth investments through joint-venture partnerships with developers. They are particular about the sectors and regions that they invest in with an eye for growth and opportunity. The ‘floating rate’ nature of most of their mortgage portfolio is particularly attractive in a period of higher interest rates.
Q: Sandra, how would you describe Trez’s overall investment strategy?
Trez makes real estate investments focused on growth markets in both Canada and in the US Sunbelt – we ultimately follow the migration of people and job creation. Today Trez manages $5.5 billion of which $5 billion relates to debt investments and $0.5 billion relates to equity investments.
Within our chosen markets, we continue to focus on the residential and industrial asset classes due to favorable fundamentals of longer-term undersupply. On the residential side we focus on affordability, preferring rental products as the rising cost of home ownership tilts demand to renting as well as the development of pre-sold lots for national and regional home builders that focus on more affordable, entry-level housing products.
The same overarching themes of population and job growth and the undersupply of housing underpin both the debt and equity strategy at Trez - on the debt side through short-term mortgages to real estate developers for the purposes of acquisition, construction, development, or bridge financing of real estate properties, as well as on the equity side through both short- and long-term partnerships with best-in-class developers.
Q: From your perspective, how does Trez differ from other real estate managers?
There are three major aspects of the Trez investment process that differentiates us:
1. Our “Boots-on-the-Ground” approach – we have offices and talent directly in markets across Canada and the US with 20 originators on the ground. This provides us with in-depth local insights and allows us to leverage local networks and forge long-term relationships – more than 50% of our loans since 2009 have been with repeat borrowers.
2. A strong culture of risk management - we have institutional-grade risk processes and rigorous underwriting underpinning each financing with oversight from an independent board of governors. Our best-in-class risk management has resulted in historical loan losses totaling only 35 basis points.
3. Customized financing solutions – we provide quick approvals on flexible and customized terms. Our 25-year track record in real estate allows us to engineer financing solutions that are effective for our borrowers and partners while also mitigating risk and providing attractive returns to our investors.
Q: Sandra, what’s driving Canadian real estate markets? How does the US differ?
In Canada, we continue to see a strong immigration policy driving population growth in the major metropolitan cities - Toronto, Vancouver, Calgary, Edmonton, and Montreal. In the US, we continue to see strong migration of people within the country as people move from higher-tax to lower-tax, business-friendly states with higher job creation – states that have a more affordable cost of living and offer a better quality of life. Texas is a perfect example of this – in 2022, the state saw the largest annual population gain of any state with people relocating from other parts of the country.
Q: Interest rates rose significantly on both sides of the border in 2022. How has that impacted your overall business and outlook?
This is a great question. And there are two aspects to it.
On one hand, the lion’s share of our debt portfolio is floating rate. This means that throughout 2022 – and into 2023 – we have seen our yields consistently going up which is a benefit to our investors. In 2022 we have raised our distribution rates in our debt funds multiple times and have just implemented another distribution rate increase in January 2023.
On the other hand, increasing rates puts pressure on asset values and the ability for borrowers to refinance. In the second half of 2022 we have seen an overall cooldown, or normalization, in real estate markets on both sides of the border, as buyers and sellers could not agree on pricing and borrowers were faced with stricter underwriting and higher cost of financing. Values rose to peak levels in earlier parts of 2022 and then normalized; however, these normalized values remain elevated from prior year values.
That being said, the fundamental factors that underlie our investment thesis still remain intact: internal migration in the US, as well as an undersupply in housing, create an opportunity for residential investments in the Sunbelt region, where the predominant share of our US investments are focused.
Despite the recent uncertainty in the broad macroenvironment we remain positive in terms of the outlook for 2023 and beyond for real estate investment in the markets and asset classes in which we focus.
Q: Assuming we’re closer to the end of this rate-hike cycle, what is your outlook for the funds going forward?
Assuming we are closer to the end of the hike, we expect borrowing costs to stabilize which should spur higher activity on both refinancings and sales. Already in 2023 we are seeing some signs of this happening. In the case of the residential segment, US mortgage rates have declined from their peak of 7.08% in November 2022 to about 6% by the end of January, which combined with the incentives that builders continue to offer homebuyers, has led to a jump in January new home sales per community to 30% above the seasonal January numbers as measured between 2013 and 2019.
An increase in transactional activity should lead to continued strength in repayment and sales activity across the fund mandates and also lead to more opportunities for new investments as developers see more certainty to move forward with new projects.
Q: If rates continue to rise through 2023, will that pose challenges for the funds? Or opportunities?
If rates continue to rise through 2023, for example, as a result of a stronger-than-expected labor market, this poses both challenges and opportunities for the Trez funds.
We perceive the challenges as being rather short-term. If rates continue to rise, market participants – developers, investors, financiers and renters – will continue to exercise caution in light of the uncertainty. This may cause short-term extensions to some of our loans as borrowers manage through slower more cautious credit processes and or longer asset sale processes. This does not mean we expect stress on the underlying investments – we focus on assets in growth markets with favorable supply-demand fundamentals and long-term outlooks for this reason – but rather a delay in potential liquidity events to our funds and a slower redeployment into new investments. As I noted previously, with the rise in values overall the past two to three years commensurate with the duration of our loans, the portfolio quality remains strong and well-positioned.
Talking about opportunities, higher rates imply higher yields for the debt funds based on our portfolios of primarily floating-rate loans. And if rates continue increasing, we will consider further increases in our distribution rates. In the case of equity investments, this also creates a great opportunity for opportunistic acquisitions as some prices may come under pressure.
Finally, rising rates will likely cause falling values in the stock market, which further underlines the importance of alternative asset classes, such as real estate, that are able to provide both diversification and more stable return to a portfolio.
Q: Thanks for that perspective. Looking specifically at the investments in the WealthCo portfolios, what has the impact of rising rates been?
On the debt side, the funds have benefited from portfolios with primarily floating rate loans leading to multiple distribution rate increases through 2022 and into 2023. More specifically, Trez Capital Yield Trust increased from an annualized distribution rate of 5.16% at the start of 2022 to 7.20% today. Trez Capital Yield Trust US increased from 6.48% at the start of 2022 to 7.80% today. We expect to see additional distribution rate increases in 2023. Furthermore, with the run-up in values that has occurred over the past three years, our portfolio remains strong and well-positioned and borrowers continue to see the ability to refinance and exit our loans.
On the equity side, Wealthco is invested in our opportunistic build-to-sell equity strategies known as the Opportunity Funds (TOFs) which have seen strong results from robust sales activity despite the rising rate environment. This included two large sales in the latter half of Q4 – a 10-acre parcel sold to Andretti Indoor Karting & Games and a 12.5-acre tract of land sold to Bass Pro Shops – in a commercial land joint venture with a local Dallas-based developer. Additionally, in January 2023, two Class-A garden-style multi-family projects in the Austin region were sold at a cap rate of 4.4% or nearly USD$281K per unit compared to the underwritten exit value of approximately USD$192K per unit – a truly exceptional result.
Q: Do you have any closing thoughts to share with WealthCo investors?
I think it is important to remember to look beyond the noise in some of the headlines we see and understand that not all real estate asset classes and geographic markets are the same and this will be a differentiator in performance. Selecting a manager who has the talent, experience, and track record to invest in the right areas of the market is critical to attaining strong risk-adjusted returns.