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How a real estate analyst's picks left peers in the dust

When it comes to real estate stocks, Brad Sturges found that thinking small led to big returns over the past year.

"My coverage area tends to focus on smaller-cap REITs [real estate investment trusts]," the 31-year-old CIBC World Markets Inc. analyst said. "They generally carry above-average risk, but they also have the potential for above-average returns."

They certainly have been delivering on that potential for Mr. Sturges. Stock market analytics firm StarMine Corp. ranks him first out of 14 Canadian real estate analysts based on the performance of his stock recommendations for the past 12 months. And among 95 analysts North America-wide who track REITs, Mr. Sturges's stock picks beat them all.

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Data compiled by StarMine – a service owned by Thomson Reuters – show that Mr. Sturges's recommendations generated excess returns of 17.5 per cent above the overall Canadian real estate sector over the past year, well ahead of second-place Sam Damiani of TD Newcrest (11.9 per cent). In the North American REITs rankings, his picks generated a 19.4-per-cent excess return over the sector benchmark, comfortably beating the next-best score of 13 per cent from Ki Bin Kim of Macquarie Research.

"The larger-cap REITs … outperformed in 2009 and early 2010, really relating to a recovery coming out of the credit crisis. As a result, the valuations for those REITs were quicker to recover," he said. "In the last 12 months, as those valuations for the larger-cap blue-chip REITs have become more in line with fair value, investors have focused more on the smaller-cap REITs that have offered greater yields and discount valuations.

"You do get that opportunity for above-average returns by looking at names that do carry above-average risks."

StarMine's industry excess returns ratings use each analyst's stock recommendations to create a "long-short" investing strategy – mimicking the effect of going long on stocks the analyst rates "buy" and shorting the stocks he or she rates "sell". This way, the analyst gets credit for both "buy"-rated stocks whose returns exceed the overall industry benchmark, and "sell"-rated stocks whose returns underperform the benchmark. (Stocks rated "strong buy" or "strong sell" are awarded double credit; ratings of "hold" or "neutral" receive no score.) The eight stocks in Mr. Sturges's coverage list generated an overall average return of 38 per cent for those he had rated either "outperform" or "perform" – but lost 18 per cent for those rated "underperform."

Among his most successful calls of the past year were Retrocom Mid-Market REIT , which gained 43 per cent while he had it rated "outperform" (versus a more modest 24-per-cent rise when he had it at "perform").

"They have a portfolio of shopping-centre assets that have underperformed in the past. But with the change in the management team recently, and the relationship the REIT now enjoys with SmartCentres … they have the opportunity to improve the leasing prospects of the portfolio over time, and really generate growth," he said. "It had an above-average yield and it was heavily discounted in the market."

On the other side of the ledger, he had hotelier Royal Host Inc. rated as an "underperform" the entire year – and it lost 44 per cent.

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"There have been some concerns about corporate governance over the past few years," he said. "The hotel sector in general was more exposed to the credit crisis and the downturn in the economy. And the assets that Royal Host tends to own are generally in smaller markets and are lower-quality, more challenging assets. Those assets have underperformed the Canadian hotel industry."

Mr. Sturges said there's both "an analytical, quantitative perspective and a qualitative perspective" to his approach to stock-picking. Quantitatively, he looks at valuation relative to both a company's market peers and its historical norms, focusing on price to cash flow and net asset value as key valuation metrics.

Qualitatively, Mr. Sturges looks at a wide range of issues, such as the quality of the management team; the quality and execution of a company's strategy; how well it communicates its strategy to investors; the track record of the business's performance; and the quality of the properties a company has in its real estate portfolio.

And given that he is focused on smaller-capitalization names, he also spends time assessing the risks to which each of these stocks may be exposed.

"We look at what specific risks are involved … Would those certain risks put the [cash] distribution [to shareholders] at risk?" he said. "Whether it be tenant concentrations that would lead to credit risk, or the lease maturity profile, the debt maturity profile … How do those stack up [against] the growth potential that the REIT would offer?"

Given that REITs do have substantial cash distribution payouts to investors, Mr. Sturges acknowledges that a company's distribution yield, as well as its cash payout ratios as a percentage of cash flow and its ability to sustain those payout levels, are "important" factors when assessing a stock in the sector. However, he said the company's potential to grow its business – and hence its stock price – is also a big element to his selection process.

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Mr. Sturges's current top pick among the stocks he tracks is Transglobe Apartment REIT , an Ontario-based operator of apartment properties in major urban centres in several Canadian properties.

"It's trading three [price to adjusted cash flow] multiple points lower than its apartment-REIT peers. It's carrying an above-average yield of 6.6 per cent," he said. He added that the company could be poised for better-than-average growth, due to potential for acquisitions.

For the sector as a whole, though, Mr. Sturges is mixed about prospects for REITs over the next year.

"The underlying real-estate fundamentals are general positive and stable. We're seeing in Canada high occupancy levels and stable-to-rising rental rates across most asset classes," he said. However, he sees annualized total returns for the REITs to average 10-15 per cent over the next 12-18 months – and that includes a 6-per-cent average annual distribution yield. That's a far cry from the 25 per cent the sector generated in 2010 – or the huge 59 per cent seen in the rebound of 2009.

"That's a reflection of more fair valuations across the REIT sector. You're looking at valuations that are slightly above historical averages," he said. "The larger-cap REITs are trading above historical levels, and you could even suggest that for the smaller-cap REITs."

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About the Author
Economics Reporter

David Parkinson has been covering business and financial markets since 1990, and has been with The Globe and Mail since 2000. A Calgary native, he received a Southam Fellowship from the University of Toronto in 1999-2000, studying international political economics. More

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