REITs See Unprecedented Combination of Conflicting Signals
Lowering NAVs and Target Prices to Reflect Macro Uncertainty
It is difficult to overstate how much the past few months have not met our initial expectations for 2022. The REIT Index gained a healthy +9% in the two months following the release of our 2022 Outlook, but subsequently lost 17% over seven weeks (through May 10). A modest recovery since then has left the REIT Index down 10% YTD (-8.9% total return), with Diversified REITs (+5%) and Seniors (flat) leading, while Industrial and Residential REITs have lagged (-16%/-15%).
Although some attribute the decline in the REIT index to the very sharp ~165bps YTD rise in the 10-year GoC bond yield, we do not believe this argument to be entirely true, given that other interest-sensitive sectors, such as utilities, are trading near 52-week highs. In our view, the sell-off reflects an equal concern about near-term economic uncertainty and its impact on earnings, as well as worries that NAVs will decrease.
Valuation Mixed Messages: Although P/NAVs are close to historically low levels (13% discount on average currently, even after the 5% average NAV estimate reductions we introduced today — Exhibit 1), spreads to the 10-year GOC bond yield (4.1 percentage points on FFO yield, 2.5 percentage points for implied cap rates) have rarely been this tight during the REIT industry's history. Never before have we seen REITs exhibit a valuation dichotomy such as this.
The Tailwinds: In our view, current REIT valuations can be sustainable and rebound with some combination of: 1) the market entering a new and tighter investing spread range (a prospect we believe has some merit); 2) inflation concerns subsiding and the economy experiencing a "soft landing"; and 3) GoC bond yields heading back lower in the near term.
The Headwinds: On the other hand, we could see further downside in REIT prices if economic recession fears prove correct or worsen — particularly if interest rates simultaneously stay elevated.
Lowering Our NAVs and Target Prices: With the increased macro volatility and uncertainty, we believe property values will be affected and with this report, and we are lowering our NAV estimates (on average by 5%; Exhibit 1) and target prices (on average by 5%; Exhibit 2) for most names under coverage.
Assuming that the economy avoids recession, we believe the property sector is poised to perform well going forward, and see current discounted valuations as attractive entry points for the majority of names under coverage. Our preferred sectors remain Industrial and Residential as we believe they have the best operating fundamentals under almost any macro scenario, and with the YTD underperformance, are also attractively valued. Our ACTION LIST BUY names are CAR.un, FCR.un, and GRT.un. Other high-conviction BUY-rated names are BEI.un, DIR.un, and SIA.