CIBC Core HoldingEQUITY RESEARCH
January 6, 2023 Industry Update
2023 Real Estate Outlook
Rates, Recessions, And REITs
Our Conclusion
We are indeed in untested waters. A call (with any degree of accuracy) on the magnitude and direction of the REIT complex’s returns for 2023
presumes one can glean from history what it looks like to exit a global
pandemic, enter into a worldwide rate hiking cycle that for all intents and
purposes is unprecedented, and have an economy land “softly,” avoiding a global recession – a task that might seem more suitable for the likes of
Nostradamus than modern-day prognosticators. However, within the context of history, we can make some observations that could serve as a compass for our muted, and arguably conservative, expectations for the year.
Valuation multiples are at, or near, long-term averages and while NAV
discounts appear too wide by historical standards we’d make the observation that consensus NAVs have recently assumed more of a “follow” than “lead” position and that perhaps in a higher rate environment NAVs may actually be closer to current unit values than may widely be accepted. If we couple valuations that might be fair (with the reality that 2023 will be the first year in some time that debt refinancings will be a real headwind for the space) with the prospect of recessionary fears that may pressure rental rates to varying degrees of severity depending on the sub-class, then we have a backdrop unlike anything witnessed since perhaps the GFC (however the GFC resulted in a decade of near-zero interest rates – a dynamic that has decidedly shifted), the last time that the sector put up back-to-back negative years. Will this time be different?
Key Points
Total Return Outlook For 2023: Given the sector’s significant
underperformance last year, we see a path to more moderate ~10% returns within the sector (we’ll call it a 5%-15% range) in 2023. Underlying this range are expectations for: 1) moderate FFO growth for the foreseeable future. For context, we estimate sub ~4% Y/Y growth in 2023E; 2) flat to modestly lower valuation levels. The REIT sector currently trades slightly below the five-year pre-pandemic average on a NAV basis; and, 3) a mid-single-digit distribution yield (the sector currently offers a ~6% yield).
Top Picks: Within the “safety trade,” our top picks include GRT, KMP, BSR, and TCN. Within the “recovery trade,” our top picks include REI and SRU and we continue to view BN as a core holding. We note that if the sentiment towards a deeper recession gains traction, the “safety trade” may carry lower valuation risk (despite these REITs generally trading at higher valuation levels overall).
An Active Approach Should Fare Better: With a myriad of macro factors
set to unfold (the path of interest rates, inflation, the unwinding of
government bond purchases), we foresee significant swings in the market’s sentiment towards equities, and real estate is unlikely to be an exception. As such, a more tactical approach to trading around core positions as volatility increases and declines may be the most compelling path towards alpha generation for the coming 12 months.