October 6, 2021
Real Estate Investment Trusts
Quarterly Review and Sector Outlook – Q4 2021
Recommendations
From the universe of 38 TSX-listed REITs, we have 12 Outperforms: Allied Properties REIT, Boardwalk REIT, BSR REIT, CAPREIT, Dream Industrial REIT, European Residential REIT, First Capital REIT, Granite REIT, InterRent REIT, Killam Apartment REIT, Minto Apartment REIT, and SmartCentres REIT. Also rated Outperform are Chartwell Retirement Residences and Colliers International Group. We remain overweight rental residential and industrial, which rank at the top of our fundamental pecking order.
Highlights
Listed real estate takes a breather, after a solid first half sprint. The TSX REIT Index registered a 3% total return in Q3/21, ahead of the TSX Composite (flat), S&P 500 (1%), US REITs (1%), and 10Y GoC bonds (2%). The sector’s pace of recovery eased considerably from 1H/21, consistent with trends across equity markets. Still, the 25% 9M/21 total return from TSX REITs remains well above broader Canadian and US equity benchmarks. Listed real estate returns across developed markets are also on the mend. Through 9M/21, TSX REITs outperformed the US (23%), Asia (15%), Europe (10%), and the Global Index (15%).
We still like the sector setup, but are mindful of risks brewing in the system. As we think about the year ahead, we continue to see a strong line-up of structural supports that should position the sector for healthy returns. Notable drivers include 1) better economic traction, 2) firming property fundamentals, 3) stronger earnings momentum (2022E/2023E of +7%/+5%) and healthy NAV upside (+6% in N12M), 4) low interest rates, 5) reasonable valuations, and 6) corporate liquidity at record highs. Yet, as recent weeks have reminded us, the sector is not immune to escalating macro risks, particularly with respect to further potential sharp steepening of the yield curve and effects from the ongoing pandemic.
Sector’s real return attributes underpin good form to navigate inflationary pressures. Building on last quarter’s upward trend, headline inflation accelerated in Q3/21. As the debate continues on whether pricing pressures will prove more transitory or lasting, we took a closer look at REIT returns in periods of 1) varying levels of inflation, and 2) rising and falling inflation. As detailed here-in, the REIT sector has a good track record of absolute and relative performance in periods of elevated and rising inflation. Notably, the sector has also generated positive returns in the majority of periods when inflation is rising.
Valuations are looking a little more appealing, as NAV discounts widen. After a modest late Q3/21 pullback, the sector’s P/NAV discount has expanded to 5%, down from -3% last quarter, and below the 1% LTA premium. On a P/AFFO basis, the current 20x forward AFFO multiple (5.0% AFFO yield) is unchanged sequentially and above the 10-year average (17x), while the 348 bps AFFO yield spread to the 10Y GoC is modestly below long-term levels (368 bps). Notably, however, the 165 bps AFFO yield spread to corporate yields (Moody’s BAA Index) remains well above average (101 bps).