July 26, 2022
Q2 2022 Preview: Canadian REITs and REOCs
Resetting the goalposts for higher rates and a cloudier macro view
Our view: Our recommendations are intact, although we are lowering our price targets across our universe. In this Q2 2022 preview, we took the opportunity to update our earnings and NAV forecasts to reflect a higher interest rate environment and slower anticipated economic traction. Our price targets declined by an average of 9%, mirroring the declines in our NAVPU estimates, while our FFOPU estimates slipped a modest 1% annually. Admittedly, the combination of rising rates, a decelerating economy, rising replacement costs, and slower deal flow has clouded the picture on underlying asset values. That said, we believe cap rates are biased higher and have adjusted our valuations accordingly for now, with further revisions possible. Our Outperform recommendations are intact and remain skewed to the multi-family and industrial subsectors, where we continue to see above average earnings and NAV growth profiles. For a full list of our recommendations, see Exhibit 5.
NAV estimates curbed to reflect higher cap rates and a murky macro picture...Rising interest rates and prospects of a material economic deceleration have weighed heavily on listed real estate and broader equity markets through much of 2022. Indeed, questions surrounding the impact on cap rates, NAVs, and earnings have dominated our conversations. Initial Q2/22 data from Altus points to modest cap rate expansion across most property types, with larger upticks in office vs. slight compression in industrial (see Exhibit 2). Still, as bid-ask spreads widen and transaction volumes slow, price discovery will likely take more time to surface. Nonetheless, in light of higher borrowing costs and reduced macro visibility, we raised our NAV cap rates by an average of +28 bps (see Exhibit 1), with the smallest revisions in industrial (average +18 bps) and the largest in office and diversifieds (+35 bps). In select instances, we also reduced our forecast NOI. The changes drove our current and forward NAVPU estimates down an average of 9% each, with more pronounced declines among the diversified and office REITs/REOCs. However, we believe rising replacement costs should provide a degree of downside support, particularly for subsectors with stronger fundamentals, including multi-family and industrial.
...and trimming our earnings estimates too. We also adjusted our 2022E-23E FFOPU for higher interest rates and, in select cases, slower organic growth. However, revisions were generally minor as most of the adjustments for higher borrowing costs were made last quarter. On average, our 2022E-23E are down 1% annually, albeit with more limited changes in industrial and multi-family. Our revised forecasts reflect average FFOPU growth of 4% in 2022, followed by 6% in 2023 (vs. our prior 7%).
Expecting a decent quarter of earnings growth as recovery continues. Our Q2/22 forecasts reflect average 4% YoY FFOPU growth, matching the 4% registered last quarter. We expect organic growth to serve as the principal driver, with the balance mostly from acquisitions and developments, partly offset by dispositions, including some significant capital recycling by a few. While the pandemic continues to weigh on select segments, we expect its impact to fade in the coming quarters. Earnings season moves into higher gear this week, with Morguard North American Residential REIT out after close on July 26. See Exhibit 4 for reporting dates, along with our Q2/22 FFOPU estimates and expected growth rates.
Valuation looks reasonable across our core gauges, but volatility could persist. The S&P/TSX REIT Index has delivered a -15% YTD total return, trailing the -9% from the S&P/TSX Composite. The sector has narrowed the gap in recent weeks, up 4% since Jun-14 (vs. -2% for the TSX Composite), alongside a sharp drop in the 10Y GoC yield (-74 bps to 2.9%). Still, a wider-than-typical margin for error persists, with the sector’s 12% discount to NAV below its historical parity. Until the macro picture stabilizes, particularly on rates and inflation, we believe a material narrowing of the discount could prove challenging. On an AFFO basis, the sector’s current 5.8% AFFO yield (17x NTM AFFO) reflects a 290 bps spread to the 10Y GoC, within fair value parameters, as is the current 52 bps spread to the Moody’s BAA index yield.
Summary of Valuation Changes
Boardwalk REIT (BEI-U)
Our $61 price target equates to a 5% premium to our $58 NAVPU estimate one year hence, which implies a 26x multiple to our 2022E AFFOPU. Our target valuation metrics are supported by our confidence in Boardwalk’s affordable apartment portfolio to deliver mid- to high single- digit SP-NOI growth as the economic recovery continues to gain ground. We believe the REIT’s revenue and NOI recovery potential, taxable income-only distribution policy, and comparatively high financial leverage could allow NAVPU growth to compound at a high single-digit pace over the next three years. Based on relative risk-adjusted return expectations, we rate Boardwalk’s units Outperform.
BSR REIT (HOM/U)
Our $21.00 price target is based on a 5% premium to our $20.00 NAVPU estimate one year hence, which implies a 27x multiple to our 2022E AFFOPU. We believe our target valuation multiple reflects BSR’s internal management platform, significant insider ownership, and the necessity-oriented nature of its portfolio. These factors are mildly tempered by the presence of a control block and a small float. Based on relative, risk-adjusted return expectations, we rate BSR’s units Outperform.
Chartwell Retirement Residences (CSH-U)
Our $13.50 price target is based on a ~3% premium to our $13 one-year forward NAVPU estimate, which implies a 20x target multiple to our 2023 AFFOPU estimate. We believe our target P/NAV ratio and P/AFFO multiple reasonably reflect our constructive mid- to longer- term view on seniors housing fundamentals, and the associated earnings and NAV upside potential in Chartwell's units. We also believe our target valuation fairly balances Chartwell’s portfolio attributes, its mix of property, mezzanine loan interest and fee income, its financial leverage, and its overall “franchise value.” Our price target supports our Outperform rating.
Dream Industrial REIT (DIR-U)
Our $16 price target is based on parity to our $16 one-year forward NAVPU estimate, which implies a 20x multiple on our 2023 AFFOPU estimate. Our target premium is below its TSX- listed industrial peers, but above the average of our REIT/REOC coverage universe. We believe our target valuation is supported by DIR's predominant focus on Canadian industrial, a robust outlook for industrial fundamentals, improving portfolio quality, below-average leverage, and healthy growth profile, partly offset by its external management structure. Our price target supports our Outperform rating.
European Residential REIT (ERE-U)
Our price target is €3.75, which converts to Canadian dollars at $5.00 (rounded). This is based on parity to our €3.85 NAVPS one year hence at a 1.31 CAD/EUR FX rate, which implies a 24x multiple to our 2022E AFFOPS. We believe ERES's units should trade at parity to NAV due to the support of strong residential sector fundamentals in the Netherlands, its strategic relationship with CAPREIT, and the potentially large-scale consolidation opportunity that we believe may lie ahead. Based on our risk-adjusted return expectations versus its peers, we rate ERES's units Outperform.
Granite Real Estate Investment Trust (GRT-U)
Our $99 price target is derived by applying a ~8% premium to our $92 one-year forward NAVPU and implies a 23x multiple on our 2023 AFFOPU estimate. Overall, we believe our target valuation metrics are reasonably reflective of factors such as Granite’s portfolio mix (special purpose properties, multi-purpose properties, and modern logistics and warehouse/distribution properties), geographically diversified footprint, tenant concentration, tax efficiency, low financial leverage, and overall franchise value. Our price target supports our Outperform rating.
Our $18.00 price target is derived through a 10% premium to our $16.25 NAV per unit estimate one year hence, which implies a 35x multiple to our 2022 AFFO per unit estimate. Our target valuation metrics reflect the REIT’s attractive long-term growth prospects stemming from its value-add business model, management’s public-market track record, the REIT’s overall franchise value, and meaningful insider ownership. These factors are tempered by near-term operating headwinds. Based on relative risk-adjusted return expectations, we rate IIP units Outperform.
Minto Apartment REIT (MI-U)
Our $23.50 price target is based on a ~5% premium to our $22.25 NAVPU estimate one-year hence, which implies a 32x multiple to our 2022E AFFOPU. Our target valuation multiple compares to the ~5% premium-to-NAV valuation applied in deriving price targets for the REIT’s three closest peers. We believe our target valuation multiple reflects the REIT’s institutional quality portfolio and what we see as a top-tier operating platform. These factors are mildly tempered by near-term operating headwinds, the REIT’s small float, and the Minto control block. Based on our risk-adjusted return expectations versus its peers, we rate MI’s units Outperform.
Summit Industrial Income REIT (SMU-U)
Our $21.50 price target is based on an ~13% premium to our $19 NAVPU one-year hence, which implies a 30x multiple to our 2023E AFFOPU. Our target multiple compares to the average premium-to-NAV of ~20% over the last three years, and an average target premium- to-NAV of 5–20% for other industrial REITs under our coverage. We believe our target valuation multiple reflects: 1) strong fundamentals relative to other property classes; 2) limited means through which to gain exposure to industrial real estate; and 3) an internalized and aligned structure. Based on relative risk-adjusted return expectations, we rate the REIT’s units Sector Perform.