RBC Quarterly Review January 6, 2023
Real Estate Investment Trusts
Quarterly Review and Sector Outlook – Q1 2023
Recommendations
After a year in which listed property valuations retreated in size, we believe fundamentals will return to the forefront in 2023, particularly as the economy downshifts to lower gear. Against this backdrop, our investment bias remains skewed to subsectors where we expect operational traction to remain more resilient, particularly in multi-family, industrial, self-storage, and defensive retail. Our Outperform ratings include: Allied, Boardwalk, BSR, CAPREIT, Chartwell, Dream Industrial, European Residential, First Capital, Granite, InterRent, Killam, Minto, Morguard N.A. Residential, RioCan, and SmartCentres.
Highlights
A sharp reversal of fortunes. After posting its second best year on record in 2021 (+35%), the TSX REIT Index delivered a -17% total return in 2022, marking its second worst year. The sector trailed the TSX Composite (-6%) and 10Y GoC bonds (-10%), but tracked in line with the S&P 500 (-18%). The drawdown was certainly not unique to Canada, as rising interest rates played a pivotal role in weak performances across listed real estate markets around the world (-37% Europe, -25% US, -24% Global, +2% Asia).
The path forward will likely prove bumpy... Despite the sector’s sharp correction last year, multiple factors still weigh on investor sentiment. Central banks remain on a tightening path to tame heated inflation, economic growth seems set to stall, geopolitical tensions have yet to ease, tax/regulatory risks persist, and we’re still sleeping with one eye open for new Covid variants. Slower deal flow in private property markets has driven an extended period of price discovery, while the run-up in bond yields could siphon fund flows away from real estate allocations. Against this backdrop, our investment strategy remains overweight subsectors we see as equipped to deliver superior NOI, earnings, and NAV growth.
...but less turbulent than our recent ride. While the broader macro picture still lacks good visibility, we believe some key ingredients are in place for the sector to deliver positive returns in the year ahead. Notably: 1) fundamentals continue to improve across most property types (~2-3% 2023E SP NOI growth); 2) earnings growth looks decent (4% 2023E); 3) replacement costs remain high; 4) corporate liquidity is strong; and 5) valuations seem reasonable. As for potential catalysts, easing domestic inflationary pressures may set the stage for rate hikes to moderate further, while forecasts for declining interest rates at the long end of the yield curve could ease the upward pressure on cap rates. As well, should NAV discounts persist, we believe M&A could accelerate, particularly where fundamentals are strongest.
As valuations have dialled back, we see a larger margin for error. The sector’s trading at 20% below NAV, well below historical parity and only moderately above the early 2020 COVID lows. While downside risks to NAVs are certainly possible, the sector’s current 6.6% implied cap rate is already reflecting a sizeable dose of cap rate expansion and/or NOI erosion relative to our 5.9% average NAV cap rate. The current 17x P/AFFO multiple is in line with the 10Y average, while the 272 bps AFFO yield spread to the 10Y GoC remains in fair value range. In contrast, the 18 bps AFFO yield spread to the Moody’s Baa Index and the 330 bps implied cap rate spread to the 10Y GoC remain below long-term levels.
Investment recommendations: Summarizing our Outperform-rated securities
MI has a high quality portfolio well located in major urban cities of Canada as well as several loan investments in assets being constructed. The portfolio’s performance lagged during the pandemic given a tilt to urban areas and as such, is likely to outperform on the other side. The management team is well established operating multi-family assets. We expect revenue growth next year to be in the high single digit range driven by further occupancy improvement, portfolio rent growth of 5-6% and continued repositioning activity. (Target $21.50)