Analyst comments initiating coverage Citing rising interest rates and an “oncoming” recession
, iA Capital Markets analyst Johann Rodrigues expressing concern about investing in long duration office real estate, instead he feels “safer watching ... from the sidelines.”
In a research report released Wednesday, he initiated coverage of
Slate Office REIT (
SOT-UN-T -0.41%decrease) and
True North Commercial REIT (
TNT-UN-T -0.46%decrease) with “hold” recommendations, seeing both struggling to rebound from pandemic-related downturns.
“Like many other asset classes, the pandemic has been tough on Canadian suburban office, weakening fundamentals across the board,” he said. “Not only have vacancy rates crept higher throughout the last two years, Q1/22 set new highs, both nationally and in Toronto. According to CBRE, suburban vacancy is 16 per cent nationally and 19 per cent in the GTA, both peaks not seen since 2003. Additionally, sublet space has spiked to decade-highs, at 22 per cent nationally and 18 per cent in the GTA. As a result, rent growth has been minimal, though this follows a trend that started prior to the pandemic. In fact, five-year compounded growth in net rents (0.2 per cent nationally and 0.8 per cent GTA) has been roughly half that of the previous ten-year period. The lone spot of good news is that there is a minimal amount of new suburban construction, with less than 1.0 per cent in the GTA (30-per-cent pre-leased) and 1.7 per cent nationally (38-per-cent pre-leased); both 15-year low.”
Mr. Rodrigues also emphasized long duration real estate underperforms in a rising rate environment, declaring we have “clearly entered an inflationary period.”
“In the last 20 years prior to the current period, there have been six distinct periods of sustained rising rates (200-plus days) and not only did the TSX Capped REIT Index lag the broader market (12 per cent vs. 30 per cent on average), short duration real estate (less than 4-year WALTs) almost tripled the performance of long duration peers (less than -year WALTs), with medium duration property (4-8 years) splitting the difference,” he said. “Both Slate and True North have WALTs that approach 5 years and as such, we believe they will underperform the broader market as long as rates continue to rise and until the BoC has reined in inflation.”
With the threat of a recession intensifying, Mr. Rodrigues noted the work-from-home trend has been damaging to both REITs, adding: “Most businesses are having trouble finding and retaining talent these days, as employees enjoy options and flexibility borne out of a labour shortage. As such, employers who might not otherwise be keen to offer work-from-home (WFH) flexibility have their hands tied. Should a recession hit in the next 12-18 months, this dynamic would substantially change though it remains to be seen whether this would be a net positive for office landlords. Having employees return to the office in a more permanent fashion would help ensure space is not given back on renewal, though a recession is evidently a negative for broader office fundamentals. In speaking with Slate and True North, both management teams believe a recession will come with a reversal in the WFH trend and view this as a positive for their businesses. While we tend to agree, this does not necessarily mean a recession will be a positive for their stocks. Investor sentiment generally moves against office equities in recessionary environments and though their yields should be safe, providing unitholders with a decent place to park cash, on a total return basis, both REITs are likely to underperform the broader TSX.”
Calling it “a NAV-focused suburban office play,” Mr. Rodrigues set a target of
$5.25 for units of Slate Office, seeing an emphasis on value creation and “sizeable” NAV upside. The average target on the Street is $5.27.
“Though many institutions avoid looking at Slate Office due to the external structure, high leverage, thin liquidity and suburban focus, they are missing out on a name with 20-per-cent-plus NAV upside, a juicy yield, and a management team focused on increasing that figure,” he said.
Mr. Rodrigues thinks True North Commercial is “trading NAV growth for a sector-leading distribution,” setting a $7 target for its units. The average is $7.13.
“While primarily designed as a retail vehicle, True North has a place in the portfolios of certain institutions,” he said. “The REIT pays a massive 9.1-per-cent yield, an 350 basis point premium to the Canadian office average and 500 basis points over the broader Canadian REIT sector on average. While we would not expect above-average growth or NAV creation, those wanting to hide out and earn a stellar distribution should circle True North.”