Q3/22 Sector Review - Forecasts Now Appear Near Trough Levels
Operating Fundamentals Remain Firm in Most Sectors Higher Interest Costs Pushed Down 2023 Forecasts
Real Estate sector Q3/22 results demonstrated continued strength in fundamentals across most property types. Overall average sector AFFO/unit increased +2.3% y/y and beat our forecast by +1.5%, with only four of 26 companies (excluding Seniors) missing our forecasts by 6% or more (Exhibit 1).
Most management teams reiterated favourable near-term outlooks, underpinned by continued strong demand. Our view remains that real estate fundamentals are on a very strong footing heading into whatever slowdown is coming, with particular strength in the Industrial, Residential, and Retail property sectors.
The pullback in acquisition activity has become more widespread in H2/22. The Industrial property sector is a notable exception with the acquisition of Summit Industrial Income REIT by Dream Industrial REIT and GIC, in addition to private capital players resuming activity.
Our 2023 AFFO/unit estimates fell by 2% on average during Q3/22 earnings season – almost exclusively due to higher forecast interest costs. Our NOI forecasts (which generally already assumed some economic weakness) remained largely intact. We believe our cumulative downward revision since pre-Q1/22 — now at 7% — puts our current forecasts largely at trough levels for this cycle. Our forecasts (Exhibit 2) now call for a sector-wide AFFO/unit CAGR through 2024 of 3.5%, with annual 2022/2023/2024 growth rates at 4%/1%/5%.
To our surprise, downward revisions to IFRS values decelerated in Q3/22 — to 0.4% of asset value from 0.9% in Q2/22 (Exhibit 3). The lack of transaction activity is certainly a key factor. Most REITs did increase cap rates and discount rates, however, higher NOI assumptions muted the fair value declines. Among index names, FCR (-3.0%), Granite (-2.7%), and H&R (-2.6%) made the largest reductions. We anticipate greater reductions with Q4 earnings.
Our NAV/unit estimates are down 8% on average since Q1/22, implying an approximate asset value reduction of ~5%. Our NAV/unit estimates are now 2% below IFRS on average, versus a premium in Q1/22. Our NAV cap rates are +33bps on average over this time frame (Exhibit 3).
Q3/22 reporting season confirmed our overall sector outlook. Although the REIT Index is roughly flat since our June upgrade to OVERWEIGHT, we continue to see good value and see upside to our estimates should a meaningful economic slowdown not materialize or 5-10 year GoC bond yields move lower or remain below late October/early November levels. On valuation, the sector is currently trading at a 21% discount to NAV vs. historically in-line, and an FFO yield spread to the 10-year GoC that is in-line with its historical adjusted average of 4.9% (Exhibits 4 & 5). Our sector pecking order in terms of fundamentals remains Industrial, Residential Rental, Retail, Office, and lastly Seniors.