RBC Notes April 11, 2023
Real Estate Investment Trusts
Quarterly Review and Sector Outlook – Q2 2023
Recommendations
Our Outperform ratings include: AP, BEI, CAR, CSH, DIR, ERE, FCR, GRT, HOM, IIP, KMP, MI, MRG, REI, SRU, SVI. As concerns over access to liquidity have added another dimension to investor worry, our picks are largely anchored in subsectors where we expect superior operational resilience (multi-family, industrial, self-storage, & defensive retail). While sector valuations seem reasonable, we see improving confidence in private market values and credit availability as prerequisites for sentiment to build.
Highlights
Decent start to the year for Canadian REITs; mixed results globally. After posting its second worst year on record in 2022 (-17% total return), the TSX REIT index regained some lost ground in Q1/23 with a +4% total return. The sector trailed broader North American equity benchmarks, including the S&P 500 (+7%) and TSX Composite (+5%), but kept pace with 10Y GoC bonds (+4%). Globally, listed real estate returns were mixed, with Canadian REITs ahead of the US (+3%), Global (+1%), Asia (-1%), and Europe (-4%).
Macro backdrop has shaken investor confidence (again)...At the outset of the year, we noted the path forward will likely prove bumpy. The thesis played out in Q1, with a new layer of uncertainty surrounding credit availability post recent banking system stress among US regionals and select parts of Europe. Concerns are more acute for property owners where fundamentals are more challenged (no shortage of office headlines). Layer on an anticipated economic slowdown (albeit with conflicting signals), volatility in rates, and limited conviction in property values, investors have ample rationale for a cautious stance.
...yet sector’s underpinnings provide good reason for optimism. Although the recent issues have surfaced beyond our borders, lender underwriting and the availability of credit could certainly tighten here on home ice, driving costs of capital higher. That said, Canadian REITs and REOCs have access to multiple sources of debt financing, with secured debt mostly sourced from large, well-capitalized, and highly regulated financial institutions, including banks and lifecos. As well, sector liquidity is in good form (14% liquidity ratio vs. 10% LTA), debt maturities are well balanced (10-15% maturing annually through 2024), and overall floating rate debt exposure is modest (11%). Importantly, in our view, fundamentals are improving across most property types (~2-3% 2023E SP NOI), the outlook for earnings growth remains healthy (+3-5% in 2023E-2024E), replacement costs are high, and valuations screen reasonable.
On the whole, valuations look a little better than where we started the year. The sector’s trading at 21% below NAV, well below historical parity and down slightly from the end of 2022. With private market cap rates rising in Q1/23, we acknowledge downside risks to NAVs remain. Still, the 80 bps gap between the sector’s 6.8% implied cap rate and our 6.0% average NAV cap rate already seems to be baking in a healthy dose of cap rate expansion and/or NOI erosion. On P/AFFO (N12M), the current 16x multiple is slightly below the 10Y average. The 327 bps AFFO yield spread to the 10Y GoC and 43 bps spread to the Moody’s Baa Index have expanded from 2022 year end and are within fair value parameters, while the 393 bps implied cap rate spread to the 10Y GoC has risen to levels closer to the LTA.