Q2/23 Real Estate Sector Preview
Solid NOI Growth Remains Tempered by Higher Y/Y Interest Costs
Our Q2/23 forecast has AFFO/unit growth of 2.4% y/y (index names only, see Exhibit 1), marginally ahead of the +2.2% pace seen in Q1/23. Overall, we expect Q2/23 results to exhibit themes consistent with recent quarters, where robust leasing fundamentals and NOI growth is offset by varying degrees of higher y/y financing costs (depending on balance sheet leverage and variable rate debt exposure).
SPNOI growth for the Retail/Industrial/Residential sectors (= 87% of the REIT Index) averaged 6.5% in Q1/23, and we are modeling 5% for FY2023.
As the year progresses, we expect the impact from higher y/y financing costs to ease as the sector begins to lap easier comps as is evidenced by our 2023 AFFO/unit growth forecast of 3%, with a further acceleration to 8% (7% ex-Seniors Housing) in 2024.
By sector, we expect Industrial-focused REITs to maintain their leadership with +13% y/y AFFO/unit growth, followed by Seniors (+7%), Retail (+1%), and Residential (+1%; +3% excluding TCN), while we forecast 10% y/y declines for both Office and Diversified. For more details, see Exhibits 1, 6, and 7 which provide our estimates, consensus, and conference call details.
Key Themes for Q2/23. Key trends we will be focusing on include any indications of a slowdown in leasing momentum/fundamentals due to emerging “cracks” in the economy, progress on dispositions/capital recycling, and debt refinancing terms. It is our view that any near-term cooling in the economy (given the sharp rise in interest rates) is largely reflected in our/consensus estimates as well as current trading valuations. That said, the latest two BoC rate bumps were not factored into our estimates, and will likely represent a modest headwind as we update forecasts through Q2/23 reporting.
Valuations and trading prices (Exhibits 2 through 5), in our view, continue to be driven by the yield curve inversion over the past 15 months, with GICs/term deposits continuing to see accelerated inflows at the detriment to REIT sector fund inflows. On a P/NAV basis, the REIT index is trading at 78%, which is slightly above the recent low of 72% last September, but still well below the long-term historical average of par. On a yield spread basis to the GoC 10-year, the sector looks undervalued at 5.4% versus the 4.9% adjusted historical average. Given the inverted yield curve, REITs continue to appear expensive on an FFO yield spread basis to the GoC 2- year at 4.1%, which compares to the adjusted historical average of 5.8%.
Based on current valuations and near-term fundamentals, we continue to prefer the Industrial, Residential, and Retail property sectors. Our ACTION LIST BUY-rated names are CAPREIT, First Capital REIT, and Granite REIT.