CIBC Notes EQUITY RESEARCH
October 4, 2023 Industry Update
Canadian REITs Monthly
Here For Longer
Our Conclusion
“It’s ain’t what you don’t know that gets you into trouble. It’s what you know
for sure that just ain’t so.” – Mark Twain
Looking through the next BoC meeting and into 2024, the lingering question
remains “when will the rate cuts come?” Absent a crystal ball, it seems the
only thing we can say with certainty is that the market has, thus far... been
wrong. The magnitude of the rates increases, as well as the speed, has
broken even the most dire of predictions. Putting this into context, should we
really assume that we can predict how long rates will remain elevated with
any real measure of certainty? It is perhaps more important (and practical) to
shift focus to the valuation of the REIT sector in the context of both elevated
and perhaps sticky interest rates.
Given the rapid back-up in interest rates and with the 10-year GOC now
back at levels last seen “pre GFC,” the REIT sector has reacted accordingly
to the negative. Although yield is far from our favored valuation metric at the
best of times, it may be relevant in the current environment as investors
weigh the option of locking in fixed rate investments over highly variable
securities. The spread between REIT yields and the GoC 10-year bond yield
is now slightly below the long-term average during non-credit-crisis periods.
With REIT yield spreads having spent a good portion of the most recent
cycle at 500 bps or more, we believe the new normal spread range of 350
bps to 500 bps could be a reliable valuation tool in an environment of more
moderate (and in some cases quite soft) property fundamentals, volatile
interest rates, and potentially lower economic growth. All things equal, the
current yield spread of ~400 bps would suggest that REIT prices could still
drop, or in the alternative, rate expectations one year out are indeed lower
(see our CIBC Economics forecast).
Key Points
Yield Trade: In that context, we looked for a basket of REITs that offer
above-average yields and lower payout ratios (i.e., a higher margin of safety)
that resulted in a mix of five core names (CRR, APR, KMP, DIR, CSH) and
one “Neutral rated” REIT (AP; although Neutral rated, it boasts a high yield
that we believe is well covered in the near to medium term) which we
estimate should fare well in such an environment.
Is Inflation Worse Than A Pandemic? REITs are trading at an average
~35% discount to NAV and ~11x P/FFO, compared to ~7x P/FFO during the
trough of the GFC (~11x P/FFO during pandemic lows). While we do not
suggest that valuations could go as low as during the GFC (absent a
material credit crisis), current valuations suggest that market participants
believe a recession is perhaps a greater fear than that of the pandemic.
REIT Performance This Month: Returns remain mixed in September. The
top-performing REITs/REOCs in the month were Minto Apartment (+6%),
StorageVault (+4%) and InterRent (+2%), while Invesque (-25%) and Dream
Office (-20%) lagged.