RBC Notes November 24, 2023
Canadian REITs and REOCs: Q3 2023 recap
Earnings growth picked up, but sentiment still left behind
Our view: Our Outperform ratings are intact and include Allied, Boardwalk, BSR, CAPREIT, Chartwell, Colliers, Dream Industrial, FirstService, First Capital, Flagship, Granite, InterRent, Killam Apartment, Minto Apartment, Morguard Residential, RioCan, SmartCentres, and StorageVault. Q3 results were largely in line with our calls, with FFOPU growth gaining some steam on strength in fundamentals across multiple subsectors. Notably, organic NOI growth remains well above historical levels. Still, our earnings outlook for the year ahead and NAVPU estimates were dialled back, partly on headwinds from higher interest rates. Indeed, uncertainty surrounding the direction of rates and economic traction has likely impeded stronger fund flows into the space. Hence, our preferred picks remain mostly skewed to where we expect operational and earnings resilience to hold up comparatively better, particularly in multi- family (incl. manufactured housing), industrial, select seniors housing, self-storage, and defensive retail.
A stronger showing, as earnings growth improved. Q3/23 FFOPU increased 4% YoY for our coverage universe (excluding significant outliers), in line with our +4% forecast and up from +2% in Q2/23. By subsector, seniors housing took the lead with +16% YoY growth (excluding EXE), followed by solid advances from multi-family (+7%) and industrial (+7%), and respectable growth from retail (+3%). Meanwhile, office (-18% YoY) and diversified (-3%) continue to lag. Among reporting entities, 71% (27 of 38) delivered earnings that met our forecasts, while 13% were ahead. However, 16% fell short of our expectations, where results were impacted by lower NOI, higher G&A, and/or higher interest costs. Among subsectors, seniors housing and other (REOCs) had the highest proportion of entities that came in ahead of our forecasts (Exhibit 2).
Organic growth in solid form, with seniors housing out front by a substantial margin. SP NOI increased an average 5% YoY in Q3/23, down marginally (~40 bps) from the record 6% print last quarter and well above the 2% LTA. Notably, seniors housing SP NOI accelerated to an impressive +13% YoY, aided by a mix of higher rents/service rates, higher occupancy, and better cost controls. Multi-family (+9% YoY) and industrial (+7%) followed, with attractive mark-to-market opportunities on in-place rents pointing to strong momentum ahead for both. Self-storage posted an encouraging uptick (+5%) following last quarter’s moderation, followed by diversified (+4%), retail (+2%), and office (+2%).
2024E earnings outlook trimmed; leadership should come from where fundamentals are strongest.
Post Q3 results, our 2023E FFOPU held relatively steady, but are down 2% for 2024E, with higher interest rates playing a significant role. As shown in Exhibit 4, office REITs suffered the deepest cuts, while seniors housing saw the largest improvements. Our forecasts reflect +2% 2023E FFOPU growth, rising to +3% in 2024E (vs. prior +5%), with 2025E at a similar +3%. Narrowing in on 2024, we expect growth leadership from seniors housing, industrial, and multi-family (mid-to-high single digit %-range). From an NAV standpoint, our estimates dropped 6% post Q3, mainly from higher cap rates, and are down 12% since the BoC tightening cycle commenced in Mar-2022 (10Y GoC +201 bps). That compares with IFRS NAVs which declined an average 2% QoQ in Q3, but have increased an average 3% since Mar-2022.
Valuation screens reasonable; we expect capital to follow fundamentals in the near term. Headwinds from higher rates and an economy losing traction have weighed on the sector, with the TSX REIT index posting a -7% YTD total return. While the 29% discount to NAV screens attractive (Exhibit 9), we expect investor focus to remain on cash flow multiples and spreads amid an extended period of price discovery in private markets. With that in mind, the sector’s current 320 bps AFFO yield spread (vs. 363 bps LTA) and 379 bps implied cap rate spread (vs. 424 bps LTA) to the 10Y GoC are both within our view of fair value range (Exhibits 11-12). The recent pullback at the long end of the yield curve has helped the sector recoup some losses. Absent further bond yield compression, we expect capital to follow fundamentals.