Canaccord Narrative While acknowledging “the current environment may not be the most ideal time for vending development land,” Canaccord Genuity analyst Mark Rothschild thinks Canadian retail real estate investment trusts should “reconsider the amount of value in assets not producing income,” believing it would be “accretive and appreciated by many investors.”
“The modern Canadian REIT market was created largely as more conservative ‘yield vehicles’, and every dollar not invested in income producing property was considered ‘dilutive’ to the distribution,” he said. “The new REIT operating model was more conservative than private real estate companies, and although payout ratios were initially close to, if not above 100 per cent, and leverage was elevated compared to current levels. REIT’s mostly took little risk in operating the business. Though there were some management teams with value creation expertise and active projects, this was mostly conducted external to the REIT to reduce risk.
“Over time, however, the REIT market evolved and matured with investors placing greater value on even lower leverage and more conservative payout ratios. Also, investors learned to appreciate that there are some management teams with the ability to create significant value through various forms of development and redevelopment. Further, there were almost always conflicts of interest in having this activity conducted externally. Therefore, investors encouraged REITs to internalize development in order to benefit from the value creation.”
In a research report released Monday, Mr. Rothschild “applauded and encouraged” the transformation, but he thinks it “now appears that some REITs may have taken this too far and own large development sites which will take decades to fully develop and are, in our view, not the best use of public REIT capital.”
“In many cases, the development land or extra density was ancillary to an income producing property, and only became valuable of late with greater land and residential values,” he noted. “Further, we believe that some REITs took on too much development risk and certain large well-publicized development projects have been dilutive.
“Currently, when REITs are generally trading below NAV, thus reducing the ability (or attractiveness) to raise new equity to fund growth, having precious equity tied up in development is a questionable use of capital. This is notwithstanding the fact that some REITs have, in our view, not proven to be able to manage this risk effectively. We, therefore, believe it would be appropriate for REITs to reconsider the amount of value in assets not producing income, and while the current environment may not be the most ideal time for vending development land, ultimately this would be accretive and appreciated by many investors.
“The spread between cap rates and financing rates have moved closer to historical averages,” he said. “Therefore, not only do we not expect further upward pressure on cap rates, there could be some move lower in cap rates. We are therefore lowering our utilized cap rates by an average of 15 bps for five REITs. Our NAV estimates increase by an average of 5 per cent and our target prices rise by an average of 9 per cent. Our ratings remain unchanged.”