With long-term interest rates rising “rapidly,” Canaccord Genuity analysts Mark Rothschild and Christopher Koutsikaloudis think there is now “a greater risk” of capitalization rates increasing.
“As a result of the recent rise in long-term interest rates, the spread between cap rates and Canadian BBB bond yields is now 115 basis points, down from 247 bps at the beginning of 2022 and below the long-term average of 214 bps,” they said. “In the near term, there remains a wall of capital targeting investments in real estate, and we expect demand to remain strong. However, with spreads between cap rates and the cost of debt now well below the long-term average, we view the risk of cap rates rising as more material.”
In a research report released Wednesday, they adjusted their ratings and target prices for several real estate investment trusts in their coverage universe, believing “investors will, and should, consider the potential for cap rates to rise and the impact on property values.”
Cap rates represent the rate of return owners should expect to earn on a property, measured by comparing anticipated rental income to a building’s value.
In addition, they emphasized a number of REITs have performed well so far in 2022 “and the implied returns have become more modest,”
“Following a total return of 35 per cent in 2021, the S&P/TSX Capped REIT Index returned 0.9 per cent in Q1/22, below the return of 3.8 per cent from the S&P/TSX Composite Index, yet better than U.S. REITs, which posted a total return of negative 3.5 per cent. We attribute the underperformance of REITs relative to the broad market to rising long-term interest rates, widening credit spreads and outsized returns for the Canadian energy and materials sectors.”
The analysts’ target changes were:
- Canadian Apartment Properties REIT (“buy”) to $63 from $66. Average: $67.20.
- Dream Industrial REIT ( “buy”) to $19 from $21. Average: $19.64.
- Granite REIT ( “buy”) to $105 from $115. Average: $110.27.
- InterRent REIT (, “buy”) to $19 from $19.50. Average: $19.63.
- Killam Apartment REIT (, “buy”) to $25.50 from $26.50. Average: $25.94.
- True North Commercial REIT (, “hold”) to $7 from $7.50. Average: $7.63.
“The lower target prices reflect our belief that investors will, and should, consider the potential for cap rates to rise and the impact on property values,” they said. “In the near term, there remains a wall of capital looking to invest in real estate, and we expect demand to remain strong. Also, most REITs are well positioned to grow cash flow and NAV through raising rental rates and value-add development projects.
“However, with corporate bond yields having risen more than 130 bps so far in 2022, and spreads between cap rates and the cost of debt well below the long-term average, we view the risk of cap rates rising as more material. In addition, a number of REITs have performed well in 2022 and the implied returns have become more modest. As a result of this performance, and the lower target prices, we are reducing our ratings for six REITs from Buy to HOLD.”
Mr. Rothschild and Mr. Koutsikaloudis highlighted a group of REITs that they believe should outperform over the next year, saying: “Factoring in year-to-date returns and updates to our target prices, we believe current valuations for a number of REITs including Eastern Canada-focused apartment REITs (InterRent, CAP REIT, Killam and Minto), Dream Industrial REIT and First Capital REIT are attractive, and these REITs should outperform over the next year. In addition, we believe Brookfield Asset Management (BAM) should benefit from rising allocations to alternative investments and growing management fees.”