May 25, 2023
Canadian REITs and REOCs: Q1 2023 recap
Results in line, operationally sound, but sentiment facing some hurdles
Our view: Our Outperform ratings are unchanged and include Allied, Boardwalk, BSR, CAPREIT, Dream Industrial, European Residential, First Capital, Granite, InterRent, Killam Apartment, Minto Apartment, Morguard Residential, RioCan, SmartCentres, Chartwell, FirstService, and StorageVault. Q1 results were largely in line, with a notable acceleration of organic growth. Our forecasts continue to reflect healthy earnings and NAV growth for the year ahead. Nonetheless, investor sentiment seems to be struggling to gain traction amid an anticipated pullback in economic activity, higher rates, and nervousness surrounding the availability of credit, particularly for property types facing fundamental pressures. With this in mind, our picks remain largely anchored in subsectors we expect to exhibit stronger operational resilience, particularly multi-family, industrial, self-storage, and defensive retail.
Modest earnings growth to start the year, with majority of REITs “in line”. Q1/23 FFOPU increased 1% YoY for our universe, in line with our forecasts, but down from 3% in 2022. By subsector, seniors housing posted the strongest growth (+44% YoY), aided by an outsized print from EXE on prior year cost recoveries. Industrial was next (+10% YoY), followed by multi-family (+4%) and retail (+1%), whereas office lagged (-18%). Among reporting entities, 68% (25 of 37) delivered earnings that met our forecasts, while 13% exceeded our calls. However, 19% fell short of our expectations, across a mix of property types where results were impacted by lower NOI, higher G&A, and/or higher interest costs. Among subsectors, seniors housing had the highest proportion of entities that came in ahead of our forecasts (Exhibit 2).
Organic growth accelerates on solid momentum in multi-family and seniors housing. Q1/23 same- property NOI increased an average 6% YoY (+80 bps vs. Q4/22) across our coverage. The strong start to the year is well above the 2% long-term annual average and ahead of our full year call for growth of ~2-3%. Key drivers included higher rents and occupancy gains, partly offset by higher operating costs, particularly labour (for gross lease businesses). Consistent with last quarter, multi-family led, with growth accelerating to a record high 11% YoY on exceptionally strong fundamentals. Seniors housing also materially improved (+9% SP NOI) on stronger traction in occupancy, rents, and lower pandemic costs, followed by industrial (+8%), self-storage (+6% YoY), diversified (+4%), retail (+3%), & office (flat).
Estimate revisions were minor; fundamentals should dictate growth leadership. Our 2023E reflect FFOPU growth of 2%, rising to 5% in 2024E. Post Q1 results, our seniors housing estimates experienced the strongest upward revisions (Exhibit 4), while office saw the steepest declines, mainly on lower NOI amid soft fundamentals. In 2023, we expect earnings growth leadership from seniors housing, industrial, self-storage, and multi-family, with the same group out front in 2024. IFRS NAVs for our universe were stable sequentially (-1% QoQ) with limited changes in IFRS cap rates (+5 bps QoQ, +29 bps YoY). On a YoY basis, IFRS NAVs decreased an average 1%, albeit more notably in office (-5% YoY) and diversified (-4% YoY). In comparison, our NAVPU estimates slipped 1% QoQ (-8% YoY), mainly on higher cap rates.
Macro picture needs to improve for sector to regain some traction. The sector has given back a substantial portion of its gains since early February as concerns surrounding economic deceleration, a higher rate environment, and tighter credit conditions (particularly for office) have weighed heavily on sentiment. Still, returns are highly bifurcated (Exhibit 8), with leadership from subsectors where fundamentals remain strong or are accelerating. The recent pullback has driven the sector’s NAV discount to a substantial 23%, well below historical parity. While the steep discount seems appealing, we believe low conviction in underlying asset values has investors placing greater weight on multiples and spreads. Notably, the AFFO yield spread to the 10Y GoC sits at 314 bps, with the implied cap rate spread at 381 bps. While spreads have risen since early February, they remain within fair value ranges (Exhibits 9-12). In short, we think some of the macro clouds need to start parting for the next leg up in valuation.