October 5, 2022
Real Estate Investment Trusts
Quarterly Review and Sector Outlook – Q4 2022
Recommendations
Amid higher rates and a slowing economy, we remain overweight names where we see more resilient fundamentals, particularly in multi-family, industrial, and defensive retail. Outperforms include: Allied, Boardwalk, BSR, CAPREIT, Chartwell, Dream Industrial, European Residential, First Capital, Granite, InterRent, Killam, Minto, Morguard N.A. Residential, RioCan, SmartCentres, & StorageVault.
Highlights
Listed property returns well into correction territory. The tone across equity markets weakened further in Q3/22 and Canadian listed real estate was no exception. The TSX REIT Index registered a total return of -8%, driving its 9M/22 total return to -24%, on pace for its second worst year on record. The sector is trailing the TSX Composite (-11% YTD) and 10Y GoC bonds (-9%), but is tracking in line with the S&P 500 (-24%). Listed real estate returns have retreated across developed markets. Still, TSX REITs have outperformed REITs in Europe (-39%), the US (-28%), and the Global Index (-29%), but trail Asia (+3%).
A heavy fog has settled over the macro view, making the path forward hard to see...Restrictive central bank policies and hawkish commentary, rising interest rates across the curve, heated inflation, shaky geopolitics, and growing calls for recessions across geographies – no shortage of reasons for investors to dial back equity exposure. For listed real estate, concerns over declining asset values from cap rate expansion and lower NOI have weighed heavy. Our NAVPU estimates are down ~5% through 9M/22, marking only the fourth year of erosion since 1996. With cap rate spreads to debt costs negative across multiple property types, further downside is entirely possible, particularly if rental inflation does not materialize. Hence, we remain overweight subsectors where we see the strongest fundamentals.
...yet, every cloud has a silver lining. The sector’s drawdown has driven an increase in inbound enquiries from generalists and specialists in recent weeks, particularly from value seekers. While some clarity on the macro front is a likely prerequisite for stronger fund flows, the growing interest is encouraging nonetheless. As well, we believe key drivers should provide some downside support, including: 1) improving fundamentals across most property types (~3% 2022E SP NOI growth); 2) decent earnings growth through 2023 (3-7% 2022E-23E); 3) rising replacement costs; 4) strong corporate liquidity; 5) an active pace of unit buybacks; and 6) reasonable to attractive valuations across our key gauges.
Turning back the clock on valuation. The sector’s trading at 23% below NAV, the steepest discount since 2020 COVID lows. Indeed, current levels seem to be baking in a fair amount of cap rate expansion and/ or NOI erosion, with the sector’s 6.7% implied cap rate 90 bps above our average 5.8% NAV cap rate. The current 15x P/AFFO is in line with the LTA, while the 335 bps AFFO yield spread to 10Y GoCs has risen closer to historical levels. While the 48 bps AFFO yield spread to the Moody’s Baa Index and implied cap rate spread to the 10Y GoC remain below average, both are within fair value range. In short, the sector’s correction provides better entry points – for outsized returns, one cannot wait for all clouds to lift.