Debt Levels in Focus as We Roll Out 2025 Forecasts
Forecasting 12% Cumulative AFFO Growth in 2024 & 2025 Lowering Some Target Prices
TD Investment Conclusion
The S&P/TSX Capped REIT Index has now fallen 22% (price-only) from its post- pandemic high of 211 in March 2022, as interest rates and bond yields spiked higher and the yield curve inverted. While overall REIT prices arguably have adjusted to today's higher interest rates, we believe the full effects of a “higher for longer” scenario may not be fully reflected across the sector — particularly on a relative basis. The opposite scenario — where rates fall sooner and more sharply than consensus, and funds invested in GICs/money market funds revert into equities — could cause a sizable rally in REIT prices, in our view. We believe a higher for longer interest rate scenario will focus more attention on balance sheets, and have accordingly adjusted some target prices downward (Exhibit 2).
Please see our separately-published bulletin for more analysis on REIT balance sheets.
Forecast Updates for Q3/23, 2023 and 2024; Introducing 2025
We are forecasting attractive average AFFO/unit growth of 4%, 7%, and 6% for 2023, 2024, and 2025, respectively, for the Real Estate/REIT sector (Exhibit 1). Our forecasts now reflect both the impacts of an economic slowdown in 2024 and today's higher market interest rates persisting through mid/late next year before slowly moderating into 2025. Overall, our 2023 estimates are unchanged, while our 2024 estimates decline just 1%, as most estimates had already reflected a slowdown, and the impacts of "higher-for-longer" interest rates which take time to be fully reflected.
In general, our coverage universe has been able to sustain solidly positive AFFO growth despite the ~10% increase in interest costs relative to EBITDA between 2021 and 2023F. With the impacts immediately felt on floating rate debt, and increasingly reflected as fixed-rate debt is re-priced, we forecast a meaningfully slower pace of interest expense increases going forward (i.e., interest expense growth matching EBITDA growth now through 2025).
We see near-term sector trading valuations remaining highly dependent on movements in both short-term interest rates and long-term government bond yields. On balance, we reiterate our OVERWEIGHT sector call for Real Estate. The sector's current 76% average P/NAV valuation is near all-time lows (historically an attractive entry point), cash yields are well covered with two-thirds of our coverage universe offering cash yields at or above 5%, and AFFO growth expectations (+7% in 2024 and +6% in 2025) reflect strong underlying fundamentals. That said, we do acknowledge the potential increased risk of flat or underperformance if the interest rate environment takes longer than expected to improve. Our three ACTION LIST BUY names are CAP REIT, First Capital REIT, and Granite REIT. Other large cap favourites are Chartwell Retirement Residences and RioCan REIT. Our small cap preferred names are BSR REIT and Minto Apartment REIT.