September 29, 2023
Real Estate Investment Trusts
Quarterly Review and Sector Outlook – Q4 2023
Recommendations
At the outset of the year, we felt that fundamentals would move to the forefront after last year’s sizeable retreat in valuation and expectations for an economic downturn. Nine months into the year, our views are largely unchanged. Indeed, as headwinds from rising bond yields mount, we expect the bifurcation in returns to persist, with subsectors delivering superior organic NOI & earnings growth likely to maintain leadership, including multi-family, industrial, and select seniors housing. Bottom line, stronger macro support is likely a prerequisite for fund flows to pick-up. In the meantime, we see better entry points to our top picks: AP, BEI, CAR, CIGI, CSH, DIR, FCR, FSV, GRT, HOM, IIP, KMP, MHC, MI, MRG, REI, SRU, SVI.
Highlights
Love is in short supply for global listed property markets. The TSX REIT index is on pace for its second straight quarterly decline (-4% total return in Q3/23 to date), reducing the YTD tally to -4%. CDN REITs are lagging North American equities, including the S&P 500 (+14% YTD) and the TSX Composite (+5%). For the most part, developed REIT markets around the world have posted uninspiring performances, including Europe (-2%), the US (-1%), and Global (-3%), although Asia remains the standout (+3%).
“Higher for longer” weighing heavy on minds, as investors recalibrate expectations. From our lens, the material run-up in bond yields, particularly in recent weeks, has played a central role in the sector’s slide. Indeed, the appeal of fixed income investments continues to expand, with the 10Y GoC yield rising to >4% (+72 bps YTD), levels not seen since late 2007. Throw in an economy losing its grip, tighter credit conditions, and a prolonged period of opacity in private market pricing, sector fund flows are understandably under pressure. While stronger headwinds have formed, we believe the sector remains on sound footing, particularly our preferred property types. Notably, fundamentals are in good shape across most subsectors (organic growth tracking near record levels), liquidity ratios remain above trend (13% vs. 11% LTA), floating rate debt exposure is low (average 11% of total debt), debt maturities are well-balanced, and the outlook for earnings growth remains decent (+1-4% in 2023E-2024E).
Valuations have taken another step back, but frankly seem reasonable on the whole. The sector’s NAV discount expanded in Q3 to 28%, well below the historical average (-1%). While the discount has some appeal, we believe investors are placing less weight on NAVs amid limited conviction in underlying asset values, with greater emphasis on cash flow growth and related multiples. Indeed, our analysis suggests that P/NAV has proven less consistent in providing buy signals (p. 71). On P/AFFO (N12M), the sector has contracted to 15x (6.7% AFFO yield), in line with the LTA. The AFFO yield spread to the 10Y GoC narrowed to 267 bps, below the LTA (362 bps) and to levels that have historically not provided a particularly strong buy or sell signal (p. 70). The sector’s 7.3% implied cap rate reflects a 326 bps spread to the 10Y GoC, also below the LTA (424 bps). In short, barring stronger macro support (lower bond yields would help), we think selective sector exposure remains warranted, with a focus on where fundamentals are strongest.