Examining Real Estate Sector Recession Scenarios
Far Less Earnings Impact Expected vs. Past Cycles Superior Financial Condition Should Mitigate Downside Risks
With a Canadian economic recession becoming increasingly likely, in this report, we examine how REITs have performed during past recessions and provide some estimates of how we believe FFO and NAV estimates could be affected during this cycle.
The S&P/TSX Capped REIT Index has declined 23% from its recent peak on March 22, 2022, marking one the largest declines since 2000 (Exhibit 1) and resulting in most REITs now trading at or near past recession-trough valuations (and some lower) on both P/AFFO and P/NAV (Exhibit 4). Year-to-date, the average implied price/SF has fallen 15% and average implied cap rate has increased 80bps. Trading valuations, in our view, now reflect expectations of a meaningful economic slowdown (likely a recession), in contrast to the current strong fundamentals most property sectors have been experiencing.
We see meaningfully less risk of reduced FFO/unit and AFFO/unit compared with past economic downturns. Most REITs today have much stronger balance sheets and liquidity positions, as demonstrated by the ~$1bln of unit buybacks completed by the REIT sector over the past eight months (link). REITs' today have average balance-sheet leverage (D/GAV) of just 41% (vs. 49% pre-2015 oil crash and 56% pre-GFC) and average AFFO payout ratios of just 72% (vs. 83% pre-2015 oil crash and 96% pre-GFC), as most remaining REITs with the highest payout ratios "right- sized" their distributions during the pandemic. In contrast to past downturns, we therefore see much less need for the sector to raise expensive and dilutive capital (which exacerbated past negative impacts on per-unit FFO, AFFO, and NAV). With most of today's REITs in superior financial condition, we see a limited earnings impact in the event of a recession.
As shown in Exhibit 3, the recession scenarios we have modelled for 12 REITs (two in each of the six main sectors) indicate potential downward revisions averaging approximately 6% for FFO/unit. This compares favourably with the 12% average shortfall between actual and originally forecast AFFO/unit for 2009 (Exhibit 5). This would also result in largely flat y/y growth in 2023, and compare favourably with the 7% average y/y declines experienced in 2008/2009 and 2020 (Exhibit 2). If 6% downside proves to accurately reflect the sector's trough-level FFO and AFFO, then today's FFO yield and FFO yield spread valuations (both slightly above adjusted long-term averages) would represent compelling value, in our view.
We see greater downside risks to NAV/unit estimates. Exhibit 3 shows an average potential recession-scenario decline in NAV/unit of ~12%. We have reflected a further 20bps average increase in cap rates (on top of the 20bps adjustment we made last month (link)), ~3% average lower NOI, and a 25% valuation reduction to undeveloped land.