June 29, 2023
Real Estate Investment Trusts Quarterly Review and Sector Outlook – Q3 2023
Recommendations
They say that time heals all wounds. We believe there’s some truth in this saying, but REIT investors will need to wait longer. As macro headwinds persist, our recommendations remain skewed to property types where we see tailwinds to support resilient organic growth, including multi-family, industrial, self- storage, & defensive retail. On the back of the sector’s recent pullback, we see better entry points to our top picks: AP, BEI, CAR, CIGI, CSH, DIR, ERE, FCR, FSV, GRT, HOM, IIP, KMP, MI, MRG, REI, SRU, SVI.
Highlights
Sector returns retreat; similar story globally, but Canada’s pain was more acute. After a strong Q1, the TSX REIT Index posted a -8% total return in Q2 to date, leaving the sector in the red (-4% YTD) as 1H/23 draws to a close. Canadian REITs are trailing North American equity benchmarks, including the S&P 500 (+15% YTD) and the TSX Composite (+3%). Listed real estate returns are mixed around the world, with Canadian REITs ahead of Europe (-8% YTD), but lagging Asia (+5%), the US (+2%), and Global (-1%).
The sector’s ailments have yet to subside, though foundation remains on sound footing.The usual suspects that have plagued the sector over the past year seem to have taken a heavier toll in the recent pullback—rising bond yields at the long-end of the curve, further anticipated rate hikes as central banks work to suppress inflation, and prospects of a recession—take your pick. Liquidity concerns are likely also still weighing on select property types, particularly office. Yet, on balance, we see the sector as well-positioned to navigate this extended period of heightened uncertainty. Fundamentals in most subsectors are in good form, the sector's liquidity ratio is strong (14% vs. 11% LTA), debt rolls are well- staggered (10-12% annually through 2024), the earnings picture remains decent (+2-5% in 2023E/24E), replacement costs are high, and we would hardly characterize valuations as demanding.
Valuation screens reasonable, with pullback providing opportunity to add selective exposure. The sector has dialled back to a 27% discount to NAV, well below historical parity and just shy of the 2020 COVID lows. Yet, considering reduced visibility on underlying property values amid slower deal flow, we believe investors are placing more weight on NOI growth, cash flow growth, and multiples at this stage of the cycle. With this in mind, the sector is trading at 15x N12M AFFO (6.6% AFFO yield/7.1% implied cap rate), in line with its LTA. The current 319 bps AFFO yield spread to the 10Y GoC is below average, yet within fair value range. Notably, current levels (i.e., within 1 STD DEV of the mean) have historically not provided a strong buy or sell signal. However, as detailed on page 70, the REIT Index has exhibited a rising frequency of outperformance vs. the TSX Composite as AFFO yield spreads to the 10Y GoC widen. In contrast, the sector’s track record of relative returns at various P/NAV ranges is more mixed. Bottom line, we believe select exposure remains warranted, particularly in our preferred property types where above average AFFO growth profiles and reasonable to attractive valuations position them well to outperform.