Q1/23 Real Estate Sector Preview
For our coverage universe in Q1/23, we forecast +2.4% y/y AFFO/unit growth for index-included names (Exhibit 4), keeping pace with the Q4/22 performance as our coverage universe continues to balance overall constructive leasing fundamentals against the backdrop of higher interest rates on refinanced and existing variable- rate debt. Our two preferred sectors have the strongest expected Q1/23 AFFO/unit growth: Industrial at +7% and Residential at +6%. Exhibits 5 and 6 provide our estimates, consensus, and conference call details. Our current forecasts point to accelerating growth, with +3% expected in FY2023 and +6% in 2024.
During the Q4/22 earnings season, our coverage reported an average +1.6% beat on AFFO/unit. Forward guidance from management teams was also more constructive than the economic slowdown we had previously built into our 2023 estimates. This led to our 2023-2024 AFFO forecasts increasing on average by 1%-2%
For the Q1/23 earnings season and given the increasingly uncertain macro environment, we see a greater likelihood of management teams including more caution in their 2023 outlooks. Therefore, we see greater downside risk versus upside potential to our full-year estimates, albeit not by a meaningful amount in either direction. We also see more downside potential to IFRS fair values during the quarter (our Office and Diversified sector NAVs are on average ~20% below IFRS).
Commercial real estate credit (particularly in the U.S.) has increasingly become a concern for investors, which in turn, in our view, has negatively impacted trading valuations for Canadian REITs. That said, we do not foresee any major challenges for Canadian REITs on the refinancing front. Furthermore, we view the current liquidity levels across the vast majority our coverage as ample to weather today's tightened credit markets. Please click here to view our recent, detailed report on the real estate credit environment in Canada versus the U.S., along with debt and liquidity metrics across our coverage.
On valuation, in our view, Canadian REITs at a 20% discount to NAV (versus the long-term average of essentially in line) look attractive. On a yield spread basis to the 10-year, the sector also looks undervalued at a 5.2% FFO yield spread, which is +100bps since February and compares with the adjusted historical average of 4.9% (Exhibit 2). Today's inverted yield curve continues to make REITs look relatively expensive on shorter-term bond yields, with the current 4.3% FFO yield spread to the 2-year GOC bond yield remaining tighter than the 5.8% adjusted historical average spread.
Based on current valuations and near-term fundamentals, we continue to prefer the residential, industrial, and retail asset classes. Our ACTION LIST BUY-rated names are CAPREIT, First Capital REIT, and Granite REIT.