Real Estate Delivers Strong SPNOI Growth in Q1/23
Fundamentals Pull AFFO/unit +2% y/y Despite Interest Cost Spike
Q1/23 results (Exhibit 1) overall met our expectations with weighted average sector AFFO/unit growth (index names only) of 2.2% (just 10bps below our forecast). The impact of higher interest costs, which increased by 31% y/y (weighted average, index names), was not enough to offset very strong SPNOI growth in Q1/23. This quarter likely had the most difficult y/y interest expense comparisons. Despite this, some REITs most exposed with shorter WADMs and/or higher levels of floating rate debt surprisingly beat on lower-than-expected interest costs.
SPNOIG in Q1 was exceptionally strong at +5.8% (Exhibit 3). Excluding Seniors (+10.6%), which are recovering from depressed pandemic earnings, the top sectors were Residential (+8.6%), Industrial (+8.5%), and Diversified (+5.6%). Our revised SPNOI forecasts increased to +4.5%/+4.9% for 2023/24 (from 4.0%/4.4%) led by Seniors (+13.5% average), Industrial (+7.1%) and Residential (+6.9%).
Overall, our AFFO/unit estimate forecasts (index names only) were largely unchanged with 2023/24 -0.7%/+0.2%, as were our target prices and NAVs (Exhibit 2). By sector, during Q1 Industrial performed the best with the highest growth in both y/y AFFO/unit growth (+12%) and revisions to 2023/24 AFFO/unit estimates (excluding Seniors), while Residential followed with +4% AFFO/unit growth (2023/24 AFFO/unit estimates: -2%/0%).
Except for Office and Seniors, sector fundamentals remain strong. For Residential, heightened demand for apartment rentals across Canada is flowing through to operating metrics with most REITs recording double-digit uplifts on new leases, a trend we expect to continue as monthly stats continue to show upward pressure on asking rents. Industrial leasing momentum remains strong, market rents continue climbing higher (although not at the same pace as 2022), and there remains virtually no pushback on asking rents. Retail leasing has continued at a strong pace despite macroeconomic concerns, and the quick take up of most Bed, Bath & Beyond leases was very encouraging. Sentiment improved for the Seniors' sector in Q1 following encouraging outlook commentary, leading to our increased confidence for a potential return to a normalized operating environment in 2024.
On valuation, the dynamic we have seen since short term interest rates moved higher in mid-2022 remains (Exhibits 4, 5 & 6). On a P/NAV basis, at 79%, the sector remains well below the historical average of essentially in line, and at these levels, looks attractive to us. On an FFO yield spread basis to the GoC 10-year, the sector also looks undervalued at 5.5% versus the adjusted historical average of 4.9%. Given the inverted yield curve over the past year, the FFO yield versus the 2-year GoC remains relatively expensive at 4.5% (adjusted historical average: 5.8%).
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.