December 20, 2024
Canadian Real Estate Investment Trusts
Quarterly Review and Sector Outlook – Q1/25: Reasons for optimism
Our view: As CDN REITs limp to the 2024 finish line, we expect macro narratives will remain in the driver’s seat in the year ahead. Still, we see levers to support stronger 2025 returns, incl. additional monetary policy support, healthy fundamentals, decent earnings growth, and valuations that look increasingly appealing. Our top picks include names where we see superior operational resilience and/or discounted valuations: BEI, CAR, CIGI, CSH, DIR, FCR, GRT, HOM, HR, IIP, KMP, MHC, MI, MRG, PMZ, REI, SRU, SVI.
Highlights
Yeesh...a moody year to say the least. The sector’s Q3/24 rally turned out to be a summer fling. Having given back a good portion of its gains in Q4 to date, the TSX REIT Index posted a +1% YTD total return (to Dec-12/24), well behind the TSX Composite (+25% YTD) and S&P 500 (+29%). Of note, the sector is on pace for its third consecutive year of underperformance vs. the TSX. In the global context, Canadian REITs lagged their counterparts in the US (+13% YTD) and Asia (+3%) but edged ahead of Europe (flat).
Reasons for optimism in a world full of anxiety. At the time of writing, listed real estate on both sides of the border is under pressure as bond yields rise amid a more hawkish tone from the Fed. We believe other factors have also weighed on Canadian REITs, including a lethargic economic outlook, moderating fundamentals in previously favoured subsectors, and US investor outflows. Tack on immigration curbs, & well, investors have lots to be anxious about. Still, we see reasons for optimism. Indeed, we believe the sector can deliver stronger 2025 performance, supported by: 1) further anticipated BoC policy easing; 2) healthy fundamentals in most property types; 3) decent earnings & NAV growth (low-to high-single digit %); 4) liquidity at record levels; and 5) valuations that look well within reason. Potential compression at the long end of the yield curve could also light a spark under fund flows, in both public & private markets.
Our recommended subsector positioning balances growth expectations and valuation. Our pecking order has seniors housing at the top (valuations well-supported by superior earnings growth), followed by industrial (normalizing fundamentals, yet earnings growth stacks up comparatively well with heavily discounted valuations), multi-family (above historical average NOI growth with cloudier outlook), retail (good value for solid fundamentals and steady earnings growth), self-storage (feeling effects of weaker consumer and low housing activity) and office (recovery requires more time).
Pullback has valuations looking more appealing. At 19% below NAV, we see a sizeable cushion for error. Still, we believe investors continue to place more weight on cash flow multiples and implied cap rates amid slower deal flow. With that in mind, the sector’s trading at 15x N12M AFFO (6.6% AFFO yield)/7.1% implied cap rate. Notably, the AFFO yield spread to the 10Y GoC (348 bps) has risen closer to the LTA (361 bps), with the current 396 bps implied cap rate spread also approaching long-term levels (422 bps). While stronger macro support from lower rates and better economic visibility are likely prerequisites for more robust inflows, we see compelling entries available in our top picks.
Investment recommendations: Summarizing our Outperform-rated securities
(only posted for the REITs I own)
BEI.UN Boardwalk’s portfolio is concentrated in Western Canada with ~75% of SP-NOI generated from Alberta and Saskatchewan. In recent years, with relative housing affordability and improvement in energy prices, Alberta has seen significant migration, leading to meaningful market rent growth and vacancy improvement. AB and SK are provinces without rent control and as such, BEI is able to benefit immediately from the improvement in rental fundamentals. In the context of the possibility of no population growth in Canada over next two years, we think BEI could outperform peers given lower non-permanent residents and higher interprovincial migration in its markets.
CSH.UN We remain constructive on CSH as the benefits of its operational changes become increasingly evident in results. A trifecta of operational strides, new construction starts at nine-year lows, and demographic tailwinds has laid the groundwork for a multi-year runway of solid NOI growth. A significantly improved cost of capital has also allowed CSH to shift from defense to offense, with >$1B of acquisitions that high-grade portfolio quality while simultaneously driving modest earnings accretion. Combined with double-digit forecast organic NOI upside underpinning a compelling earnings trajectory, plus a good line of sight to lower leverage, we see attractive upside from current levels.
DIR.UN Normalizing industrial fundamentals have taken the wind out of the subsector’s sails, while bond yield volatility certainly hasn’t helped either. In DIR, though, we continue to see an attractive mix of above sector average earnings growth and a discounted valuation. Specifically, ON and QC comprise ~50% of expiring GLA to Q4/25 with a ~78% mark-to-market opportunity on in-place rents. Combined with easing new supply, we see support for SP NOI growth to accelerate next year. As well, we’re encouraged by progress on developments, providing an incremental source of growth. Bottom line, we see a compelling entry point at current levels.
FCR.UN We believe FCR is well positioned to capitalize on the urbanization trends across Canada and navigate a soft patch in economic activity, supported by its superior quality, grocery-anchored portfolio. Indeed, management raised its 2024 SP NOI growth outlook to “meet or exceed 3%” on a better than anticipated 9M/24, with our forecasts reflecting an acceleration in 2025E. We’re also encouraged by progress on the portfolio optimization and de-leveraging plan, as FCR works toward its ~$1B disposition target from 2024 to 2026. We view current levels as a discounted entry to a name with an improving growth profile, high quality assets, a large pipeline of value-add opportunities, and line of sight to lower leverage.
GRT.UN Strategically, GRT is focused on growing scale in large markets with a portfolio of modern industrial properties in Europe, the US, and Canada. Amid normalizing industrial fundamentals, we believe GRT’s US occupancy slippage has weighed on investor sentiment. Still, with a sizeable leasing pipeline, robust leasing spreads, and slowing new construction starts, we expect SP NOI growth to register another decent year in 2025, relatively close to 2024 levels. As well, the balance sheet is in solid form with below average leverage and no significant debt maturities until 2026. Coupled with a strong overall earnings growth profile and ample capacity for continued distribution growth, we see current valuation as a solid entry point.
IIP.UN Given its value-add business model and strong operating team, IIP has delivered above-average NAV and SP NOI growth historically. Near term, we see earnings momentum from continued strength in apartment fundamentals, its value-add model and interest expense being less of a headwind over the next two years although the prospect of slightly negative population growth in next two years and slowing market rent growth including rent decline in certain of pockets could have modest negative impact. For 2025, we expect SP NOI growth in the range of 5%.
KMP.UN Although KMP’s portfolio remains ~62% geographically exposed to Atlantic Canada, we view KMP as a way to play growing mid-sized Canadian markets. Moreover, KMP’s portfolio is relatively newer vs. peers and it has been relatively active in new developments. Not well known by the market is the fact that in the last 10 years, KMP posted the strongest FFO/unit CAGR vs. its CDN peers. As such, given its portfolio exposure, the relative age of the portfolio, its track record and leverage in line with peers, we believe KMP should trade at least on par with peers. KMP’s preliminary 2025 outlook was a relatively constructive one and for 2025, we expect SP NOI growth of 5-6%, driven by KMP’s low in-place rents, healthy MTM cushion and above-normal renewal rate growth.