June 30, 2022
Real Estate Investment Trusts
Quarterly Review and Sector Outlook – Q3 2022
Recommendations
As detailed herein, we have 16 Outperforms: Allied Properties, Boardwalk, BSR, CAPREIT, Chartwell Retirement Residences, Dream Industrial, European Residential, First Capital, Granite, InterRent, Killam Apartment, Minto Apartment, Morguard North American Residential, RioCan, SmartCentres, and StorageVault. Amid higher interest rates, our picks remain skewed to names we view as more resilient in delivering NOI, FFO, NAV, and distribution growth, particularly in industrial & multi-family.
Highlights
A tough tape, as listed real estate and broader equities dial back. The TSX REIT Index has posted a -19% total return (to Jun-23/22), on pace for among its weakest first-half returns on record. The sector trails the TSX Composite (-11%) and 10Y GoC bonds (-14%) but ranks relatively in line with the S&P 500 (-20%). Listed real estate around the world has faced a tougher road in 2022. TSX REITs have outperformed REITs in Europe (-25%) and are tracking close to the US (-20%) and Global Index (-20%) but trail Asia (+4%).
Reduced macro visibility has given investors plenty to worry about. After riding a wave of reopening and depressed interest rates in 2021, investor optimism has quickly turned to fear in 2022. Broad-based inflationary pressures have set central banks firmly on a tightening path. We believe the combination of the sharp rise in interest rates (particularly at the long-end of the yield curve) and growing concerns of a potential material economic slowdown has weighed heavily on sector sentiment. As private market cap rates will take time to adjust, spreads to debt costs are likely negative across several property types. In short, we believe cap rates are likely biased higher. While our NAVs are intact, every +25 bps in our assumed cap rates reduces our NAVs by an average ~8% and every -2% NOI reduces our NAVs by ~4%.
The other side of the coin. Taking a step back, we believe there are several drivers that should provide the sector with downside support, including: 1) healthy, albeit moderating, economic growth; 2) the continued recovery in property fundamentals (~3% 2022E SP NOI growth); 3) decent earnings (3– 7% 2022E–23E) and NAV (5%) growth; 4) rising replacement costs; 5) reasonable valuations; 6) solid corporate liquidity; and 7) a still strong private market appetite for real assets. Indeed, while deal flow will likely pause in the near term, we note that Q1/22 marked a record quarter of transaction volume.
A reasonable but not excessive “margin of safety”. The sector is trading at 23% below NAV, well below its LTA, with investors likely discounting higher cap rates and/or lower NOI ahead. Notably, the sector’s 6.3% implied cap rate is 80 bps above our 5.5% avg. NAV cap rate. The current 17x P/AFFO (6.0% AFFO yield) is in line with the 10Y avg. The 268 bps AFFO yield spread to the 10Y GoC has returned to fair value range, as has the 62 bps spread to Moody’s Baa Index. That said, the 304 bps implied cap rate spread to the 10Y GoC (vs. 428 LTA) still screens expensive. All said, we see valuation as reasonable, with a stabilizing macro picture (particularly inflation & interest rates) a likely prerequisite for stronger inflows.