What's Going On With REITs?
Investing is never easy, no matter what someone might say when a stock or a sector is doing well. Even the best investors will have many losing positions. We may not hear about them or the size of the losses, but all investors prefer to discuss their winning positions rather than their underperforming positions.
Lately, interest sensitive investments have struggled, particularly Real Estate Investment Trusts (REITs). A REIT is a real estate company that buys and manages properties using money from investors, with the REIT then distributing income back to investors. This could include residential properties, offices, shopping malls, industrial buildings, and healthcare buildings. Many REITs in Canada are publicly traded on the Toronto Stock Exchange, which means that you can buy them just like you would buy a stock.
REITs on the Toronto Stock Exchange are income trusts, which means that shares are called units, with the REIT required to distribute most of their income to unitholders. Not all REITs are publicly traded though. Private real estate investment trusts are only open to accredited investors or eligible investors. They often offer a more stable Net Asset Value (NAV) in exchange for less liquidity, as you are not always able to easily redeem or sell your investment if funds are required. Unlike public investments, where share price will fluctuate daily, private real estate values are slow to ‘mark-to-market’ despite owning similar real estate investments. When there are fewer transactions in the sector, as we have seen this year, it becomes more difficult to price assets and private REITs will hold on to past valuations that may not be considered real time, market-value.
Over the last year, higher interest rates have put pressure on both private and public markets, which are in price discovery mode as investment volumes remain low. Debt capital is available, but at more expensive levels. This has pressured REITs that either have high debt levels or need access to equity or debt to grow. When interest rates were at lower levels, companies were able to finance accretive acquisitions. Today, many REITs trade below their NAV, which makes it dilutive to issue equity, unable to add to their portfolios and debt has become expensive.
As of May 31, 2023.
As a result, Real Estate equities underperformed in 2022 and have continued to do so recently as bond yields have moved higher. There are some stronger sub-sectors of real estate such as industrial, which has had very little available space to lease and continues to see strong rent growth. We have also started to see smaller REITs announce strategic reviews to look at other options, or reduce their distributions as a result of declining property values
S&P/TSX Sector Quilt
At the start of the year, there was some optimism that we start to see lower bond yields by the end of 2023 and potentially see the Bank of Canada cutting rate. That view has since changed somewhat. At some point, central bank tightening activity will slow, possibly even ease and provide a valuation tailwind. That said, there is no certainty around this. Given tight spreads between implied cap rates (the net operating income of a REIT divided by its net property asset value) and bond yields, investors have to be patient putting new money to work at today’s valuations. For example, as of writing a REIT ETF (XRE) offers a dividend yield of 4.36% while fully guaranteed money market funds pay 4.30% and a 2-Year Government of Canada bond offers a 4.53% yield.
This continued hawkish rate environment has reduced demand for REITs at the moment - good news isn't being rewarded and bad news is sending names down ≥10%. Many hedge funds have also been more actively shorting the space, so these combined factors is leading to some trading dislocations. Another issue is there is not a ton of incremental capital coming into the space to offset these moves, whereas the REIT dedicated funds are moving positions around they are not adding to overall exposure. Investors are avoiding the sector and the lower liquidity can lead to outsized moves to the downside, with a lack of buyers to support REIT prices.
With challenging sentiment at this time, our recommendation would be to stick to quality at this stage: REITs with strong assets, strong management teams that have managed through tough periods, and with less near-term debt maturities. The sub-sectors that have some tailwinds include multi-family Apartment and Industrial.
The top picks at this time are Minto Apartment REIT, InterRent REIT, Killam Apartment REIT and Dream Industrial REIT, which have also been under pressure. Allied Properties REIT had some positive news last week that was not rewarded by the market, selling their urban-data-centre portfolio in downtown Toronto for $1.35 billion, $118M above net asset value, which just further highlights the negative sentiment. Allied currently has a 8.4% yield. Choice Properties REIT, Canadian Tire REIT and Chartwell Retirement Residences are other REITs with strong portfolios in defensible sub-sectors.
For a specific example of the disconnect being seen, Dream Industrial REIT has had a weaker share price despite its strong fundamentals of market rent growth continuing to exceed inflation (supply is far behind demand in the industrial space). Further reading: Dream Industrial – GTA Property Tour Notes
Investors will have to be patient as the rate environment remains a major headwind. That said, we saw what a tone shift from Central Banks can do on the positive side earlier this year when the sector had a strong move in January. There will be some opportunistic pricing levels when the cycle turns, but we may be unlikely to see an inflow of funds into the space until the tightening cycle is over, which will require some patience. Healthier yields will provide some income in the meantime while investors wait for a turnaround.
In the meantime, this provides investors with opportunities to potentially offset future capital gains by crystalizing losses in these positions. By moving around in the space they could also add to quality names trading at more attractive valuations.
Further reading: Public Versus Private Real Estate Market Returns: Mean Reversion Opportunity?
The information contained herein was obtained from sources we believe to be reliable, but is not guaranteed by us and may be incomplete. The opinions expressed are based on our analysis and interpretation of this information and are not to be construed as a solicitation or offer to buy or sell the securities mentioned herein. The opinions expressed herein are those of the author and do not necessarily reflect those of National Bank Financial.
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