The real estate and REIT sector has been extremely popular among Canadian investors since the financial crisis, not least because they’ve offered competitive cash flow for income-oriented portfolios.
In 2022, however, the S&P/TSX Composite Real Estate Industry Group Index has dropped 20.8 per cent so far. Jenny Ma, an analyst at BMO Capital Markets, recently cut price targets for 13 real estate investment trusts in her 2023 outlook report while warning investors to temper their expectations for the year. Real estate investments may not be so popular by the beginning of 2024.
Ms. Ma entitled her year ahead report Something’s Gotta Give. This refers to a valuation divergence that the analyst believes will be resolved during 2023.
“Our coverage is trading at a weighted average net asset value discount of 11 per cent,” she wrote. “This suggests an attractive entry point when compared to the long-term average discount of 0.9 per cent.” On the other hand, she added, AFFO yield spreads are “well below” the long-term average, and the outlook for earnings growth through 2024 is “relatively muted.”
(AFFO stands for adjusted funds from operations; for yield spreads, Ms. Ma is comparing 10-year government of Canada bonds with BBB-rated corporate bonds.)
The situation is somewhat equivalent to a stock trading cheaply on price-to-book value but prohibitively expensive on price-to-earnings and price-to-cash-flow. By slashing her REITs’ price targets and emphasizing the muted outlook for earnings growth, the analyst is suggesting the valuation divergence will be settled in favour of AFFO yield. In other words, unit prices are unlikely to grow significantly.
The rise in bond yields are the problem for REIT investors. At the beginning of 2019, for instance, the dividend yield of the real estate index was 4.34 per cent, 2.9 percentage points higher than the 10-year bond yield. Now, however, the index’s 3.84 per cent yield is only one percentage point higher than the 10-year bond. The safety of government bond yields is now far more attractive relative to real estate investments.
Ms. Ma’s top investment ideas for 2023 include the relatively defensive residential REIT space with InterRent REIT and Boardwalk REIT. She also likes Crombie REIT and H&R REIT.
— Scott Barlow, Globe and Mail market strategist
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