National Bank Financial analysts Matt Kornack and Tal Woolley say that if a sharp recovery emerges, these Top 10 REITS will materially outperform their class.
This report contains the result of our efforts to reset our forecasts, targets and ratings across the entirety of our coverage universe. This report also contains our first-quarter 2020 reporting season outlook. Put simply, first-quarter financials will not have nearly as much relevance as the individual outlooks each management team provides.
Liquidity needs look manageable across our public universe, especially since private markets have tended to employ higher leverage (making public players relatively safer credits in the industry). With the significant liquidity measures employed by central banks and CMHC (Canada Mortgage and Housing Corporation), we have heard from most management teams that lenders have been supportive when it comes to extending or refinancing debt.
For example, we have seen companies announce new credit facilities during mid March when the COVID-19 pandemic hurt the markets. For most of the REITs (Real Estate Investment Trusts) in our coverage universe, we see a viable path to meeting refinancing requirements, or having sufficient liquidity to bridge them for a period if credit tightens.
Liquidity is also coming from other non-traditional sources to help fund operational shortfalls. Beyond the traditional metrics of cash, undrawn credit and unencumbered asset pools, we are seeing some measures coming into place to help manage tenant difficulties. Various municipalities are allowing for 60-90 day deferrals on key REIT profit-and-loss expenses like property taxes.
Target prices reduced
We have made downward revisions across our entire universe, reducing target prices on average 19 per cent. This reduction is modestly understated, since some names reported in the fourth quarter of 2019, and later in March, were already adjusted for the new economic environment.
In terms of our approach, we have assumed that most REITs will be deferring rental payments from a fraction of their tenant rolls for a period of two months. The immediate impact of these deferrals on earnings, leverage or net asset value (NAV) is limited, since we expect management teams have accounted for tenant creditworthiness when granting deferral requests, meaning the incremental collectability provision on this deferred rental revenue is likely to be small. Whether these provisions have been sufficient will take longer for investors to find out.
We also have concerns that while April payment trends (for those who have disclosed them) look manageable, mounting economic fallout may mean May or June looks different. We have generally revised occupancy lower across the universe to reflect the increasing risk. We have also increased cap rates in our NAV (on average around 50 basis points) to reflect the rising cost of capital for industry participants, anticipating that we will see the transaction market adjust valuations to the “new normal”.
More resets likely
CBRE (Coldwell Banker Richard Ellis)—the commercial real estate services and investment firm—estimated cap rates increased 80 basis points from trough to peak during the 2008-2009 time frame (of the subprime mortgage crisis). We have also greatly reduced NAV premiums (increased discounts) to reflect higher leverage/liquidity risks near term.
This likely will be the first reset, not the last, given the sensitivity to the length of the economic shutdown. More important than deferrals is the future occupancy risk, since some tenants may not be granted deferrals (i.e., they were likely vacancy risks already) and the risk of tenant failure increases the longer the shutdown persists (finding replacement tenants will also be more difficult too).
We also believe that the cost of the economic shutdown is not linear with time: we believe it rises at an increasing rate the longer it goes on, due to the liquidity squeeze/failure risk for tenants.
Near-term liquidity looks adequate
All that said, we did not aim to be as bearish as possible, since near-term liquidity for the group looks adequate on average; domestically, it appears that pandemic mitigation efforts are having an impact; and governments and central banks have not hesitated providing economic stimulus.
If a sharp recovery emerges, we expect our Top 10 REITs below to materially outperform. We have one rating change in this report, and numerous downward target revisions. We have upgraded Boardwalk REIT (TSX—BEI.UN) to “outperform” from “sector perform”.
We are cognizant of the exposure to Alberta where the combined impact of an energy crisis and COVID-19 social distancing restrictions will have a harsh economic impact. That said, the REIT’s affordable housing focus, access to CMHC-insured financing, deep trading discount to replacement cost and solid liquidity position warrant an upgrade.
We previously had a bias in our recommendations to stronger balance sheets; as a result, our preferences have not changed that much in the current environment. Our Top 10 ideas by total return regardless of asset class: H&R REIT (TSX—HR.UN), RioCan REIT (TSX—REI.UN), Chartwell Retirement Residences (TSX—CSH.UN), Sienna Senior Living Inc. (TSX—SIA), Cominar REIT (TSX—CUF.UN), Automotive Properties REIT (TSX—APR), Canadian Apartment Properties REIT (TSX—CAR.UN), Boardwalk REIT (TSX—BEI.UN), Dream Industrial REIT (TSX—DIR.UN) and Tricon Capital Group Inc. (TSX—TCN).
Attractive long-term outlooks
The common threads with these stories are: names that were beaten down, along with the market, but have not participated to the same degree in the recent rally; and/or concentrated in asset classes or have tenant exposure that has easily identifiable near-term risks, but have far more attractive long-term outlooks (e.g., seniors housing/long-term care).
Cap rate expansion and occupancy impairment drive target price cuts. We have made broad adjustments to target prices across our coverage universe to account for our take on a new post-COVID normal. Multi-family (-16 per cent), industrial (-16 per cent) and retail (-17 per cent) were least impacted. The latter benefiting from single-tenant names, which we expect to outperform from an operations standpoint in light of strong counter-parties and long-term leases. Worst off were healthcare (-19 per cent), office (-23 per cent) and diversified (-30 per cent). Of note, even after our deep cuts to the diversified REIT target prices, they still offer the highest total return (+33 per cent) given drastic sell-offs in the component companies.
Half of the names in our top-10 by total return changed with the target price changes made in this document. The surviving incumbents are H&R, Sienna, Cominar, CAP REIT and Tricon, most of which have a “value” skew. New additions include RioCan, Chartwell, Automotive Properties, Boardwalk and Dream Industrial. Healthcare names figure prominently, given our relatively positive long-term outlook on this segment in spite of current COVID-19 noise and weaker recent trading performance. The only asset class not represented is office, with Allied Properties REIT (TSX—AP.UN) missing inclusion by a small margin.
Rent deferrals should not be significant
In going about our revisions, we endeavoured to take similar approaches across the stocks and asset classes. For our forecasts, we aimed to make some broader asset class assumptions on expected deferrals and future vacancy risk. For valuation, we made an assumption that we anticipate cap rates will rise across all of the asset classes. Here is what we found going through the process:
First off, rent deferrals are not significant in and of themselves for earnings-to-NAVs in the near term. Yes, financing rent deferrals for tenants will lift leverage, but financing a couple of months of rent missed on a fraction of base rent, will not create a dramatic rise in leverage for most names. The deferred rent will also not cause much earnings or NAV noise. The deferred rent will still get booked as income with a receivable offset.
Management teams will have to make an estimate with respect to the collectability of that rent and take a provision against it. That provision will get expensed in earnings and the NAV. Since we anticipate one of the guiding principles for landlords in granting deferrals will be creditworthiness, we suspect the provisions will not be that large.
The bottom line: investors should not expect a big “earnings signal” from the act of deferring rent itself in the short run—it will take months or longer to determine if the provisions taken were sufficient or not (i.e., if the deferred rent is not ultimately collectible, we will not discover that for months in the future, after it is written off). Investors may notice a negative “blip” in earnings with the provision, but if the rent is ultimately collected, there will be almost no impact on earnings-to-NAVs resulting from these deferrals.
We have made provision estimates for two-month deferrals in our forecasts for 2020, with a modest negative funds from operations (FFO) relative to NAV impact from them.
Future vacancy assumptions are important
Secondly, future vacancy assumptions matter more. The real value in understanding not just the volume of deferrals, but the percentage of requests granted, helps in determining future vacancy risk. If 10 per cent of your revenue sources are in need of deferrals, and you only granted relief to 70 per cent of the requested tenants, that implies that you are denying 30 per cent of the requests. By extension, you could assume that those denied are not likely to remain tenants, and you may have three per cent vacancy risk as a result.
Note that for the purposes of this analogy, exclude financially sound companies that may request deferrals that won’t be granted by landlords. The amount of time the economic shutdown lasts also matters a great deal. Early April data we are getting from some REITs looks manageable, but there is risk of these numbers deteriorating further in May.
The same would be true for June as well. Crudely speaking, a one per cent decrease in occupancy generally drives a -2 per cent or more revision to FFO per share forecasts on an annualized basis. Or put another way, if you are looking at an asset class like retail where same property net operating income tracks in the one-to-three per cent range, a one-to-three per cent occupancy hit will offset the growth in the rest of the portfolio.
Commercial vacancies could hit harder and sooner
We have assumed across most names, some deterioration in occupancy. The challenge with modeling it is that the vacancies on the commercial side tend to be “chunkier” (e.g., if a national retail chain folds), so the impact may not be as gradual as modeled.
Thirdly, future cap rate assumptions matter a great deal. Again, across most names we have assumed in our NAV estimates some degree of cap rate expansion. We concede this is early: with transactions scarce in the short run, it will take time to get confirmation from brokerage activity where cap rates ultimately settle out.
Across all classes, CBRE estimated that cap rates expanded on average up 121 basis points from peak to trough (on average) through the last financial crisis. We also think that investors have been sympathetic to the view that cap rates declined, as REITs’ costs of capital (both debt and equity) declined in recent years. It makes sense that cap rates should expand: the cost of equity has risen, and the cost of debt, while helped by the fall in the Government of Canada’s 10-year bond rates, is likely still rising while credit spreads increase (e.g., CBRE has been reporting that it estimates floor rates of four per cent are happening on new mortgages).
Again, the longer this shutdown lasts, the more concerned we remain about credit spreads. We have assumed something smaller than the trough-to-peak cap rate expansion seen last crisis, prospects still remain for a V-shaped recovery; however, that could change over time.
Lastly liquidity and leverage risks must be recognized in valuations. We argued in previous reports that leverage risks were not being priced into stocks very efficiently, that investors were focusing primarily on SPNOI (Same Property Net Operating Income) growth as there was almost no correlation between leverage and valuation. (We would expect to see some kind of negative correlation: levered price-to-FFO multiples should be higher for those with less leverage, all else equal).
We think that since credit markets are far less liquid now and the state of uncertainty in the economy, balance sheet strength should come back into vogue. Of paramount importance in the short run is liquidity.
Matt Kornack and Tal Woolley are equity analysts for National Bank Financial. They cover real estate companies for the bank. Both are based in Toronto.
This is an edited version of an article that was originally published for subscribers in theApril 24, 2020, issue of Investor’s Digest of Canada. You can profit from the award-winning advice subscribers receive regularly in Investor’s Digest of Canada.
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