Volatile today, stable tomorrow

CIBC has introduced a quarterly preview of our office, seniors housing and diversified real estate coverage. In opening, we believe the current sell-off could prove an attractive long-term entry point, although property and stock valuations will remain under pressure until the picture on inflation and possible recession becomes clearer.


These REITs are volatile today but will stabilize

We recently ran sensitivity analyses under both recession and stagflation scenarios; we generally found potential FFO (funds from operations) impact to be in the mid-single to low-double digits under these scenarios, respectively.

As such, we have broadly reduced our price targets across our coverage universe to align with historical price-to-NAV (net asset value) averages, and have thusly embedded modest discounts for the retail, office and seniors housing REITs, and NAV parity for industrial and apartment REITs.

In the current rising rate environment, we believe that market concerns on refinancing risk are overstated: well-laddered maturities and the fact that most debt currently maturing was initiated at interest rates similar to current levels indicate that the impact of rising rates on FFO should be modest for our coverage.

We have observed the work-from-office versus work-from-home discussion evolve from talk on issues such as collaboration, team building and culture, to harder issues such as compensation growth, career progression, mentorship and senior managements leading by example.

Best picks for office REITs

Office properties best positioned for the hybrid work world are those that can help employers attract and retain employees – this means buildings that are bright, open, flexible, environmentally focused and well located near transit and amenities.

This contributes to ongoing market bifurcation, with differentiated product outperforming more commoditized and environmentally archaic product; we favour Allied Properties REIT (TSX—AP.UN) and Dream Office REIT (TSX—D.UN).

What has “outperformer”-rated, $47.50 per-unit target Allied Properties been up to in the recent quarter? On May 24, Allied Properties REIT announced the appointment of Hazel Claxton to the board. This addition is part of a broader board renewal plan outlined by Allied.

Ms. Claxton is a board member of TELUS Corp., the University Pension Plan Ontario and Unity Health Toronto. On June 15, Allied Properties REIT and RioCan REIT announced that the office portion of The Well (an ambitious mixed-use endeavor in downtown Toronto) is 98 per cent leased and the retail portion is 66 per cent leased. The retail segment is expected to open in mid-2023.

Our $47.50 price target (from $50) reflects a five per cent discount to our NAV (net asset value) estimate, assuming cap rates of 5.25 per cent on office and 4.75 per cent on data centres, based on 2023 NOI (net operating income) estimates; this equates to 18.1 times estimated 2023 FFO.

Company-specific risks include fluctuations in occupancy levels; or the diversion of investors’ capital flows away from high-yielding real estate equities toward other asset classes, and the functional obsolescence of real estate

How will “outperformer” Dream Office REIT reach its $27-per share price target? On May 18, Dream Office REIT announced that it received a Platinum Level award by the Green Lease Leader program. This award builds on the Gold level it achieved last year, in recognition of its advancements in building energy-reduction goals. Dream Office is one of the few applicants to receive the Platinum award, due to its sustainability training, utility data tracking and sharing, cost recovery for capital improvements, and building resilience.

We forecast FFO per unit of $0.40 for the second quarter, in line with consensus. We foresee no material changes to long-term return-to-office plans, leaving our bullish thesis intact. We expect to see continued strong leasing spreads in the Toronto area, dragged down by the REIT’s relatively small secondary markets.

Our $27 price target (from $28.50) reflects a five per cent discount to our $28.50 NAV estimate and equates to 14.7 times 2023 estimated FFO.

There are risks associated with the REIT’s significant 12 per cent ownership stake in Dream Industrial REIT, including the REIT’s exposure to a real estate asset class with different market dynamics and operating risks; dilution of the REIT’s exposure to the office asset class (downtown Toronto in particular); and, investors’ possible preference to gain exposure to the industrial real estate market through direct investment in a pure-play REIT (including Dream Industrial REIT itself).

Senior pick for senior housing

Seniors housing, meanwhile, requires a longer-term investment horizon. The lingering pandemic continues to weigh on occupancy and rate growth, compounded by labour availability issues and inflation, and thus pressuring operating margins. Looking through the current turmoil, long-term fundamentals for seniors housing remain sound, bolstered by strong demographic tailwinds. We favour Chartwell Retirement Residences (TSX—CSH.UN) for its 100 per cent exposure to private-pay retirement residence.

How will “outperformer” Chartwell Retirement Residences REIT reach its $14.25 per-unit target? Our $0.14 second-quarter FFO-per unit estimate is slightly above $0.13 consensus. We will look for updates on projects under development as well as those that have been deferred to determine what impact the pandemic has had on timing. We will also look for updates on any initiatives management has to increase occupancy levels.

Our 12- to 18-month price target of $14.25 per unit (from $15) reflects a five per cent discount to our one-year forward NAV of $15. Key risks include real estate industry risk, changes in government healthcare funding policy, competition risk, interest rate risks, failure to raise capital,changes in taxation or ownership rules, litigation risks, operating risks, including labour disruptions, and capital markets risks. We note that the multiple classes of units retain equal voting rights, thus limiting the governance issues that typically arise from dual class ownership.

This is an edited version of an article that was originally published for subscribers in the August 19, 2022, issue of Investor’s Digest of Canada. You can profit from the award-winning advice subscribers receive regularly in Investor’s Digest of Canada.

Investor’s Digest of Canada, MPL Communications Inc.
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