Westmount Retirement Residence, a seniors housing property owned by Chartwell Retirement Residences REIT, opened in 2012. The property overlooks the Laurentian Wetland.Jennifer Lewington/The Globe and Mail
Real estate investment trusts are due for a rally, according to an analyst at GMP Securities Inc.
Research by GMP said REITs have been trading at around an 11-per-cent discount to their underlying property values. REIT prices have uncharacteristically been tracking bond yields over the past two months, according to GMP. But for the better part of this year, there was an inverse correlation between bond yields and REIT prices – when one goes up, the other goes down.
Following the beating the markets took starting last Friday, Jimmy Shan, managing director of real estate equity research, said that discount could have grown. He added REIT prices won't be tracking bond yield prices for long, and it's about time REITs experience a rally.
"We're approaching that bottom again," Mr. Shan said, recalling when a rate hike scare in May, 2013, triggered a sector selloff, around the last time REITs traded above their net asset value. "Except for the fact that I don't think anyone is expecting rates to rise." The sector sold off with energy from November, 2014, and even while interest rates were falling.
In an analyst note earlier this week, Dundee Capital Markets said the TSX Capped REIT index, on a price basis, is down almost 12 per cent since April and two per cent for the year. "We feel this is somewhat irrational as the sector is now trading at a 10-per-cent discount to NAV," the Aug. 24 note read.
Frederic Blondeau, head of real estate research at Dundee, said there is a disconnect between what's going on in the direct property market and what's going on with REIT prices. He said private investors and pension funds have been plowing capital into the direct property market, which shouldn't translate into REITs trading lower.
"Given the current interest rate environment/outlook and the strong fund flows in the direct property market, REITs shouldn't trade at such a discount," Mr. Blondeau said. "We should see it more as a safe haven – a conservative sector where you can hide from what's going on in the resource sector or in the commodities sector." Mr. Blondeau added his firm is favouring sectors such as multi-family, senior living and industrial because they offer more stability and better fundamentals.
There was a time in 2012 when 11 REITs produced an average yield of more than 7 per cent; around the same time they were trading above net asset value. Today, there are about 25 REITs that have an average yield of more than 7 per cent – about a 9.5-per-cent earnings yield by GMP's measure – while Government of Canada 10-year bonds are sitting on a yield of about 1.4 per cent.
"At some point people are going to look at this and say, 'the sector is trading at 12-per-cent [discount] to what it's worth,' " Mr. Shan said in an interview last week. "It has a big attractive yield relative to where the 10-year Government of Canada bond yield is – that spread between the REIT yield versus the 10-year bond yield is historically high.
"They're trading like [10-year] Greece bonds [compared to 10-year U.S. Treasuries]."
Because the whole sector has been sold off, investors can't go wrong with their picks, according to Mr. Shan. He pointed to REITs with exposure to Alberta apartments like Boardwalk REIT and Mainstreet Equity Corp.; REITs with exposure to the U.S., including Slate Retail REIT, Pure Multi-Family REIT LP, Agellan Commercial REIT and Milestone Apartments REIT; and REITs with exposure to Europe – where property values are going up and the euro is strengthening against the Canadian dollar – including Inovalis REIT and Dream Global REIT. He also mentioned smaller names including InterRent REIT and Amica.
REITs have historically been viewed by the market as interest-rate sensitive. So while they offer stable income, and are considered bond-like for that, a competing fixed government bond with rising yields would likely make REITs look less attractive.
Mr. Shan said discounts as wide as they are now produce likely take-out scenarios, where buyers see huge bargains for underlying properties that are worth more than what the REIT stock suggests. And while take over activity has been below market observers' expectations, it shouldn't take much to draw attention back.
"If we see one or two more M&A transactions, that's going to get people's attention," Mr. Shan said. "Based on fundamental reasons, they shouldn't be trading where they are trading today.
"At some point, the sector is going to have to bounce back."