Did Loblaw just call a long-term top in the REIT market? Admittedly, that was our first thought. But a look at the numbers suggests that the rally in the sector is not threatened by current valuation levels and remains attractive.
The industry standard for valuation in the REIT sector is Adjusted Funds From Operations (AFFO) yield – essentially, operating profits after property maintenance costs – divided by the unit price. For individual REITs, the AFFO yield provides an important indication of how much cash flow an investor will likely receive for each unit purchased.
To assess valuations – the degree of cheapness – in the sector as a whole, AFFO yields are compared with Government of Canada bond yields. As an example, an REIT with an AFFO yield of 8 per cent would be extremely attractive now, given that its yield is 6.3 per cent higher than government bond yields. By contrast, that REIT would be a terrible investment in 1995, when 10-year government bonds paid more than 9 per cent.
The chart at left shows the market cap-weighted average AFFO yield for the 10 companies in the S&P/TSX REIT index where data was available, compared with the 10-year Government of Canada bond yield. (For those keeping score at home, they are Riocan, H&R, Dundee, CanREIT, Calloway, Cominar, Boardwalk, Canadian Apartment, Allied Properties, Chartwell Seniors Housing, and Crombie).
By this measure, there appears little reason for concern. The difference between AFFO and bond yields is actually rising – increasing the relative value of the REIT sector – as government bond yields continue their decline.
Loblaw's management has proven adept at managing the company's real estate holdings but investors should not interpret recent developments as a sign of impending doom in the REIT sector. Valuations remain attractive relative to bond yields and investors can feel confident in selectively adding to holdings.
Scott Barlow