5 real estate names to buy as bond yields turn nasty for REITs

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Inside the Market's roundup of some of today's key analyst actions. This post will be updated with more analyst commentary during the trading day.

Given that the S&P/TSX Capped REIT index has fallen nearly 10 per cent since long-term bond yields began ticking up on May 21, it's not too surprising to see that Canaccord Genuity this morning is slashing its price targets across the board on players in the Canadian real estate sector.

The cuts aren't drastic – they average about 5 per cent – and the newly revised targets still suggest healthy double-digit returns for most names in the sector over the next year.

More interesting is that Canaccord analysts have done a historical study on the REIT sector in the U.S. to see how it performed in times of rising long-term interest rates.

Their conclusion: rising long-term rates do hurt REIT valuations, but when accompanied with strong inflation, the investment vehicles do well and outperform the broad market.

The problem here is that Canaccord analysts (and the majority of market observers) aren't expecting a surge in inflation over the next couple of years.

That leaves Canaccord with two likely scenarios: 1) bond yields will remain flat or decline – a positive for REIT valuations, or 2) long-term bond yields will rise further in a low inflation environment – which would be extremely negative for REIT valuations.

But REIT investors may not have a lot to fear – at least so far. Over the past 10 years, there have been a number of pullbacks in Canadian REIT unit prices, almost always coinciding with an increase in long-term interest rates. In each instance, bond yields subsequently dropped and REIT unit prices recovered, Canaccord notes.

That said, the analysts believe that even if yields hold steady or fall back a bit, the prospect of higher rates will be weighing on investors' minds and keep a lid on REIT unit prices for the remainder of the year.

That makes REIT selection particularly important right now.

"Clearly, if long-term bond yields remain at current levels the entire sector should perform well, and we would favour those REITs that are trading at the biggest discounts to net asset value," the Canaccord analysts, lead by Mark Rothschild, said. "Alternatively, should interest rates rise without a corresponding increase in inflation, those REITs with long-term leases, defensive portfolios and strong balance sheets should outperform."

Under Canaccord's two most likely scenarios, it sees five real estate income trusts or real estate operating companies outperforming: First Capital Realty, H&R REIT, InterRent REIT, Killam Properties and Pure Industrial REIT.

Here's the breakdown of what Canaccord had to say about each:

First Capital Realty's share price has fallen by 6 per cent since May 21. FCR boasts the highest-quality portfolio of retail assets among the retail REITs/REOC, and has been steadily paying down debt and reducing its leverage over the past few years. With a substantial portfolio of unencumbered assets, strong balance sheet, and a pipeline of development opportunities expected to drive future growth, we expect First Capital to perform well in an environment of rising interest rates. Our $19.60 (Canadian) target price, combined with an annualized dividend of $0.84 per share equates to a 12-month forecast total return of 11 per cent.

H&R REIT's unit price has fallen by 9 per cent since May 21, and the REIT's units currently trade at an 8.6 per cent discount to our estimate of NAV, and 13.8x our 2014 estimate of AFFO per unit. The REIT owns a portfolio of high quality assets (including flagship AAA assets such as The Bow in Calgary and a one-third interest in Scotia Plaza in Toronto), with long-term leases to credit worthy tenants. Additionally, the REIT boasts a long-term debt profile and many of its properties are leased on a long-term basis.

Combined with an annualized distribution of $1.35 per unit, our target price of $25.75 (Canadian) equates to a 12-month forecast total return of 21 per cent.

InterRent REIT's unit price has fallen by 14 per cent since May 21, the most severe drop within our coverage universe. Despite posting sector-leading same-property net operating income growth which has also driven strong growth in cash flow per unit, InterRent's units currently trade at a steep 22 per cent discount to our estimate of NAV. The REIT's 4.7-year weighted average debt term to maturity is among the longest for multi-family REITs/REOCs under coverage, providing some protection from rising interest rates. We also note that, with the benefit of CMHC-insured debt financing, InterRent should have ample access to debt capital. Our $7.15 (Canadian) target price, combined with an annual distribution of $0.20 per unit equates to a 12-month forecast total return of 32 per cent.

Killam Properties' share price has fallen by 11 per cent since May 21, and currently trades at a 19 per cent discount to NAV. Despite a relatively short weighted average term to maturity of 3.4 years, Killam's weighted average in-place interest rate is 4.45 per cent, the highest among multi-family REITs/REOCs. In a rising interest rate environment, we expect that Killam's high in-place average cost of debt would still allow the company to realize interest rate savings when refinancing, while many of its peers could be refinancing maturing debt at higher rates. Combined with an annualized dividend of $0.56 per share, our target price of $13.60 (Canadian) equates to a 12-month forecast total return of 29 per cent.

Pure Industrial REIT's unit price has fallen by 11 per cent since May 21, and is, in our view, compelling at current levels. The REIT's units trade at a 17 per cent discount to our estimate of NAV, and at a 2014E AFFO multiple of only 11.9x, among the lowest within our coverage universe. Industrial fundamentals remain strong, and we believe that Pure is well positioned relative to its peers. Combined with an annual distribution of $0.31 per unit, our target price of $5.70 (Canadian) equates to a 12-month forecast total return of 31 per cent.

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CIBC World Markets upgraded WestJet Airlines Ltd. to "sector outperformer" from "sector performer," noting that the stock has lost significant altitude since first-quarter results were reported in early May.

That has made the stock more attractive based on valuation metrics. But analyst Kevin Chiang also tied the upgrade to the company's "compelling growth story."

"Over the last 12 to 18 months, WestJet has outlined its growth strategy (to be rolled out over the balance of this decade), including premium economy, fare bundling, the launch of Encore later this month, and partnership agreements with other airlines," he said. "While there are concerns that WJA is adding a significant amount of new capacity, we do not believe this is a sign that irrational pricing will return. WJA and AC.B are growing capacity in different markets and both carriers have significant flexibility around fleet expansion plans.

"WJA's focus will be on execution, and so far it is progressing smoothly. Premium economy has been rolled out and WestJet's IT upgrade is complete. And looking back, this company has successfully executed on some of its more recent growth platforms, including WestJet Vacations."

Target: Mr. Chiang maintained a $27 price target. The average target among analysts is $27.20, according to Bloomberg data.

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RBC Dominion Security downgraded U.S. insurer Prudential Financial Inc. to "outperform" from a "top pick" rating.

RBC analyst Eric N. Berg is still bullish on the stock, but notes that it has been among the strongest performers among U.S. insurance companies since November of last year.

"We still see substantial, long-term upside to the stock as large companies across corporate America slowly look to transfer their liabilities to emerging leaders in this growing market like Prudential," he said.

Target: Mr. Berg maintained a $92 (U.S.) price target. The average target is $75.26.

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Surge Energy Inc.'s decision to buy a crude oil producing asset in Saskatchewan and convert to an income-producing company is largely winning applause from analysts, who note that a new equity financing will help sustain the dividend.

"In our view, Surge has laid out a solid foundation for its dividend payout, with a reduced 25 per cent decline rate and a much stronger balance sheet following the asset acquisition, which was effectively financed with shares through the equity offering," commented Desjardins Securities analyst Tim Murray.

"Although market appetite for yield may have tempered slightly in recent weeks, with bond yields finally showing sparks of life, we believe Surge's transition into a dividend payer will be rewarded by investors as the company rapidly emerges into one of the premier small-cap dividend players in the sector."

Target: Mr. Murray maintained a "buy" rating but sliced his price target by $1 to $7.50. The average target is $6.45.

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A downturn in spot metallurgical coal prices has prompted Dundee Securities analyst Joseph Gallucci to downgrade Cardero Resource Corp. to "neutral" from "buy."

Dundee earlier this week cut its outlook on coal prices, citing recent signs of a slowdown in the Chinese economy.

Mr. Gallucci sees little upside right now in Cardero, a Vancouver-based mining company focused on the Carbon Creek metallurgical coal project in northeastern British Columbia, given that it has "very large financing needs in an extremely difficult environment."

But once it secures financing and resolves port issues, Mr. Gallucci believes the Carbon Creek asset will be a prime takeover target due to its location and production profile.

Target: Mr. Gallucci maintained a 70-cents-per-share price target. The average target is 85 cents.

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General Dynamics Corp. has the potential to raise both its dividend payout and share buybacks to match its peers, which would boost investor interest and earnings per share estimates, said RBC Dominion Securities analyst Robert Stallard.

With the stock trading at 11 times estimated 2014 earnings per share, he thinks the market is valuing it solely as a defence company, a sector facing big government spending cuts. But its aerospace division should contribute almost 50 per cent of its earnings before interest and taxes by 2015.

"On a sum of the parts basis, we think GD has the potential for a positive re-rating as the business jet outlook improves, and the company steps up the cash deployment," he said.

Target: Mr. Stallard raised his price target to $86 (U.S.) from $81 and reiterated an "outperform" rating. The average target is $79.08.

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For more analyst actions, breaking investing news and analysis, follow Darcy Keith on Twitter at @ eyeonequities