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H&R REIT and a consortium led by KingSett Capital acquired Primaris Retail REIT, owner of such properties as Kelowna, B.C.’s Orchard Park Shopping Centre, the biggest M&A deal in Canada in 2013, as of May 1.
H&R REIT and a consortium led by KingSett Capital acquired Primaris Retail REIT, owner of such properties as Kelowna, B.C.’s Orchard Park Shopping Centre, the biggest M&A deal in Canada in 2013, as of May 1.

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

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.

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