Compared with Canaccord Genuity, which earlier this week forecast double-digit returns for Canadian real estate investment trusts this year, CIBC World Markets is almost sounding downbeat.
In its own outlook for the REIT sector today, CIBC forecast total returns – including distributions – of zero per cent to 10 per cent.
Such a wide forecast, if not overly insightful, at least runs a good chance of coming true. It also highlights the importance of selecting REITs that can hold up well in a new environment of higher interest rates.
Key to its forecast is that CIBC thinks the Canadian REIT market has reached the end of a 20-year era of falling interest rates and – consequently – stellar returns. In the last 15 years, Canadian REITs delivered an impressive average compound annual return of 13 per cent – some 700 basis points higher than the TSX composite index per year.
But now, CIBC believes, we're in the dawn of a new era, where interest rates will no longer be declining. It'll have a profound impact on the REIT market, characterized, it says, by:
- Less competitive cost of capital and reduced effectiveness of acquisition growth;
- Potentially lower funds from operations and adjusted funds from operations growth as refinancing benefits diminish;
- A reduced frequency and magnitude of REIT distribution increases in the near term;
- Increased focus on value-add, development and redevelopment growth strategies;
- Competitive strategic advantage in more flexible capital structures and payout ratios.
In such an environment, the most successful Canadian REITs will be those with the financial flexibility and expertise to come up with alternative growth strategies.
"In a sense, we are changing our view from having supported the Canadian REIT model, to now advocating the adoption of a U.S. REIT model for Canadian REITs," explained the CIBC analysts, led by Alex Avery.
"From a strategic perspective, we would characterize the U.S. model as more focused on 'alpha' growth strategies, while the Canadian REIT model has traditionally focused on 'beta' growth strategies. We view spread investing as a beta strategy (amplifying positive industry trends), well suited to a declining rate/improving fundamentals environment. We would describe value-add, development and redevelopment strategies as alpha strategies, largely independent of broader market conditions," they said in a research note.
"Whereas the success of beta strategies are maximized by high leverage and high payout ratios (optimizing cost and access to capital), alpha strategies require more flexible capital structures and payout ratios, to allow for the short-term volatility in AFFO (adjusted funds from operations) often produced by alpha strategies," they added.
So which REITs are already positioned for this new era? CIBC listed these five, and provided the following commentary:
"Allied Properties REIT has intentionally pursued a much more flexible capital structure and payout ratio over the past five years in light of the very large magnitude of development, redevelopment and intensification opportunities in its portfolio. The REIT has been highly active in pursuing development and redevelopment opportunities, with book value of properties under development at 6.4 per cent of assets, and a number of additional properties currently classified as operating properties pending commencement of redevelopment.
Boardwalk REIT has adopted a conservative capital structure and payout ratio over the past 10 years, taking advantage of strong growth in its core Alberta markets, which drove considerable internal NOI growth. The REIT has maintained a conservative and cautious approach to capital investments over the last several years, with virtually no property acquisitions, just a handful of dispositions, and quite limited capital investment in development opportunities, while it has invested considerably in capital improvements to its existing operating properties. Properties under development represent 0.3 per cent of assets, and the REIT has a few future development sites under consideration, potentially aggregating roughly 2 per cent of assets (our estimate). With $144-million of cash (~$2.75 per unit), the REIT is well positioned to pursue future opportunities, if desired.
Canadian Real Estate Investment Trust is one of Canada's oldest REITs, having first been listed on the TSX in 1993, and has maintained a very conservative approach to all aspects of its business for more than a decade. The REIT has been less active than many other Canadian REITs in pursuing accretive acquisition growth, while maintaining a consistent program of investing in new developments through mezzanine loan agreements, typically with purchase rights upon completion. The REIT's investments in property under development aggregate 1.6 per cent of assets, with an additional 5.7 per cent of assets invested in mortgages receivable, including mezzanine loans, vendor financing and co–owner financing. While the mezzanine loans primarily finance property developments, the loan structure typically secures rights to acquire completed developments on market terms, rather than providing participation in value created through the development process.
Granite REIT is the newest of the five REITs, having recently converted (January 2013) from a corporation to a REIT. It carries a conservative capital structure and payout ratio as a result of its previous relationship and common controlling ownership with Magna International, which remains its largest tenant at 87 per cent of annual rent (though no ownership interest remains).
The REIT's strategic priorities include diversifying its tenant base, and divesting of some of its more specialized properties, preferring more generic industrial formats. Reflecting its recent REIT conversion and other strategic priorities, Granite's development assets represent 1 per cent of assets. With exceptionally low leverage, Granite is well positioned to take advantage of any development, redevelopment or value–add investment opportunities that may arise.
Northern Property REIT has consistently maintained a conservative capital structure and payout ratio since its IPO in 2002, partly reflecting the unique original focus of the REIT on smaller far–north markets. This conservatism continues to be a core component of the REIT's strategy, and leverage was reduced further in 2012 with the sale of ~$200-million of non-strategic assets.
While most of this capital has been re-deployed, the REIT continues to carry well below average leverage and a below-average payout ratio. Northern has been among the more active developers of property, particularly in smaller markets where the REIT is a large or dominant landlord. Development assets represented 1.5 per cent of assets at Q3/13, down from 2.8 per cent at Q2/12 following Q3/13 completions in Iqaluit and Regina. We expect further construction starts to increase development assets over the next several quarters."