The REIT market was not spared in the March sell-off as investors rushed to hit the sell button while the world’s economies shut down to fight the spread of COVID-19. The benchmark Canadian REIT index (S&P/ TSX Capped REIT Index) tumbled over 46% from its February highs to its March lows. As I write that number, -46%, it is still hard to fathom that almost half of the index value was wiped out in such a short period of time. But with big sell-offs come big opportunities.
The two most common valuation techniques for REITS are price-to-net asset value (NAV - the value of the underlying real estate minus liabilities) and the adjusted funds from operations multiple (AFFO). Currently, the REIT sector is trading between a 20% to 30% discount to NAV and has fallen as low as 40%. Historically, the sector trades in a band from a 15% discount up to a 10% premium. AFFO multiples have also contracted as the market fears the deferral of rent collection will lead to lower funds from operations.
The focus on percentage of rent collected per month, which most REITS are now reporting on a monthly basis, is not something that we are getting too hung up on. It’s nice to see where rent is being paid and where it isn’t, but this is short-term thinking and real estate is a long-term game. It’s been said that the biggest flaws to REITs is that they are valued daily and real estate is not something that should or can be correctly valued on a day-to-day basis.
The REIT market has matured over the years. Sector-focused REITS now dominate listings and diversified REITS are few and far between. As the market has started to recover, certain subsectors have performed much better than others. It should not be surprising that money has flowed into subsectors that have had strong rent collection and perceived strong demand for their asset class.
Multi-Family (apartment rentals) and Industrial real estate have led the way. People need places to live and the rental market in most major Canadian cities is still very tight. Occupancy rates for Canadian REIT landlords is currently about 97% with average monthly rents well below market averages. Upon turnover (which has slowed during the pandemic), multi-family REITs are likely to pick up some rent growth. Society’s reliance on ecommerce and certain supply-chain disruptions brought on by the shutdown have shone a new spotlight on the importance of industrial warehousing and that subsector has performed very well in recent months.
Office REITS have experienced strong rent collections but have not performed as well as other sectors as the debate continues as to what office space will look like in a post COVID-19 world. The Toronto office market still has very low vacancy rates and office REITs are suggesting that lease terminations will be low. Some will even be welcomed as they may be replaced with higher rents. The Toronto office vacancy rate was 2.0% in the first quarter versus the historical average of 6.9%. Montreal and Vancouver were similarly well below average. The tight supply and longer-term nature of the leases can lead to big leasing spreads.
The subsectors that have struggled the most are Hotel/Hospitality and Seniors. It is no surprise that hotels have struggled as revenues basically went to zero for a few months and it will be a long road back for both business and personal travel. Seniors housing has seen major pressure from increased costs for PPE and staffing, a lack of new tenants entering and a political firestorm for mismanagement in long-term care facilities.
Finally, I want to touch on Retail; the retail sector in Canada is made of power centres and small grocery anchored plazas. There are no listed mall REITS, which face a different set of issues then the power centres, which tend to have strong lead tenants rounded out by other essential-service tenants. Many of these listed REITS also have redevelopment opportunities, which the market is not attributing any value to. There are some pressures with tenant bankruptcies and the changing retail landscape, but we feel the rewards outweigh the risks in many cases.
The majority of listed REITS have strong balance sheets and ample liquidity to ride out the business disruption that has occurred during the last few months. As we return to the norm and investors look for income in this world of zero interest rates, we believe this will be a driving force back into the sector. REITS will also be able to refinance at better terms which will further strengthen their balance sheets.
We have not seen real asset values decline during the pandemic and take comfort in the fact that private equity firms have raised billions of dollars for real estate investments. That money is currently on the sidelines, waiting to be deployed, and should act as a stop for real asset values. The REIT sector has lagged the broader market rebound and remains attractive, especially on a long-term basis, which is why we continue to add to our weightings in our institutional income funds.
- Michael McNabb is an Analyst and Trader at Purpose Investments who specializes in real estate