MARKET OUTLOOK:

In spite of surging inflationary readings across both Canadian and U.S. consumer price indices, policymakers have delayed raising interest rates in response to headwinds challenging the global recovery, namely the Omicron variant continuing to hinder economic activity and cloud prospects for global growth. 

The market is further challenged by the U.S. Federal Open Market Committee announcing at its January 26th meeting that it would accelerate shrinking the Fed’s balance sheet, placing upward pressure on bond yields and causing a broad sell-off of North American equities.

Notwithstanding macroeconomic forces and the risk of war on the European continent, fundamentals that dictate the prospect of publicly-traded real estate securities remain strong, suggesting the recent indiscriminate pullback in share prices have left select REITs/REOCs trading significantly below the net asset value at which they would be appraised in the private market.

The REIT sector has generally served as an effective hedge against inflation, benefiting twofold from growing cash flows as operators mark rents to market and underlying property values appreciating to reflect the higher replacement cost of new developments.

Applying this assessment to the broad asset class may prove inappropriate, as pricing power attributable to tight supply-demand dynamics must be present to realize rent growth. Property types such as multi-family apartments and self-storage also benefit from short lease durations, allowing for a faster conversion of existing tenants to market rents.

REIT balance sheets remain healthy in the face of an imminent liftoff of interest rates, refreshing the false narrative that rising borrowing costs disadvantage the sector. A record-low interest expense ratio and opportunistic refinancing to extend REIT terms to maturity have stabilized key expenses, as upward earnings revisions for REITs benefiting from favourable fundamentals continue unabated.

A $364 billion wall of capital earmarked for real estate continues to underpin property valuations as M&A transaction volumes remain at elevated levels.

TOP PICKS:

Boardwalk REIT (BEI-U TSX)
With the price of oil rebounding and several new technology firms announcing expansions into the REIT’s core markets of Calgary and Edmonton, the outlook for a complete removal of tenant concessions where the majority of NOI is generated is increasingly likely. 

Additionally, management has indicated that the occupancy trajectory of the REIT is on track to improve to 97 per cent in 2022, positioning its portfolio to realize outsized FFO growth in 2022, as rents are marked-to-market. 

Finally, recent private market transactions indicate a significant mispricing of the REIT’s units, which may lead to cap rate compression in future appraisals. Combining all four catalysts have the potential to increase the near-term NAV per unit of BEI to $74.

Dream Industrial REIT (DIR-U TSX)
The REIT’s focus on “last-mile” urban logistics space is well-suited to meet the growing needs of e-commerce distribution as consumers shift towards a sustained increase in online shopping on a long-term basis. As a result, same-property NOI, on a constant currency basis, grew by 7.5 per cent year-over-year in Q3 2021 as pricing power persists in historically tight supply-demand conditions. 

A key differentiator for DIR is its presence in mainland Europe, a market with limited supply sites, compounded by complex zoning laws that may inhibit development. European consumers have significantly lagged the U.S. in its adoption of e-commerce to date, and as their economic activity in this space accelerates, so to should upward pressure on industrial rents. 

The REIT also benefits from a relative borrowing advantage as European interest rates remain anchored well below North America, which has resulted in DIR operating with a weighted average interest rate below 0.86 per cent reported at the end of Q3. 

Today, we estimate DIR trades at a 16 per cent discount to its NAV, whereas its U.S.-listed peers trade at a significant premium.

StorageVault Canada (SVI TSX)
The investment thesis for StorageVault is based on two primary principles: (i) an attractive cash flow profile that is both high-growth and low in maintenance capital; and, (ii) the ability to accretively consolidate the industry’s ownership base. 

StorageVault’s third quarter results highlighted this high growth cash flow profile as same-property revenue increased 23 per cent year-over-year and AFFO or free cash flow increased 46 per cent. The month-to-month nature of StorageVault’s leases allows the company to raise rents in response to the current inflationary environment much faster than traditional property types with longer term leases. 

Canada has about 70 per cent less storage space per capita relative to the U.S., a key factor underlying the company’s strong rent growth profile. This free cash flow is also being used to consolidate ownership within the industry. Despite StorageVault’s significant asset base, the company still represents only 5 per cent of the Canadian market. 

The top 10 owners combined hold only 15 per cent market share in Canada. There remains a large opportunity for StorageVault to acquire smaller operators and improve the profitability of their assets through leveraging the economies of scale of StorageVault’s operating model.

The corporation’s current implied cap rate of 4.7 per cent is well above U.S. portfolios transacting from 3.1 per cent to 4.0 per cent, and should compress as the Canadian industry continues to mature. Closing the gap would imply a share price over 30 per cent higher.

PAST PICKS: January 28, 2021

BSR REIT (HOM-U TSX) 

• Then: $14.22
• Now: $22.25
• Return: 56%
• Total Return: 61%

Irish Residential Properties REIT (IRES ISE) 

• Then: €1.43
• Now: €1.66 
• Return: 16%
• Total Return: 20%

European Residential REIT (ERE-U TSX) 

• Then: $4.56
• Now: $4.24
• Return: -7%
• Total Return: -3%

Total Return Average: 26%