Funtap
Interest rate sensitive sectors, such as Real Estate Investment Trusts, have felt the weight of high rates in recent quarters. Sam Damiani, Director for Equity Research at TD Cowen, tells MoneyTalk’s Greg Bonnell, why the outlook for REITs would likely improve once those rates start to come down.
Transcript
Greg Bonnell: Rate-sensitive sectors like real estate investment trusts have had a tough ride amid the recent central bank hiking cycle. But with interest rates cuts expected by many this year, could things be turning around for the sector? Joining us now to discuss is Sam Damiani, Director for Equity Research at TD. Sam, great to have you on the program.
Sam Damiani: Pleasure to be here. Thank you.
Greg Bonnell: So, obviously, real estate is the kind of topic that everyone loves to talk about quite a bit. As investors, we can look to the REITs. How have they been faring in this high rate environment?
Sam Damiani: Yeah. It’s been tough. The REIT index, if we look at that, is down about 25% from pre-COVID. We made it all back by the end of 2021, but 2022 was a big down year. And last year was flat.
But that masks the story of huge volatility. I think at one point, the REIT index was down 25%, and then up 25%, finished the year flat. And so we’re still down 25% from pre-COVID. And the big challenge over the last couple of years has been the rising interest rates, for sure.
Greg Bonnell: Because when you think about it, you start thinking about REITs, and you can break them down, whether it’s office, or industrial, or residential. But in the end, when you talk about distributions, just like a yielding stalk, if you’re starting to get money market rates of 5%, that is a challenge, I’d imagine.
Sam Damiani: Yeah, that’s a huge challenge. We looked at the Bank of Canada information, and they show the inflows into GICs and term deposits is about $250 billion over the last two years. And you layer on top of that the money market funds, which aren’t captured by that Bank of Canada data, that’s a massive flow of funds.
And obviously, a good chunk of that would have come out of yield-oriented sectors of the equity market like REITs. So the overall REIT index has a market float of $50 billion. So $250 billion just into GICs and term deposits, maybe another $200 billion, who knows, into money market funds – even a small fraction of that would have a massive impact on price. And we’re sure it has.
Greg Bonnell: So you already have that sort of challenge for the sector where people want those distributions. They’re looking at yield. They’re looking at money market funds. And then we start to break it down. As we’re saying, through the pandemic, office has obviously struggled. Does that become more challenging – first headwind here is high interest rates, and then we started thinking about, how are we living life post-pandemic? Office seems to be the most glaring one.
Sam Damiani: Office is tough. And it gets a disproportionate amount of attention. Especially when you turn on a US TV channel, you’ll see US commercial real estate in trouble. But really what they mean is office properties. And so the fortunate thing for the Canadian market is that the REIT index today just has one REIT in it specializing in office properties.
So 85% of our coverage universe is shopping centers, warehouses, and apartments. And all those three sectors are doing much better than office. And so the return to office, I think the outlook has gotten a little more clear.
There’s kind of a consensus forming as to how it’s going to evolve. But it’s going to be a very bifurcated market. And the good buildings are going to hold up just fine. Some of them will actually do better than they would have pre-COVID. But there’s probably a bottom – whatever it is – 10% or 20% of the buildings or the space in the market that becomes functionally obsolete.
And some of it will be converted to residential. Some of it will be just outright demolished or repurposed in other ways. So it’s been a challenging sector, and we’ve seen distribution cuts out of that sector, in particular, over the last four years.
Greg Bonnell: Now, as we assess the health of the REITs as we head through this year, we actually have some earnings. I don’t think we’ve got them all in for the most recent quarter, but we’ve got a handful of them. What are you starting to see? Are there themes that we’re picking up on here?
Sam Damiani: Yeah. Yeah. We’re about 3/4 of the way through earnings season for the REITs. The REITs — some of them tend to report quite late. So we’ll be talking Q4 results in the middle of March, unfortunately. You’re well into thinking about Q1. But overall, it’s been, on balance, a good quarterly report so far. We were looking for 4.5% AFFO growth year over year.
Greg Bonnell: That’s funds from operations, right? That’s the key metric when we’re talking about…
Sam Damiani: Adjusted funds from operations. So it’s kind of a smoothed measure that’s comparable across all REITs. So it takes out the noise that sometimes gets reported from quarter to quarter. And so on that measure, we were looking for the fastest growth in two years.
So that’s reflective of the interest rate headwind that has obviously increased interest expense. That impact has started to taper off. And so now the strong underlying property performance is now able to flow through to the bottom line and to this 4.5% AFFO growth that we were looking for in Q4.
And for the most part, we’re seeing more beats than misses. I think, on average, we’re seeing results about 1% ahead of forecast. So that’s good. Particular strength is being demonstrated in the apartment sector. Particularly, any apartment with Alberta exposure is seeing very, very strong demand, big, big rental uplifts. And Boardwalk was one that reported recently and put out guidance that was very, very strong.
Greg Bonnell: Now, when we think about that rental space that Boardwalk is in, obviously, we’ve had very robust immigration in this country. So it always seems like – it’s interesting when you talk about real estate. You talk about the challenge of a higher borrowing environment, but then we also have other factors in play, including a growing population that makes some of these sectors, I think, a little more interesting than others.
Sam Damiani: Absolutely. Over the last two years, Canada’s population is up 5%. And that’s an astounding number, I think, that probably surprised every level of government. And I think we can read the papers and conclude that the country wasn’t really prepared for that level of population growth.
And so the first thing people need is a place to sleep. They also need to feed themselves, go shopping for the basic essentials. And so in apartment leasing and in essential-oriented retail property like grocery-anchored shopping centers, we’ve seen very, very strong demand, occupancies at peak levels, and rental spreads that are to the positive more than we’ve seen in a long, long time.
So it’s really a strong tailwind for the sector. And this is offsetting the impact of interest rates. I just want to get back to that because we talk about the funds flow. Hopefully, that sort of reverts, or stabilizes, and eventually reverses. The interest cost burden is significant.
But when we put it into context, our coverage universe saw interest expense equal to 28% of EBITDA two years ago. That’s increased to 31%. So interest expense has eaten up 3% of EBITDA over the last two years.
The good news is our forecasts, which capture the consensus view – TD Economics view for interest rates over the next couple of years, we don’t see that 31% going any higher. So going forward, the strong operating environment should be able to flow through to the bottom line and allow the REIT sector to report accelerating bottom line AFFO per unit growth this year and next year.
Greg Bonnell: Interesting perspective on there. Of course, for full disclosure on the companies covered by TD Cowen, see the link to the TD Securities website at the end of this program. I’ve got to ask you one more thing. So this is the setup, and you’re saying we think we’ve peaked out in terms of the effect that interest rates are having.
Of course, the market is pricing in interest rate cuts from both the Bank of Canada and the Fed this year. Once those begin, what are we thinking about in terms of the REIT sector?
Sam Damiani: So it could be a setup for a positive finish to the year. And I say that because one of the biggest challenges has been the absolute level of interest rates, but also the volatility. And this has resulted in many companies deferring capital decisions. So we talk about the leasing market for apartments. That’s a no-brainer, if you will.
But on the industrial side, even the office – some companies are still thinking about expansions or relocations. But they don’t really know what their cost of capital is. And so they’re hesitant. And so as interest rate volatility settles out, and even more so we start to see these cuts, I think you’ll have a return of confidence in businesses deploying that capital. And that should result in acceleration of expansionary moves by companies.
