5 Key Industry Drivers For Real Estate Investment Trusts In Canada

July 23, 2018

Over the past decade, REITs listed on the Toronto Stock Exchange (TSX) have offered some of the strongest returns, while the TSX REIT Index has approximately doubled the performance of the TSX Composite Index over the same period. The chart below outlines the Total Returns (TR) of the S&P/TSX Capped REIT Index vs. the S&P/TSX Composite Index since 2008.

Chart: Performance comparision

Fiscal 2017 ended with some of the highest levels of capital flowing into assets in recent years — and the lowest capitalization (cap) rates on record. The outlook for the industry remains positive; analysts expect valuations to remain stable, returns to continue to outperform the general market, and industry revenue to grow at an annualized rate of approximately 3% to 2022.

REITs in Canada typically trade on average around 13.0x Funds From Operations (FFO). Fiscal 2017 concluded with the last twelve month (LTM) FFO multiples on par with 10-year averages. Valuations are affected by interest rates as well as by the outlook for economic growth. Property fundamentals remain favourable, suggesting valuations are low to fair. Rising interest rates could leave valuations vulnerable in the coming periods.

Chart: Price/FFO

Industry Drivers That Will Affect REITs

REITs should be aware of the following five key industry drivers which are expected to continue to fuel industry growth:

1. Rental Vacancy Rates

Rental vacancy rates capture the percentage of Canadian rental properties that are without tenants; this can be used as a proxy for rental demand over certain time frames. Low vacancy rates indicate high demand for rental units. As reported by Canada Mortgage and Housing Corporation, the rental vacancy rate fell just below the 10-year average in 2017 to 2.9%. Vacancy rate compression is expected to continue until 2019, on account of rising home prices and increasingly expensive mortgages, which will steer people away from home ownership and into rental agreements. Declining vacancy rates will contribute to industry growth over several periods.

Chart: Rental vacancy rates

2. Per Capita Disposable Income

Per capita disposable income represents personal income after taxes. Consumer confidence and levels of disposable income will largely determine the amount of retail spending. With higher disposable income and retail spending, demand for retail space will increase as companies expand and enter storefront properties. Retail makes up more than 40% of the Canadian REIT market and is its largest sector. Consequently, changes in consumer spending habits have a significant impact on the REIT industry in Canada.

Per capita disposable income is projected to increase through to 2022, demonstrated through growth in Canadian GDP and lower unemployment, and should help drive industry growth over this time frame. Overarching questions remain about whether the spending patterns will turn to brick and mortar or the virtual marketplace. Retail property will remain an essential component in the distribution of products, and shouldn't be materially affected in the long-term. In the short-term, however, many retailers could struggle with the shift in buying preferences.

Chart: Per capita disposable income

3. Interest Rates

The REIT industry relies heavily on capital markets for financing construction, property purchases, and business acquisitions — therefore, activity is largely determined by the cost of capital. As prevailing interest rates rise, so does the cost of capital. Since economic growth continues to be strong and consumer debt levels are at all-time highs, the central bank will likely look to increase rates in the near-term.

Rising interest rates are often the main concern with both REIT executives and institutional investors. With the Bank of Canada raising interest rates in the first quarter of 2018, and further expected hikes throughout the remainder of the year, REIT valuations and profit margins stand to be affected.

In theory, rising interest rates will hurt operating profits for REITs as well as calm valuation metrics. In a growing economy, however, interest rate hikes should not have a major impact on operating profits. A strong economic environment will lead to increased rents and lower vacancy rates, which can help offset the steeper cost of financing.

As rising rates will have a minimal effect on cash flow, any resulting equity sell-off periods could be a good buying opportunity for investors with an income-oriented, long-term thesis.

There are also fears that rising interest rates will put upward pressure on cap rates, which causes property values to fall. With cap rates and interest rates as low as they are, it is likely that they will eventually trend upward over the long-term, especially with the continued health of the economy. In the short-term, cap rates should be able to weather an interest rate raise, as there is a notable spread between long-term bond yields and cap rates.

The spread between a long-term government bond yield and cap rates is reflective of the risk premium associated with investing in real estate vs. a risk-free government bond. In Canada, the long-term average spread has been 3.75%. As of Q1 2018, the national average to 10-year bond spread was 3.58%, showing current spreads remain close to historical averages. This current spread suggests some insulation if bond yields continue to trend moderately upwards, leaving cap rates relatively stable.

4. Corporate Profits

Corporate profits determine the demand for rental space. Leasing contracts generally span multiple years and depend on the financial health and performances of businesses.

Corporate profits are anticipated to increase in the next five years. Sinking oil prices in 2014 through to 2016 have set a low base year in 2018 for future growth. Non-oil exports are expected to increase with downward movements in the Canadian dollar, and profits in the manufacturing and service sectors are expected to grow. Rising oil prices and stability in the overall economy will also help fuel future growth.

Chart: corporate profits

5. Number of Businesses

Commercial portions of the REIT industry include real estate for the office, industrial, and retail spaces. Strength in the corporate sector and the number of establishments play a large part in filling the demand for leased space (i.e. the more businesses there are, the more rental space is needed).

Business activity in Canada continues to rebound after several stagnant periods following the 2008 recession. Strong performances in the housing market and construction sectors have driven economic growth, even with slower periods in 2015 due to dropping commodity prices and a housing bubble scare. Despite interest rate increases, the number of businesses in Canada is expected to continue to grow thanks to rising corporate profits and domestic GDP growth, low volatility in commodity markets, and lower unemployment.

Key Success Factors

Leadership teams should look to align their REITs with the following four factors moving forward:

1. Asset Quality

The quality of assets within the portfolio is a key success factor for REITs. Quality can impact several factors including tenant profile, base rental rates, occupancy levels, tenant retention, and relative property value. Factors affecting quality can include asset classification, location, accessibility, asset age, attractiveness to potential tenants, amenities, surrounding facilities, construction quality, customer service, and brand image.

2. Diversification and Operating Stability

REITs should look to employ a diversification strategy, whether through geographical location, tenant profiles and lease structures, industries, or asset type (commercial, retail, office, apartments, industrial, hotels, etc.). Diversification in one or more ways will strengthen the stability of operating income within the REIT over various economic cycles.

3. Management and Strategy

REITs that employ the top managers will outperform industry peers. REIT managers make various decisions regarding optimizing capital structure, identifying assets for purchase or sale, planning for programs that enhance property values, tenant marketing and retention, and capital expenditure policies. Managers who drive value through enhancements, cost efficiencies, and a strong brand for the portfolio will create higher and more stable operating margins.

4. Financial Policy

Sound financial policies and strategy towards financial risks will differentiate the stronger REITs in the market. Financial targets such as growth, leverage, debt structure, dividend policy, and hedging policy, as well as the REIT's track record of fulfilling financial obligations, determine the level of financial strength. Financial flexibility is a key factor in the industry.

Capital structures must be carefully examined. Various factors can play a pivotal role in the success of a REIT, including debt to equity ratios, total capital, cash flows, and debt composition (i.e. local vs foreign currency, short-term vs. long-term, fixed vs floating rates, etc.).

In general, in a flat or rising interest rate environment, higher-leveraged REITs with greater payout ratios will underperform lower-leveraged REITs with lower payout ratios. REITs should generally target an EBITDA interest coverage of 3.0x or higher, and a payout ratio of approximately 80% of Adjusted Funds From Operations (AFFO) — with FFO adjusted for capital expenditures. These targets will provide flexibility to pursue development activities, acquisitions, and redevelopments.

Is Your REIT Prepared for the Future?

The REIT industry in Canada is poised for overall growth in the coming years, even in the face of interest rate increases and a struggling retail sector. REIT owners and managers should be prepared for both the opportunities and challenges that lay ahead.

BDO's Real Estate industry team has knowledgeable audit, tax, and advisory professionals who specialize in the REIT sector. We help our clients protect their assets and navigate a variety of business needs in the complex and changing real estate markets. Contact us to find out how we can help.

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