From an investment standpoint, the real estate sector is about midway through the property market cycle from the depths of early 2009, according to Neil Downey, Managing Director of Global Equity with RBC Capital Markets.
“Certainly capital markets have had a huge move for the last three years,” he said. Canadian REITs, for example, gained 55% in 2009, 23% in 2010 and 22% last year. It was the third-consecutive year that REITs outperformed broader indices such as S&P/TSX Index (down 9%) and Global REITs (off 6%).
Last year’s growth got a substantial boost, said Downey, from the large decline in bond yields over 2011, with the yield on the 10-year Canada bond falling from 3.1% to 1.9% by year’s end.
With real estate overall more or less at the mid-way point of the cycle, RBC provided an outlook for each major property cycle as part of a recent 200-plus page REIT quarterly review and outlook. By major property sector, it reads as follows:
Office – Positive momentum for 2012. The unexpected strength in 2010-2011 absorption and the limited new supply which can be delivered over the next 12 months (suburban) to 24 months (CBD), leaves this sector with positive
momentum heading into 2012. Leasing velocity will in all likelihood slow in 2012, but rents should hold firm or tick higher in most major markets.
Retail – A favourable 2012 outlook for landlords, yet increasing caution may be warranted for 2013-14.
Industrial – A soft recovery cycle in the east, versus strength in the west. With greater exposure to the manufacturing sector and non-resource-oriented exports to the U.S., occupancy and rents in Central Canada (Montreal and Toronto) have lagged. In Western Canada, the strength of the resource sector and/or supply-side constraints have led to tighter vacancy and higher rents. We expect these trends to broadly continue into 2012.
Multi-res – Affordability and credit tightening become headwinds to home ownership, while jobs and household formation drive rental demand (all in the face of little landlord expense pressure).
Lodging – 2012’s rate of improvement should accelerate from 2011’s, but an eclipse of former peak profits is still a number of years away, as this recovery cycle remains tepid.
NEW YEAR'S PREDICTIONS
RBC Securities kicked off its lengthy report with three predictions for 2012:
1. Growth in market cap and capital raising will decelerate. Rising valuations and a heady stream of secondary offerings were the key drivers behind the $8.9 billion (+28%) increase in TSX-listed REIT equity market cap in 2011. This year, the sector will be unable to match the pace of $6 billion of equity and equity-related financings in 65 transactions (more than a deal a week, on average) of 2011.
2. Little change in the number of TSX-listed REITs. After a muted 2011 for M&As and only one new REIT listing there is potential for one or more new listings, along with several REIT-to-corporate conversions. There may also be one VSX-to-TSX listing shift.
3. Going Global Trend Has Legs. Listed REITs acquired approximately $3.1 billion of property outside of Canada in 2011. That is estimated to represent 25-30% of aggregate acquisition activity by all listed entities last year. Those expected to be most aggressive internationally according to Downey? Dundee International REIT and RioCan REIT.
The RBC analyst is now advising investors to take a less aggressive stance with regard to real estate generally – a “Defence Over Offence” approach. The investment firm said it will look with favour on REITS that display these characteristics:
1. Lower payout ratios;
2. Lower financial leverage;
3. Evidently more self-sustaining business models (i.e., less dependence upon growth-by-acquisition strategies);
4. and, Broadly less reliance upon debt and equity capital markets. As we see income stability as paramount, our recommendations are tilted toward more defensive property sectors.
From its sector outlook, RBC selected what it considers the top REITs from the group of 27 TSX-listed REITs. Its top five list of “Outperforms” were comprised of: Calloway REIT, CREIT, Dundee REIT, H&R REIT and Morguard REIT. The report also gave an Outperform to five others: Brookfield Asset Management, First Capital Realty, MI Developments, Morguard Corp. and Killam Properties Inc.
There’s More … Other highlights from the RBC report:
· TSX-listed REITs began 2011 with an equity market capitalization of $32.0 billion. At yearend, it had increased by $8.9 billion, or 28%, to $40.9 billion. A total of 24 TSX-listed REIT’s saw their market caps increase in 2011, just five declined. As at December 31, 2011, 14 REITs had equity market caps in excess of $1 billion (12 at the beginning of the year) and seven REITs had market caps greater than $2 billion (six at the outset of 2011).
· Record year for capital raising with $6.0 billion of total equity and equity-related offerings by Canadian REITs and REOCs in 65 transactions last year, topping 2010’s volume of $5.1 billion of activity conducted (56 offerings) and the 1997 record of $5.8 billion record (38 offerings).
· M&A activity remained muted in 2011 and RBC Securities not expecting “big things” in 2012. It sees the potential for a handful of deals in 2012 noting that several entities are “ripe for consolidation.” The key themes: i) likely too small to economically carry on as listed business; or, ii) they are under-followed and probably undervalued.
· Earnings growth also progressing with the cycle. RBC’s 2012 outlook calls for aggregate earnings growth of +6%. This reflects: i) steady to improving market fundamentals across virtually all property segments; ii) the full-year effect of 2011’s heightened acquisition volume; and, iii) significant interest rate roll-down opportunities. In 2013, the investment firm sees growth reverting to a more normal long-term average of +3% to +4%.
· Payout ratios continue to decline. 2012 distribution increases will be modest and from the minority. RBC Securities found that four TSX-listed REITs/REOCs increased their distribution/dividend in 2011 and there were two cuts.