Sairam Srinivas explains what a higher cost of capital means for public real estate assets
Each month at WP we focus on a particular topic of interest to advisors. This October we’re focusing on private assets and alternatives.
Canadian REIT prices enjoyed a solid year, until the end of July. The S&P/TSX Capped REIT index rose by about 11 per cent between January and July of this year, roughly in line with the overall TSX. That was something of an aberration for the REIT sector, which typically starts a year strong and starts to ebb around the end of March. Over the course of July, however, yields on the Canadian 10-year bond began to rise and that rise has continued through the rest of the year so far. As yields rose, REITs fell and the sector is now hovering around where it began the year.
Sairam Srinivas, Director of Equity Research for Real Estate & REITS at ATB Cormark Capital Markets in Toronto, says that REITS have typically been penalized for macroeconomic uncertainty over the past five years. He explains that the sector’s broad levels of leverage and overall interest rate sensitivity has turned it into a proxy for rising capital costs in investors’ minds. Despite structural trends impacting the sector, he notes that specific REIT subsectors and management decisions make the area worth considering.
“REITs as an instrument flourish when rates are low, when equity markets are running, and when they can use capital markets to reinvest in the business. When this tap gets turned off, management is already in a position of capital tightening,” Srinivas says. “Management teams who have been good at capital allocation have been rewarded… Historically, Canadian and US REITs diverged on their leverage metrics from around 2010 or 2011, but over the past five years you’ve seen Canadian REITs become more focused on deleveraging. You can see a bit of a trend where they’re now moving closer to their US peers in terms of stronger balance sheets.”
What REIT subsectors look strong, and weak, now
While Srinivas says the whole sector has been penalized for its interest rate exposure, he believes that opportunistic investors can find certain subsectors with attractive qualities. He believes that by looking at capitalization rates and asset yields investors can begin to identify attractive properties and REITs. They can assess interest rate risk through a combination of refinancing risk and the platform’s capacity to absorb a refinance and generate accretive adjusted funds from operations (AFFO) growth.
Looking at those metrics, Srinivas says that retail tends to perform well. He believes the subsector has been penalized for a long time due to the large number of bankruptcies in large format retail. The result has been a sector with cap rates significantly higher than financing rates. A good operator can absorb that interest rate and generate NOI growth, though Srinivas says identifying a good operator can be challenging. He cites the example of Primaris, a mall operator, which as been rewarded for its quality management with roughly 35 per cent year to date growth.
On the other side, Srinivas highlights the factors that should give investors pause on a REIT. First, he says, is a degree of concentration risk. For example, a retail REIT with a concentrated balance sheet of suburban assets carrying different maturities across different years ought to face more interest rate exposure.
Looking at subsectors, Srinivas adds that multifamily may not be able to absorb as much of the interest rate cost. Rents are not increasing at previous rates, and supply of multifamily is growing. Despite the advantages in borrowing costs that come with CMHC financing, the pathway to higher net operating income is much more limited.
Geographically, Srinivas says that REITs have tended to be strongest on Canada’s directional extremes, largely due to tariff risk. Central Canada has struggled as tariffs cut away at Ontario and Quebec’s manufacturing base. Western and Atlantic Canada have faced fewer tariff headwinds but have enjoyed tailwinds from some of the monetary easing and fiscal policy supports offered nationwide in response to the tariffs.
Finding the right vehicle
Given their sensitivity to interest rates, Srinivas understands that some investors may look at private REITs for interest rate exposures, given the smoother ride that less frequent pricing gives an investor. Given the deeply cyclical nature of real estate, smoother returns might be easier to stomach. However, he argues that the publicly traded REITs offer a combination of reactive pricing and size that savvy investors can take advantage of. There are sometimes opportunities to pick up assets at a better price. Moreover, the private market may simply lack the scale to deliver some of the specific kinds of property that investors can access through public REITs.
Whatever the preferred vehicle, Srinivas is of the view that today’s rising yields may not sink all boats and that while advisors and investors may be wary of the sector, there is opportunity to be found in REITs.
“Just because the rates have gone up doesn’t mean that the entire sector is bad and you need to get out of the sector. A lot of the conversations I have are people are underweight REITs because rates are going up. There’s a historical relationship there, and I’m not debating that,” Srinivas says. “But I would push investors to kind of look beyond that headline and start identifying themes and look at it from a stock picker’s perspective within the sector. And you will see those pockets of growth.”
