Andrew Moffs, senior vice president and portfolio manager, Vision Capital

FOCUS: Real estate stocks 

MARKET OUTLOOK:

In the wake of a strong and broad rally across the North American publicly-traded real estate securities in the fourth quarter of 2023, pricing has been pared back year-to-date. This is in response to stronger economic data and the risk of above-trend inflation impacting the likelihood of three interest rate cuts currently modelled into the U.S. Federal Reserve’s dot plot in 2024.

Amidst this consolidation, REITs (real estate investment trusts) appear to be approaching a point of inflection, where market factors that have previously registered as headwinds are weighing on sector prospects are now shifting to tailwinds. First, the prospect of peak interest rates (with the pace and scale of reductions to be determined) eases upward pressure on property capitalization rates, placing a floor under property valuations. With REIT implied cap rates continuing to trade at a material spread to both appraisal and transaction values in the private market, the backdrop for convergence in pricing should benefit REIT unit prices.

Second, Bank of America reports fund managers' REIT holdings are near the extreme lows of the great financial crisis in 2008, at 20 per cent net underweight. A recovery of investor sentiment should benefit REIT fund flows as managers rebalance toward historical exposures, enhancing demand and pricing for REIT securities.

Finally, as a capital-intensive sector, a recovery in credit markets will continue to drive greater transaction volume and improve the prospect of mergers and acquisitions for REITs trading at discounts to their forward-looking intrinsic value. 

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TOP PICKS:

Dream Industrial REIT (DIR.UN TSX)

Dream Industrial REIT is a pure-play industrial REIT focused on owning primarily distribution and logistics assets across Canada (66 per cent of investment property value, excluding assets held for sale) and Europe (34 per cent). It also owns a 25 per cent interest in a private open-ended U.S. industrial fund, in which the REIT earns fees for property and construction management as well as leasing services.

The REIT recently formed a joint venture with Singapore Sovereign Wealth Fund to acquire Summit Industrial Income REIT for $5.9 billion. In addition to participating as a 10 per cent equity owner, the REIT will earn management fees from this new platform allowing the deal to be immediately accretive to earnings. The REIT’s portfolio is concentrated in low-vacancy, high-barrier-to-entry industrial hubs across North America and Europe, which over the last several years has experienced sizeable market rent growth.

Specifically, the REIT has 33 per cent of its portfolio in Greater Toronto and Montreal, which experienced market rent growth of over 45 per cent and 55 per cent respectively in the past two years. Despite a slowdown of leasing activity due to macro conditions, availability rates in its core markets remain amongst the lowest in North America at three per cent, as new supply in these markets is de minimis. As a result, above inflationary market rent growth should continue in its markets for the next few years, which in turn should further improve the REIT’s already strong earnings growth profile. The REIT achieved 11 per cent same-property NOI (net operating income) growth and 10 per cent FFO (funds from operations) growth in 2023, placing it amongst the fastest-growing industrial REITs in North America. Furthermore, the REIT is achieving this growth with a conservative balance sheet at 36 per cent debt to assets. Despite this, units of the REIT continue to trade at a compelling 27 per cent discount to its underlying net asset value.

First Industrial Realty Trust (FR NYSE)

First Industrial Realty Trust, Inc. is a fully integrated owner, operator, and developer of U.S. industrial real estate. The REIT’s 64.8 million square feet portfolio is highly concentrated in 15 of the strongest industrial warehouse markets in the United States.

First Industrial’s portfolio is located in the top fifteen U.S. industrial hubs with a concentration in Southern California (25 per cent of revenue). Its exposure to these markets has allowed the REIT to achieve one of the strongest NOI and FFO growth profiles amongst its peers, and this exposure should once again benefit the REIT’s earnings growth profile in 2024. With availability rates below national averages in the REIT’s core markets, strong market-rent growth over the last several years has created a positive gap between in-place rents and market rents of between 40-to-50 per cent. Looking ahead, this spread should remain elevated as supply in its markets is projected to remain muted. As a result, the REIT should have sustained top-quartile NOI and FFO growth for the next several years. In addition to its strong internal growth, the REIT’s development pipeline offers accretive external growth prospects as, upon completion, it would expand its portfolio by 28 per cent. Notably, the REIT strategically acquired its land bank before the pandemic at an attractive cost basis and therefore allowing for strong development profit potential.

Complementing its positive internal and external earnings growth profile, First Industrial operates with a well-managed balance sheet with no maturities until 2027 and at a low 5.1 times net debt to EBITDA. Notwithstanding this, shares of the REIT trade a 16 per cent discount to NAV, the widest amongst the peers, which if sustained, makes the REIT a potential takeover candidate.

Chartwell Retirement Residences (CSH.UN TSX)

Chartwell Retirement Residences is the largest owner of senior housing in Canada with more than 25,000 suites located across Ontario, Quebec, Alberta, and British Columbia. Chartwell’s occupancy has been increasing rapidly over the last 12 months as the aftereffects of the pandemic continue to fade and seniors once again move into retirement homes to receive the care and support they need. Supply under construction has diminished to only 1.2 per cent of inventory as higher interest rates and construction costs make development projects unprofitable at the same time as the population growth rate of seniors has increased to over four per cent. These factors combine to create a supportive operating environment for Chartwell and this has led occupancy to rise by over five per cent to 85 per cent during the last 12 months. Further occupancy growth is predicted over the course of 2024. With the Trust currently trading at a near seven per cent implied cap rate or an approximate 18 per cent discount to NAV, this turning point in supply and demand fundamentals creates a compelling investment opportunity as Chartwell’s occupancy and earnings continue to grow.