RBC Capital Markets, 10 January 2006
Investment Opinion
• Amidst the universe of 25 TSX-listed REITs we have a “basket” of eleven Outperform-rated entities. We believe the most timely names currently include: Allied Properties REIT, Calloway REIT, Canadian Hotel Income Properties REIT, CREIT, Chartwell Seniors Housing REIT, H&R REIT, Morguard REIT, Northern Property REIT, and Retirement Residences REIT.
• The Canadian REIT industry finished 2005 with an equity market capitalization of $22.1 billion. Over the course of 2005, the group’s market cap surged by over $4.5 billion, or +26%. Market cap growth in 2005 was driven by a combination of new equity issuance plus strong and broad-based unit price appreciation. The end-of-year figure represented an all-time high for the Canadian REIT universe. Of the 24 REITs that were public for the full twelve months of 2005, only three (Retrocom REIT, Retirement Residences REIT, and TGS North American REIT) finished 2005 with unit prices that were lower than at the beginning of the year. This statistic compared favourably to six REITs with declining units prices during the prior year. Secondary equity offerings and one initial public offering added approximately $1.9 billion to the industry’s equity market cap during 2005, while the balance of $3.6 billion was due to the combined effect of unit price appreciation and distribution reinvestment programs. Offsetting these amounts was the Q4 2005 privatization of O&Y REIT, which removed 59.1 million trust units at $16.25 each, thus reducing the industry’s equity market cap by some $960 million. As at December 31, 2005, six REITs had equity market caps in excess of $1 billion, up from four issuers at the end of 2004.
• Economic & Property Sector Review – Our economic and property sector review concludes that property segments are almost universally stable or improving. Nationally, office owners seem to be experiencing stronger demand than during the past several years, and we believe that rental growth will soon follow. While retail property markets posted another very strong year, we expect growth in consumer spending to temper in 2006, and we foresee a slowing pace of retail development the next year or two. The Canadian dollar remains be strong, and this continues to work against the lodging sector. The dollar has yet to hurt industrial demand, but we believe the effect could be more noticeable in eastern industrial properties in 2006. Following upon several years of somewhat challenging operating conditions, apartment owners are seeing more stable occupancy statistics. Unfortunately cost pressures have increased, and we believe it could take until 2007 before rental growth becomes more noticeable. Regardless of their specific property sector or focus, the Canadian REITs appear operationally and financially well positioned.
• The Ideal Environment – REITs currently offer an equity risk-premium that is approximately 75 basis points below historical averages. In 2005, however, REITs gained “mainstream” acceptance in Canada, an event that was symbolized through their inclusion in the S&P/TSX Composite Index. Higher valuations and volatility could be two consequences of this. Funds flow and interest rates have, and should continue to be, the sector’s two most important determinants of short-term performance. We believe the present group-average multiple of 15.1x (15.5x on the REIT Index) AFFO to be reasonable within the context of current interest rates and property market fundamentals. Our target valuations are driven from the one-year forward implied 10-year Canada bond yield, which equates to approximately 4%. The industry remains awash in capital (private, pension fund and REIT) and M&A activity has been a growing theme within the U.S., despite seemingly high REIT valuations. After one high profile transaction during 2005 (the O&Y deal) we see potentially more activity in Canada in 2006.
• With the group finishing 2005 at an AFFO yield of 6.6%, or the equivalent of a 15.2x AFFO multiple, the above analysis means that we see little in the way of prospective multiple expansion for the group over the next year. On the other hand, with AFFO growth possibly in the 5% range, even steady multiples provide the opportunity for modest capital appreciation. Therefore, with a 6.6% average distribution yield (6.3% on the S&P/TSX REIT Index) and modest AFFO growth, the macro conditions suggest to us that Canadian REITs could be poised for total returns of 7% to 11% in 2006.
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Investment Opinion
• Amidst the universe of 25 TSX-listed REITs we have a “basket” of eleven Outperform-rated entities. We believe the most timely names currently include: Allied Properties REIT, Calloway REIT, Canadian Hotel Income Properties REIT, CREIT, Chartwell Seniors Housing REIT, H&R REIT, Morguard REIT, Northern Property REIT, and Retirement Residences REIT.
• The Canadian REIT industry finished 2005 with an equity market capitalization of $22.1 billion. Over the course of 2005, the group’s market cap surged by over $4.5 billion, or +26%. Market cap growth in 2005 was driven by a combination of new equity issuance plus strong and broad-based unit price appreciation. The end-of-year figure represented an all-time high for the Canadian REIT universe. Of the 24 REITs that were public for the full twelve months of 2005, only three (Retrocom REIT, Retirement Residences REIT, and TGS North American REIT) finished 2005 with unit prices that were lower than at the beginning of the year. This statistic compared favourably to six REITs with declining units prices during the prior year. Secondary equity offerings and one initial public offering added approximately $1.9 billion to the industry’s equity market cap during 2005, while the balance of $3.6 billion was due to the combined effect of unit price appreciation and distribution reinvestment programs. Offsetting these amounts was the Q4 2005 privatization of O&Y REIT, which removed 59.1 million trust units at $16.25 each, thus reducing the industry’s equity market cap by some $960 million. As at December 31, 2005, six REITs had equity market caps in excess of $1 billion, up from four issuers at the end of 2004.
• Economic & Property Sector Review – Our economic and property sector review concludes that property segments are almost universally stable or improving. Nationally, office owners seem to be experiencing stronger demand than during the past several years, and we believe that rental growth will soon follow. While retail property markets posted another very strong year, we expect growth in consumer spending to temper in 2006, and we foresee a slowing pace of retail development the next year or two. The Canadian dollar remains be strong, and this continues to work against the lodging sector. The dollar has yet to hurt industrial demand, but we believe the effect could be more noticeable in eastern industrial properties in 2006. Following upon several years of somewhat challenging operating conditions, apartment owners are seeing more stable occupancy statistics. Unfortunately cost pressures have increased, and we believe it could take until 2007 before rental growth becomes more noticeable. Regardless of their specific property sector or focus, the Canadian REITs appear operationally and financially well positioned.
• The Ideal Environment – REITs currently offer an equity risk-premium that is approximately 75 basis points below historical averages. In 2005, however, REITs gained “mainstream” acceptance in Canada, an event that was symbolized through their inclusion in the S&P/TSX Composite Index. Higher valuations and volatility could be two consequences of this. Funds flow and interest rates have, and should continue to be, the sector’s two most important determinants of short-term performance. We believe the present group-average multiple of 15.1x (15.5x on the REIT Index) AFFO to be reasonable within the context of current interest rates and property market fundamentals. Our target valuations are driven from the one-year forward implied 10-year Canada bond yield, which equates to approximately 4%. The industry remains awash in capital (private, pension fund and REIT) and M&A activity has been a growing theme within the U.S., despite seemingly high REIT valuations. After one high profile transaction during 2005 (the O&Y deal) we see potentially more activity in Canada in 2006.
• With the group finishing 2005 at an AFFO yield of 6.6%, or the equivalent of a 15.2x AFFO multiple, the above analysis means that we see little in the way of prospective multiple expansion for the group over the next year. On the other hand, with AFFO growth possibly in the 5% range, even steady multiples provide the opportunity for modest capital appreciation. Therefore, with a 6.6% average distribution yield (6.3% on the S&P/TSX REIT Index) and modest AFFO growth, the macro conditions suggest to us that Canadian REITs could be poised for total returns of 7% to 11% in 2006.
