Fixed Income Viewpoint
Real Estate/REITs – April 2014
Sector Rating: Outperform Relative Value
5-Year: Outperform 10-Year: Outperform
Spread View – We view REIT/REOC sector spreads as gener- ally attractive and anticipate the sectors’ bonds will continue to outperform in 2014. The sector provides an attractive pick- up in spread over the telecom and retail sectors. The sector experienced a bout of primary market digestion issues in late 2013 but remained resilient and still managed to outperform the universe. The sector is also vulnerable to underperformance if investors’ global risk tolerance deteriorates.
Credit Curve – The 5s-10s indicative curve for the real estate sector narrowed in Q1/14 to 51 bps from 60 bps at December 31, 2013. The curve is slightly steeper than Telecom (49 bps) but slightly flatter than Retail (54 bps).
Sector Value – REIT/REOC bonds are generally attractive, pro- viding spread pick-up over telecom and retail bonds. We expect the sector to outperform in 2014 due to solid underlying asset quality and financial profiles, which we anticipate to remain intact in 2014, and we expect manageable primary market new issuance. The real estate sector average spread in the short end of the curve of 198 bps is the widest in the Canadian universe. Similarly in the mid-term the sector’s average spread of 206 bps is the widest. The sector provides a pick-up of 88 bps over retail and 84 bps over telecom, which is attractive, although diminished as sector bonds continued to outperform in 2014. The Real Estate sector total return of 2.31% in the short end of the curve in Q1/14 outperformed the DEX universe return of 1.39%.
Recommendation
We rate the sector Outperform based on our view that the sec- tor’s solid fundamentals will remain intact in 2014 and offset another likely year of active new issuance. We like the real estate sector as it provides an attractive pick-up over other sectors and is supported by good underlying fundamentals. First Capital Realty is our favourite credit supported by its unencumbered assets, quality tenant portfolio, bond liquidity and relative value.
Risks
External – Canadian GDP is expected to pick-up modestly in 2014, although still at tepid levels. Increased funding costs could put property cap rates at risk. Nonetheless, the moderate pace
of economic growth should continue to support de- mand for space across the real estate sector and yield increased rental revenues. High consumer debt levels is an area of vulnerability for the sector.
Trading Liquidity – While liquidity is generally limited for REIT/REOC bonds, it has improved with recent new issue activity. Second- ary trading volume tends to follow new issue flow and there is generally always a bid for bonds.
Trevor Bateman, CPA, CA, CFA
BMO Nesbitt Burns Inc. trevor.bateman@bmo.com (416) 359-8238
New Issuance – Year to date, the real estate sector has issued ~$1.6 billion, which compares to $705 million issued during the same period in 2013 (Table 1). We are looking for total sector new issuance to be in the range of $3 to $4 billion in 2014. We expect the sector to remain active issuing bonds in the future. While there is only one senior unsecured bond maturing in 2014 for $100 million, the maturity schedule for issuers in our universe picks up in 2015 and beyond and averages nearly $1 billion through 2019.
M&A – The sale of Bayview Village in late 2013 at a cap rate of sub 4% by BCIMC indicates the appetite for quality proper- ties remains strong.
Credit Profile
Sector Financials – Revenues, EBITDA and AFFO are expected by BMOCM Equity Research to grow solidly in 2014, which generally supports moderately improved leverage.
Sector Fundamentals – Asset quality measures (occupancy and rents) are generally stable across the sector with some continu- ing to improve. REIT/REOCs have improved access to unse- cured debt funding, which bolsters their liquidity and funding profiles. We anticipate that cap rates will eventually move higher in 2014 driven by gradually increasing interest rates. The trend by corporations to divest ownership of their real estate could indicate a peak in commercial real estate valuation.
Credit Ratings – Ratings are generally stable. A wrinkle for investors in this sector is that there are a number of single rated bond issuers.