Institutional investors have been piling into certain classes of commercial real estate – particularly industrial warehouses and rental apartment buildings – and this interest has skewed market norms.J.P. MOCZULSKI/The Globe and Mail
The latest property owner to attempt an initial public offering is aiming to pay an annual yield around 2 per cent, an uncommonly low rate that illustrates the heavy demand for Canadian apartment buildings.
Late last week, Toronto-based Continuum Residential Real Estate Investment Trust filed the paperwork for its IPO. According to two people familiar with the offering, the issuer is looking to raise $300-million and would pay investors 2 per cent annually if its units are priced at the mid-point of their marketing range. The Globe and Mail granted the sources confidentiality because they were not authorized to speak publicly.
If the deal is successful, it will mark a significant evolution of the sector. Historically, retail investors adored real estate investment trusts (REITs) because they tended to pay yields around 5 per cent or 6 per cent, offering some relatively stable annual income to the boomers and retirees who bought them in droves.
Lately, however, institutional investors have been piling into certain classes of commercial real estate – particularly industrial warehouses and rental apartment buildings – and this interest has skewed market norms. Amid such heavy demand, Minto Apartment REIT was able to go public in 2018 at a 2.8-per-cent yield and, 16 months later, Continuum is targeting an even lower level.
Continuum declined to comment for this story.
Continuum’s bet reflects the conditions of the current market. Canadian Apartment Properties REIT, the country’s largest publicly traded rental-unit owner, now trades at a 2.4-per-cent yield, and Minto’s units have performed so well since the REIT’s IPO that they now yield 1.9 per cent. (Yields have an inverse relation to unit prices, so they fall as the unit price rises. Minto’s units are up 57 per cent since the company went public.)
Yet potential investors will have to consider whether a 2-per-cent yield is adequate compensation for a company with no public market track record, when safer Government of Canada 10-year bonds currently pay a 1.3-per-cent yield.
They will also have to reassess the role they expect REITs – or at least apartment REITs – to play in their investment portfolios. An asset class that used to be a safe bet for risk-averse buyers is starting to look much more volatile.
“With long-term interest rates across the globe continuing to hover around 52-week lows, there is no question that the ‘thirst for yield’ has provided support for all high-yielding equity sectors," a team of REIT analysts at CIBC World Markets wrote in a note to clients last week. The S&P/TSX Capped REIT sub-index has delivered a 25-per-cent return, including dividends, since January, outpacing the broader market.
Apartment REITs are arguably even more at risk of a correction to the market average. Over the past two decades, Canadian REITs have traded at an average of 15 times their adjusted funds from operations (AFFO), according to analysts at RBC Dominion Securities. (AFFO is a commonly used metric in the REIT sector and is a proxy for cash flow.) Since mid-2013, residential apartment REITs have seen their values skyrocket, to trade around 27 times their AFFO.
Investors worried about REIT valuations will have to judge potential headwinds. Higher interest rates are the major variable, because they would make REIT yields look much less attractive. However, they aren’t the only factor and the potential for rent increases must also be considered.
Because many regions, such as the Greater Toronto Area, face a rental shortage – Continuum boasts an occupancy rate of 99 per cent across its portfolio – the expectation is that building owners will be able to raise rents when their tenants turn over. Some apartment REITs have already seen rent increases of 25 per cent. However, there is no guarantee this will persist – or that turnover will happen quickly.
Despite the current shortage of rental units, CIBC’s analysts have noted that “portfolio turnover in Ontario, on average, may be in a secular decline as tenants seek to avoid materially higher rents. This could serve to increase the spread between in-place and market rents, which will in all likelihood be captured over a longer period of time than before."
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Tim Kiladze