How, and where, rising rates are impacting REITs

“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.