Andrew Moffs' Top Picks for October 31, 2024

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

FOCUS: Real estate stocks

Top Picks: First Capital Realty, Chartwell Retirement Residences, Empire State Realty Trust

MARKET OUTLOOK:

Less restrictive monetary policy and a resurgence in transaction activity suggest early signs of recovery for publicly traded real estate securities after a sustained bout of volatility driven by tight lending conditions, troughing property values and broad economic shifts impacting business activity.

The commencement of rate cutting cycles from the Bank of Canada and U.S. Federal Reserve offer many potential compelling benefits to listed real estate investment trusts (REITs).

First, loosening financing conditions for the institutions that traditionally act as a source of capital increase real estate operators’ abilities to secure new loans and refinance existing loans on better and/or more flexible terms. These institutions include banks, private credit firms, life insurance companies and the commercial mortgage-backed securities (CMBS) market.

Second, a stabilization in borrowing costs builds a level of certainty into the loan-to-value ratios of property portfolios, aiding financiers in their ability to underwrite and manage risk in both originating and refinancing activities.

Third, these dynamics should ignite greater volume in transactions, and by extension, enable price discovery and confidence in market valuations.

Today, the credit quality of listed REITs allows operators to tap the unsecured bond market at borrowing rates 60-90 basis points below comparable credit facilities in the private market for real estate. The operators can aggressively bid on assets that offer longer-term growth at lower cap rates than its unlisted peers. We are beginning to see this dynamic reflected in transaction data, as S&P Global reports Canadian REIT capital raising activity up 35 per cent year-over-year annually through the third quarter 2024.

Investors are taking note, with revitalized sentiment for the sector resulting in strong positive net fund flows over the same period. However, it is likely we are in the early innings of a multi-year REIT recovery, with the BofA Global Fund Manager Survey reporting its respondents are still net negative 17 per cent underweight their historic allocation to the REIT sector. A continued reversion towards the mean should be supportive of REIT pricing as the bid outstrips the ask, and renewed demand stimulates performance in listed real estate equities.

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TOP PICKS:

First Capital Realty (FCR.UN TSX)

First Capital REIT (“First Capital” or the “REIT”) owns or manages over 22 million square feet of grocery anchored, necessity-based retail real estate in Canada’s urban centers, with approximately half of its portfolio located in Toronto. The REIT also has 23 million square feet of potential future development, incremental to the existing retail base. Vision believes this is the highest quality and best-located grocery store-anchored portfolio globally.

In early 2024, First Capital REIT updated its three-year strategic plan with the goal of increasing net asset value (NAV) and funds from operations (FFO) per unit by more than three per cent annually while also reducing debt-to-EBITDA leverage by at least one times. This plan focuses on utilizing First Capital’s expertise in rezoning to add entitlements to current properties and then to monetize up to $1 billion of that excess development density to maximize unitholder value. The selective monetization of these high-density assets, which generate low-income yields, is aimed at enhancing per-unit earnings and bolstering the REIT’s balance sheet strength. First Capital has recently secured an additional $66 million in sales agreements, set to close by early 2025, and divested over $700 million in non-core assets at an average yield below three per cent and a 20 per cent premium to its IFRS values. This disciplined approach has solidified First Capital’s position as one of the top-performing Canadian retail REITs in 2024. Despite this strong performance, the REIT’s units still trade at a 15 per cent discount to their IFRS valuation, which only reflects 29 per cent of the total potential development pipeline. Vision expects that First Capital’s high-quality urban assets and value-driven strategy will continue to drive outperformance.

Chartwell Retirement Residences (CSH.UN TSX)

Chartwell Retirement Residences (“Chartwell” or “the Trust”) is Canada’s largest seniors housing owner, with over 25,000 suites located across core markets in Ontario, Quebec, Alberta, and B.C. In 2024, Chartwell achieved substantial occupancy growth, reaching an occupancy rate of 88.9 per cent at the end of September, an increase of 300 basis points since the start of the year and over 500 basis points year over-year. This strong occupancy growth brings Chartwell closer to its 95 per cent occupancy target and directly enhances the Trust’s net operating income (NOI), as occupancy growth in the 85-95 per cent range carries a very high NOI margin as it requires very little additional staffing.

Chartwell’s unit price has appreciated as earnings have grown and the balance sheet metrics have improved and this allowed the Trust to successfully complete a $345 million unit offering in June the proceeds of which enabled the Trust to acquire five premium retirement residences in Quebec. This was followed by the purchase of three additional residences on Vancouver Island, a sought-after retirement market with high barriers to entry. These accretive acquisitions are set to improve Chartwell’s earnings growth rate further. Supported by favourable supply and demand fundamentals, growing cash flows from occupancy gains, and a strategic capital allocation plan, Chartwell remains a core holding in the Vision Fund.

Empire State Realty Trust (ESRT NYSE)

Empire State Realty Trust, Inc. (NYSE: “ESRT”, “Empire State” or the “REIT”) is a New York City focused REIT that owns and operates a portfolio of modern, amenity driven and well-located office (58 per cent of NOI), retail (12 per cent) and multifamily assets (five per cent). The REIT’s flagship Empire State Building, features the world renowned Empire State Observatory (25 per cent of NOI), recently voted the number one attraction in the world. While the overall office market in North America faces challenges, New York City is one of the few markets that is experiencing improvements in leasing volume and tenant utilization. However, the office market remains a story of have and have nots, with broad-based demand only occurring in select submarkets that are close to mass transit and within luxury class A buildings or recently renovated class B buildings with strong amenities. Empire State recently modernized its whole office portfolio enhancing its competitiveness with class A product, but at a price point that offers value to tenants who are priced out of the class A options.

This has resulted in leasing volumes accelerating for the REIT and improving its leased rate in its portfolio from 85 per cent in 2021 to 93 per cent today, and has positioned the REIT to have pricing power over tenants for the first time since the pandemic. As a result, the REIT’s earnings are positioned to accelerate through 2027 and grow at a faster pace than its publicly listed peers. In addition, Empire State has one of the best balance sheets in the office sector operating at 5.2 times net debt to EBITDA and no meaningful debt maturities until 2026. This allows the REIT to withstand short-term disruptions in capital markets, and take advantage of any distressed acquisition opportunities that arise. Moreover, despite 42 per cent of its earnings derived outside of office and Empire State having one of the strongest balance sheets in the sector, shares of the REIT trade at a worse valuation than its pure play office peers. Shares of the REIT trade at a 28 per cent discount to its net asset value and at an implied cap rate that is 200 basis points higher than its NYC listed peers. Thus, creating a unique opportunity to buy shares of a well capitalized, iconic real estate portfolio at a discount to its underlying asset value at a point in time when earnings are poised to accelerate.

PAST PICKS: SEPTEMBER 27, 2023

Dream Industrial REIT (DIR.UN TSX)

• Then: $12.85
• Now: $13.32
• Return: 4%
• Total Return: 10%

Sun Communities (SUI NYSE)

• Then: US$118.81
• Now: US$134.19
• Return: 13%
• Total Return: 17%

Boardwalk REIT (BEI.UN TSX)

• Then: $65.63
• Now: $73.06
• Return: 11%
• Total Return: 14%

Total Return Average: 14%