Shift into residential has traditional retail REITs poised for growth

Retail REITs are poised to reap tremendous benefits from a number of tailwinds over the next couple of years, despite rising interest rates and the growth of e-commerce, as they pivot to mixed-use and residential development, analysts say.

Apartment and retail REITs have been moving in opposite directions over the past year, with residential generally outperforming as retail lagged due to Amazonfuelled fears of the demise of bricks and mortar.

No surprise, then, that a number of the retail REITS — RioCan, SmartCentres and Choice Properties, to name a few — have announced the move into residential and mixed-use development.

But now, as the Bank of Canada signals more aggressive rate hikes — boosting mortgage costs and pulling capital away from income stocks — the question is whether the retail REITs have missed their opportunity.

Absolutely not, says Mark Rothschild, an analyst at Canaccord Genuity. While the threat of higher interest rates is generally bad news for real estate, Rothschild says the tight urban housing market in Canada acts as a kind of hedge.

“If they raise rates, what happens is, it becomes more difficult to buy single-family homes or to buy condos,” he said. “So raising rates actually helps the rental apartment market and makes the business case to build rentals even more compelling.”

The only thing that could derail the momentum for residential development, Rothschild says, would be if the urbanization movement were to suddenly reverse itself, and young people decided to move en masse to the suburbs.

“If you think population growth in Toronto is going to drop off, well then yeah, (the REITs) are probably late and maybe this may not turn out to be as successful an investment as many of us think it will be,” he said.

That’s an unlikely scenario, if the figures around population growth are any indication. Over the past decade, the number of residents in the Greater Toronto Area is up nearly 15 per cent, to 6.3 million people, and the CMHC expects population to rise to 6.6 million next year, as Ottawa follows through on its promise to raise immigration targets by 50 per cent.

Most of these immigrants — 450,000 per year by 2020 — will settle in urban centres, pushing down rental vacancy rates further. This year, Toronto’s vacancy rate is at a 16-year low of just one per cent, according to the CMHC, and rents are rising five per cent a year.

If that weren’t enough, Michael Smith at RBC Capital Markets points to tougher mortgage rules imposed by the federal government, including a stress test that requires applicants to prove they can make payments even if rates go up by two percentage points.

“So it’s harder to qualify for a mortgage, it’s harder to buy a condo, it’s harder to buy a house because of that qualification,” said Smith, “and that pushes people to rent.”

But the retail REITS aren’t just moving into residential because they see a better business model. As Smith explained, they’re being pushed into residential by cities that have shifted from rigid zoning — residential, commercial, industrial — to a much more flexible strategy.

“The city is saying, we don’t want you to put all retail there,” said Smith. “But if you do mixed-use, you do some office, you do some retail, some rental, some condos, you’re more likely to get approval for your higher levels of density.”

That’s like “hitting the jackpot” for retail REITs, Smith said, because they’re sitting on dozens of underused properties — typically one- or two-storey commercial buildings surrounded by expansive parking lots.

For many locations, developers have the opportunity to increase density ten-fold by stacking condos on top of retail and office complexes and moving parking underground.

REITs most likely to take advantage of the trend to residential and mixed-use development, Smith said, include RioCan REIT (which closed Wednesday at $23.93 and has $26.50 price target at RBC Capital Markets), SmartCentres REIT (closed at $30.29; $36 PT) and First Capital Realty Inc. (closed at $21.06; $23 PT).