Can Reits survive the downtown downturn?
When the stock dropped in the spring to half of What it Was trading at earlier, We had available cash. We thought it Was a great opportunity to buy more of these incredible assets that We have.
— Michael cooper
there were plenty of ways to make good money as an investor in 2020, but buying up shares of Canadian commercial real estate investments trusts, or REITS, was generally not one of them.
Typically seen as stable income-generators for large institutions and retail investors alike, commercial REITS were thrown into uncertainty as the COVID-19 pandemic undermined fundamental assumptions about the way Canadians will work and shop in the future. Now, market watchers and REIT executives say it’s too soon to know when the commercial REIT market will return to normal — or, indeed, if there’s even a “normal” to return to.
Michael Cooper, chair and chief executive of dream Office real Estate Investment Trust, which saw its unit price plummet from $36 to under $16 in March, acknowledges the uncertainty. “We’re not changing our strategy,” he says. “And the reason we’re not doing that is that we really don’t know enough yet. But we’re watching everything and we think we’re really well positioned as the market changes.”
The DREAM stock was trading at around $19.50 on Friday.
REITS invest in real estate and distribute the proceeds to shareholders. REIT yields and unit prices fluctuate with financial markets, but are underpinned by the value of the trust’s real assets. In the case of a commercial REIT, those assets might include malls, office buildings, or industrial properties.
Before the onset of the COVID-19 pandemic, the Canadian REIT sector was experiencing a boom. The S&P/TSX Capped REIT Index had just attained its highest value in at least a decade. There was little reason to think that a reversal in fortune was likely. And then it happened: The index returned negative 13 per cent in 2020.
Not all segments of the Canadian commercial REIT market were equally hard hit by the pandemic. Trusts whose assets consist mostly of industrial properties delivered, on average, positive returns to investors in 2020. Tenants of those industrial properties were able to continue operating through the pandemic, meaning they were able to pay rent to their REIT landlords.
Losses in the commercial REIT market have instead been concentrated among companies whose portfolios are oriented toward office or retail space. The market has yet to decide whether either of those sectors can rebound fully from the damage done by months of lockdowns and other restrictions.
The investor skepticism stems from the fact that office and retail REITS are having trouble with their tenants. Government-backed relief programs — The Canada Emergency Commercial rent Assistance program (CECRA) and its successor, the Canada Emergency rent Subsidy (CERS) — have provided subsidies to struggling businesses, and this stream of relief money has flowed into the coffers of commercial REITS, in the form of rental payments. But this public assistance hasn’t completely eliminated the impact on cashflow for landlords.
The most vulnerable are those with exposure to lockdown-sensitive businesses such as clothing retailers, gyms, and movie theatres. “Certain types of retail have been impacted in a big way, and the move to online shopping has accelerated rapidly,” says Canaccord Genuity analyst Mark rothschild.
Office-focused REITS have not been as intensely plagued by rent collection issues, but are seen as vulnerable to longer-term adjustments in work culture. A report from real estate consultancy CBRE Group Inc. pegs the national office vacancy rate, as of the end of 2020, at 13.4 per cent, the highest level since 2004.
“I think the office business has changed for a long time, if not forever,” rothschild says. “Many people will not be back in the office five days a week any time soon. And that is something that is going to weigh on office REITS for many years.”
At least 11 Canadian REITS have responded to pandemic-related cashflow issues by reducing distributions to unitholders, an unusual course of action in the normally placid REIT space. Among the companies who have recently chosen to cut payouts are two of the biggest names in Canadian real estate.
One of them is riocan real Estate Investment Trust, which announced on dec. 3 that it would be cutting its monthly distribution by one third, from $0.12 per unit to $0.08 per unit — the first time in the company’s 26-year history that it has reduced its payouts. In a news release, the company said the distribution cut would bolster its balance sheet by $152 million per year.
First Capital real Estate Investment Trust, another major commercial REIT with a retail-focused portfolio, announced its own distribution cut on Jan. 12 — a roughly 50-per-cent reduction from $0.0716 per unit to $0.036, which will produce savings to the company of $95 million per year. In a news release, the company said the extra cash would give it “meaningful financial flexibility” as it copes with the continued uncertainty of the pandemic.
Earlier this month, in an apparent move to shore up balance sheets without cutting distributions, Brookfield Asset Management Inc. and a group of investors offered to acquire the stake in Brookfield Property Partners that they don’t already own, in a us$5.9- billion bid to take the real estate company private. royal Bank of Canada analyst Pammi Bir believes the offer is “underwhelming.”
BPR owns us$88-billion in assets across some of the world’s biggest cities, including Brookfield Place in Toronto, but investors remain skeptical, highlighting the parent group’s increased exposure to retail, and the debt required to fund the acquisition.
“Bottom line, we think the market has focused on some of the perceived deal challenges more so than the longer-term positives,” Mario Saric, analyst at Scotiabank, said of the Brookfield transaction in a note to clients. “While understandable, we also think it provides an attractive entry point for longer-term investors into a high-quality blue-chip company capable of significant FCF (free cashflow) growth over the next 2+ years.”
In normal economic times, REITS are often reluctant to reduce distributions, because doing so excessively can harm more than just their unit prices and reputations. If a REIT’S payout ratio dips below a prescribed level, the trust can lose its special status in the eyes of the Canada revenue Agency, placing it in a new and less advantageous tax category.
From riocan’s perspective, reducing distributions was a difficult but necessary response to the pandemic’s squeeze on the company’s cashflow. “What was happening prior to that distribution reduction was that our payout ratio was getting to a point where it was too high for our comfort level,” says Jonathan Gitlin, the company’s president and chief operating officer. “It was a very difficult decision for us. It was one that our board and management did not take lightly. But it was for the long term. And it’s that long-term view that we are fixated on.”
As retail and office REITS head into 2021, a year that promises more challenges but also some relief, there is no easy way of predicting their longterm fate. The pandemic’s many uncertainties have made it difficult to place valuations on the properties themselves, let alone the trusts that own and operate them.
There are reasons for investors in retail and office REITS to be optimistic, and not all of them are vaccine-related. For one, 10-year Government of Canada bond yields, which heavily influence the price of commercial real estate mortgages, are at their lowest point in decades. The availability of cheap debt could cause property values to rise.
And Canada’s retail and office REITS generally entered the pandemic in good financial condition. Before the onset of COVID, many of them had already started the process of redeveloping portions of their properties for residential use, allowing them to tap into Canada’s profitable — and resilient — urban housing markets.
“Most of the Canadian REITS went into the pandemic with strong portfolios and healthy balance sheets,” says rothschild, the Canaccord Genuity analyst. “If this happened five or 10 years previously, it would have been a lot worse.”
royal Bank of Canada wrote in a report earlier this month that the “great lockdown is almost behind us; better days lie ahead in 2021-22.”
But the bank also warned that REITS’ profitability will heavily depend on the efficiency of vaccine rollouts and a resurgence in the job market. In an RBC survey of real estate clients late last year, more than 60 per cent of respondents were concerned about the viability of hotels, entertainment and food service retail space, regional malls and Class B offices.
Cooper, the dream Office CEO, believes real answers will take time to materialize. “I think the big question for the value of office buildings isn’t what happens over the next 12 months,” he says. “The question is what happens over the next five or six years. We have a lot of long-term leases, so it will take a while to figure out how people’s behaviours are going to change.”
Earlier this month, dream Office’s shares were trading at around a 27 per cent discount relative to the net value of the trust’s assets, according to an analysis by RBC Capital Markets. The same analysis found that the average Canadian REIT was trading at a nine per cent discount, whereas the 20-year average is a 1 per cent premium.
For its part, dream Office is continuing to buy back its shares.
“When the stock dropped in the spring to half of what it was trading at earlier, we had available cash,” Cooper says. “We thought it was a great opportunity to buy more of these incredible assets that we have.”