Expect an Uneven REIT Recovery

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Trevor Bateman, CFA, CA

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Trevor Bateman, credit analyst in the fixed-income research and portfolio management team at CIBC Asset Management.

Improving employment trends generally support economic growth, and that supports rental revenue growth as well as occupancy amongst this commercial real estate asset class. However, not all REITs will share in that improvement equally. It will depend on the asset class.

First of all, on the retail sector, to start the year generally visibility into earnings is somewhat clouded as the retailers have been negatively impacted by some of these Covid-related closures for non-essential retailers. And that is putting pressure on already stressed retailers in general. And how that will impact REIT earnings and balance sheet is somewhat clouded. So, we’re watching that carefully.

In the retail classes, the experience of the pandemic initially suffered a meaningful decline in collections. The retail collections, has on average, declined to about 87%, typically near a 100. And it did bounce back in the third quarter, but I wouldn’t be surprised if we see a setback in this fourth-quarter end or the first quarter of 2021.

Contrast that to the industrial sector, which performed quite well through the pandemic, fairly insulated, and its collections of rent were still in the high 90s area — a big difference relative to retail.

So, what that meant was for the retail sector in 2021 was impact on earnings of over 4%, with respect to bad debt charges and rent abatements.

Another major theme in this sector is e-commerce. And the pandemic really accelerated consumer adoption of e-commerce, and I suspect a large portion of that stepup in e-commerce usage will be sustained in 2021 and beyond. What that means for the demand for retail space is probably more negative. Retailers will likely demand less space than in the past, but this trend was already in place pre-Covid, but the pandemic certainly accelerated that.

And we saw First Capital REIT cut its distribution by 50% in mid-January of this year of 2021, as well as RioCan cut its distribution by 33% in early December 2020. Part of that was in the context of active development, spending plans. So the cut in distributions will help to fund some of that development and then take some pressure off the balance sheets. So, we continue to monitor those companies for their development spending and how they’re managing with their balance sheets.

Another major sector here in Canada is senior housing. This industry has been hard hit by the pandemic in terms of there’s been an immediate acute impact on occupancy that has declined, which has negatively affected earnings. And until all residents and staff are vaccinated, I anticipate that occupancy will be weak, especially as they report fourth-quarter results and into the first quarter of 2021.

Another major sector asset class is the office space. The office space here in Canada has been negatively impacted by the pandemic, but it’s still early days. And I think it will take time for it to unfold. We’ve seen vacancy rates, for example, in downtown Toronto, they’re now over 7% as of the fourth quarter of 2020. And that compares to just over 2% a year prior.

The industry is starting from a very strong position in terms of vacancy, which looks at historic lows, but it’s coming off sharply. It remains to be seen how that impacts on rent revenue growth.

We’ve already seen a slowdown in the fourth quarter. Revenue growth has fallen to about 1.8% from over 3%. But the office REIT players — they’re in good position to face this challenge over the next few years. They started with a good position with low vacancies and good balance sheets. Not all leases expire in 2021, and it will happen over a number of years, so management teams have time to adapt to a new office environment.

The last major asset class I’ll talk about is industrial. Covid certainly demonstrated the importance of e-commerce and really accelerated e-commerce sales. Tenants have had to invest more in their complex logistics networks across the country. And that means that those industrial properties that are closer to the cities and well located are more important than ever and that helps these retailer-type tenants to reduce the last mile delivery costs. This industry, I would expect to do well in 2021.

And in terms of new issuance from a technical perspective, I think the outlook for primary market is constructive. We’re estimating only about five billion in new issuance, and that would be down from 2020, and I think on the surface that looks constructive for bond spreads.

In terms of valuations — and this sector was hard hit, especially at the inception of the pandemic last spring. Credit spreads have not recovered like other sectors have; we’re still somewhat wider. And I think until we see some better visibility in terms of the retail REITs and perhaps office REITs, will we then see a further tightening in the REIT sector overall.