REITs have become one of the fastest-growing investments in the last decade, with tight rental market conditions in the Greater Toronto Area fueling the fire. Kim Parlee talks to Jonathan Kelcher, Real Estate Equity Analyst at TD Securities, about the opportunities and risks for Canadian REITS on the horizon.
Well, the Canadian REIT sector we think is pretty attractive. The report we did was on the residential REITs in particular, and we think they're very attractive, A, because they're probably the most defensive real estate asset class. And I say that really because the supply/demand fundamentals favor these REITs right now.
In terms of supply, in Canada there hasn't been a whole lot of new supply in purpose-built apartments. We've seen a lot in condos, particularly in Toronto, Vancouver. But in purpose-built apartments, there hasn't been a whole lot of new supply in the last 40 years.
And I just want to ask you, purpose-built apartments being those meant to rent. That's the intent.
Yes. 100% of the units are for the rental market, whereas the condo you might have 25, 30% rental, and the rest for home ownership.
On the demand side, Canada's got good immigration policies. We have 250 to 300,000 new immigrants a year. You have natural population growth. And you put those together, you get population growth of a little bit north of 1% a year in Canada. People do need to live somewhere, so that's another reason the apartments are defensive. So you get good population growth, you've had limited new supply, that translates into good, steady earnings growth.
And I think if you look at the fundamentals over the last 20, 25 years, what you've seen is average vacancy's been in and around 3%. It's a little bit higher right now. I think it was 3.2 or 3.3% in 2016. And that's really just due to weakness in the Alberta market. But you've averaged 3% or so over the last 25 years. And you get good rental growth when you have fairly tight vacancy. So your rental growth has been 2.5, 3%. And that translates into good, steady earnings growth for these apartment REITs.
And some of these apartment REITs you highlight in your report that you wrote recently is that obviously those with more-- excuse me-- urban concentration, those with lots of units in GTA, have been doing fairly well because of what's been happening in GTA. So explain to me a little bit about that. What are you seeing in the greater Toronto area, and how is that translating into valuation increases for some of these residential REITs?
Well, what we're seeing in the GTA is really an extension of the strong housing market. If you just sort of think of the natural life cycle that people-- you move out, you go to university, you get your first job, you get an apartment, condo, first starter home, and so on, the affordability issue has sort of delayed that one step. So what that's really translated into is the number of years that people will live in an apartment.
So we look at it as turnover. Eight, 10 years ago, turnover was probably a third. So people on average would live in an apartment for three years. That's down to between 20 and 25% now in the big city markets. So less people are moving out. As I said earlier, there's not a whole lot of new supply coming. And that's really allowed rental rates in the market to be very, very strong.
Let me ask you, because there's a couple things-- and again, your note highlights this-- that are coming that could change that dynamic, or perhaps want to change the dynamic?
Whether they can or not we're going to have to see. But the first was a rent control bill. Is that a problem for some of these REITs?
It shouldn't be. Again, the devil's going to be in the details.
Details, of course.
So the way the rent control works right now is any apartments that were built before I think it's October 1991 are subject to the province's rent control rules. And that is a system called Vacancy Decontrol. So what that means is, on any renewal rates, the province sets a renewal rate limit every year. For 2017, it's 1.5%. They call that their guideline increase. For any vacant unit, so if somebody moves out, the landlord's free to charge market rents.
So that's called Vacancy Decontrol. And that's allowed the REITs, you get-- on average, you get access to the apartment every four years. But it allows it to sort of-- the REITs--
To creep up. To stay close to market rents. So in any new rent control-- and I know the NDP member put in a private members' bill last month. He didn't-- there is no mention of the vacancy decontrol. So as long as that stays in, the public apartment guys should be OK. I think what they're talking about is eliminating or changing that 1991 year so anything built after 1991 is free market rent. So you can charge-- at the end of a lease, you can raise it however much you want.
Now, they put that in in 1997. At the time, that's a six-year gap. Right? And you do want-- I think there should be a period of market rent for new apartments for the developers, because what a lot of times a developer will do is he builds a new building, he needs cash flow. So he's not necessarily going to charge market rent, he's going to want to get that building full as quickly as possible. And market rents are probably going to be a little bit higher. So on renewals, he's going to want to push up to market.
So if you're giving-- and in 1997, when they brought this in, they gave six years. So if you give-- we put 10 years in our report, that's more than enough time for a developer to get his apartment stabilized, and allow-- and then be in the guideline increase, the annual guideline increase.
Hm. Let me ask you about the other thing, of course, making big headlines. You know, could we see some sort of measure, tax, vacancy tax, I mean all sorts of things that have been talked about that could be coming into the Ontario market, specifically GTA again-- again, we don't know what's coming, but we've heard rumors that it could be coming soon, even before the Ontario budget. What impact could that, or would it have on residential REITs?
It shouldn't have much of an impact. The apartment REITs in Canada basically own old buildings.
So they don't have a lot of the new buildings. So they're not really going to be impacted one way or the other. I guess if they bring in measures to make housing more affordable, you might have some people--
Right. A turnover might--
But again, that depends on-- like, just because it's-- a house is 5% more affordable doesn't make it affordable to the person who's paying $1,200 or $1,300 a month rent.
Yeah. Good point.
So it shouldn't have too much of an impact.
Let's go through some of the names that you highlight in the report. And you've got some revised target prices. And you highlight some in terms of who has concentration of units in the GTA area. CAPREIT, you've got a target price of $37. 37% inventory in GTA.
Yes. They're the largest player in Toronto. They're by far the largest apartment REIT in Canada right now. They have about a 4.5 billion market cap. They've got 48,000 units in total, 37% in Toronto. Now, some of the media we're seeing on people are getting the rents up 50, 75%, that, again, doesn't apply to the apartment-- the public guys, because most of their buildings were built before 1991, and they're all subject to the guideline increases.
But what CAPREIT's seeing right now is, on the turnover, where they are allowed to charge market rent, they're getting seven, eight, 9% rental rate increases. And that's a lot higher than the typical two to 3% that they were doing even two, three years ago. So we think there's-- and we didn't change our estimates on this, but we think there's potential for that to start to translate through into earnings. So what we did do is we took our multiple up a little bit, and raised our target on the back of that.
Let's get a couple more names. Morguard, a residential REIT. Again, $17 price target. And just about 31% of its inventory in GTA.
Yeah. Morguard is an interesting name. It's a smaller cap name.
It's about 700 million. And it's Morguard North American Residential, just to be clear, because there is a Morguard REIT that's commercial.
They're-- about 40% of their NOI comes from Canada, and 60% from the US. So what they have is they have 40% the stable GTA. You're going to get good market increases, steady growth. And 60% of their NOI comes from the US, mostly the Sun Belt, where you are seeing elevated growth.
So it's actually a name that's probably-- we've got it growing at eight or 9% a year. It trades at about a 15% discount to NAV. And part of that is because it's externally managed. Part of it's small float. But it's a good value name, and it's got a nice yield and a low payout ratio.
Last one I want to talk to you about, Interrent REIT. Again, almost 16% of inventory in GTA. You've got a target you've upped a little bit, to $9.
We actually had upgraded our rating to buy from hold on the back of this report, and the fact that they do own-- they're 16% GTA. If you add in their Hamilton stuff, they're probably north of 20%. That's a very-- that's a high-growth name for us. They're a little bit different than CAPREIT in that they buy-- and they're smaller cap. They're about $650 million in market cap.
They'll buy assets that need quite a bit of work to them. They'll put the capital in, they'll empty them out, they'll fix them up, bring the rents up, and then refinance and sort of continue on that. Very, very strong operators. You need to be to do the-- to execute the business plan they have. Been frankly waiting for an excuse to upgrade them. They've historically traded at a fair sized premium to the group. And that's a function of the better-than-average earnings growth they have.
They did a big equity issue about two months ago. It brought the stock price back more in line with the group. So we were able to upgrade them on-- when we put out this report.
Well, great insights. Thanks so much for coming on.
Thanks for having me.