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The rate-cutting program by the Bank of Canada is in full flow, with three 25 basis-point cuts in the last few months. This reduced short-term rates to 4.25%, the lowest for over two years.
Meanwhile, the 12-month Consumer Price Index (CPI) increase slowed to 2.5% in July, down from 2.7%. Shelter inflation fell to 5.7% in July from 6.2% in June, with the decline driven by dropping electricity and fuel oil costs and a lower (21%) increase in the mortgage component. The slowing Canadian economy is reflected in unemployment rising to 6.6% in August, up 1.5% since April 2023.
Bank of Canada Governor Tiff Macklem is evidently confident that inflation is, if not down to his 2% target, at least well contained. The focus of policy will now be concentrated on aiming for the fabled “soft landing,” where the economy slows down enough to tame inflation but not so much as fall into a full-blown recession with high unemployment and bankruptcies.
Whether this will be possible is obviously highly dependent on developments in the U.S., where the same drop in inflation and rise in unemployment is taking place. CPI is down to 2.7% in July and unemployment is up to 4.2% from 3.8% a year ago.
The central banks of England, Switzerland, Sweden, and most recently the European Central Bank, have all reduced their short-term rates, the latter by another 25 bais points, to 3.5%. In September, the U.S. Federal Reserve followed suit with a 50-basis point cut in the federal funds rate, to 4.75%.
All of these reductions have focused investors’ attention on sectors regarded as sensitive to interest rate movements, such as utilities, pipelines, telecoms, financial services, and real estate investment trusts (REITs).
While the size of their underperformance against the broader indexes over the last two years was always somewhat overdone, given how much of their debt was fixed rate (and in many cases refinanced at very low rates during the Covid period of ultra-low interest rates), their rebound over the last couple of months has been impressive. The iShares S&P/TSX Capped REIT Index ETF is up 14.3% year to date to Sept. 30.
Moreover, within the REIT space, certain subsectors have done better than others. Office REITs that have cut or eliminated their distributions, such as True North and Dream Office, were up 50% and 25% respectively to the end of August. But even office players such as Artis and Allied Properties that have maintained their distributions, were up 20% and 13% respectively, while H&R REIT was up 18.5%.
More surprising is that defensive plays like grocery- and retail-anchored REITs, such as Slate Grocery, Primaris, RioCan, Crombie, CT REIT, and SmartCentres also posted similar advances. Unlike the office REITs, whose occupancy levels are still well below pre-Covid levels, these REITs are also ahead over one year and some over five years, before taking distributions into account. Smaller increases have been seen by apartment and industrial REITs, which held up better through the pandemic and the rise in interest rates.
However, most apartment REITs, even industry leader CAP, have barely risen over the past five years, even as immigration has soared to over 500,000 new entrants a year, and housing prices have remained strong, pricing out many potential buyers. This seems counterintuitive, given the need for accommodation and the rise in apartment rentals in lockstep with wages.
One exception is Killam Apartment REIT (TSX: KMP.UN), a regional specialist in the Atlantic provinces. It is the fourth-largest quoted company by market capitalization in the region.
For the year ended Dec. 31, 2023, Killam’s revenue of $348.2 million increased 5.8% from 2022, NOI was up 8.3%, to $224 million, and AFFO rose 5.6%, to $111.8 million ($0.97 per unit).
Killam is a conservatively financed play on continued growth in demand for well-located rental apartments. Debt as percentage of total assets is 41.2%, down from 42.9% in 2023 and the lowest in Killam’s history. Killam is for investors willing to accept a lower but reasonable yield for the prospect of substantial growth in revenues and NOI as new developments come on stream. Note that REITs are not without market and interest rate risk. Consult with your advisor before investing to ensure your investment meets your risk tolerance level and long-term financial objectives.
Gavin Graham is a veteran financial analyst, money manager, formerly Chief Investment Officer of BMO Financial, and a specialist in international investing, with over 35 years’ experience in global investment management.
Notes and Disclaimer
Content © 2024 by Gavin Graham. A longer version of this article first appeared in The Income Investor newsletter. Used with permission.
The commentaries contained herein are provided as a general source of information, and should not be considered as investment advice or an offer or solicitations to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however, accuracy cannot be guaranteed. Investors are expected to obtain professional investment advice.
The views expressed in this post are those of the author. Equity investments are subject to risk, including risk of loss. No guarantee of performance is made or implied. The foregoing is for general information purposes only. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.
Image: iStock.com/Jason Finn
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