With the retail sector softening, Scotia Capital analyst Pammi Bir says it is time to get defensive when it comes to investing in real estate investment trusts and real estate operating companies.
The analysts initiated coverage on four REITs and one real estate corporation and says investors should be looking for landlords with tenants selling consumer staples and value oriented goods.
Mr. Bir. said:
Offense wins games, but defense wins championships. In uncertain markets, stack the defense. In the midst of what has now evolved into a global financial and credit crisis, we believe defensively positioned real estate entities will outperform their peers.
Our approach to defense is twofold: property types and overall investment attributes. Cooling housing markets, decelerating employment gains, and deteriorating GDP growth expectations point to softening domestic retail fundamentals.
Against this backdrop, Mr. Bir sees greater cash flow stability among retail landlords more heavily weighted in consumer staple and value-oriented tenants. He added that the volatility in equity markets and the dearth of credit have raised the cost of capital, favoring entities with well-funded balance sheets.
Mr. Bir rated First Capital Realty (OTC:FCRGF) as his top pick because of a portfolio than includes urban supermarkets and drugstore anchored retail malls. "We believe First Capital is poised to generate the strongest total return in our retail coverage universe," he says.
The analyst said retail REITs valuations are at a modest premium to the overall REIT world.
The 34.3% year-to-date correction in REIT prices (down 47.3% from their February 2007 high) has pushed sector valuations to levels not seen since late 2000. Although current valuations may suggest near trough levels, we believe calling the bottom may prove difficult, given negative investor sentiment.
Based on his net asset valuations, Mr. Bir believes current retail real estate stock prices are trading at a 23.1% discount. Overall, Canadian REITs are trading at a 33.5% discount to NAV. By comparison, U.S. retail REITs are trading at a 46.4% discount to net asset value.
Mr. Bir said:
Until stability is restored across credit markets allowing real estate transaction flows to accelerate (and support our NAV cap rate assumptions), we expect discounts to NAV will persist.
Despite that, he is predicting a 24.1% total return for retail REITS over the next 12 months, with 9.4% of that figure coming from yield and 14.7% from capital gains.