The Bank of Canada swiftly raised the policy interest rate from 0.25% in March 2022 to 5.0% in July 2023 to put inflation under control. The policy interest rate stayed at 5% until the Bank of Canada decreased it to 4.75% last month. Many believe that more rate cuts could be coming. Though, Canadians should not expect rates to return to the very low levels of about 0.25% anytime soon.
How will interest rate cuts affect Canadian real estate investment trusts (REITs)? Eventually, they will lead to lower interest rates for their new or refinanced debt, which will lower their interest expense. How much interest expense is saved depends on the amount of the cuts and how quickly or not they occur. Generally, the cuts would lower the Canadian REITs’ cost of capital as they have large debt levels, which means REIT stock valuations could normalize and rise. So, basically, investors can consider REITs that are trading at good valuations today.
Here’s what happened when interest rates rose.
Let’s take Granite REIT (TSX:GRT.UN) as an example. In 2021, when interest rates were still very low and its debt-to-asset and debt-to-equity ratios were 38% and 61%, respectively, its interest expense was $39.4 million for the year.
In 2023, after a rapid increase in interest rates, Granite REIT’s debt-to-asset and debt-to-equity ratios were 42% and 72%, respectively. And its interest expense was $72.9 million (roughly 85% higher than the 2021 level).
GRT.UN data by YCharts – stock price change since start of 2022
In a higher interest rate environment, especially in the early days of rising interest rates, Granite REIT experienced a sell-off in its stock. In other words, its valuation came down. This was a common scenario across the board for Canadian REITs.
Granite REIT’s fundamentals have stayed resilient. The industrial REIT’s recent occupancy rate was 95% and it has a weighted average lease term of six years. It greatly reduced its concentration risk in Magna International from 93% of its gross leasable area in late 2012 to 19% by the end of 2023, while it has steadily increased its funds from operations per unit (FFOPU). For instance, its five-year FFOPU growth rate was 6.2%.
In late 2021, the stock peaked at a price-to-FFO ratio of about 26.8 at $105 per unit. Today, at $72.66, it trades at about 14 times FFO, which is a good valuation for an industrial REIT that’s expected to continue marching on with steady growth.
Currently, analysts think the stock trades at a discount of 16% with the potential to appreciate about 19% over the next 12 months. The industrial REIT also offers a cash distribution yield of 4.5%, paid out in monthly distributions.
Other than industrial REITs, there are also residential, retail, and diversified REITs that could be worth looking into. If you’re not sure which ones to buy, you can consider an exchange traded fund (ETF) like the iShares S&P/TSX Capped REIT Index ETF, which had been more resilient than Granite REIT in the interest rate hike sell-off.
Accounting for cash distributions, XRE’s total return since the start of 2022 was -17% versus Granite REIT’s -24%. Granite REIT is XRE’s third-largest holding, making up over 9% of the fund’s assets. XRE’s recent yield was 5.3% and it could be less of a bumpy ride on a turnaround.
