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Canadian Retail Sector – Keep it Simple

Canadian macroeconomic expectations have deteriorated in the second half of 2024. Immigration policies are becoming more conservative, adding to uncertainty. Unemployment rates have lately jumped off as the private sector employment is in recession. In such context, personal income growth per capita should decelerate meaningfully across the country in 2025, while households remain impacted by higher debt service ratios. Expected spending growth is thus trending down, and retail sales volumes have been decreasing since 2022. 

Turning to retail real estate fundamentals, new retail supply has recently been, and should continue to be, minimal in Canada. This is despite the surge in population seen in recent years, which has been beneficial to landlords. Therefore, retail real estate is effectively operating at frictional vacancy in Canada. In parallel, the expected rental rate growth is lower in Canada, a reflection of the slowing economy and Canadian households’ overall condition, which is impacting retailers. The retailer pool is shallower in Canada, constraining the ability to push rents. 

All things considered, market conditions are beneficial to retail REITs. In 3Q24, the sector’s covered names generated SPNOI ranging from 2% to 5%. The group should generate SPNOI growth rates between 2.5% and 3.0% on average in 4Q24 and in 2025. One significant sector risk is retail REITs’ focus on residential density within their existing portfolio. Mixed-use projects, specifically those with a large apartment/condo/townhouse component, are common. 

Current development activity is destroying value for every retail REIT. This is partly due to expected yields that were skinny at the onset and cap rates that have jumped during the development period. Retail market rents suggest new development will not pencil.

bar chart showing current 2Q24 development pipeline within the 7 core REITs under examination in this blog

 

In addition, almost all retail REITs have identified additional density, mostly mixed-use with a significant residential component, to develop. However, if the cost of capital is development prohibitive for apartment REITs, then there's no magic bullet to accretive development for the retail REITs either. Green Street estimates land values at a 10%-50% drop to published values for land that is under various stages of zoning, thereby further eroding net asset value. 

Most retail REITs are scaling down their mixed-use development activities in the near term and are addressing elevated leverage levels. This process should improve balance sheets, and ultimately profitability. 

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