CA - Choice Properties REIT: A 5%+ Yielding Grocery REIT

2023-04-17 11:30:00 ET

Summary

• Choice Properties has the same majority owner as its largest tenant. This reduces the tenancy risk.
• The REIT is guiding for a 2-3% FFO per share increase this year.
• 99.8% of the debt has a fixed interest rate. This means the interest expenses will only gradually increase.
• The REIT increased its dividend by a symbolic one cent per year, the first increase since 2017.

Introduction

REITs have been the biggest victim of the interest rate increases in the past year. Rightly so as higher interest rate result in a higher finance expense while it also has a negative impact on the capitalization rates used to determine the fair value of the assets. I liked Choice Properties ( OTC:PPRQF ) ( CHP.UN:CA ) as it has Loblaws as its largest tenant and the Weston family is the largest shareholder of both Choice Properties as well as the main tenant, which means the latter will be very 'sticky'. Thanks to this excellent relationship, Choice Properties got through the COVID crisis without any issue and it also helps to explain why the stock is trading at relatively high levels: if's a safety premium.

The Q4 results were traditionally pretty weak

Rather than looking at the REIT's full-year results, it makes more sense to single out the final quarter of the year as that will provide a better overview of how the higher interest expenses are being dealt with. This article is meant as an update of previous articles so for a better background overview of the REIT and its activities, I'd like to refer you to my older articles on Choice .

In the fourth quarter of 2022, Choice reported a C$579M loss. This was mainly caused by the C$859M adjustment to the fair value of the exchangeable units while the C$193M increase in the property valuations was deducted again as well. This resulted in a FFO of C$174.2M or C$0.241 per share. The full-year FFO per share came in at C$0.964 which means the REIT is currently trading at about 15 times the FFO.

I don't want to solely base my decisions on the FFO performance of a REIT and I also like to have a look at the AFFO as that provides a more realistic outlook of how the REIT is actually performing. As you can see below, there are about C$35.5M in capital expenditures and an additional C$5.2M in tenant improvements. This meant the AFFO per share came in at just C$0.175 which is pretty low.

I'm not terribly alarmed by this as Choice Properties usually has a very capex- heavy fourth quarter and 2022 wasn't any different. As you can see, about 50% of the 'property capital' was spent in the final quarter and that obviously is a disproportionately high percentage. But we saw a similar result in 2021 when in excess of 65% of the annual 'property capital' was spent in the final quarter.

This means the final quarter is traditionally very weak on a reported basis, but the result gets 'smoothed out' during the year and the AFFO for the entire financial year came in at almost C$582M or C$0.804 per share. This indicates Choice is trading at about 18 times the AFFO. The REIT is guiding for a 2-3% FFO per share increase and we can likely expect a similar increase in the AFFO performance for this year, which would further increase the AFFO per share to C$0.82-0.83 per share.

Fortunately Choice Properties made the smart decision to lock in pretty much its entire interest rate risk. Approximately 99.8% of its debt has a fixed interest rate (on a GAAP basis), as you can see below.

And thanks to its staggered maturity profile , the interest expenses will only gradually increase and could very well be mitigated by increasing rental revenues. It is encouraging to see the REIT is guiding for a small FFO increase this year, but the real litmus test will following 2024.

The distribution was hiked for the first time since 2017

Choice Properties has been paying a distribution of C$0.74 per share per year payable in twelve equal monthly installments but from this year on, the distribution will be increased to C$0.75 per share . The distribution will still be paid out in twelve monthly payments of C$0.0625 per share. This means the dividend yield currently exceeds 5%, and that's quite attractive for a REIT with a 'sticky' largest tenant.

One of the main complaints I heard about Choice was the REIT not having increased its dividend for a very long time, and this year's symbolic 1 cent increase could perhaps be the start of additional small increases in the future.

Investment thesis

I generally don't like to pay 18 times the AFFO for a retail REIT but there are some mitigating circumstances here. First of all, and likely the most important element, is the strong connection to the Weston family. Weston owns the majority stakes in both Choice Properties and its largest tenant, and this pretty much 'guarantees' the main tenant will stick around. And fortunately Loblaws are paying normal market rents to Choice Properties so it's not like the superstore chain is getting 'special treatment'.

Secondly, the distribution is well-covered and even after the recent increase, the payout ratio will likely still be just around 90% which means Choice Properties will likely be retaining C$40-50M per year in AFFO to fund its development portfolio.

Choice Properties is not the REIT with the highest yield, but it offers safety. I have a long position in Choice Properties REIT but will only add on dips.

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