CA - First Capital REIT: Focusing On AFFO Growth After The Shareholder Fight

2023-07-04 10:35:00 ET

Summary

• First Capital REIT is a Canadian commercial REIT with most of its rental income generated from necessity based tenants.
• The Q1 FFO and AFFO was hit by C$7M in non-recurring expenses related to a shareholder fight.
• I expect the AFFO/share to exceed C$1 in 2024.
• Thanks to strong leasing spreads, First Capital has a shot at completely compensating higher interest expenses by a higher NOI.

Introduction

First Capital REIT ( FCR.UN:CA ) ( OTC:FCXXF ) is a Canadian commercial REIT that has recently been the subject of a shareholder activist campaign. Artis REIT ( OTC:ARESF ) ( AX.UN:CA ) acquired a stake in First Capital and pushed for changes, and in March of this year, both companies came to an agreement after the board of directors and chairman were replaced . This means the REIT can now direct its attention to the day-to-day operations again. First Capital also saw its share price decrease in the past few months as the REIT lost about a quarter of its value. Plenty of reasons for me to have a closer look at its performance and how the increasing interest rates may impact the FFO and AFFO results.

A breakdown of the REIT’s focus and Q1 performance

The REIT is predominantly focusing on Eastern Canada as about half of its portfolio value is located in the Greater Toronto Area while about 65% of the annual minimum rent is generated in the provinces of Ontario and Quebec.

Although the REIT is classified as a commercial REIT, there are several differences between the different types of commercial REITs. In First Capital’s case, about 17% of the rent comes from grocery stores with an additional 15.5% generated by medical and healthcare-related tenants. Pharmacies account for an additional 9% of the rent while banks and dollar stores (including Walmart) add about 6%. This means that in excess of 50% of the annual rental income comes from tenants that should perform well, irrelevant to how the local economy evolves.

First Capital was able to increase the occupancy and the rental income in the first quarter of this year. The average occupancy increased to 96.2% while the lease renewals happened at a 9.3% net rental rate increase. Only 650,000 square feet of leases (about 3% of the portfolio) had to be renewed so the impact on the financial results won’t be too impressive, but the trend and evolution is encouraging.

Looking at the net operating income in the first quarter of this year, First Capital saw a 2% increase in the total rental revenue and a similar percentual increase in the operating costs. This means the total NOI margin remained virtually unchanged at 58.5% and the total NOI came in at C$103.1M. A good result as the rent increases on the remaining assets compensated for the dispositions that were completed subsequent to the end of the comparable period last year.

A strong increase in the NOI is interesting, but unfortunately First Capital had to deal with a lower FFO and AFFO. As you can see below, the FFO decreased by approximately 2% to C$53.5M. As there are currently 212.5M units outstanding, the FFO per unit was approximately C$0.25.

Moving over to the AFFO calculation, we need to deduct the sustaining capex and the different lease adjustments from the equation. This results in an AFFO of C$43.9M for just under C$0.21 per share.

While it sounds disappointing to see a 2% NOI increase but a lower FFO and AFFO result, keep in mind a substantial portion of that difference could be explained by the increasing interest expenses. According to the income statement, the net interest expenses increased from less than C$31M to just under C$33M. This obviously does not explain the entire difference and the main reason for the lower FFO and AFFO are the non-recurring expenses the REIT incurred related to the fight with the activist shareholder. According to the footnotes to the income statement, First Capital spent about C$7M in legal, advisory and settlement costs . This means these non-recurring items had a negative impact of about C$0.03 per share on the FFO and AFFO result and on an adjusted basis, the normalized AFFO in Q1 would have been around C$0.24 per share (this still includes the higher interest expenses).

The REIT is currently paying a monthly dividend of C$0.072 , which works out to C$0.864 per share per year for a 5.9% yield. The distribution is fully covered by the AFFO (adjusted for the non-recurring expenses it incurred in Q1 2023).

The main risk? The increasing cost of debt

It goes without saying REITs are feeling an awful lot of pressure from the debt markets. Although FCR’s gross debt to assets ratio is a reasonable 44.6%, keep in mind the average cost of debt is just 3.8% right now. A 200 bp increase in the cost of debt based on the C$4.2B gross debt would increase the total interest expenses by about C$84M, or C$21M per quarter. That’s C$0.10 per share and this would result in a pro forma AFFO of C$0.14 per share.

Of course that’s just a theoretical example as the total cost of debt obviously won’t increase by 200 bp overnight. As you can see below, the maturity dates of the existing debt are well-spread out in time and we will only see a gradual increase of the average cost of debt over the next few years.

There’s very little doubt the average interest rate will increase (just to give you an idea, the 2028 debenture is trading at a yield to maturity of around 6%), but I anticipate the average annual increase will be just around 50-55 bp per year. This means that the impact will likely remain limited to C$0.10 per year to the AFFO on a per-share basis. This also means that an annual increase in the NOI by 5% would completely offset the impact of the gradually increasing interest rates.

Other than the increasing cost of debt, First Capital will obviously have to put in an effort to keep the occupancy high. Based on the lease maturity profile (below), about 30% of the annualized minimum rent will be up for renewal between now and the end of 2025. Recent lease spreads were encouraging but it will be more important to keep the assets occupied rather than pushing through aggressive rent hikes. That being said, as you can see below, the average minimum rent per square foot up for renewal in 2024 is just C$22.47 which is about 10%-15% below recent market rates, so we should definitely see an uptick there, but it will likely remain limited to the mid to high single digits.

Investment thesis

While I definitely expect First Capital to report a higher result in the second quarter as the non-recurring items related to the shareholder fight should no longer occur, this doesn’t mean the stock is cheap. Even after the recent share price decrease, First Capital is trading at about 15 times its normalized AFFO based on the Q1 results.

That being said, First Capital recently announced the sale of C$184M in assets which have an average 3% NOI yield. This means the REIT is giving up less than C$6M in NOI while it can use the cash to reduce its interest expenses by C$10M+ per year for a net positive impact on the AFFO of C$0.02 per year. So I like the direction the REIT is heading and I expect to see the AFFO exceed C$1/share next year thanks to the strong leasing spreads which should mitigate the impact of the higher interest expenses.

I currently have no position in First Capital, but I will keep close tabs on the stock.

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