CA - Granite REIT: Revisiting This Industrial REIT

Summary

• Granite REIT is a top-class Canadian industrial REIT.
• We have stayed away due to its lofty valuations in the past.
• We review it in light of the recent results and price action and suggest an alternative.

All values are in CAD unless noted otherwise.

Granite Real Estate Investment Trust ( GRP.U ) ( GRT.UN:CA ) is an owner and manager of logistics, warehouse and industrial properties in North America and Europe.

This Canada-based REIT has been busy adding properties to its roster since the last time we covered it in 2021. It is now larger by net 24 properties since Q1 2021. While its portfolio and consequently revenue have increased since we last reviewed Granite, its weighted average lease term or WALT has reduced from 6.1 and occupancy levels are down from 99.1% comparatively.

Magna International Inc. ( MGA ) is a solid company, and we think highly of it. Nonetheless, it is good to see Granite making a concerted effort to reduce its concentration in Magna year after year. To put it in perspective, Magna occupied 94% of the gross leasable area or GLA back in 2011 compared to the 21% we see today. Annualized revenue has similarly moved lower from the high 90s to just 28% today.

We chose to stay out after reviewing this REIT in July 2021, as the valuation was too rich for our taste, quality notwithstanding.

Granite has performed poorly since then, but that has been the case for pretty much all REITs as they have been hit by dual worries of higher rates and a recession. In light of the downward price action, let's review the recent results to see if this is an opportunity to buy.

Q2-2022

2022 revenue and funds from operation (FFO) numbers have come in better than the prior year, even the per unit amounts despite an increase in the number of units.

What was most notable here was one of the rare fair value write-downs on property values. Under IFRS, Granite marks its properties to what it believes are fair values. In the case of industrial properties, this has been a one-way train for pretty much all of the last seven years outside of two to three quarters during COVID-19. Granite wrote down its properties by $251 million, which is reflected under the net loss above. This was the expected response to the increasing interest rate environment, resulting in a capitalization rate expansion.

One aspect that is fascinating here is the overall cap rate is still at a tiny 4.53%. Canada's cap rate was estimated to be at 5.34%. While we are not debating exactly where these numbers stood at the end of Q2-2022, we want to draw the reader attention to the fact that these have moved just 20 basis points in Canada from December 2021. From late last year to now, the 1-year GIC (equivalent of US CD) has moved more than 250 basis points. Our simple conclusion here is that we think the REIT is underestimating the cap rates and expect the write-downs to continue in the subsequent financial results. Granite's price to tangible book value has also compressed, likely reflecting a new-found fear of more NAV write-downs. The stock is trading at one of its lowest NAV multiples outside of the COVID-19 crash.

Keep in mind, though, this NAV multiple runs off what the management thinks is fair value today. While the 14% discount to NAV sounds rough, it appears the market has just priced the REIT based on a 5% cap rate. We think the stock has further to fall. As you can see below that even with a slight increase to a 5.5% cap rate assumption, the current stock price is actually higher than the NAV.

The management however is showing tremendous confidence in the Q2 NAV as the REIT has started buying back shares slowly. In the first half of this year, they purchased around 380,000 shares at an average price of $79.

This is of course different than the large swaths of stock Granite issued when the stock was trading at a premium.

Dividend

Granite boasts of 12 consecutive annual dividend hikes. With modest payment ratios, we think the REIT has done admirably in that regard, and some of the historical data can be seen below.

While we definitely do not expect a cut, it will be interesting to see if we see another increase next year. As it stands, it falls in the middle of the pack among its peers.

While the yield is respectable, we can see that historically, Granite has yielded a higher spread to the 10-year Government of Canada (GoC) rates.

Why 10-year GoC rates? There are a couple of reasons for this. The first being that it is the "risk-free" rate and prices everything else. In the case of REITs, capitalization rates also tend to move with the same rate. In an ideal world, we would like to see at least a 200 bps spread before we buy the REIT for its yield.

Verdict

Granite is easily one of the best REITs in the world, in our opinion, thanks to a strong focus on risk management and extremely low leverage. That advantage is somewhat offset by having very low cap rate properties. Valuation is particularly sensitive at the low end of the cap rate spectrum, and we forecast some more hits to NAV. The offset here is that raging inflation pushes up land prices and replacement cost values of buildings, so we would not expect cap rates to expand as much as the 10-year rate rises. Our choice in the industrial space remains Dream Industrial ( OTC:DREUF ) ( DIR.UN:CA ), but we are warming up to Granite as well. We have our eyes on a couple of strikes for selling Cash Secured Puts, and if the price and option premium are right, we will place our bid. At present, we rate this as a "hold/neutral".

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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