EFRTF - Nexus Industrial REIT: A Compelling Blend Of Robust Growth And Strong Yield

2024-01-08 08:18:12 ET

Summary

• Nexus Industrial REIT is aggressively expanding in the industrial property market, positioning itself as a pure-play industrial REIT with strong potential for rental growth and attractive relative valuation.
• Nexus demonstrates a robust financial performance with a high occupancy rate, substantial acquisitions, and significant development investments, contributing to an increased net income through property value adjustments.
• Nexus's primary catalyst for growth lies in the potential for significant rental revenue increases, particularly in Ontario, where a major portion of its portfolio is located.
• The REIT faces potential risks such as a high AFFO dividend payout ratio, share dilution concerns, and susceptibility to fluctuating interest rates, which could impact its debt servicing and overall.

All figures are in unless otherwise noted

All financial information is from Seeking Alpha unless otherwise noted.

Investment Thesis

Nexus Industrial REIT ( NXR.UN:CA )(EFRTF) has demonstrated remarkable aggressiveness in the industrial property acquisition market in recent years. This strategic focus has not only expanded Nexus's portfolio but also streamlined its operations, solidifying its status as a pure-play industrial REIT. From an investment perspective, Nexus offers a compelling opportunity, characterized by promising rental growth that is expected to surpass its peers, along with an appealing relative valuation. The prospect of decreasing interest rates could further bolster Nexus's growth trajectory. However, investors should be mindful of potential challenges, including the possibility of a dividend cut and the impact of recessionary pressures in the short term.

Despite these concerns, I am optimistic about Nexus's ability to navigate these hurdles effectively. For investors with a long-term view, Nexus represents an attractive proposition, combining a robust dividend yield with growth potential, all available at a favorable price point. This blend of income and growth potential positions Nexus as a noteworthy option for those seeking to diversify their investment portfolio in the real estate sector.

Introduction

Nexus Industrial REIT, based in Oakville, Ontario, specializes in industrial real estate and boasts a portfolio of 115 properties , spanning an impressive 13.6 million square feet in gross leasable area or GLA. Nexus directly owns approximately 12.1 million square feet, representing 89.11% of the total GLA.

Their diverse property mix includes 84 industrial sites, 16 retail spaces, 13 office buildings, 2 parcels of industrial land marked for redevelopment, and 1 mixed-use facility. All of these assets are located within Canada.

Asset Class, Geographical, and Tenant Mix

Nexus REIT's 2023 Q3 financials highlight that their industrial properties are the cornerstone of their business, contributing a significant 90.7% to the net operating income or NOI. Retail and office properties make a smaller impact, contributing 5.1% and 4.2% respectively. Geographically, Ontario leads with 31.8% of the NOI, followed by Alberta at 25.7%, and Quebec City contributing 22.4%. Saskatchewan accounts for 14.2%, while New Brunswick adds 3.5%. The remaining 2.4% is split between British Columbia (1.1%), Manitoba (0.7%), and the Northwest Territories (0.6%).

Nexus Industrial REIT holds a strong tenant profile, with their top 10 tenants accounting for 39.5% of the annualized base rent. This tenant roster includes nationally recognized tenants such as Loblaws (11.8%), Ford (3.9%), and Sobeys (3.4%).

Acquisitions and Dispositions

Nexus Industrial REIT has shown a high level of activity in the property acquisition market. In the first 3 quarters of 2023, they expanded their portfolio significantly, acquiring five industrial properties for about $322 million, thereby adding approximately 1.43 million square feet to their gross leasable area. In 2022, Nexus spent roughly $317 million acquiring various industrial properties across Canada.

Concurrently, they've streamlined their assets by selling two properties including one industrial and one retail property. This aligns with their strategic focus on becoming a purely industrial REIT, as evidenced by their plans to sell four office properties valued at $31.6 million.

On the development front, Nexus has also been aggressive, investing $42.4 million in various projects during the first three quarters of 2023. They are currently developing an additional 523,000 square feet, with plans for another 1,083,000 square feet in the pipeline. The projects that are currently underway are expected to be completed in 2024 and are anticipated to yield an average return of 7.2%.

Property Metrics

As of September 30, 2023 , Nexus Industrial REIT's total portfolio boasted a 97% occupancy rate. Breaking it down, the industrial segment led with a 98% occupancy rate, followed by retail at 88%, and office spaces lagging somewhat at 75%.

The lease maturity profile across Nexus's portfolio is well-staggered. About 11.1% of leases are set to expire in 2024, 13% in 2025, 9.1% in 2026, 4.4% in 2027, and the remaining 60.7% extends from 2028 and beyond. The industrial segment has a weighted average lease term or WALT of 7 years, with the retail and office segments at 3.8 and 4.5 years respectively. Across the entire portfolio, the WALT stands at 6.7 years, favorably aligned with the 5.87-year average term to maturity on their mortgages.

In Q3 2023, Nexus successfully renewed 166,805 square feet of expiring leases at a remarkable rental growth rate of 69% and also managed to lease an additional 15,215 square feet of vacant property. Notably, all new leases incorporate rental steps to help mitigate the impact of inflation.

During the first three quarters of 2023, Nexus realized a fair value adjustment of $60.4 million, reflecting an increase in property values. It's important to recognize that these are unrealized gains, contributing 38.3% to the year-to-date net income (Author's calculation). This increase is primarily driven by the growing appeal of industrial properties among investors in Canada. However, I anticipate that this trend might decelerate as we head into 2024.

To conclude our overview of Nexus Industrial REIT, let's turn to their financing structure, particularly focusing on their mortgage and credit facility obligations. As of September 30, 2023, the weighted average interest rate on their property-secured mortgages stood at 3.31%, a slight increase of just 10 basis points from the year-end 2022 rate of 3.21%. The outstanding mortgage balance is approximately $705 million, with these mortgages having a weighted average term to maturity of 5.87 years. Nexus's investment properties are valued at $2.26 billion. However, it's crucial to consider their additional debt from credit facilities, which amounts to $442 million. These credit facilities have variable interest rates, and as of the same date, the weighted average rate was 5.67% (Author's calculation), and over the first 3 quarters of 2023, the variable interest rate paid was 5.74%.

Catalysts

Rental Rates

In my view, the potential for a significant increase in rental revenue stands out as the key catalyst for Nexus Industrial REIT. As of September 30, 2023, Nexus's weighted average in-place rental rate is $9.53 per square foot, while the estimated market rental rate is considerably higher at $11.91 per square foot. This represents a notable 25% potential increase from the current rates.

A major portion of this anticipated rental growth is linked to Nexus's industrial properties in Ontario, which is particularly beneficial given that 43.5% of their GLA is located in this province. In Ontario, the market rent is projected to be 47.8% higher than the current in-place rent. While the expected increases in other provinces are more modest, they are still noteworthy. Alberta, representing 25.2% of GLA, has an estimated rent increase spread of 3.1%, Saskatchewan (15.4% of GLA) a spread of 4.1%, and Quebec (10.1% of GLA) an impressive spread of 42.3%.

When comparing Nexus's estimated market rent to the Q3 2023 industrial report by CBRE , it seems that Nexus's projections are well-grounded and not overly optimistic.

We can see that in Calgary and Edmonton, the rates of $11.27 and $10.51 per square foot would translate to their prediction for Alberta at $11.53. I anticipate the difference between the estimates made by Nexus and CBRE is driven by the fact that the properties Nexus holds in Alberta may be higher-tier assets then compared to the average.

Across Ontario in London, Waterloo, and Toronto we see rates of $10.27, $13.51, and $18.35 per square foot respectively. Comparing that to the estimate made by Nexus at $11.23 it's clear that Nexus is not being overly optimistic with their forecasts. Once again, I believe the main difference in the estimates is due to the bulk of Nexus REIT's investment properties being located in London.

Across Canada, rental rate growth has begun slowing due to a higher supply of industrial space. The pace slowed to 11.8% YoY as per the CBRE report and I anticipate this trend to continue however, Nexus is still in a position to benefit from these higher rates. In fact, the uptick in rental growth has already started to reap benefits for Nexus as the same property NOI for YTD Q3 2023 increased by $2.35 million or 4.1%.

Given all of this optimism, it would be prudent for me to consider that with a weighted average lease term of 6.97 years, the realization of higher market rates could be gradual, unfolding as leases come up for renewal. However, as of the time of writing, Nexus offers an attractive dividend yield of 7.63%, based on a closing price of $8.39. This means investors can benefit from a substantial yield while awaiting the anticipated increases in rental rates. In addition to the yield, Nexus currently has a DRIP in place which offers a 4% discount on shares purchased by dividends further adding to the incentive for holding Nexus for a longer period.

Relative Valuation

Nexus is most comparable to Dream Industrial REIT ( DIR.UN:CA )( DREUF ) and Granite REIT ( GRT.UN:CA )( GRP.UN ) as these are both Canadian industrial REITs. Given that Dream and Granite are both much larger in size, I would expect there to be a small size premium. A size premium leads to inflated pricing multiples for larger companies as investors expect to be compensated more for holding a smaller company.

Based on the latest analyst estimates from Capital IQ and Seeking Alpha, Nexus is projected to achieve a Funds From Operations or FFO of $0.8111 per share and an Adjusted Funds From Operations or AFFO of $0.6788 per share. As of January 5th, 2024, this positions Nexus with a P/FFO multiple of 10.34x and a P/AFFO multiple of 12.36x. When we compare these metrics to its industry peers, Dream and Granite, we observe a notable variance. Dream's multiples stand at 13.37x for P/FFO and 15.07x for P/AFFO, while Granite's are at 14.47x for P/FFO and 16.18x for P/AFFO.

This comparison reveals that Nexus is trading at substantial discounts. Relative to Dream, Nexus's discount is 22.66% for P/FFO and 17.98% for P/AFFO. When compared to Granite, the discounts are even steeper: 28.54% for P/FFO and 23.61% for P/AFFO.

As I mentioned, I would expect Nexus to trade at a discount to these peers as Dream and Granite are larger companies however, I feel the current discounts are greater than what they should be. Therefore, investors are presented with a potential opportunity to pick up Nexus shares at a cheaper price than fair value.

To bolster this argument further, looking at the price-to-book value ratio we can see that over the past year, the spread between Nexus and its peers has expanded and that the current P/B is quite low compared to what it was a year ago today.

In summary, I believe Nexus stands out as an exceptional investment opportunity, offering a compelling valuation reflective of its significant growth prospects. While there may be a waiting period before the full impact of rental increases materializes, the current dividend yield, notably higher than its peers, positions investors favorably for potentially higher returns.

Risks

With every investment, there are a number of risks. I'd like to remind prospective investors that this list is not exhaustive and there are other risks to consider. I believe the following risks are the most critical to the investment thesis.

Potential Dividend Cut & Dilution

As previously noted, Nexus offers a higher dividend yield compared to its industry peers, which is certainly a positive factor. However, it's important to address the company's AFFO dividend payout ratio, which stood at a high 99.1% for the first three quarters of 2023. This marks a noticeable increase from the 92.7% payout ratio at the same point last year, raising some concerns about sustainability.

While the possibility of a dividend cut cannot be entirely dismissed, recent trends suggest a more stable outlook. Specifically, the AFFO payout ratio dropped to 96.1% in Q3 2023, which is lower than the year-to-date average. If this downward trend continues, it would keep the dividend at a more manageable level, although I would prefer to see further reductions for greater confidence. This will be a key aspect to monitor in the fourth quarter of 2023 and throughout 2024.

Additionally, Nexus has expanded its share count significantly, with a weighted average increase of 10.25 million shares from 78.696 million to 88.946 million. This increase is primarily due to the issuance of shares for acquiring new investment properties. While some investors might not see this as a concern, given that the NAV per unit has risen by $0.44 to $12.89, suggesting value-additive deals, there remains a risk. My primary concern is the potential impact on NAV if there's a reversal in the fair value adjustments of investment properties. Despite the general stability of industrial properties, a 0.25% rise in the capitalization rate could erode property values by $89.3 million . This risk factor, albeit somewhat mitigated, is something that requires careful consideration in Nexus's overall investment profile.

Higher Interest Rates & Debt Costs

The dramatic increase in interest rates in Canada is not a secret and I believe its full impact on the economy and real estate sector might still be on the horizon, potentially leading to a tumultuous 2024. Nexus Industrial REIT, like many others, is not insulated from these shifts. Nexus has incurred an additional $8.24 million in interest expenses year-to-date as of Q3 2023. However, it's important to note that this rise is more attributable to an increase in overall debt rather than the hike in interest rates per se. Nevertheless, the prevailing higher interest rate environment could further strain Nexus's dividend payout ratio.

Assessing Nexus's debt position, the current debt ratio stands at 48.5%, which I regard as adequate but something that warrants close monitoring. A notable point is that in Q4 2023, Nexus faced the renewal of mortgages amounting to $29.3 million, carrying a weighted average interest rate of 2.36%. It will be important to see how these renewals played out and at what rate were these mortgages renewed.

Nexus has shown a keen awareness of these financial risks. As stated in the outlook section of their MD&A, they are exercising prudence. While committed to completing existing acquisitions and development projects, Nexus plans to be highly selective about new acquisitions until the economic climate shows signs of improvement.

Looking ahead, if interest rates start to decline, Nexus could potentially benefit from the changing landscape. However, in the current uncertain environment, the risks associated with higher interest rates and the broader economic response to these changes are factors that cannot be overlooked. Nexus's cautious approach in this climate is a prudent strategy, balancing growth ambitions with the need for financial stability.

Conclusion

Key Highlights:

• Growth Potential: Nexus's robust growth prospects are highlighted by their potential for increased rental revenue, particularly in their industrial segment, which constitutes the majority of their net operating income.
• Attractive Dividend Yield: The REIT offers an appealing dividend yield, which is notably higher than its peers, providing investors with a lucrative income stream.
• Relative Valuation: When compared to industry counterparts like Dream and Granite REITs, Nexus appears undervalued, trading at significant discounts in both P/FFO and P/AFFO multiples.

Risks to Consider:

• High AFFO Payout Ratio: The AFFO dividend payout ratio stands at a high 99.1% for the first three quarters of 2023, up from 92.7% last year. While recent trends indicate a stabilization, the potential for a dividend cut cannot be completely ruled out.
• Share Dilution: The significant increase in share count due to property acquisitions raises concerns about potential NAV impact, especially if there's a reversal in fair value adjustments of investment properties.
• Higher Interest Rates: Further increases in interest rates as well as recessionary fears could pose issues for debt serviceability.

Therefore, I believe that those with a long-term investment horizon should consider Nexus as the possibility to benefit from a mixture of growth and income could prove beneficial however, investors must consider their own personal goals, risks, and financial situation before making any investment.

For further details see: