SRRTF - Slate Grocery Q3: Finding No Reason To Agree With The Market

2023-11-29 13:04:52 ET

Summary

• Slate Grocery REIT's valuation has recently become more detached from the underlying fundamentals and the average multiple of sector peers. Currently, Slate trades 40% below the sector average.
• In Q3, 2023, Slate continued to deliver double-digit leasing spreads and further improved its occupancy ratio.
• The risk remains in the 2024-2025 debt maturities, which could impose a higher cost of financing and thus challenge the existing dividend.
• Yet, this risk is rather minimal given that the existing cost of financing levels are already high and close to the levels that Slate can access via mortgage financing.
• 40% discount, in-place rents below the market levels, and resilient fundamentals make the investment case very attractive together with the currently provided 11% dividend yield.

About a half year ago I initiated covering Slate Grocery REIT (SRRTF) with a recommendation to go long.

There were really three major drivers behind the bull thesis:

1. Resilient FFO with a strong growth momentum. SRRTF operates in a durable grocery-anchored segment and carries in-place rent levels that are way below market levels. The fact that the portfolio is greatly occupied and the retention rate of grocery-anchored lease renewals has been 100% over the past couple of months indicates a high degree of resiliency.
2. High debt, but with already priced in impact. In my opinion, one of the reasons why SRRTF has been so discounted by the market is the relatively debt-saturated balance sheet. SRRTF has a leverage ratio of 49% and a fixed charge coverage ratio of 2.3x. While both of these measures imply a fair degree of financial risk, if we compare them to the stipulated covenants (65% for leverage ratio and 1.5x for fixed charge coverage ratio), the risk of distress seems quite distant. The most important thing here is that SRRTF's debt which is already reflected in the books yields 4.3%, which is not too far away from market level cost of financing. This means that a combination of internal (undistributed) FFO with incremental like-for-like cash generation should be sufficient to offset any further headwinds on the interest expense front.
3. Unjustified discount. SRRTF trades at a Price-to-FFO multiple of 9.2x, which results in a 35% discount relative to the U.S. equity retail competitors. Given the resiliency of cash flows, embedded rents that are below market levels, and to a large extent already absorbed effects from higher SOFR a discount in the vicinity of 30% does not seem logical.

Yet, since the publication of my first bull article, SRRTF has considerably underperformed the broader REIT market.

On a total return basis, SRRTF decreased by ~11%, while the overall REIT market registered a positive growth at ~4% over the trailing six-month period.

As a result, SRRTF's valuation in terms of P/FFO (and on a TTM basis) has diverged even further from its U.S. peer universe reaching a discount of 42% (P/FFO of 7.2x versus 12.5x). Consequently, SRRTF's dividend yield has increased to 11%.

Now, the question is whether after Q3, 2023 results Slate has become a fundamentally weaker investment that could justify the widening of the valuation gap; or perhaps, the opposite, the investment case has become more attractive.

Synthesis of Q3, 2023 results

During the Q3 period, SRRTF continued to deliver robust results on the leasing end, capturing a spread of ~11% to average in-place rents. Importantly, these new deals that are associated with either unoccupied properties or new tenants generate a huge spread, i.e., at ~18%.

On the portfolio occupancy front, SRRTF continued to register improved results. The end-of-quarter occupancy increased by 20 basis points reaching 94.1%, which, in turn, translates to a year-to-date increase of 90 basis points.

As a result of this, the same store NOI grew by 2% accordingly.

The most important message here is that there is a structural demand for SRRTF properties considering resilient occupancy and double-digit leasing growth. It also means that the embedded rent (lease) levels are below the market level and, importantly, SRRTF seems to be able to capitalize on these spreads.

If we compare SRRTF to its closest peers operating in the U.S. equity REIT (freestanding) segment in terms of the in-place rents, SRRTF sticks out as a clear laggard. On average, competitors have priced their lease agreements a bit over $20 PSF, while for SRRTF the weighted average rent level is at ~$12.4 PSF. This translates to a discount of ~40%, providing a solid basis for SRRTF to generate double-digit spreads (which we can already notice by looking at the recent leasing activity).

Fortunately, SRRTF's lease expiry schedule indicates that there will be opportunities to capture incremental spreads in 2024 as roughly 17% of the total leases have already been resigned at double-digit spreads that will start generating new rents in 2024. Plus, SRRTF has an additional ~14% of leases left that could be subject to improved rent levels. Granted, there is a risk of not finding new tenants or not renegotiating with the existing ones, but given the historical performance, this seems like a rather low-probability event.

So far we have established that from the business operation and organic NOI perspective, SRRTF is well-positioned to deliver strong returns on a go-forward basis.

However, as mentioned a bit earlier, SRRTF's capital structure is not among the safest ones in the sector. As of now, SRRTF carries ~50% of leverage and has a fixed charge coverage ratio of 2.2x.

While in 2023 there are no material debt maturities, the 2024-2025 period is heavily exposed to potential refinancing risk as many term loan fall due at that time. Roughly $850 million of maturing debt is a lot given the annual FFO generation capacity of ~$65 million (or $130 million for that matter).

In my opinion, there is not a risk of not accessing financing. This is also something that the CEO has confirmed; according to Blair Welch - CEO in the most recent earning call:

"And we are also fortunate that whether it's Life Cos banks or other structured finance, buyers of paper want the stability of grocery. So we have not heard of any of our lenders kind of backing off out of this space. We know in other spaces they are. But I think we're still in positive leverage."

The key risk is related to higher debt financing costs that would stem from freshly refinanced term loans. Rolling over ~$850 million of debt at, say, a couple of hundreds of basis points above the prevailing levels would impose notable headwinds to the underlying FFO generation and SRRTF's ability to service the dividend given ~80% FFO payout ratio.

With that being said, I do not think that the forthcoming debt maturities will impact the existing distributions to the shareholders. There are three reasons for this:

1. Currently, SRRTF's weighted average cost of financing is at 4.2%, which is rather close to the market levels. In other words, it is highly unlikely that the repricing of debt over 2024 and 2025 would consume all of the remaining shares of the FFO payout.
2. The two most recent financings showed that SRRTF is able to access mortgage financing that is somewhat in line with the current weighted average cost of financing of 4.2%. For instance, in the last transaction back in 2022, SRRTF refinanced its mortgage loan for $46.5 million at an interest rate of 4.56%. According to the Management , an interest rate of ~5% seems currently totally accessible on the mortgage financing level.
3. By looking at the current projections on the Fed Funds rate, there is a high probability of experiencing some first rate cuts already in 2024, which should further come in handy for SRRTF during the refinancing of its term loans.

The bottom line

The disconnect in the valuations of SRRTF and the sector peers is unjustified. It seems that the market has been heavily punishing SRRTF because of its relatively considerable debt maturities in 2024 and 2025 and fully neglecting the improvements (and resiliency) in the underlying operating performance. Plus, it is difficult to rationalize the ~40% discount, when SRRTF has so significant potential embedded in its portfolio that is related to the renegotiations of its underpriced lease agreements.

Moreover, the risk of maturing debt proceeds is to a large extent mitigated due to a combination of growing NOI, already high interest costs, and the general expectation by the market of falling interest rates next year.

For me, SRRTF is a clear buy with a nice dividend of 11%, while waiting for some reduction in the valuation gap.

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