CA - Slate Grocery REIT: A Defensive Stock During Recession

2023-03-20 09:38:09 ET

Summary

• Private financing from NA Essential Fund to support growth and defend against liquidity crunch.
• USD denominated distribution benefits Canadian investors as CAD is devaluing against USD.
• Kroger's acquisition of Albertsons created unexpected concentration risk for Slate Grocery.

Slate Grocery REIT ( SGR.UN:CA ) is an owner and operator of grocery-anchored real estate in the United States. As of December 31, 2022, Slate Grocery owns and operates 117 properties with 15.3 million square feet of gross leasable area ("GLA") with major of the properties located on the East Coast. This real estate portfolio is about US$2.4 billion in total.

Slate Grocery's strategy is to own and operate assets that are essential to local communities such as grocery, pharmacy, and financial services people rely on every day, with each property anchored by a major grocery tenant such as Kroger ( KR ) and Walmart ( WMT ).

Slate Grocery's current market capitalization is CAD$828 million (US$608 million) as of March 17, 2023 and provides a yield of 8.67% based on the current rate of distribution at US$0.072 per unit per month.

In 2022, Slate Grocery earned US$177.5 million in rental revenue in 2022 and paid about US$65 million in property management expenses and US$47 million in interest and financing costs. If we think of this as purchasing a single property worth US$100,000, we would earn US$29,194 rent per year, pay US$10,690 on property management expenses, US$3,000 on closing costs, and US$4,730 on interest costs for the year. At least in Canada, this would be a very attractive real estate asset to own.

Capital Access from NA Essential Fund

During the current economic environment, where interest rate is rising swiftly, inflation rate is still high and recession is looming, REITs face various headwinds such as lower valuation on existing assets, increased need for cash to pay higher interest costs on new mortgages, and higher expectation on yield by investors to beat inflation.

In this critical time, during 2022, Slate Grocery completed a strategic partnership with NA Essential Fund, also managed by Slate. NA Essential Fund provides Slate Grocery important access to a large amount of capital. With this, Slate Grocery can maintain its strong balance sheet and confidence with lenders, which helps Slate Grocery obtain favorable mortgage terms. In fact, 92.9% of Slate Grocery's debt has a fixed term that is not impacted by the near term rising of interest rates. Also, this capital allows Slate Grocery to identify acquisition opportunities to continue adding properties to its portfolio. With the initial contribution of US$180 million from NA Essential Fund, Slate Grocery acquired 14 properties in 2022 for an aggregate purchase price of US$424.5 million. To put it in perspective, this acquisition represents about 20% of Slate Grocery's total portfolio.

Anchor and Non-Anchor Tenants

One of the competitive advantages that Slate Grocery has is its relationship with its anchor tenants such as Kroger, Walmart, and Albertsons ( ACI ). In a property that Slate Grocery manages, it typically brings in an anchor tenant with a lease term between 5 and 10 years and relatively lower base rent. With such anchor tenant, the property then attracts non-anchor tenants to fill the remaining space with generally shorter lease term between 3 and 5 years and higher base rent.

Retention rate with anchor tenant for 2022 is 100% meaning that no anchor tenant has not sought a renewal upon lease maturity with Slate Grocery.

However, one may be concerned to learn that retention rate with non-anchor tenant for 2022 is only 87.6%. This is in fact better for Slate Grocery. Churning over non-anchor tenants helps Slate Grocery lease existing areas to new non-anchor tenants at a rental rate closer to market. This is how, on average, Slate Grocery can increase in-place rent rate gradually closer to market rent.

USD Denominated Distribution for Canadian Investors

As a Canadian investor myself, although modern technology has made it extremely easy to buy U.S. stocks or index funds, I still find it inconvenient. For example, if I purchase VFV S&P 500 Index ETF listed on TSX in CAD, my return is generally decreased by the 15% withholding tax imposed by the U.S. on distribution. The only way around is for me to purchase VOO S&P 500 Index ETF listed on Nasdaq with USD funds through a USD RRSP account. However, I would need to have existing USD funds in my USD RRSP account to make such purchase. Otherwise, I would have to exchange my CAD funds to USD funds with various foreign exchange fees and use the USD funds to make the purchase of U.S. stocks in RRSP.

With Slate Grocery, because it is listed on TSX, I can purchase CAD denominated REIT units from TSX and gain exposure to the fairly diversified real estate portfolio in the U.S. without worrying about the 15% withholding tax impacting my return.

Slate Grocery's USD denominated distribution is exchanged into CAD when being received by unitholders. Given that such USD denominated distribution is constant, as CAD becomes cheaper relatively to USD, the CAD funds received by unitholders would be greater. For example, in March 2022, a US$0.072/unit distribution resulted in CAD$0.09022/unit while in February 2023, the same US$0.072/unit distribution resulted in CAD$0.09839/unit. This is a 9% increase on distribution without Slate Grocery actually increasing its side of distribution. As Bank of Canada holds interest rate while the U.S. Federal Reserve continues to hike interest rate, CAD is at risk of continued devaluation against the USD. Slate Grocery's USD denominated distribution will help unitholders benefit from such a trend.

Room for Growth

Slate Grocery's occupancy is at 93.2% currently while similar REIT such as Plaza REIT and RioCan is at 97% for 2022. Through the consistent capital expenditure in recent years to improve existing properties, Slate Grocery may expect to increase occupancy rate, which results in direct organic growth on AFFO.

However, despite these opportunities, there are challenges facing Slate Grocery that investors should be aware of.

AFFO Payout Ratio

Slate Grocery's AFFO payout ratio is at 96% for 2022 Q4, much higher compared to some other grocery strategy REITs based in Canada, such as Plaza REIT (87% for 2022) and RioCan REIT (67% for 2022).

Interestingly, Slate Grocery's AFFO payout ratio has always been on the high end compared to other REITs. It may signal its management team's confidence on its real estate portfolio and capital access that it can afford to pay out to unitholders at such a high rate. Still, the AFFO payout ratio is close to 100% and if things don't go as expected, there will be a reduction on distribution for Slate Grocery while RioCan has ample room to increase distribution from its 67% AFFO payout ratio currently.

Inflation and Interest Rate Increases May Outpace Slate Grocery's Ability to Increase In-place Rent Accordingly

Although Slate Grocery has 92.9% of its debt at fixed rate, it still has 7.1% of its debt at variable rate (approximately US$81 million) that is increasing Slate Grocery's interest costs slowly. In addition, there is a mortgage of US$104 million (interest rate of 4.03%) that is to be renewed on Dec 6, 2024. There may be an increase on interest cost upon renewal if interest rate continues to rise.

In addition, although Slate Grocery's in-place rent is steadily increasing from US$11.6 in 2021 Q4 to US$12.22 in 2022 Q4, this 5.3% increase on in-place rent is still relatively lower than the current rate of inflation. If Slate Grocery's property management expenses increase faster than the increase on in-place rent, Slate Grocery would be at a net loss position. Fortunately, Slate Grocery's management team has been able to control expenses to steadily decrease AFFO payout ratio in 2022, this may be more difficult to achieve in 2023 and 2024.

Largest Anchor Tenant, The Kroger Co., Just Acquired 5th Largest Anchor Tenant, Albertsons

Among the top 5 anchor tenants of Slate Grocery, Kroger (currently 6.5% of total base rent and 25 stores with Slate Grocery) just acquired Albertsons (3% of total base rent and 10 stores with Slate Grocery) in October 2022. Together, Kroger will now contribute 9.5% of total base rent and have 35 stores across Slate Grocery's portfolio. 35 stores represent presence in 30% of 117 Slate Grocery's properties, which is very significant. It is not difficult to imagine that Kroger would like to achieve synergy from the acquisition of Albertsons, by either closing down Albertsons stores that are competing with existing Kroger stores or by re-negotiating better lease terms with Slate Grocery. Either way, it is something Slate Grocery management has to address in the near term.

Conclusion

Slate Grocery's access to capital, strong anchor tenant relationship, and solid grocery based real estate strategy in the U.S., and USD denominated distribution position itself as an attractive investment for investors, especially Canadian investors looking for diversified exposure.

However, Slate Grocery's management has a lot of work to do to continue controlling expenses below the rate it can increase in-place rent and manage the relationship with Kroger.

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