After the U.S. banking crisis, investors are worried about stocks whose assets are losing value due to rising interest rates. Then there is an anticipation of a property bubble waiting to pop, as Canada’s housing prices dropped 15.8% year over year in February 2023. Could these external factors of drying liquidity and falling real estate prices affect your monthly passive income from SmartCentres REIT (TSX:SRU.UN)?
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SmartCentres REIT’s Walmart connection
SmartCentres REIT’s strength and weakness is its huge exposure to Walmart (NYSE:WMT). Walmart has built resilience to the worst recession by selling almost everything. SmartCentres used this very strength of Walmart and made it its own. The real estate investment trust (REIT) earns 25% of its rental income from Walmart stores and another good amount from Walmart-anchored stores.
Walmart has helped the REIT survive the pandemic without any distribution cuts, as the former’s stores were categorized as essential services. The biggest risk for SmartCentres is if Walmart decides to close its stores. But that risk is unlikely to materialize in the current crisis.
Is your monthly passive income from this REIT safe?
A REIT pays monthly distributions from the cash flow it receives from rents and capital gain from the sale of the property. So, if you are worried about the safety of your monthly distributions from your investment in SmartCentres, look at three fundamentals: occupancy ratio, distribution payout ratio, and leverage ratio.
The occupancy ratio tells you how much percentage of the properties the REIT owns are occupied by tenants and generating rental income. During the pandemic, the occupancy ratio fell drastically, which caused some REITs to cut distributions. At the end of 2022, SmartCentres had a 98% occupancy ratio, which is in line with its pre-pandemic level.
The distribution payout ratio shows the percentage of cash flow earned from operations the REIT distributes to shareholders. SmartCentres’s payout ratio increased to 96.7% in 2022, as its net income and cash flow reduced by 38% and 4%, respectively. Such a high payout ratio is not sustainable for a longer period. The REIT can preserve its distributions if it doesn’t face a liquidity crunch and can raise capital.
The leverage ratio tells you whether the company’s operations can repay its debt obligations. A leverage ratio could rise in the current environment where borrowing has become expensive, and real estate prices are falling. SmartCentres’s leverage ratio (adjusted debt to adjusted earnings before interest, taxes, depreciation, and amortization) increased to 10.2 as on December 31, 2022. This ratio increased, as rising interest rates reduced the fair value of its properties, thereby reducing its net income by 35.6%, or $351.7 million, in 2022. Unlike banks, REITs realize the losses from the decline in property value, which saves them from any surprises.
The above ratios show that SmartCentres’s distributions are stressed and at risk of a distribution cut.
Is SmartCentres REIT stock a buy in the dip?
| Year | 2017 | 2018 | 2019 | 2020 | 2021 | 2022 |
| Annual distribution per share | $1.71 | $1.76 | $1.81 | $1.85 | $1.85 | $1.85 |
| Adjusted cash flow per share | $2.1 | $2.13 | $2.08 | $2.11 | $2.05 | $1.9 |
| Payout ratio | 81.80% | 83.00% | 87.50% | 87.20% | 89.50% | 96.70% |
The REIT managed to keep its distributions at $1.85 per year, even when its payout ratio surged. But investors have priced the interest rate risk, pulling the stock down 22% since the first rate hike in March 2022. SmartCentres is also exposed to property bubbles.
In the best-case scenario, rate hikes will pause, property prices will begin rising, SmartCentres payout ratio will improve, and your monthly passive income remains safe. If you buy the stock now, you earn a 7% yield and get a chance at 15-18% capital appreciation.
In the worst-case scenario, the property bubble bursts, SmartCentres stock price dips further, and it slashes distribution by around 30%. This cut could reduce the distribution yield to 5%. If you buy the stock now, you would earn a 5% yield and see a 15-20% dip in stock price.
SmartCentres is a risky stock but is also offering a higher reward. Weigh your risk and reward before investing. And diversify across sectors to mitigate the downside.
