Income investors were surprised by RioCan REIT (TSX:REI.UN) when the Canadian retail real estate investment trust (REIT) cut its monthly cash distribution by a third in 2021. The rapid increase in interest rates since 2022 put a lot of businesses off guard. They lead to a higher cost of capital that deters growth.
Despite higher interest rates, the Canadian retail REIT appears to be in a good position to provide safe returns for investors. The stock valuation has come down, and its cash distribution is sustainable.
RioCan REIT has a premium retail real estate portfolio
RioCan REIT’s portfolio consists of about 182 income-producing properties that are primarily in major markets in Canada. The net leasable area is diversified as follows: 56% in the Greater Toronto Area, 13% in Ottawa, 12% in Calgary, 6% in Vancouver, 5% in Edmonton, and 3% in Montreal.
Moreover, it targets owning necessity-based retail properties and open-air shopping centres. Therefore, its properties have a premium valuation to the sector. It also has 10 properties that are under development.
The REIT’s property type is diversified at 85.8% in retail, 10% in office, and 4.2% in residential. About 87.4% of its net rent is from strong and stable tenants.
Balance sheet remains solid
RioCan has a solid balance sheet. It has an investment-grade S&P credit rating of BBB. In a higher interest rate environment, it has actually limited the use of debt issuance. On the trailing 12 months that ended at the end of the third quarter (Q3), the REIT only issued $172 million in new debt to help fund its development pipeline. As of the end of Q3, its weighted average interest rate was manageable at 3.8%.
After reporting its Q3 results, RioCan REIT’s chief executive officer, Jonathan Gitlin, appeared on BNN Bloomberg and noted that they’re trying to reduce debt on its balance sheet. Because of higher costs, such as in financing and labour, over the medium term, the retail REIT is expected to slow down on its construction.
At the end of Q3, its adjusted debt-to-adjusted EBITDA (a cash flow proxy) was 9.5 times. It is targeting reducing the ratio to eight to nine times by 2026. This ratio will improve as its developments (primarily in residential) generate income and residential portfolio stabilizes.
Lower valuations in properties but cash flows remain resilient
Gitlin also noted that generally speaking, as interest rates go higher, cap rates, the expected return when you buy a property, also go higher. This implies that the account value of property values go lower in such an environment, which has triggered a write-down of its assets.
The year-to-date retention ratio was decent at 85.7%. Importantly, it’s able to renew at a higher rate. Specifically, its renewal leasing spread was 10.2% (up from 8.2% a year ago). As well, the committed occupancy rate remains high at 97.5% (up from 97.3% a year ago).
In the period, its funds from operations marginally improved to $398.4 million. On a per-unit basis, they increased 3.1% to $1.33, which equates to a FFO payout ratio of about 61%. The payout ratio is more conservative than most REITs likely because RioCan has been selling non-core assets and making acquisitions (such as in residential rental properties and land assemblies for development).
RioCan REIT is a cheap stock to buy for monthly passive income
Gitlin also noted that there has been essentially no retail property building in the sector over the last decade. And it would make no sense for someone to do so today because the replacement cost is high.
At $17.51 per unit at writing, the undervalued stock trades at a discount of 31% from its net book value per unit of $25.49 at the end of Q3. According to TMX, recent analysts who rated the stock believe it should be worth about $22.09 in the next 12 months. This represents a solid discount of about 21%. It also offers a high cash distribution yield of under 6.2% on a sustainable payout ratio.
In the past, RioCan’s cash distribution has primarily been comprised of other income and capital gains. So, interested investors should consider holding units in tax-advantaged accounts like the Tax-Free Savings Account.
