A few more comments from RBC initiating coverage
November 23, 2022
Slate Office REIT
A Differentiated Canadian Office REIT; Initiating at Sector Perform
Our view: We are initiating coverage of Slate Office REIT (SOT) with a Sector Perform recommendation, and $4.75 target price. With its concentration on suburban and secondary markets, and international diversification, SOT occupies a unique niche amongst Canadian office REITs. While our neutral stance is driven by total return expectations vs. the broader REIT/ REOC sector, and a cautious outlook on the office subsector, the recently launched strategic review could serve as a potential catalyst for units.
Key points:
• Suburban & secondary market focus; capital recycling has augmented portfolio quality. Often times overlooked by larger market participants, the REIT’s focus on suburban and secondary office markets generally provides attractive going-in yields. Geographically diversified with assets in Canada, Chicago, and Ireland, capital recycling initiatives have augmented portfolio quality over the years—a trend we expect will continue. Since the beginning of 2019, we estimate the REIT has generated a total levered IRR of circa 20% on $423 million of dispositions.
• Growth has been a focus, but strategic review underway. Strategically, SOT has historically focused on growth via acquisitions in search of enhanced scale. The REIT leverages the expertise of the Slate-AM (its external manager) platform with a focus on acquiring properties below replacement cost, with MTM opportunities on rents. While we see the merits of this strategy, the current macro backdrop, SOT’s cost of capital, and elevated leverage (we estimate SOT’s net debt/EBITDA ratio at 12x vs. our Cdn office peers at 11x) create some challenges looking ahead. With a strategic review now underway, we await further clarity on potential shifts to the go-forward strategy.
• Earnings outlook reflects diverging inputs, but comes with catalysts. Our 2022E/23E/24E FFOPU outlook sits at $0.51/$0.45/$0.46. This reflects low-single-digit SP NOI growth, offset by rising interest costs and net dispositions in 2H/22 which we expect to weigh on earnings into 2023E. While circa $729 million of debt maturities (as of 3Q/22) through year-end 2023E (4.3% WAIR) are a headwind, the REIT has made good progress on refinancings, and should benefit from debt relationships brought by Slate-AM. Our NAVPU sits at $5.00, with our one-year FWD NAVPU reflecting 7% YoY growth (vs. office peers at 9%). In our view, substantial portfolio lease-up could serve as upside to our estimates.
• Trading at a premium to office peers on RBCe NAV; initiating at SP. SOT is trading at a 9% discount to our NAVPU, above our Cdn office peer group avg. discount of 16%. We believe the Trust should trade at a discount to peers given a below-average AFFO CAGR, elevated leverage, and an external management structure. In our minds, the current premium to peers speaks in part to SOT’s above-average yield (8.8%), and income focused investor base. Our target is based upon a 15% discount to our FWD NAVPU (vs. our office peer group average discount of 12%).
Key fundamental questions
Slate Office has framed a growth strategy. What are the benefits, and what risks does this create?
SOT has historically focused on strategic growth via acquisitions in an effort to obtain greater scale, a lower cost of capital, and improved trading liquidity. While we see merit to the above for a small cap REIT, we also believe the current macro backdrop, coupled with SOT’s unattractive cost of equity capital (significant discount to IFRS NAVPU), and elevated leverage create some challenges to this strategy looking ahead. On balance, we prefer to see the issuance of units at or above IFRS NAVPU. That said, while difficult to predict the ultimate outcome, the recently announced review of strategic alternatives, along with unit repurchases—the first since Q1/20, could suggest a more balanced approach to growth looking ahead.
How do higher interest rates impact the REIT?
As of 3Q/22, SOT had a significant $729 million (63% of total debt) of debt maturities through year-end 2023E (4.3% WAIR). Broadly speaking, management has pointed towards LTV's in the range of 60% on maturities. While we are less concerned with the availability of financing, in part due to the size and debt relationships of Slate-AM, we do expect refinancings, for which the REIT has made strong progress since Sept 30, to be completed at higher interest rates (+30 - 225 bps vs. expiries), and weigh-in on earnings into 2023E. Increasing interest rates also present some challenges in relation to potential growth initiatives, given the impact on cost of capital, and potential influences on transaction activity and cap rates. All else equal, a 25 bps increase in cap rate equates to a -11% impact on our NAV estimate.
SOT has historically traded at a discounted valuation vs. office peers, why?
In our view, SOT’s historical discounted valuation reflects a number of factors including its relative market cap/trading liquidity, elevated financial leverage, and an external management structure. In addition, we believe the discounted valuation is also impacted by SOT’s negative per unit earnings growth over the past 5+ years. Looking ahead, we believe that consistent and improved performance with respect to portfolio fundamentals (SP NOI, occupancy), and earnings growth represent significant catalysts that could help narrow the REIT’s valuation gap.
How does leverage compare vs. peers?
At 58% D/GBV, and 73% LTV (based on our NAVPU), Slate Office’s leverage metrics sit above our Canadian office peer group avg. at 45%, and 54%, respectively. Slate Office will target a D/GBV of 55% over the medium term.
What is the outlook for SOT’s distribution?
SOT’s current annualized distribution sits at $0.40/unit, with a corresponding yield of 8.8% (above our office peer group avg. of 7.7%). We hold the current $0.40/ unit distribution flat through the balance of our 2022-24E outlook. We estimate the Trust’s 2022E/23E AFFO payout ratio at 93%/106%, which is elevated, but stands in the vicinity of our office peer group average of 95%/101%.
Slate Office is externally managed, do we see a path to internalizing?
Slate Office REIT is externally managed by a related party, Slate Management ULC (a subsidiary of Slate-AM). Given SOT's focus on growth, coupled with the asset management platform, lending relationships, and unique market expertise, we believe the external structure is likely to remain in the near-to-medium term. While provisions of the agreement do provide a path to internalization, we view the contract as effectively perpetual in nature (see page 25 for further detail), and would prefer to see a more clearly defined path to internalization.
Initiating coverage at Sector Perform; $4.75 Price Target
We are initiating coverage of Slate Office REIT (SOT) with a Sector Perform recommendation, and a one-year price target of $4.75 per unit. Our price target is based on a 15% discount applied to our one-year forward (FTM) net asset value per unit (NAVPU) estimate, and compares to the average discount of 12% applied to our office peer group. In our view, elevated leverage, an external management structure and below average 2021-24E AFFO earnings CAGR (compound annual growth rate) vs. office peers support the discount multiple.
Rising interest rates and dispositions weigh-in on earnings into 2023E; significant lease-up presents material potential upside to our outlook
Our 2022E-24E FFOPU outlook of $0.51, $0.45, and $0.46, reflects low-single-digit SP NOI growth, offset by rising interest costs, and net dispositions in 2H/22 which weigh on earnings into 2023E. Indeed, we expect the circa $729 million of debt maturities (as of 3Q/22) through year-end 2023E (4.3% WAIR) to result in increased interest expense over the coming quarters. With that said, the REIT has thus far made good progress on refinancings, which includes the extension of the maturity date on its Canadian and U.S. revolving credit facilities ($310 million drawn) from 2023 to October 2024. Net disposition activity over the course of 2H/22, by virtue of SOT’s $97 million sale of 95-105 Moatfield Drive in Toronto, partly offset by the $27 million Class A Chicago acquisition, also impact earnings into 2023E. Given the broader macro backdrop, and SOT’s elevated leverage (we estimate the REIT’s net debt/EBITDA ratio at 12x with a D/GBV of 58% vs. our Cdn office peers at 11x, and 45%), we do not forecast any pro[1]forma acquisition or disposition activity into our outlook.
We see significant potential upside to our estimates should SOT achieve substantial lease[1]up across its portfolio. We estimate every +100 bps change in occupancy from current levels of 81.9%, all else equal, equates to incremental FFOPU of $0.02 (+5% vs. our base 2023E outlook). In our minds, the establishment of a consistent track-record of earnings growth could help narrow the valuation gap for which SOT trades at on P/AFFO basis vs. our office peer group (Exhibit 2). While this discount is also influenced by factors such as market capitalization/trading liquidity, portfolio makeup, and an external management structure, we believe a below average earnings CAGR has also played a large role. As a point of reference, over the 2017-21 timeframe, we peg SOT’s AFFO per unit (AFFOPU) CAGR at -7%, below our office peer group average of +1%.
Portfolio fundamentals—occupancy expected to hold relatively flat into year-end
As of Q3/22 occupancy stood at 81.9% (-170 bps QoQ, -140 bps YoY), which falls below our Canadian office peer group average of 88.7%, and compares to SOT’s average occupancy of 87.4% over the 2015-22 timeframe (Exhibit 14). By geography, occupancy sits at 75.6% in Atlantic Canada, 80.8% in Ontario (GTA), 86.6% in the U.S., and 93.5% in Ireland. The sequential drop in Q3/22 occupancy levels was mainly driven by the Ontario segment (-390 bps QoQ), as SNC-Lavalin relinquished space at 195 The West Mall (as previously disclosed), and the disposition of a higher than average occupied property (190-195 Moatfield Drive) weighed-in. Looking ahead, management remains confident that an uptick in oil & gas activity in Atlantic Canada should help drive occupancy—with a corresponding uplift in market rents. All said, the REIT expects occupancy to hold flat into year-end, with further leasing in 2022 translating into higher occupancy levels into 2023 following fixturing periods.
SP NOI—showing signs of recovery in 2022
From a same-property (SP) NOI perspective, SOT experienced negative organic growth over the course of the pandemic as select tenant departures and occupancy levels weighed on results amid a difficult and uncertain office market. Over the 2017-22 timeframe, we estimate SOT’s quarterly average SP NOI growth has been essentially flat (Exhibit 15). More recently, Q3/22 SP NOI growth registered +4.6%, representing the third consecutive quarter of positive SP NOI growth, and an acceleration from 2Q/22 levels of +1.1%. Looking ahead, our estimates factor in low-single-digit SP NOI growth into the 2024 timeframe. This dynamic reflects mark[1]to-market lease opportunities across the portfolio (see below), built in rent step-ups, and select increases in occupancy within both the Ontario and Atlantic Canada segments.
Top tenants—well anchored by investment grade credits
SOT’s top 10 tenants are responsible for 37% of rent receipts, and 27% (2.0 million sf) of GLA (Exhibit 16). At 7.0% of base rental receipts, and 324,900 sf of GLA across 3 properties, CIBC is SOT’s largest tenant, in large part due to its anchor lease at the REIT’s 120 South LaSalle property, in Chicago. Overall, we see a tenant base that carries a strong assortment of investment grade credits, and government entities, along with manageable lease terms. In total, government entities, both Federal (including Ireland) and provincial, encompass circa 1.1 million sf, or 16% of base rent, with a weighted average lease term of 5.2 years.
Lease expiries manageable, and come with MTM potential
With SOT’s total weighted average lease term (WALT) sitting at 5.6 years (office peers at 5.1 years), and the largest yearly percentage expiry sitting at 13% (in 2027) over the coming five years, we believe lease maturities are manageable (Exhibit 17). On balance, the REIT sees market rents that sit 5.3% above current in-place rents, across the portfolio, providing opportunities to augment organic growth over the coming years as leases mature. In Q3/22, leasing volume totaled 109,100 sf, including 47,600 sf of renewals (11 leases), which were completed at a spread of +18.3% (Exhibit 18). Looking ahead, SOT remains upbeat in Ireland, where further opportunities exist for rent uplifts, including from the repositioning of buildings from an ESG perspective
Financial Review and Outlook
SOT’s enterprise value currently sits at $1.5 billion. Since the beginning of 2015, Slate Office has raised about $519 million of equity (gross)—primarily to fund property acquisitions.
Capital structure; SOT carries above average leverage vs. office peers
Slate Office’s total enterprise value (EV) (Exhibit 20) sits at $1.5 billion and is comprised of:
· A $390 million equity market capitalization, which accounts for 80.2 million trust units, and 5.3 million Class B LP units (exchangeable at the option of the holder for trust units on a one-for-one basis) outstanding. The Class B LP units are held by Slate-AM, who also hold 2.9 million trust units (for a total economic interest of 9.5%). Since the beginning of 2015, SOT has issued circa 70.2 million Trust units for gross proceeds of $519 million, with funds primarily earmarked for property acquisitions (Exhibit 19).
· Mortgages of $600 million (face value), which carry a weighted average interest rate of 4.09% (range of 2.53% - 6.29%), and an average term to maturity of 1.6 years.
· Revolving credit facilities of $310 million (drawn amount) with a WAIR of 5.75%. The maturity date of the facilities was extended to October 2024 (from 2023) post Q3/22.
· A term loan totaling $127 million which is secured by 23 properties in Ireland acquired via the Yew Grove acquisition paying interest at Euribor+265 bps. The term loan was extended to a 5-year term loan in Q2/22 (April 2027 maturity).
· Convertible debentures totaling $158 million (par value of debt component). The total amount is split between $28.8 million of 5.25% convertible debentures maturing Feb-2023 ($10.53/unit conversion price), $84.2 million of 5.50% convertible debentures maturing Dec-2026 ($6.50/unit conversion price), and $45.0 million of 7.50% convertible debentures maturing Dec-2027 ($5.50/unit conversion price). The Dec-2027 debentures were recently issued in conjunction with SOT’s US$19.8 million purchase of a Class A office property in Chicago.
Balance sheet carries elevated leverage; Targeting a 55% D/GBV ratio
As of Q3/22, SOT’s D/GBV stood at 58% (we peg LTV at 73% based upon our NAVPU); with a corresponding debt to EBITDA of 12x. This sits above our Canadian office peers at an average of 45%, and 11x (Exhibit 21). Over the medium term, the REIT is targeting a D/GBV of 55%, something we believe will likely consist of a gradual journey lower, as opposed to any step[1]wise reductions in leverage. Available liquidity as of September 30 stood at $52 million or 4% of total debt (vs. our Canadian office average at 11% of total debt) (Exhibit 22), and included cash on hand of $37 million, along with undrawn revolving credit facilities of $15 million.
Substantial debt maturities through year-end 2023, solid headway on refinancings post Q3
As of Sept. 30, Slate Office had a significant $729 million of debt maturities + principal repayments, totaling 63% of total maturities due through year-end 2023. This included $154 million in 4Q/22 (3.0% WAIR) (primarily mortgages), and $575 million in 2023 (4.7%) WAIR.
Given current interest rates, we expect refinancings to be completed at higher rates (vs. expiries) and weigh-in on interest costs (and earnings) into 2023E-24E. Of note, SOT has made good progress since September 30, completing a number of refinancings, and as of Nov 2, had $12 million of refinancing left in 2022. The REIT also extended the maturity date of its revolving credit facility ($310 million outstanding as of 3Q/22) to October 2024 (from 2023).
Income statement—FFO & AFFO outlook
Our 2022E-24E (diluted) FFOPU estimates for SOT stand at $0.51, $0.45, and $0.46, respectively, with corresponding 2022E-24E AFFOPU estimates of $0.43, $0.38 and $0.38, pointing towards a 2021A-24E CAGR of -6% (below our Canadian office peer group average of nil) (Exhibit 23). Our estimates are underpinned by i) low-single digit SP NOI growth into 2024 (reflective of MTM opportunities on expiries, rent-steps, and incremental leasing), ii) G&A expenses of circa $9.0-$9.7 million per year (circa 5% of rental revenues), and iii) rising interest expense via debt refinancing over 2022-23. Given the macro backdrop, and a view that the market transactions will likely slow as buyers and sellers adjust to higher interest rates, we do not forecast any pro-forma acquisition or disposition activity. Of note, our diluted per unit estimates account for the impact of convertible debentures, where dilutive, irrespective of whether or not the debentures are ‘in-the-money’ (vs. the strike price). In addition, our AFFO estimates factor in normalized maintenance capital spending + leasing costs equal to 15% of NOI (vs. SOT at 10% of NOI).
Above average yield; though payout ratio is elevated
SOT’s current annualized distribution sits at $0.40 per unit, which equates to an 8.8% yield and an annual cash outlay of circa $34 million (including Class B LP units). The distribution was most recently adjusted in April 2019, as an elevated payout ratio and a focus on retaining incremental cash flow for leverage reduction or growth resulted in a 47% reduction (net annual savings of $26 million). Our outlook incorporates a steady-state $0.40 per unit annualized run rate through 2024. We estimate the Trust’s 2022E/23E AFFO payout ratio at 93%/106%, which is elevated but stands in the vicinity of our office peer group average of 95%/101%.
NCIB and ATM programs in-place; NCIB activity began post Q3/22
Slate Office’s current normal course issuer bid (NCIB) allows for the repurchase and cancellation of up to 6.2 million trust units over the 12-month period ending June 21, 2023. The REIT repurchased 150,800 units in October 2022 for $0.7 million, marking the first repurchases since Q1/20. We have not forecasted any repurchases beyond previously disclosed amounts. SOT has also established an at the market (ATM) equity program which allows the REIT to issue up to $40 million in trust units from time to time (at its discretion). The ATM program is effective until May 29, 2023. We do not factor in any proceeds from ATM issuances over the 2022-24E timeframe.
Valuation
Our $4.75 price target is derived by applying a 15% discount to our one-year forward NAVPU estimate. In our minds, our target multiple appropriately reflects the REIT’s elevated financial leverage, limited trading liquidity, and an external management structure. The implied return to our price target supports our Sector Perform rating.
Upside scenario
Our $5.25 upside scenario assumes that NOI growth exceeds our base case forecast by 2% and that units trade at a circa 10% discount to our NAV per unit one year hence. In this scenario, where the REIT is exceeding our forecast, we think a higher P/ NAV ratio would be justified.
Downside scenario
Our $3.00 downside scenario assumes that NOI growth falls short of our base case forecast by 2%, capitalization rates rise by ~50 bps, and the units trade at a circa 20% discount to our NAV per unit one year hence. In this scenario, where cap rates are expanding and the REIT is falling short of our forecast, we think a lower P/NAV would be justified.
Investment summary
We rate the units of Slate Office REIT Sector Perform. Key attributes of the Slate Office story include:
A suburban and secondary market concentration with broad geographic diversification. With its concentration on suburban and secondary markets in Canada, along with international diversification, SOT occupies a unique niche amongst Canadian listed office REITs. The property portfolio is primarily Canadian based at circa 73% of GLA, with a major presence in the GTA, and Atlantic Canada. The REIT also owns a presence in Chicago’s downtown core, and has more recently entered the Irish market.
Growth has been a focus; but strategic review underway. Strategically, SOT has historically focused on growth via acquisitions in search of enhanced scale. The REIT leverages the expertise of the Slate-AM (its external manager) platform with a focus on acquiring properties below replacement cost, with MTM opportunities on rents. While we see the merits of this strategy, the current macro backdrop, SOT’s cost of capital, and elevated leverage create some challenges looking ahead. With a strategic review underway, we await clarity on any potential shifts in the go-forward strategy.
Above-average yield, though payout ratio is elevated. At an annualized rate of $0.40 per unit, Slate Office’s current distribution maps to an above-average yield of 8.8%. That said, we estimate the Trust’s 2022E AFFO payout ratio at 93%, which is elevated but stands in the vicinity of our office peer group average of 95%.
Risks to rating and price target
On the upside, we would flag greater-than-expected leasing velocity or rental rates which, all else equal, should translate into higher SP NOI. In general, risks associated with the ownership of real estate property include general economic conditions, access to debt and equity capital, interest rates, local real estate markets, credit risk of tenants, supply and demand for leased premises, competition, potential regulatory changes. In addition, prolonged impacts stemming from the COVID-19 pandemic could weigh on office occupancy levels and rental rates, which in turn could impact financial results and the sustainability of distributions.