Slate Office REIT 9 00 Convertible Unsecured Subordinated Debentures Exp 28 Feb 2026 T.SOT.DB

TD Waterhouse Comments

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Slate Office REIT
(SOT.UN-T) C$4.44
 
Q4 Results Miss on Write-downs; Occupancy Expected to Rebound
 
Event  - Q4/22 results and forecast update.
 
Impact: SLIGHTLY NEGATIVE
 
Core FFO/unit (f.d.) was $0.10, -21% versus Q4/21, and below our estimate/ consensus at $0.12. AFFO/unit of $0.09 was below our $0.12 estimate (Exhibit 1). The miss was driven by higher G&A expense from a write-down on a vendor take[1]back-loan that was related to a 2018 asset disposition (which management expects to resolve this year) and BDE from rent receivables at two U.S. properties. Higher current taxes also contributed to the variance.
 
SPNOI was +2.7% y/y and represented the fourth consecutive quarter of positive SPNOI growth. Occupancy fell 80bps q/q to 81.1% due to known vacancies from SNC-Lavalin at West-Metro and the previously-announced acquisition of the suburban Chicago Pfizer office asset (link). That said, management has seen a lot of interest in the vacancy at the Pfizer office (~67% leased) and highlighted that SNC-Lavalin completed the last phase of its exit in Q4, with the remaining 44,000sf expected to be leased. Management noted that half of the known 2023 non[1]renewals have already been replaced by leases that have not yet commenced, and expects occupancy to improve for 2023.
 
Board update. Post Q4, Slate announced a settlement agreement to appoint G2S2 Chairman George Armoyan and Jean-Charles Angers to the Board, effective immediately (link). The previously-announced requisition by G2S2 to elect new Trustees to the Board was subsequently withdrawn. We view this change favourably as it eliminates a more protracted proxy fight. Management remains committed to its strategic review announced in October (link) and expects to provide an update upon conclusion.
 
Forecast. We have reduced our 2023/24 AFFO/unit estimates by 11%/9% largely on lower NOI and higher cash tax assumptions. We expect an average ~1% growth in 2023/24. Our $5.30 NAV/unit estimate is -2%.
 
TD Investment Conclusion
Although SOT's valuation appears attractive on both an absolute and relative basis versus its larger-cap office peers and smaller-cap REIT peers, we believe the units will be range-bound until Slate can demonstrate sustained improvements in operating metrics (occupancy, SPNOI) and earnings growth. We are maintaining our HOLD rating and $4.50 target price.
 
Details – Q4/22 Highlights
 
SPNOI was +2.7% y/y (Exhibit 3) on the back of a further recovery in the hotel asset and an improvement in leasing activity in the Atlantic portfolio. Excluding lease termination income and the seasonal hotel asset, q/q SPNOI was +0.8%.
 
Leasing (Exhibit 5)
Q4 leasing activity totalled 86,266sf (Q3/22: 109,060sf) across 21 leases at a rental spread of +7.6% (Q3/22: +11.9%). New leases totalling 37,515sf, were completed at 6.0% above expiring rates. Renewals, which represented 48,751sf, were completed at a healthy +8.8%. Management estimates the current portfolio MTM at 6.5%.
 
On the known SNC-Lavalin vacancy, the company completed its last phase of exit in Q4 and management remains positive on filling the ~44,000sf space. Management has also seen strong demand on the remaining vacancy at the suburban Chicago office asset acquired last quarter (Pfizer as anchor tenant). Pfizer had previously occupied 100% of the building.
 
Balance Sheet (Exhibit 6)
Slate recorded a $96.9mm FV loss in the quarter, as the weighted average discount rate and terminal cap rate increased to 7.64% (+25bps q/q) and 7.06% (+27bps q/q), respectively. The FV loss led to a 350bps q/q increase in leverage with D/GBV now at 61.9%, remaining above management's target of 55%. Liquidity was up to $61.7mm (Q3/22: $51.7mm), including $19.9mm of cash and $41.8mm of capacity on its credit lines.
 
During Q4, Slate purchased a €93.6mm ($135.7mm) interest rate cap and reduced its floating rate debt to $75.4mm. Slate now has ~7% of its debt at floating rates (Q3: 21%), which is now below management's goal of 10%. We note that the REIT has a large chunk of its mortgages rolling at below market interest rates through 2023, which we expect to weigh on near term earnings growth.
 
Outlook
 
 Portfolio occupancy currently sits at 81.1% (Q3: 81.9%). Management expects occupancy to improve in 2023 and highlighted that approximately half of its expected vacancies have already been replaced by leases that have not yet commenced. Management has also seen positive office utilization rates among tenants (particularly across the Ireland and Atlantic Canada markets) and has seen more tenants return to office thus far in Q1. Suburban markets have also continued to outperform downtown markets, which bodes well for Slate. That said, we note that overall Canadian office fundamentals took a step back in Q4, with national office vacancy increasing after holding relatively steady over the previous two quarters (link). Looking ahead, we remain cautious on the office front as companies navigate the uncertainty on long-term office needs.
 
Valuation
Slate currently trades at 10.1x our 2023E AFFO/unit, which is slightly above the small[1]cap average at 10.0x. The REIT is trading at a 16% discount to our revised NAV/unit of $5.30 versus its small-cap peers which are trading at a 14% discount to NAV.
 
Justification of Target Price
Our $4.50 target price (unchanged) is based on a 9.75x-10.25x multiple to our 2024E AFFO/unit (previously 9.0x-9.5x on 2023E). The multiple is largely in line with where the stock trades on our 2023 AFFO estimate. Slate's target multiple is at the low end of the 9.75x-16.50x multiple range we use to value the office peers in our coverage universe. The lower multiple reflects Slate’s higher-than-average leverage, smaller public float and trading liquidity, as well as its external management structure.
 
 Key Risks to Target Price
Key risks to our target price include a prolonged impact of COVID-19; local real estate markets; competitive supply; demand swings; general economic conditions; operating cost pressures; environmental matters; interest rate fluctuations; foreign exchange rate fluctuations; inability to maintain occupancy levels; and the loss of key management personnel. In addition, there could be potential conflicts of interest with the external manager, Slate Asset Management.

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NOTE    THER    NAV     5.30   a fraction  of  what  SLAM   estimates .