At this time, I would like to welcome everyone to the Slate Retail REIT First Quarter 2019 financial results conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star then the number one on your telephone keypad. If you would like to withdraw your question, press the pound key. Thank you. Madeline Saracini, with Investor Relations, you may begin your conference.
Thank you, operator, and good morning everyone. Welcome to the first quarter 2019 conference call for Slate Retail REIT. I am joined today by Greg Stevenson, Chief Executive Officer, and Robert Armstrong, Chief Financial Officer. Before getting started, I'd like to remind participants that our discussion today may contain forward-looking statements, and therefore ask you to familiarize yourself with the disclaimer regarding forward-looking statements, as well as non-IFRS financial measures, both of which can be found in management's discussion and analysis. You can visit Slate Retail REIT's website to access all of the REIT's financial disclosure, including our Q1 2019 investor update, which is available now. I will now hand over the call to Greg Stevenson for opening remarks.
Thank you, Madeline, and thanks to the participants for joining the call this morning. We continue to gain momentum on, and our achievements in the first quarter reflect both the team's tremendous efforts and highlight the durability and attractiveness of the REIT's grocery-anchored and necessity-based real estate portfolio. Strong organic growth continued throughout the quarter. We entered the quarter with an occupancy rate of 93.3% and executed on more than 375,000 square feet of leasing, including two anchor renewals. Our proactive approach to leasing has resulted in 44% of all 2019 renewals already completed by the end of the first quarter. We also achieved an industry-leading 94.8% tenant retention ratio, demonstrating that our properties continue to be highly sought after by tenants in our markets.
As a result of these efforts, we achieved a 0.4% increase in same property NOI year-over-year, and a 2% increase when including the growth from recently completed redevelopment projects. We completed another redevelopment project during the quarter, adding to the two completed in Q4 2018. NOI attributable to our three completed redevelopment projects increased to $600,000 in the first quarter, a threefold increase over the same period last year. We expect completed redevelopment projects to continue to add to NOI growth in the coming quarters. We have begun to make progress on our disposition pipeline, selling two properties for $24.9 million at a 7% cap rate. In addition, we have sold two non-core parcels for $3.2 million at a 5.4% cap rate. The dispositions will allow us to pay down debt and reduce our leverage, further strengthening our balance sheet.
As importantly, we are able to accomplish this capital recycling program by selling properties that are stabilized, where we have executed on our business plans and extracted value, but the properties would rank in the lower tier of our portfolio. Upon execution of the disposition pipeline, we'll be left with a higher quality portfolio and excess liquidity to deploy. In addition, as income grows and capital spend on existing project nears completion, we expect our AFFO payout ratios to decline toward 90%, setting the stage for a sixth consecutive distribution increase in 2019. Units of Slate Retail generate substantial excess yield, today above 9%, and we believe represent an attractive investment opportunity. To summarize, we are entering the quarter with a 93.3% occupancy rate. Steady NOI growth was achieved, bolstered by redevelopment projects being completed.
Two property dispositions were completed at a 7% cap rate, which compares favorably to where units of Slate Retail are currently trading today. All such factors contributed to a very strong quarter. We are encouraged by the positive underlying fundamentals in our portfolio that will set the stage for our team to execute on the business plan ahead and deliver stable and growing distributions to our unit holders. I will now hand the call over for Q&A.
As a reminder, if you would like to ask a question, just press star then one on your telephone keypad. Your first question comes from the line of Stefan Boire with Echelon Wealth Partners. Please go ahead.
Thanks. Good morning. I just had one very quick question regarding the Hocking Valley Mall. I was just wondering, is the yield on the redevelopment in line with your expectations?
Slightly below expectations. That, Stefan, I think you'll see a mix of redevelopment projects. Some are going to be high yield on costs, where you see significant income generation. Others, like Hocking Valley, where the yield on cost isn't as high, which is what I think you're alluding to. You're going to see meaningful cap rate compression. That was the center that we redeveloped, and we bought at a higher cap rate that I think we've probably achieved 150 to 200 basis points of cap rate compression. The IRRs in both instances, which is whether it's a high yield on costs or cap rate compression project, are always going to be probably similar, like in the teens to low 20s. Hocking Valley, it's a 25-year brand new Kroger. We've scraped the box. It's a rebuild. New shop space tenants. Everything's relatively new.
It's a bit different than the others where we've replaced a few tenants and using the existing box and where we've seen a high yield on cost. It's just a bit of a different plan, the IRR is still very strong due to the cap rate compression.
Okay, thanks. Could you remind me what was the initial or the expected yield on that project?
It was around 6% was the expected yield.
Okay.
Yeah. I don't know that that really matters, but I think the important part is that we hit our IRR targets, which is how we calculate our return on invested capital.
Okay. Okay, great. Thanks.
Your next question comes from the line of Sumayya Hussain with CIBC. Please go ahead.
Thanks. Morning.
Morning.
Greg, in your letter to unitholders, the tone felt a bit more positive, and you mentioned that sentiment is improving. What are you seeing on the ground and maybe in your conversations that's behind this optimism? Is it just feedback from your asset sales, or do you think it was just a matter of time for people to realize that fears for e-commerce just aren't playing out the way they expected to?
I think we've always been positive. We've believed in our business, and I think going back for the last two years and more, the fundamentals have spoken for themselves and so have our results. We've been effectively 94% or 95% occupied for five years now. I think on the sentiment side, outside of these four walls, I think everyone, Slate has always been a believer. You're for sure now starting to see, and I'm sure you have as well, that the headlines on grocery retail have been more positive. We talked at the AGM yesterday a lot about Amazon saying that they're really struggling with online grocery and that they're going to create their own brick-and-mortar grocery store outside of Whole Foods. You've read about how Walmart and Kroger and Publix have been very successful leveraging their network of stores. I think it's a bit of a mix.
I think our operating fundamentals continue to be strong. Our asset sales continue to have interest, and are at prices that are very attractive, both on an absolute and relative basis, i.e., there's lots of demand for grocery-anchored real estate. Thirdly, I think the headlines, The Wall Street Journal or otherwise, have just been far more positive in the last six months than they have in the last probably two years.
That's fair. Just to pull on that, as you continue to sell more of your bottom-tier assets, how do you see the NOI growth profile of the remaining portfolio evolving? Just related to that, what kind of valuation or cap rate do you think the residual portfolio should be valued at once you're through your sales program?
I think the residual portfolio, we're definitely trying to sell assets that are either for risk profile, don't make sense, we want to upgrade the quality or two. I think just as importantly, where we believe that we've realized maximum value in executing on our asset plans from that perspective. The NOI growth that we would see from the residual portfolio, we still think would be on an annual basis between 1%-3%, depending on the year. As far as the cap rate compression, we're at a 7.9 weighted average. I think we would see that come in, all things being equal.
We think that if we sell the $170 million, $200 million of properties within the next year, it would be a positive story for what's left for growth as well as what we have for growth capital, and definitely upgrade the quality of the overall portfolio.
Okay, great. I'll turn it back. Thanks, guys.
Your next question comes from the line of Matt Logan with RBC Capital Markets. Please go ahead.
Thank you, and good morning.
Morning, Matt.
Just following up on the last question. In terms of your organic growth, in your letter to unitholders, you mentioned about 3.4% NOI growth. How much of that would be organic, and how much of that would be driven by redevelopments?
I think we've got signed leases that haven't yet commenced paying rent. That number in the letter is $1.7 million, which excludes recovery income. I think you can comfortably move that number to $2 million to include that. That's $2 million on less than $100 million of NOI, that's 2% right there. That's already contractual. That just hasn't started yet. Then I think you can probably add the other $2.5 million-$3.5 million of NOI number that we used in the letter from redevelopment. That won't all be 2019. Some of that will carry into 2018. If you add those two numbers together, you're somewhere between $4.5 million-$5.5 million of NOI on $99 million of NOI.
we've got somewhere between 4.5%-5.5% growth, and you can sort of split that between organic and redevelopment, that we expect to come in the next 18 months.
Okay. It's good color. Appreciate the commentary. Just shifting gears, in terms of some of your recent leasing activity, can you give us a sense of which tenants are expanding in your portfolio and which ones are rationalizing space?
Expanding, it's been pretty consistent. You've got your health and beauty. You've got your fitness, your medical, your dental, quick service restaurants, and your dollar stores, I would say at the top of the list. Just on the top of that list and off the top of my head. Not a ton of rationalization. I think this is because we're less power and we have virtually no apparel and no books or electronics or any of those things you see in a power center. The rationalization within our portfolio has been extremely muted. You can kind of see that just looking back at our occupancy levels. I think we've lost a Payless ShoeSource or two and that's really it. Nothing yet, and we don't see anything on the horizon.
That doesn't mean it may not come, we talk to all of our grocers and all of our junior and regional national tenants on a very regular basis, and everyone's business seems to be going quite well. In the markets that we're in, the customers are supportive of the businesses. Again, it's everyday necessity-based retail, so it's not discretionary spend. I think we're pretty optimistic on the outlook for our portfolio being as durable in the next few quarters as it has been over the last two years.
Yeah. What I would add as well is in a number of cases where we don't have grocers turning back space and haven't had any instances of that, we have had requests for additional capacity or different things at the site to be able to support some of their e-commerce activity that's being delivered by the store. Whether it be parking spots, places to deliver, van parking for delivery, all things which are positive and just making that real estate more valuable as they get entrenched in that business within our markets. From that perspective, all positive as it relates to the grocers.
In terms of your e-commerce initiatives, is it still more along the lines of click and collect, or are we starting to see grocers using their stores as kind of last-mile distribution centers to an extent?
It's been a mix. You've got your click and collect. You've got your personal shoppers. You've now got a lot of mobile and digital technology coming into the stores. You've got your grocerants, which is a word I hate to use, but that's what they call it, which is just prepared foods and restaurants that are now taking space inside the grocery stores. You've got, I think we're in the early innings, but it's gaining momentum very quickly. You've got a lot of our grocers and stores talking a lot about the last-mile distribution and leveraging their stores in order to do that. I think that's moved from speculation or from theory into practice. We talked about this at the AGM yesterday.
At $850 billion of at-home food spend in the United States, there is a lot of venture capital in the United States looking to figure out how to help the grocers turn their boxes into mini distribution centers, and there's real-life examples out there today. We talked yesterday a bit about Takeoff Technologies, and there's others. It's happening, not in massive quantities at the current moment, but the one thing we love about the U.S. is that these things tend to happen pretty quickly, so we're optimistic.
Well, I appreciate the color. That's all from me. Thank you very much.
Thanks, Matt.
Your next question comes from the line of Himanshu Gupta with GMP Securities. Please go ahead.
Thank you, and good morning. On the asset disposition, what is your asset sales target in 2019? Should we still expect $200 million of sales in the current year? How far are you in that process? What kind of bids are you seeing in the market?
Yeah, I think the plan is to hopefully still hit the $200 million. If it's $175 million or something around there, we're not going to be disappointed. I think it's still a large enough number to both get the portfolio from a quality perspective to where we need to be, increase our liquidity to where we want it to be, delever to where we want it to be, and I think as importantly, highlight that valuations relative to where Slate Retail is trading is there's some mispricing there by the public markets. We're $25 million in the first quarter. I think in Q2, we could do another 40 to 50, which would leave another $100 million for the second half of the year. That's sort of what we're seeing right now from a timing perspective.
Right. On the large public listed peer group, are they still net sellers of the product, or do you see them back in the acquisition market?
I would say they were large sellers in 2018, and I think most to all of them hit or exceeded their dispositions targets for a lot of the reasons we've talked about on this call and some of the other ones, which is there's a lot of demand still at attractive pricing for grocery strip center in the U.S. I think as a result of those REITs hitting their targets is that there's not as many of them selling as there was last year, which should be good for Slate Retail REIT with less supply in the market.
Got it. Okay. Shifting on the leasing side, looks like good momentum on the anchored tenant renewals. Around 220,000 of square footage of leases renewed at, I think $6.11. Where do you think the market rents were for these anchor renewals, and how much did you spend for that renewal?
No dollars spent on renewals for the anchors, which is usually the case. They generally fund any store remodels themselves because their cost of capital is just so much cheaper than ours. With that said, they have options. 90% of our portfolio when it comes to grocers is option rents. We've only got a few that expire without options where we think we can lift rents. Some of those have options where it's 2% or 3%, some is 0%, which is why we've always said we think the anchor growth rate is probably somewhere between 1% and 3% over time. Both of those this quarter and 90% of them going forward will be renewed at their option rents.
Right. Okay. On the Windmill Plaza redevelopment, I think Kroger will build a brand new, I think around 130,000 square footage of Kroger Marketplace. How will the space look different compared to your existing Kroger stores? Apart from click and collect, what are the landlords being asked to install now to digitize their sales experience?
They're focusing right now on the inside of the store for the most part. The parking stalls, as Bobby mentioned earlier on. It's really just coming to us for approvals on uses within their box and within the parking lot. We think that this will expand into the future, which is they're going to want more space in the parking lot, potentially for mini logistics or a sort of a distribution hub onto the side of the store, as well as designated room for more designated van parking. Again, which is why we think some of our access land could prove to be valuable in the future.
Okay. On the small shop occupancy at 87%, and I know you gave some good color on the trends in the near term, where do you see the upside or downside to this number? The 118,000 square footage of leases signed but not commenced, is that already included in that 87% number?
The small shop occupancy, yes. There is a difference between leased occupancy and economic occupancy, that's sort of the upside right now. It's two to almost three percentage point difference between lease and economic, which is obviously a good thing because that just means that there's built-in growth into our NOI. There's only upside in that small shop space occupancy. There's three boxes that drive a significant portion of that number going higher, we're making progress on all three of them. Only upside. We don't see any downside to that number whatsoever.
Right. On the same subject, overall $3.3 million of expected NOI growth. Are you accounting for certain tenant fallouts or expected vacancies in this number, or that will be over and above that?
There's a vacancy factor built into that. As we talked about in our letter, we think even with that included, we think we'll still hit that NOI growth number. That's total NOI. That includes sort of to Matt's question, that will include sort of organic plus redevelopment.
Right
We count both. I think the reason is because, this is going back six years of empirical data for Slate Retail REIT, we really expect the vacancy factor to be muted. There's no new supply. Leasing's been strong. We're spending capital at our centers. We are still a very highly sought-after landlord in our markets, I think our centers are at the top of the food chain in all of the markets that we're in. Again, I think it's been historically this way, we see no change to the future. That will remain 94%-95% occupied for some time.
Himanshu, I would add that growth target. Half of that, as Greg said before, is redevelopment. When you kind of peel back that as to the normal recurring business of 1.5%, that's well within the range we've been doing over the last couple of years as far as same store growth. We don't think there's a lot of juice in that number. We think it's completely achievable on the portfolio as a whole.
Right. Okay. Maybe just last final question. On the bankruptcy of Sears and Kmart, how do you think in general, the demand has been for former Kmart grocery boxes in the market? I know you don't have much exposure there, but generally, what are you seeing? Are the bulk of them will be backfilled? What rates are your peer group achieving on those vacant boxes?
I think there's been more demand than people expected. There's rumors Amazon's going to take 100 vacant Sears or Kmart boxes. Like I said, similar to the uses we've seen at our properties with health and beauty and fitness, medical and dental and theaters and entertainment, et cetera. It's been strong. As it relates to our portfolio, we don't have a ton of that. We've got two vacant Kmart boxes, which is again, when I said there's some units really driving that shop space number, those would be two of the reasons. We've got very strong demand at both of those. From an economic perspective, the math is pretty favorable because you can take a $2 Kmart rent up to somewhere between $9 to $13, depending on who your tenants are. You have to pay to do that. It can be expensive.
I still think that your high single-digit yield on costs, you're taking your cap rate once you get rid of your Kmart center down, at least 50 basis points. The IRR, again, is high teens to low 20s on that box. It feels pretty good.
Awesome. Thank you. Thank you for all the color. I'll turn it back.
Again, if you would like to ask a question, just press star, then one on your telephone keypad. Your next question comes from the line of Jenny Ma with BMO Capital Markets. Please go ahead.
Hi. Thanks. Good morning.
Morning, Jenny.
I just have one question with regards to the distribution. You had mentioned in the letter, the MD&A, that you're looking to raise the distribution again. I'm just wondering how you reconcile that. I understand there's some Same-Property NOI growth coming, but then you're also selling assets and you're de-leveraging, and the payout ratio is at about 100%. Given that, I guess the general trend is to reduce payout ratios in the sector. I'm just wondering how you reconcile another distribution increase at this point, and whether or not it would be more prudent to sort of hold that and save some capital for other uses.
Yeah. A couple of comments on that. One, our current AFFO payout ratio is, you're right, about 100%. A few things. One, that includes the capital leasing and TI costs that we're paying now for leases that will start about a year from now. We have historically run on leasing costs and TIs about 9% historically. We think the new norm is about 12. Our current number is about 14-15. That's because we're doing a lot of leasing, and we think that leasing is a good thing, that it's going to drive a lot of the value and NOI growth that we're expecting to get over the next year. We feel pretty comfortable from that perspective.
Secondly, on the payout ratio and the availability of capital, agreed we're selling down assets, we have $225 million of liquidity, we feel like, from a balance sheet perspective, we're well-served to be able to do that. Lastly, as far as the distribution increase that we'd have to talk to our board about, we would like to reward unit holders for the growth we're having within this business. My personal view would be that, if we do have an increase, it would be moderate. Typically, we've had 3% increases in the past, historically, since we've listed on the TSX. It might be a little lower, but it'll be in line and be prudent for how we want to manage this business.
Yeah. I think to Bobby's point, from the buybacks that we did in just 2018, that canceled $2.2 million of annual distributions, which is a big number. Even if we increased it this year, I'm going to just make up a number and say by $0.01, that's $440,000 annually. We'd actually have less distributions payable in 2019 after a raise than we did in 2018, on an absolute basis, just as a result of the buybacks last year. I do think to Bobby's point, the reduction in capital is a big part. Even if it's what we're expecting, which is about $1 million a quarter or $4 million a year, that's $0.10 that you're adding back to AFFO as capital spend comes down. That excludes any growth in NOI.
If you just take our AFFO today and add $0.10 back to it, you get about $1 on $0.86 of distributions. You're down to an 86% payout ratio. Again, that excludes any growth from income. That's sort of the math.
Additionally, we view all the capital and leasing costs that are going back into the business are really additive to value. If you peel back what we're actually earning from the business and what the business is yielding itself, our AFFO payout ratio is 70%, which we think is pretty prudent.
You're sitting at a 9% yield. Where are you getting the pressure to raise it from? I hear you on the reduction in capital, I just feel like generally, the tone from the entire sector is really just to be more conservative on the payout ratio. If you do get that coming back, I don't think it necessarily hurts to wait. Are you hearing from unit holders that they want another increase even though you're sitting at a 9% yield, or where is this coming from?
One, consistent distribution growth over a long period of time, and I'm talking about someone looking back 10 years from now, I think bodes well for our cost of capital in the future. I don't think that I'm using $0.01, and I don't even know if it will be that high or not. $400,000 on a business that generates $135 million of gross revenue is going to kill us one way or another. Said differently, if we were to keep that $400,000, would we have a much better use of capital than returning it to our shareholders? Would it make an impact on our business by keeping it?
I think that the positive message that the business is growing, that we're being prudent on capital spend, and that we're de-levering, that a distribution increase sends to the market far outweighs what Greg or Bobby or the team can do with that $400,000 that we keep inside the business.
Yeah. I guess my view is it's at least $400,000 every year-over-year. Okay. That's fine.
Yeah. We still have the option to buy back units, there's that math as well.
It just means that the unit holders that don't sell their units to the NCIB, let's assume that we do more of that, are the ones getting rewarded. On a net-net basis, we can actually keep our total distributions outstanding the same.
I just reiterate, I think Greg's point's a good one. We're not talking about having a 10% increase. We think it would be in the range of 1%-3%. 1% is $400,000, as Greg discussed. In the context of our capital allocation, that is not a big deal. We spent $17 million last year on repurchasing units. In the context of the grand scheme of things, we look to keep the consistency, but we aren't getting any pressure to increase it. It's more just a conversation we'll have with our board to deliver the returns. The business is doing phenomenally, and we think we just want to continue that and be able to communicate that to the market.
Okay. That's fair. Thank you very much.
Thanks.
There are no further questions in the queue. I turn the call back over to Ms. Saracini.
Thank you everyone for joining the first quarter 2019 conference call for Slate Retail REIT. Have a great day.
This concludes today's conference call. You may now disconnect.