Good morning. My name is Denise, and I'll be your conference operator today. At this time, I'd like to welcome everyone to the Slate Retail REIT Fourth Quarter 2018 Financial Results Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer session. If you'd like to ask a question during this time, simply press star then the number one on your telephone keypad. If you'd like to withdraw your question, press the pound key. Thank you. I'd now like to turn the call over to Madeline Sarracini , Investor Relations. Please go ahead.
Thank you, operator. Good morning, everyone. Welcome to the fourth quarter 2018 conference call for Slate Retail REIT. I'm joined today by Robert Armstrong, Chief Financial Officer, and Greg Stevenson, Chief Executive Officer. Before getting started, I'd like to remind participants that our discussion today may contain forward-looking statements. Therefore, ask you to familiarize yourself with the disclaimers 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 Q4 2018 investor update, which is available now. I will now hand over the call to Greg Stevenson for opening remarks.
Thank you, Madeline. Thank you to our participants for joining the call this morning. We continue to gain momentum, and our achievements in the fourth 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. Entered the quarter with an occupancy rate of 94.2% and executed on more than 640,000 sq ft of leasing, including several anchor renewals. We also achieved an industry-leading 95.8% 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 4.2% increase in same property net operating income year-over-year. In addition, our proactive approach to leasing has resulted in 43% of all 2019 renewals already completed by the end of the fourth quarter 2018.
We also completed two of our major redevelopment projects in Q4 at Buckeye Plaza and Countyline Plaza. The first quarter of 2019 will be the first full quarter of contribution from these projects, which had a weighted average yield on cost of 22.3%. Funds from operation has decreased as a result of de-risking our capital structure and moving to 99.2% fixed rate debt, which results in paying a higher rate of interest on our bank debt. While the increased interest cost from fixing our debt lowered FFO in the short term, we feel it was a prudent decision from a risk management perspective and protects us from future interest rate increases. In addition, we believe growth in income from leasing activity will more than offset the interest cost in the coming quarter.
Net asset value decreased over the year as a result of negative sentiment in the retail sector. In spite of taking a conservative approach to valuation this year, we believe it was the prudent thing to do. As we highlighted in our unitholder letter this quarter, we feel sentiment is improving. Deals are being completed at pricing above general market expectations. While negative sentiment may impact cap rates in the short term, the REIT's continued solid operating performance and positive underlying fundamentals in our sector will ultimately serve to drive value higher over the medium to longer term. As a result, we expect cap rates to compress and property values to increase again in 2019.
Heading into the new year, we are excited about continued growth in net operating income driven by both active projects in the portfolio today and our ability to continue to reset rents higher in line with market rents. We have identified a pipeline of properties totaling approximately $200 million that we can sell to recycle capital into more accretive opportunities, including unit repurchases. The dispositions will also allow us to pay down debt and reduce our leverage. As income grows and capital spend on existing projects nears completion, we expect our AFFO payout ratio to decline below 90%, setting the stage for a sixth consecutive distribution increase in 2019. Units of Slate Retail generate substantial excess yield, today close to 9%, and we believe represent an attractive investment opportunity for the REIT at these levels. We will continue to buy back units at these levels that we deem attractive.
Unit repurchases in 2018 and under the substantial issuer bid will also help generate excess cash from no longer paying distributions on those units of approximately $2.2 million annually. 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 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. To summarize, we entered the quarter with an occupancy rate of 94.2%, achieving one of our highest quarters of same property NOI growth at 4.2%, completed two of our redevelopment projects at a 22% yield on cost. All of this contributes to a very strong quarter.
As importantly, 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 unitholders. With that, I will turn it back to questions.
Ladies and gentlemen, to ask a question, please press star then the number one on your telephone keypad. We'll pause for just a moment to compile the Q&A roster. Your first question comes from Stephan Boire with Echelon Wealth Partners. Your line is open.
Thank you. Good morning.
[How is it going].
I was just wondering, what is your target leverage ratio by the end of the year? I know that long-term is 50%-ish, but what is it for next year? Actually, in parallel, what percentage of the $100 million sell proceeds would be used to pay down debt this year versus buyback or even land development?
Yeah. For the $100 million we have targeted in the disposition pipeline, our expectation it would be dollar for dollar were to go to repay debt from that. We think that if levels continue, we'd be active purchasers of units again and throughout the remainder of 2019. That's hard to do and target a number, but I'd say anywhere between $5 million-$15 million could be easily achievable based on what we've done in the past. Then as far as target leverage, I think, we get down to about 55% or so by the end of the year.
Okay. That's good. Okay, in the previous call, Greg, you mentioned that any acquisitions you do are going to be to replace income from sold assets if you don't have any better use for the proceeds. Right now, I'm under the impression that acquisitions are a bit on hold at the moment. Do you expect any new acquisitions at this point for the next two years?
Yes, in the next two years, I think absolutely. I think it's always going to be what's the best use of our capital, whether that's units or properties. I think the current environment basically means that there's going to be good opportunities. We're always looking. It's never on hold. We're active from an acquisition perspective in terms of hunting for things to do. We're active today, we'll be active in the future. It's going to always come down to what's the best use of our capital. As of late, it's been our units because our units traded down and became quite attractive. If we find something on the acquisition side, it's the best use of our capital, we're going to do it.
Okay, great. Just a final point, I guess on a more macro standpoint, how do you see your asset disposition program in the current economic context as there are more and more discussions about a potential recession in the U.S.?
We have no control over the macro. What I will say, what we talked about in the letter is that grocery and necessity-based retail is sort of going in its own direction as it relates to sentiment and desirability from investors, meaning that it's being favored. There's been other U.S. strip center REITs that have sold a significant amount of similar but probably lower quality product than what Slate Retail owns by a meaningful margin. They've done it successfully. I think that grocery and necessity was will continue to be highly sought after by investors for all the reasons we've talked about in the past. It's stable. You're getting rent growth. You've got limited to zero new supply in our markets, which is driving occupancy and rents.
Fundamentals are positive. If there is a recession, again, there is no predicting when or if, but it is countercyclical, this asset class. People go to the grocery store more and eat out less. I think, looking back to other recessions, this asset class performed tremendously well. It is why there is available debt for it today, and there will be in the future. It is something that we think is very attractive. I think that our asset dispositions in 2019 will actually prove out our IFRS cap rate, and if it is the lower tier of our portfolio at a 7.5% Cap, I think what that means in our view, that the 7.5% cap currently from an IFRS cap rate perspective probably looks pretty conservative.
Yeah. I would add as well, the $100 million we talked about disposing, a good chunk of that is at various points in the market, or we are getting soundings from the investment community. All the feedback has been good and consistent with our valuation so far.
Okay. That is a good point. It was also a side question. You would expect to be able to get book value from those assets for sale?
That is correct.
Okay, that's good. All right. I don't have any more questions. Thank you.
Thanks.
Your next question comes from Asma Hussain with CIBC. Your line is open.
Morning. Thank you. Just a couple of questions on mainly the AFFO payout guidance. That level of 89%, does that assume that the entire $200 million of asset sales are completed in 2019?
Correct.
Then I guess just as a follow-on, what assumptions for capital spending, maybe as a % of NOI are you guys using to get to the 89% payout level?
About 12%.
Okay.
Yeah.
Expect it to be a little higher H1 and then more normal at the back end of the year?
Yeah, that's right. I think the capital that we're spending and have spent over the last little bit is all a result of the large amount of leasing that the team's been able to do recently. It's had a trailing effect. We see that as great because we're adding value. Typically, we've run a run rate right on about 10%. If you kind of go back to, say, early 2018 and before that it was dead on 10%. We're at 16% this quarter. I think our go-forward run rate, we're expecting around 12%.
Okay, great. I'll turn it back.
Thank you.
Your next question comes from Jenny Ma with BMO Capital Markets. Your line is open.
Hi, good morning, everyone.
Morning, Jenny.
Question about the targeted dispositions. You guided to a 7.5% cap rate. Is that partly reflective of some of the transactions that you're seeing in the market? Do you contemplate the split between the conventional assets versus the outparcels? Because I know in 2018 there was a bit more on the outparcel sales versus just the conventional assets.
I think the split will be similar, maybe a few more properties as opposed to outparcels, which I would define as a standalone single-tenant building with a restaurant or a bank or something, where there's a long-term lease and no real value for us to add. As Bobby said earlier, I think the 7.5% is really just feedback from market participants on the product we've already got out in the market and that we've sold in 2018 and to date. There is one property in the bucket that we've sold so far, that if we took out the sales to date, the $52 million is 7.4% cap. It's also reflective of what we've already done.
Okay. Bobby, I think I heard you correctly, you mentioned that about $5 million-$15 million of the $100 million for sale is going to be allocated to share buybacks after you pay down debt?
Yeah. We don't necessarily have an allocation, I think we would spend up to, say, $20 million, $25 million. Realistically, what we're able to achieve on NCIB in volume, given the restrictions and our timing, I'd say $5 million-$15 million is executable.
Okay.
We also have to wait for the price to come back a little bit. We're probably buyers just in a little bit lower than this. That's a good number, I think. It's hard to estimate.
Right. As far as the debt that's attached to the $200 million bucket for dispositions, I assume it's roughly in line with the entire REIT's leverage.
Yeah, that's right. To be clear, every single dollar of net proceeds that otherwise doesn't go to the NCIB would go to repay debt.
Okay, gotcha. It would be higher than just simply repaying.
Yeah.
Okay.
It's a revolving facility, so we can then use it again should we need to.
Mm-hmm. You mentioned that there was about 40%+ of the 2019 leases committed. Can you comment on what the lift on renewal was for that chunk?
Well, that's been reported. This quarter, for instance, it was 4.4%, which includes greater than 10,000 sq ft and less than 10,000 sq ft. The greater than 10,000 sq ft are usually anywhere between 1% and 3%, because our anchors have fixed options. The less than 10,000 sq ft, they're somewhere between 7% and 10%, and you blend the two. That's been a consistent number going back to inception almost. Going forward, we think we're going to do very similar numbers into the future. If you look at our expiry profile, which we have a slide in our investor deck, we've got a weighted average rent of between $9 and $11 for the next five years, and we've been doing renewals between $12 and $14. We think for the next several years that those are spreads that we can continue to achieve.
Okay.
I think we're really happy with how the leasing has started to show itself in results with this quarter with 4% same property NOI growth on effectively high 90% of the total portfolio. Eight of the last 10 quarters have had positive same property growth. We think the team's doing good. The market and the fundamentals continue to be very healthy in the face of what you're kind of hearing from a headline perspective. On the ground, our view is the business has never been better.
Okay. My last question is sort of higher level. When you put all this together with the dispositions and the unit buybacks and the debt paydown, and then you sort of square it against your increased distribution. If most of the proceeds from the dispositions at higher cap rates are going towards debt paydown, then that would suggest it's a little dilutive. Maybe this is a discussion held at the board level more so, but how do you square sort of that pressure versus raising a distribution as opposed to keeping it at sort of a more conservative level and buying yourselves a little bit more wiggle room that way?
I think it's two things, then Bobby can add to it, is one is we're buying back units. While the cash flow savings doesn't hit FFO, it's real cash flow savings. At a 9% yield, it helps bring down our payout ratio quite significantly. I think the bigger impact is going from 16%- 12% NOI on a capital spend perspective. That's a few million dollars a year, which is quite meaningful from a payout ratio perspective as well. When you think about our last distribution increase was only, on an annualized basis, it was something like $800,000. If you're cutting capital by $4 million or $3 million per year, you're only increasing distributions by $800,000, plus you've got less distributions to pay out due to buybacks, plus you've got growth in your earnings from an NOI perspective, that's effectively how you do that.
Yeah. Maybe what I'd just add to that, just for simple math, is we're effectively selling right now at a 7.4% cap is where we've kind of landed. We're buying back units at an implied cap rate of 8.5%. We think that trade is going to be, in fact, it is accretive to unitholders as a whole, but on a top-line earnings but on a per unit basis, the value's coming straight back to the unitholder.
Okay. Is it fair to say that on a longer-term basis, you would look to hold the AFFO payout ratio sort of in and around the 90% range as opposed to bringing it down further?
I think we'd say 90% or lower.
Okay. Okay, that's it for me. Thank you.
Thanks, Jenny.
Your next question comes from Himanshu Gupta with GMP Securities. Your line is open.
Thank you. Good morning. Just to follow up on the potential disposition of $200 million of assets. Are you looking for bulk sale, I mean, portfolio sale, or is it going to be one by one asset disposition?
Be one by one. I think that's the way we believe and what we've seen so far with the 2018 dispositions that will maximize value.
Are you seeing any appetite for the portfolio sale in the market? Have you tested that aspect of it as well?
We haven't tested that, largely because the assets we're selling are in different markets and spread out across our geographic footprint. I do think that pricing for one-off assets is more favorable than pricing for portfolios today. That's effectively what we're trying to take advantage of.
Right. Just to gauge the appetite of the market for the assets, what's the profile of these buyers? Are you still seeing any gap between buyers' and sellers' expectation in the market? The point is how achievable is this 7.5% cap rate which you guys are guiding to?
I think it's very achievable. Again, a lot of it is based on feedback we've already been given. Now we feel reasonably confident, which is why we put the number out there. Secondly, I think that the buyers, I think as Canadians, we can sometimes forget how large the U.S. is, how large the capital pool is, how much money there is out there. They also have the 1031 exchanges, which allows investors in real estate to sell assets and then defer capital gains if they invest within 180 days into the same asset class. In a yield product, which is what I would describe this as for a lot of private investors, because unlevered yields are so healthy in this asset class today. There is a lot of demand.
Very simply, if you can buy a Walmart-anchored center for a 7% or even 6.5% cap relative to an underlying Walmart bond at a three, there's a lot of capital, private capital in the U.S. that don't think about capital markets, market cap liquidity or any of these things. They just say that's a really good deal. I think to summarize, there's a lot of appetite, and the 1031, I think fuels that appetite.
Right.
We feel really confident that we'll be able to execute and clear these assets at the prices we have them marked at. It's simply based on where we've transacted, the feedback we're getting. I think Slate Retail REIT, over the last couple of years where we have made dispositions, we have done or exceeded where we've had them marked on our books, in the large majority.
Got it. Just staying on the cap rate discussion, the portfolio cap rate for IFRS was slightly increased to 7.5% from I think 7.25% last quarter. Just a question, how much of the portfolio is appraised by third parties? The fair value adjustment of, I think it was around $60 million-$65 million for the full year, recorded in the books. Does that pertain to certain assets, or is it just across the board?
We built that up on an asset-by-asset basis. Every valuation we did was specific to the property, or in cases where we've gotten that asset in the market based on feedback we're hearing. As well as what we're continuing to see from an acquisition front from others. It's all our valuations. We think it's real. We feel very confident that it's if anything, very conservative.
Yeah. I think the only thing we'd add is in December when we were doing this, even the first two months of 2019, whether it's real estate or the equity markets or whatever financial asset classes, it's been quite positive, and we're already seeing sentiment and valuations and cap rates come in, and I think that for Slate Retail REIT, at least specifically, we think that there's a very reasonable possibility of cap rates coming lower into 2019 and that NAV going back up. When you think about selling some of our lower tier assets in and around our IFRS cap rate today, I think that's a very reasonable justification for doing so.
Sure. Okay, switching gears to NOI, and you mentioned in the letter of expectation of 2.5%-3% in 2019. How much is that expectation driven by redevelopment, and how much is same property? In general, what is the visibility into NOI growth? Are you budgeting some bad debt sales, some unseen vacancies as well in your forecast?
Well, I think in everything we do, we're always reasonably prudent or conservative. I would say that the split between same property and redevelopment is probably 2% same property, 1% development.
Okay.
To get to that 3% number that you just quoted.
Sure. That's very helpful. Maybe just last question on Windmill Plaza, the JV with Kroger. What development yield are you expecting here? How does the potential Kroger deal compare to Kmart? Are you looking for more such partnerships?
Yeah, always looking, and whenever you can partner with the largest grocer in the United States or North America, we think it's a good thing. We really like that deal for Slate Retail REIT. We're going to own a brand new Kroger that we're in a JV with our lead tenant on a 20+ year lease, and it'll be accretive once the income starts coming in. Kroger's paying slightly more than Kmart, but where you get the real lift is the former Kroger box that we're going to backfill. You're getting two to three times what Kroger was paying, if not more than that, on your rent.
Right. Okay. Maybe I'll just squeeze in one last question. You made an interesting point about the access land closer to the end-use customers. Are you seeing any examples of strip centers being converted for better use, like last mile distribution center in some of your secondary markets? Are you looking for any of such opportunities?
It's already started. What's really happening is it's not being converted per se, but what's happening is I'll take Albertsons, for example. They're one of the largest just behind Kroger in the U.S. as a grocer. They're already starting to add 10,000 sq ft- 15,000 sq ft onto the side of their building. What they're doing is they're bringing in technology to build a mini distribution center, which effectively allows them to do home delivery from the store. Because as we talked a lot about in the past, you've got four walls in a box, much like an industrial building, that these grocers pay anywhere between $2- $7 a foot, which is at or well below industrial rents for buildings that are 40 miles outside of the city.
I think what these grocers are saying is, "We've got the distribution, we've got the logistics, and we want to give our customers this convenience, and what's the most economical way to do it? And it's at our stores." Albertsons is doing it with Takeoff Technologies, and I encourage everybody to go to their website and look at that technology because it's state-of-the-art and it's very cool. It's just in its infancy, but it's something that we believe is something that will happen more and more. It's hard to quantify today what that value add is.
As we said in the letter, we're excited about it, and we think that what a lot of market participants are missing from an investment perspective with this asset class is that these boxes and these strip centers, due to the increase in e-commerce, are going to increase in importance and increase in value over time.
I think the couple additional comments I'd make is, if anything, because the sales are being done in the large majority from the stores, we're actually seeing store volumes go up from a grocer standpoint, which is only fantastic for us. We're getting more and more requests from grocers and our tenants to be able to accommodate delivery. Either by van parking or access to be able to facilitate that, or adding kind of quasi-distribution aspects to the existing grocer footprint. That's all hugely positive for us. I think it reaffirms the value of the real estate and only entrenches them more in our centers.
Whether or not they get it delivered to their door or they drive their car and pick it up, the sales are happening from the real estate we own, which we think is a fantastic thing and is starting to reaffirm what we've been saying for a couple of years.
Okay. No, that's very helpful. Thank you guys. I don't have any more questions. I'll turn it back.
Thanks.
Again, to ask a question, please press star one on your telephone keypad. Your next question comes from Johann Rodrigues with Raymond James. Your line is open.
Hey, Greg. Just picking up on that last line of questioning about the land. I just wanted to clarify, those 850 or so acres, is that unused at the moment?
Correct. What I backed out was the building, the real estate, and then the parking lot, which is mandated. Your parking ratios are mandated by the local municipalities. It's anything outside of that.
Is it zoned?
Yeah.
Okay. I guess in talking about that last mile distribution, what shapes and forms that would take, do you see any potential or would you use some of that in terms of adding mixed use on there and adding potential residential, given that some of it is in close proximity to major cities?
No, I don't think so. I think where we see the value is that I'll take Walmart, for example. Their e-commerce business is growing at, like, 40% a year, and that growth is because people are ordering online, and they want to either come pick it up or get it shipped to their house. The pickup in store is estimated at about $200 a basket. Amazon's order for online groceries is about $75. You're getting a two and a half times order size from the grocery store. That's today what we really think the value proposition of this access land is, and again, we're talking future. I think it's still in its infancy, but I think the nice thing is there's meaningful capital being raised around it. I don't think it's going to be multi-res or condos or anything like that.
If anything, maybe there's some self-storage just because it's in close proximity to households. Ultimately, I think it's going to have to do with last mile distributions and logistics of getting goods to consumers' home as e-commerce grows in importance.
Okay. Thanks. I'll turn it back.
There are no further questions queue up at this time. I turn the call back over to Madeline Sarracini .
Thanks, everyone, for joining the fourth quarter 2018 conference call for Slate Retail REIT. Have a great day.
This concludes today's conference call. You may now disconnect.