A yield as high as 10.6% sure raises suspicion around dividend safety, as high returns come with high risk. The real estate market has been subdued for almost two years after the sector’s bubble burst with the onset of a series of interest rate hikes. Many real estate investment trusts’ (REITs’) unit prices fell. Some commercial REITs paused their distributions as rental income fell and interest expense increased. Some REITs were better off and paused development activity until the borrowing costs became favourable.
Amid the weak real estate market, a handful of REITs stood the test of time and even grew their rental income while keeping interest expenses in check. Slate Grocery REIT (TSX:SGR.UN) is one such REIT with a resilient tenant base.
Behind the +10% dividend yield
Slate Grocery REIT’s unit price has fallen 33% since April 2022, when the interest rate hike series began and house prices started falling. While the REIT trades on TSX, its properties are in the United States, where it earns rent in U.S. dollars. While the Bank of Canada cut interest rate in June, the U.S. Fed kept it unchanged at 5.25-5.5%, reducing the possible instances from three rate cuts to one rate cut of 25 basis points in 2024.
Many REITs have significant debt, and a 5.25% interest rate significantly adds to interest expense. In such times, Slate Grocery REIT’s 94.2% total debt is fixed, with a weighted average interest rate of 4.4%. It keeps the REIT’s interest expense in check, giving it stability in a high interest rate environment.
The declining real estate prices reduced the book value of Slate Grocery REIT’s property portfolio. Since the underlying asset’s value fell, the unit price of the REIT fell as it had to report fair value adjustments. However, it did not affect the Slate Grocery’s rental income. Hence, it continued to pay distributions while the unit price fell, inflating the yield to 10.68%.
Is Slate Grocery REIT trading at a discount?
Interestingly, Slate Grocery REIT increased the rent of renewed and new leases by more than 10%. It has room to grow its rent further as its average in-place rent of US$12.49 per square foot is well below the market rate. Higher rent will increase its net operating income from properties. Moreover, a supply shortage and a strong demand for grocery stores give Slate Grocery pricing power to increase rent without affecting occupancy.
The REIT’s unit is trading at 0.7 times its book value of the property (US$2.1 billion). That is a 30% discount from the worth of the underlying asset, and that too when the real estate market has corrected.
Property prices are showing signs of stabilization, with some parts seeing a pause and some seeing moderate appreciation in property prices. Slate Grocery REIT is among this segment of the market. The unit price seems to have bottomed out, with little downside risk. A decline in interest rates and recovery of property prices could drive up the unit price, creating an opportune time to buy the dip.
Is Slate Grocery REIT’s dividend safe?
The next few months are challenging for the real estate sector as the leasing and property buying activity is slow. However, demand is strong for grocery stores, with names like Walmart planning to add more stores. Moreover, the belt where Slate Grocery REIT has stores has the lowest number of vacant stores. The REIT is confident that it can increase rent and grow its cash flow.
It is distributing 80% of its funds from operations as dividends, ensuring that dividends are safe. I don’t expect any increase in dividends as the REIT is focused on using any surplus to acquire more properties.
You could consider investing 3-5% of your portfolio in this REIT and lock in a yield of over 10% for years. You could also benefit from a 30-40% capital appreciation when the unit price returns to its 2022 level of $15-$16.
