RioCan (OTCPK:RIOCF) units (shares) have declined 18.3% over the past 52 weeks, in line with the S&P TSX Capped REIT Index. The current P/E ratio of 15.5 compares with the 13-year median P/E of 19.2. This represents an excellent opportunity to purchase and hold for the long term the premier Canadian REIT.
My Investment Approach
I have owned RioCan for more than 10 years. I continue to add to my holdings monthly through RioCan's attractive DRIP plan, which offers bonus units equal to 3.1%. Unfortunately, unitholders in the United States may not participate in the DRIP plan. Unitholders residing outside the U.S. are eligible to participate in the DRIP plan unless the laws of their countries of residence prohibit their participation.
This is my first article for Seeking Alpha. Therefore, I thought it would be useful to the reader to provide some biographical information that influences my investment style. I am semi-retired with a small pension. Dividend income is the mainstay of our family livelihood. Capital preservation and margin of safety are paramount. I don't need to hit home runs -- singles and doubles will suffice. But I do need to avoid striking out. I need to avoid disasters, which is one of many of the appealing qualities of RioCan.
I am overweight equities, however, I can sleep at night with this weighting. I think of each share holding as a proportional ownership in the underlying business. I focus exclusively on large- to mega-cap dividend-growth companies with strong financial metrics and "quality values," which combine to offer a prudent margin of safety.
I sat tight with my portfolio through the Great Recession of 2008-09. I can stomach volatility because I am enrolled in the DRIP plans for stocks trading near or below my average cost or the company's book value or NAV. And because I know I am holding solid companies in healthy sectors whose fundamentals haven't deteriorated, I don't panic in periodic market downturns like now because, to paraphrase Warren Buffett, "When hamburgers go down in price, we sing the Hallelujah Chorus." Holding onto a good investment through a market downturn is reasonable. (Holding onto a poor investment until you get your money back is not.)
Mr. Buffett succinctly described his ideal investment horizon when he said, "Our favorite holding period is forever." So is mine. A long investment horizon is a key advantage retail investors have in generating real net returns (after fees, trading costs and taxes), compared with professional portfolio managers, who are measured and rated in a very public manner every quarter and who, on average, turn their portfolios over more than once per year.
The Benefits of REITs
Before elucidating my investment thesis for RioCan specifically, I'd like to present a brief synopsis of the main value and benefits that quality, large-cap REITs offer to investors, beginning with their demonstrated ability to deliver long-term capital gains and reliable income through their tax-efficient and superior (above-market) dividends. REITs offer stable dividends, anchored by steady rents from long-term leases. REITs are required to distribute to unitholders at least 90 percent of their taxable income in the form of dividends -- significantly higher than most other equities. And dividend growth rates for quality, large-cap REITs have outpaced inflation historically.
REITs are a differentiated asset class, which has had reduced correlation to the traditional asset classes of equities and fixed income securities. They can serve as a source for protection, portfolio diversification and liquidity. REITs have generally delivered better risk-adjusted returns than global equity and fixed-income securities over virtually every long-term holding period. Adding quality REITs to equity and fixed-income portfolios has been shown to increase investors' total returns and to reduce risk.
These attributes of REITs have held true over time and through different economic environments, including the global financial crisis of 2008-2009. REITs are a valuable component of a diversified investment portfolio.
Specific to the current economic and investment environment, market volatility stemming from stuttering, uneven global economic growth; weakness in global commodities, particularly the energy sector; "China tremors" over a growing economic crisis in that country; and the prospect of further rate increases by the Federal Reserve have pushed the yield spread between Canadian REITs and 10-year government bonds to the highest it has been in decades, with the exception of a few months in 2009-2010. This presents an excellent buying opportunity. Interest rates in Canada appear to be set in concrete for the foreseeable future. Even when they do begin to tick up, quality REITs, such as RioCan, have generally performed well in a rising interest rate environment.
RioCan -- The "Granddaddy of Canadian REITs"
In this article I will place more focus on strategic factors that make RioCan the preeminent Canadian REIT and excellent long-term hold, such as market-leading position and strength of the management team. I provided some key financial metrics at the top of the article, which support the investment thesis. RioCan is in a solid financial position as its quarterly financial statements corroborate.
RioCan is the "granddaddy" of Canadian REITs. It is Canada's largest real estate investment trust with a total enterprise value of approximately $16 billion. The REIT owns and manages a portfolio of shopping centers, with ownership interests in 341 retail properties in Canada and the United States, including 15 under development, containing an aggregate of about 78 million square feet. RioCan's Canadian portfolio consists of 292 shopping centers, including grocery anchored, new format retail, urban retail, mixed-use and non-grocery anchored centers. Of these, 199 are properties held through outright ownership (195 income properties and four properties under development), while 93 centers, including 11 under development, are co-owned with 22 partners through joint agreements. RioCan's United States portfolio consists of 49 shopping centers, principally grocery anchored and new format retail centers, containing 13 million square feet.
In terms of strategic moves, RioCan recently announced the sale of its U.S. properties to Blackstone Real Estate Partners VIII (Blackstone) for $1.9-billion or C$2.7-billion, netting the REIT a nifty C$930-million profit.
RioCan's entry into the U.S. in 2009 could not have been better timed, coming on the heels of the Great Recession. U.S. commercial real estate prices had dropped precipitously -- more so than in Canada. Canadian-domiciled RioCan had access to cheaper capital than its U.S. counterparts. And RioCan's exit from the U.S. market was equally well timed, resulting in the C$930 gain, stemming from both currency exchange between the Canadian and U.S. dollar and property value appreciation in the U.S. post the financial crisis.
While the selling price was C$0.2 billion below the IFRS value, RioCan's foray into the U.S. was a huge success for the REIT and its unitholders. The sales transaction will significantly strengthen RioCan's balance sheet, positioning it in the top echelon of Canadian REITs and more in line with U.S. large cap REITs. C$238 million of the cash from the transaction will be used to buy out Kimco Realty Corp.'s stake in 22 of RioCan's Canadian properties. The remainder, approximately C$960 million, or 80% of the gain, will be applied to debt repayment, which will reduce leverage to under 40%, and to fund its Canadian expansion -- acquiring new properties and delivering on significant intensification opportunities in redeveloping older properties through a "mixed-use" residential/retail strategy. All of these initiatives will drive future FFO growth.
Strategically, the transaction will simplify its business structure and sharpen its focus on Canada, thus strengthening its advantage in its home country. The significant reduction in leverage will also lead to a higher valuation of the Canadian assets, driving NAV growth.
One of the best Canadian REIT analysts is Alex Avery of CIBC World Markets, who covers RioCan. Mr. Avery appeared on Business News Network recently to discuss the transaction, which he described as "Absolutely fantastic... It's been nothing short of a home run." The link to the full video clip is here.
Potential Threat to RioCan
RioCan's tenants in the "bricks and mortar" retail sector face the threat of online retail. This is at least partially responsible for the specific pressure on RioCan units this past year. The units have underperformed the struggling S&P TSX Composite Index by 6.6% during the last year.
Who better to address this perceived threat than RioCan CEO Ed Sonshine? In response to Financial Post reporter Gary Marr's question on this topic, he stated:
"I am a believer in the traditional enclosed mall. Notwithstanding the convenience of the Internet, the large mass of people still want to try their clothes on. Colors just don't look the same on the computer as they do in life and sizes are never right. The second part of going to a mall, if it's a certain size and done the right way, is that there is a certain social aspect to it.
"The good retailers are already adapting (Omni Channel). This means that out of that retail facility, you better be selling through video, through WiFi, over the Internet and in person. The idea is to get all those channels to circle back to the store. Sure, you can order off the Internet and we'll deliver it the same as Amazon will and, guess what, if you need to return it or it doesn't fit, come into the store. The stores become like depots.
"The other thing you'll see in power centers, as big-box retailers downsize, is more service-oriented tenancies, such as a gym. You can't get a gym over the Internet...We are seeing more and more medical clinics and restaurants. The medical system is becoming more diverse and not everything is happening in a hospital. Medical practices are moving out of offices and into malls..."
Because the incursion of online retail is the most serious threat to RioCan's tenant base, I put this question to RioCan's head of IR, Christian Green, to get the company's current perspective and received a reasoned response, which I have summarized below:
"Part of the strategy to manage this risk comes from the diversity of RioCan's portfolio. The tenant mix is broad, and no single tenant represents more than 4% of RioCan's annualized rental revenue. In addition, the nature of RioCan's largest tenants are defensive against the online marketplace; for example, grocery or "everyday needs" tenants (Loblaw, Canadian Tire, Walmart, Metro, Sobeys, Dollarama, etc.) as well as lifestyle/entertainment tenants (Cineplex, restaurants, Goodlife, LA Fitness, etc.).
"For approximately 10 years, RioCan has emphasized its strategy to focus the portfolio in Canada's core markets. These core urban markets have demonstrated greater demand for locations by tenants over the long term. As retailers' strategies evolve, the consistent element has been that tenants desire space in major markets with stronger demographics, and are willing to pay higher rents to be in these markets. RioCan's Canadian portfolio is concentrated in these major markets with roughly three quarters of the Trust's Canadian rental revenue coming from Vancouver, Edmonton, Calgary, Toronto, Ottawa and Montreal. RioCan's urban strategy is central to the Trust's initiative to intensify its retail portfolio in these markets, particularly in areas near existing and planned transit infrastructure."
Strength of Management Team
During my professional career spanning 43 years, I had the opportunity to work directly with nine different CEOs in six different companies across a broad range of industries. Most were very good; two were ineffectual and triggered the ultimate destruction of a once great company, ending in bankruptcy. For me as an investor, the single most critical factor in making my investment decision is the quality of the management team, beginning with the CEO.
A great business in a great sector can be destroyed by poor leadership. If you doubt this, think back to the disasters of Jonathan Schwartz at Sun Microsystems, Chuck Conway at Kmart, Eckhard Pfeiffer at Compaq, or John Sculley at Apple, who made numerous mistakes, the most egregious of which was to fire Steve Jobs. This list is far from exhaustive; it is simply for the purpose of illustration. In my experience, the Achilles' heel for unsuccessful CEOs is hubris, which unfortunately abounds in corner offices throughout the world.
Strong CEOs attract and retain strong talent. My first step in making an investment decision is to examine carefully the executive team to satisfy myself that it is composed of exceptional leaders with years of relevant industry experience and a demonstrated record of achievement.
RioCan has extraordinary C-level bench strength. RioCan CEO Ed Sonshine is the best CEO among all Canadian REITs and arguably the best CEO in Canada, in my opinion. Mr. Sonshine is the only CEO RioCan has ever had. He was broke when he founded RioCan in November 1993, but that didn't deter him. From an early age, he had been steeled by horrifying struggles most of us only read about. His parents were Holocaust survivors. He was born in a displacement camp in Germany. Mr. Sonshine has come a long way -- he was recognized for his success as Canada's Outstanding CEO of the Year for 2013.
RioCan management takes seriously its commitment to its unitholders through its dividend plan. As RioCan states on its website, "RioCan's purpose is to deliver to its unitholders stable and reliable cash distributions that will increase over the long term."
Mr. Sonshine's position on dividends is even clearer and stronger. When asked by the same Financial Post reporter if he had ever considered cutting RioCan's distribution during the financial crisis of the Great Recession, when RioCan was paying out more than it was earning, he stated:
"Everybody was telling me to cut (the dividend), including some members of my own board. In 2009 I think we only earned $1.22 in funds from operations (FFO) and we distributed $1.38. Taking into account capital expenditures, the shortfall was more dramatic. I made a deal with the board because I knew a lot of shareholders relied on distributions … It would have been easy to cut the distribution or just give it to people in stock. I just felt a lot of people were relying on it. I felt we have this covenant with those people." (Bold type my own for emphasis.)
Market Leader, Wide Economic Moat
One of my investment aphorisms is to only invest in the market leader. To do so means owning a proportional share of a business that has better growth opportunities and can prevail in difficult conditions.
RioCan is the preeminent player in the Canadian REIT landscape. Its size, its stability, its financial strength, its long-standing leadership presence in the Canadian real estate market, its solid relationships with its customer base, and the quality, experience and cohesiveness of its management team all give it a strategic, sustainable competitive advantage in a market sector that offers substantial barriers to entry. This powerful combination provides a wide economic moat for the company. RioCan is well positioned to maintain and strengthen its market-leading position.
Key Metrics (as of close of markets on Jan 15, 2016)
Full-Time Employees: 747
Incorporated: November 1993
Enterprise Value: C$16 billion
One Yr. Revenue Growth: 7.4%
Forward P/E: 13.8
Payout Ratio: 87.2%
Price/Book Value: 0.95
Five-Yr. Return: 6.0% per yr. incl div
One-Yr. Return: -13.4% incl. div
Paul Godfrey, Independent Chairman of the Board of Trustees
Edward Sonshine, Chief Executive Officer, Trustee
Raghunath Davloor, President, Chief Operating Officer
Cynthia Devine, Chief Financial Officer, Executive Vice President, Corporate Secretary
Riocan Yonge Eglinton Centre
Phone: +1 647 253-4973
Fax: +1 416 866-3128
Of the nine analysts who cover RioCan, the consensus rating is a buy. The rating changed on October 6, 2015 when it was upgraded from a hold.
Disclosure: I am/we are long REI.UN.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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