Don't Pass Up This 8.4% Yielder: Artis REIT

| About: Artis Real (ARESF)

Summary

Artis offers a strong yield at 8.4% and has paid a constant distribution since January 2007.

Recent occupancy challenges in Calgary and Toronto have caused investor concern.

Artis has stabilized its occupancy levels and signs of growth are showing.

There is a sufficient buffer in AFFO to cover the distribution (88.5% payout ratio).

This article includes an analysis of Artis REIT (OTCPK:ARESF) (TSE:AX.UN), including historic cash flows, business operations, management's performance and a forecast of 10-year future cash flows for the business. The present value of the business cash flows is then analysed using a discounted cash flow calculation, allowing readers to assess this business against other similar investments. A safety margin is introduced with respect to expected cash flows to identify the minimum entry price. I do the same thing for each business I review, allowing investors to compare using the same yardstick.

Description of the Business

At December 31, 2016, Artis' portfolio comprised of 250 commercial properties totaling approximately 25.7 million square feet of gross leasable area (GLA). Artis operates in both Canada and the US, with a little over 60% of its GLA located in Canada:

Artis operates a diversified portfolio, including Office, Retail and Industrial. The dominant income is derived from its office portfolio. In the US, office represents 71% of Artis' overall net operating income (Artis loves pie charts):

Analysis

The following table summarizes the historic results of Artis:

Total Units Outstanding diluted

FFO

FFO/

Unit

AFFO

AFFO/

Unit

AFFO

/FFO

Payout Ratio

Dist

2010

63,335,000

$58,539,000.00

$1.01

-

-

-

-

1.08

2011

92,370,000

$99,955,000.00

$1.21

-

-

-

-

1.08

2012

115,641,000

$140,146,000

$1.30

$122,702,000

$1.15

88.46%

88.46%

1.08

2013

133,071,000

$183,467,000

$1.46

$156,761,000

$1.26

86.30%

86.30%

1.08

2014

143,115,933

$193,461,000

$1.42

$164,585,000

$1.23

86.62%

87.80%

1.08

2015

148,082,000

$210,567,000

$1.49

$180,321,000

$1.30

87.25%

83.10%

1.08

2016

149,849,000

$219,492,000

$1.50

$176,901,000

$1.22

81.33%

88.50%

1.08

Av 4 year

6.69%

11.87%

3.64%

9.58%

1.49%

-2.08%

0.01%

0.00%

A couple of things are apparent when analysing these historics:

  • AFFO was not calculated prior to 2012

  • Unit compound growth from 2010 averages at 15.43%

  • FFO compound growth from 2010 averages at 24.64%

  • Note that AFFO growth exceeds the outstanding unit growth, leading to some AFFO/unit growth.

  • Payout ratio sits at 88.5%. There is still some room to absorb performance issues.

Operations (Occupancy)

This is why you buy a diversified REIT. Overall, Artis is performing well as a result of decent performance in its retail and strong performance in its industrial sectors. The worst offenders are offices in Toronto (4.2% of GLA) and offices in Calgary (9.6% of GLA).

Canadian Properties

2013

2014

2015

2016 Q4

Office

93.8%

94.1%

86.8%

86.3%

Retail

96.3%

95.8%

96.0%

93.7%

Industrial

97.6%

95.8%

92.5%

95.5%

Total

95.8%

95.1%

91.4%

91.5%

US Properties

2013

2014

2015

2016 Q4

Office

93.2%

93.5%

95.6%

92.6%

Retail

97.1%

97.8%

97.7%

84.4%

Industrial

95.5%

93.4%

95.6%

92.8%

Total

94.8%

93.6%

95.7%

92.5%

Note that US retail represents 1.2% of the total portfolio.

Here is the consolidated portfolio performance from 2013-2016:

2013

2014

2015

2016 Q4

Total US & CAD

95.5%

94.6%

92.7%

91.9%

Obviously 2013 showed really good performance, but I would say that 2016 isn't terrible performance given the overall retail economics (online shopping) and the Calgary downward spiral. For the details-oriented, here is the full performance by city:

I knew going into this analysis that Calgary would be a problem. It represents about 10% of the total portfolio by GLA. Red Deer is also performing poorly, but it has a good forward commitment and is a tiny portion of the portfolio. Together, Toronto, Calgary and Red Deer represent about 14.4% of the total portfolio. I think that poor performance in Calgary will continue for some time until the effect of Trumponomics can play out in the Canadian oil sands. Here are the overall office vacancy rates for these markets:

Note that Artis is performing better in Calgary and worse in Toronto than the average statistics.

Interest Rate Risk

I have no concerns regarding Artis' debt levels:

2015

2016 Q4

Debt ratio

2.5

2.1

Interest Coverage Ratio

2.92

2.99

Distribution Buffer (sensitivity analysis)

AFFO in 2016 was $176,901,000, while the total distributions paid in 2016 equaled $157,018,000. This leaves a buffer of $19,883,000. The total revenue for 2016 was $572,515,000. The current occupancy is 91.9%. If we assume a uniform revenue distribution, the total theoretical revenue is $622,976,000. Here is a sensitivity analysis based on projecting overall portfolio occupancy rates and assuming all costs are fixed:

91%: 19,883,000 - (572,515,000 - 622,976,000 x 0.91) = $14,276,160

90%: 19,883,000 - (572,515,000 - 622,976,000 x 0.90) = $8,046,000

89%: 19,883,000 - (572,515,000 - 622,976,000 x 0.89) = $1,816,000

88%: 19,883,000 - (572,515,000 - 622,976,000 x 0.88) = -$4,413,000

87%: 19,883,000 - (572,515,000 - 622,976,000 x 0.87) = - $10,643,000

86%: 19,883,000 - (572,515,000 - 622,976,000 x 0.86) = - $16,873,000

85%: 19,883,000 - (572,515,000 - 622,976,000 x 0.85) = - $23,102,000

Therefore, if occupancy rates drop below 89%, the payout ratio would become over 100% and trust dilution would occur unless the dividend was lowered. Occupancy would have to drop to 63.5% to totally wipe out the AFFO.

Valuation

Let's start with the best case scenario. I'll assume that Artis will maintain its distribution at 1.08 until kingdom come. If you were as confident as a treasury bond that Artis would continue to pay a distribution of 1.08, I would recommend paying:

$1.08/0.03 = $36

This is based on a perpetuity and a 50-year treasury bond rate of 3%. Of course this is not realistic. There are specific cash flow risks that might materialize with Artis. Let's build the worst case scenario that would align with us being as confident as getting a coupon from a Treasury bond.

Cash Flow Safety Factor

I think we are starting to see occupancy levels flatten off in Calgary, with some improvement forecasted in the commitments. The future of Calgary looks decent assuming Trudeau wants to continue the cordial relationship with Trump and pump up oil trade. Retail continues to offer challenges throughout the globe, which is reflected in Artis' declining performance.

I'm about +90% confident that the status quo or better will occur. It is too diversified to drop occupancy by another 5%.

I think there is a 5% chance of being in the 89% to 91% occupancy bracket. I don't think it's unreasonable to assume there is a statistically significant chance of this occurring. There are enough risk factors, such as rising interest rates, declining retail and overall issues with the Canadian economy.

That leaves about a 5% chance of seeing a declining distribution. To analyse this scenario as very improbable, I'm going to make the following assumptions:

  • Artis continues to issues units, growing them at 6.7% per annum

  • AFFO declines at 2% per annum for the next 10 years

  • Artis keeps the payout ratio at 90% of AFFO

  • Artis pays a constant distribution at the 10-year end rate into perpetuity

Here are the resulting 10 years of cash flows. Note they are really bad because I am matching my confidence in the cash flows to my confidence in a Treasury bond.

Units

AFFO

AFFO/Unit

Payout Ratio

Distributions

2017

159,878,237

173,362,980

1.08

0.90

0.98

2018

170,578,721

169,895,720

1.00

0.90

0.90

2019

181,995,377

166,497,806

0.91

0.90

0.82

2020

194,176,138

163,167,850

0.84

0.90

0.76

2021

207,172,145

159,904,493

0.77

0.90

0.69

2022

221,037,961

156,706,403

0.71

0.90

0.64

2023

235,831,801

153,572,275

0.65

0.90

0.59

2024

251,615,778

150,500,829

0.60

0.90

0.54

2025

268,456,159

147,490,813

0.55

0.90

0.49

2026

286,423,650

144,540,997

0.50

0.90

0.45

Here is the present value of the first 10 years:

Year

PV

Sum

2017

$0.95

$0.98

2018

$0.84

$1.85

2019

$0.75

$2.62

2020

$0.67

$3.31

2021

$0.60

$3.93

2022

$0.53

$4.48

2023

$0.48

$4.97

2024

$0.42

$5.41

2025

$0.38

$5.80

2026

$0.34

$6.15

I will capture the remaining 10 years through a perpetuity, brought to the present value using the discount rate:

($0.45/0.03) / (1.03^11) = $10.84

The total comes to 10.84 + 6.15 = $16.99. The current price is $12.88 or a 24% discount.

In fact, you would have to assume a -20% compounding decrease in AFFO for the next 10 years for the NPV to be close to the current price of $12.88.

Strategy for Dealing With the Market

The market is pessimistic about this REIT primarily due to its exposure to the Calgary market and the retail market. I expect this REIT to stabilize back to around $16-17 once investors regain their confidence. I'm about 95% confident there won't be a dividend cut, but I suggest you use your own judgment to evaluate risks before claiming a position.

Cheers,

Wayne

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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