RioCan REIT: Resilient, Forging Ahead With Mixed-Use

Summary

• RioCan's occupancy and rent collection have remained reasonably good throughout the pandemic, and it has strong liquidity.
• The large majority of its tenants (~79%) are strong and stable, while the collection rate has been 81% on the rest that is potentially vulnerable.
• As the vaccine rollout progresses, infection rates and the need for lockdowns will decline.
• The tenant mix and concentration in major markets should make the company resilient to long-term changes in shopping behaviour.
• New developments are 83% weighted towards residential, which should also mitigate sectoral headwinds for retail.

Photo by EricFerguson/iStock via Getty Images

Investment Thesis

RioCan REIT's (OTCPK:RIOCF) occupancy and rent collection have been holding up well enough throughout the pandemic, and it has strong liquidity. The large majority of its tenants (~79%) are strong and stable, while the collection rate has still been 81% on the remainder. As the vaccine rollout progresses, infection rates and the need for lockdowns will decline.

Its diversified and defensive tenant mix, and concentration in major markets, should make it resilient to the long-term evolution in shopping behaviour. Continued emphasis on mixed-use developments, notably residential, should help to create NAV and address sectoral headwinds for retail. Sentiment could take a while to recover, but I see the risk-reward trade-off as favourable.

Background

REITs are normally a haven for dividend investors, but the pandemic has meant dividend cuts and multi-year lows for some categories like retail REITs. While I'm not specifically a dividend investor, the sharp pullback in sentiment relative to continued resilience, in some cases, has led me to owning a bunch of REITs. RioCan is a retail REIT where I think there should still be further upside.

RioCan's portfolio is 90.6% retail and 7.8% office (the balance is residential), so some of its tenants have borne a heavy brunt from the pandemic in the past year. RioCan has ~90% of its annualized rental revenue coming from six major centres: Toronto (51%), Ottawa (13%), Calgary (10%), Edmonton (7%), Vancouver (5%), and Montreal (4%).

A recent surge in Covid cases has recently prompted more lockdowns, including a stay-at-home order in Ontario, where RioCan generates 64% of its annualized rental revenue. It could take another ~6 months before all Canadians can get the first vaccination, but I expect that infection rates and the need for lockdowns will diminish before then.

While there are legitimate concerns about Covid and the long-term secular e-commerce trend, operating performance has been resilient during the pandemic, so far. Here are some highlights from 2020Q4:

• Cash collection of 94.2%.
• 95.7% committed occupancy.
• ~79% strong or stable tenants, cash collection on the remainder that is vulnerable was 81%.
• Retention ratio was 85.8%, and the weighted average remaining lease term is 7.2 years.
• Spreads of 3.6% and 5.1% for renewal and new leasing, respectively.
• Strong liquidity - currently C$1.6B. Will normally be around ~C$0.9B.
• Unencumbered asset pool generated 59% of NOI and had 2.15 coverage of unencumbered debt.
• With the 1/3rd dividend cut effective in January 2021, the FFO payout should be okay at around ~60%, and a forward yield of ~4.8%.
• Strong regional fundamentals, e.g. 51% concentration in Toronto, where population and economic growth are strong, and vacancy rates have historically been very low.
• Future development pipeline is 83% weighted towards residential, which has had greater sectoral strength.

Inevitably, some of the facts and figures will overlap with other recent SA articles, including Trapping Value's "Maybe, Just Maybe, Rio'Can'" and Jaulian Financial's "RioCan REIT: Dividend is Cut, Now What". Overall, I think a moderately bullish outlook is warranted, with roughly 30+% total return upside over the next two or three years being realistic. For example, that would arise by getting back to NAV of C$24.34 while picking up the 4.8% forward yield.

Source: 2020Q4 Investor Presentation.

RioCan takes some flak on Seeking Alpha relative to SmartCentres REIT (OTCPK:CWYUF) because the latter is 73% anchored by Walmart Inc. (WMT). I own both, but tons of Walmart centres everywhere doesn't necessarily pique my imagination. Meanwhile, RioCan's anchor tenants like Canadian Tire Ltd. (OTCPK:CDNAF), Loblaw Companies Ltd. (OTCPK:LBLCF), Metro Inc. (OTCPK:MTRAF), Sobeys which is owned by Empire Company Ltd. (OTCPK:EMLAF), and others, are not flimsy operations and have done fine during the pandemic.

Liquidity and Covenants

Source: 2020Q4 Investor Presentation.

It looks like RioCan's current liquidity alone would be strong enough to cover much of their 2021 and 2022 debt maturities, if needed. Covenants, for their revolving unsecured operating line of credit and non-revolving unsecured credit facilities, also do not appear to be an issue. Further related to balance sheet strength, RioCan plans to primarily self-fund development, e.g. through free cash flow, divestiture proceeds, and strategic partnerships.

Source: RioCan 2020 Annual Report.

Occupancy and Rent Collection

Likewise, occupancy and rent measures do not look terrible especially considering that there is a global pandemic going on, with some improvement in the second half of 2020.

Source: 2020Q4 Investor Presentation.

Note that the 81% cash collection on the potentially vulnerable tenants would reflect government support that those tenants could have received. Such support is continuing under the Canada Emergency Rent Subsidy (CERS) program. For 2020 overall, 5.2% of rent was provisioned for abatements or bad debt.

Source: 2020Q4 Investor Presentation.

In general, Toronto has one of the lowest vacancy rates of any major city in North America (office: 4.7%, retail: 2.9%, residential: 1.5% for 2019). The recent jump in Toronto vacancy rates (for residential, up to 5.7% in the City of Toronto, 2.0% for the rest of the Greater Toronto Area) could also be temporary as the vaccine rollout leads to a partial return of workers and students.

Source: 2020Q4 Investor Presentation.

Long-Term Changes in Shopping Behaviour

One of the recurring debates of the pandemic has been to what extent will shopping behaviour change permanently. I'd note that the pandemic has been a near-perfect scenario for e-commerce - conditions for e-commerce aren't going to get any better than having forced closures of brick and mortar retailers. And yet the large majority of shopping still does not occur online.

Nevertheless, e-commerce has been climbing steadily, and has gotten a boost especially in periods with lockdown measures. For the United States (included for comparison), U.S. Census Bureau numbers show a gradual rise over 2011-2019, up to almost 12% e-commerce share in 2020Q1, which jumped up to ~16% in 2020Q2. The red line in the next chart shows a similar trend for Canada, but at a lower level of total retail sales, reaching 5.1% in December 2019 and peaking at 10.4% in April 2020 during the 1st wave.

Source: U.S. Census Bureau.

Source: Statistics Canada, with author calculations. Timeline on lockdown measures: Wikipedia, author's interpretation/recollection.

The increase in e-commerce share over 2016-2019 seems to have been mainly driven by e-commerce growing much faster than the rest of retail - rather than brick and mortar necessarily declining. For the most part, retail sales (excluding e-commerce) in Canada only had negative year-over-year growth from March to May 2020, and again in January 2021, when lockdown measures were the strongest (proxied by Ontario, the most populous province, in the chart).

It stands to reason that at least some online shoppers will return to brick and mortar once the vaccine rollout makes more progress. After a partial pullback, my guess is that the secular e-commerce trend will resume, with roughly ~1 percentage point growth in share per year. I'd also expect that this is not enough to completely offset positive fundamental drivers like population and economic growth in the major centres where RioCan is located.

There is a range of reasons for why one can expect brick-and-mortar retail to see some rebound post-pandemic. A few potential hindrances for e-commerce that come to mind:

• Personal preferences (habit, easier to size up products in-person, interaction with sales staff, getting out of the house).
• Less suitable for some categories (gyms, dining-in, trying-on clothes, etc.).
• Inconvenient delivery times.
• Not always the best deal.
• Returns or after-sale service are an extra hassle.
• Omni-channel alternatives.

Of course, personal preferences vary, and some retailers will see a lasting effect. RioCan's diversified and defensive portfolio should help in that regard. As of February 2021, confirmed closures of declining retail concepts totalled only about 0.9% of RioCan's annualized total rental revenue. Management has also pointed out that Canada is less over-retailed than the United States, with 29% less gross leasable area per capita.

One can further observe that RioCan bounced back from Target's departure in 2015, and Sears' departure in 2017. In 2015, committed occupancy was 94.0%, actually lower than the 95.7% in 2020Q4.

Source: 2018Q4 Conference Call Presentation.

New Mixed-Use and Residential Developments

One of RioCan's new large-scale developments is the Well. Its 1.2M of office space is now 85% leased to Shopify (SHOP), Intuit (INTU), and others, and they expect the rest to be leased "promptly", with first possession expected to take place in 2021Q3. Of the 340,000 square feet of retail space, 110,000 square feet have been leased so far, with first possession anticipated for 2022. RioCan also sold air rights for 1.3M square feet across six residential buildings, and retains a 50% stake in one of the buildings. The condos are 83% pre-sold.

RioCan's future pipeline is 83%-weighted towards residential - the residential market is not without its own risks, but this focus makes sense given sectoral trends. They've reported NAV creation relative to cost of +57% that is considerably higher for residential than for the +10% with commercial development. The housing markets of Toronto and other major centres have been booming for years, given low interest rates and constrained supply.

Source: 2020Q4 Conference Call Presentation.

RioCan's good financial condition and the large amount of NAV creation from residential projects should create some buffer for the possibility of a downturn in the housing market. It looks like the large majority of condos are pre-sold, also, and total development as a percentage of total gross book value is only 10.3%. A condo market crash might have an effect on the residential rental market too, although their overall exposure there is still small.

Vaccine Rollout

The vaccine rollout has been slow in Canada, and it looks like there will be another ~6 months before all Canadians can receive the first dose. I base this on the following:

• ~7.6M doses have been administered, as of Friday.
• ~17.8% of the population has received at least one dose.
• Around 200k doses are being administered each day.
• That gives 7.6M*(1-0.178)/0.178/200k = 175 days, or about 6 months.

However, as the vaccine rollout progresses, infection rates and the need for lockdowns should decline. Other countries that are further along in their vaccination campaigns could give clues into how things will evolve over the next months. One example will be the United Kingdom, which is set to emerge from its own lockdowns, and where over half the population has had the first dose.

Risks

Much remains uncertain, including whether initial vaccination campaigns will be sufficient to quell new variants.

• Although vaccines have seemed to be adequate enough against certain variants so far, some other countries will take longer for their vaccination rollouts. This leaves more time for additional, potentially more serious, variants to develop.
• Retailers that are currently classified as "potentially vulnerable" will continue to be under strain from lockdowns in 2021, potentially leading to more store closures and uncollected rent.
• I could be underestimating the threat to RioCan from the long-term evolution in shopping behaviour.
• Pundits have been speculating for years (at least since the 2008-09 financial crisis) that the Toronto housing market is overvalued and could crash any day. After briefly dipping in 2020, condo prices have seen growth again in 2021 - it seems that there has been a chronic underlying supply-demand imbalance (in addition to investor speculation). Chronic problems don't necessarily just go away with time, and it could take a significant expansion in supply or much higher interest rates to make a sustained dent in the boom. Condo pre-sales and balance sheet strength should help to mitigate risk for RioCan, but a correction would make residential development less profitable.
• Debt is high at 9.47x to adjusted EBITDA, although this should also improve as EBITDA recovers. Note that their new mortgage borrowings in 2020 were at a weighted average interest rate of only 2.82%, lower than the 3.64% for maturing mortgage debt.
• As always, there could be other company-specific or sectoral risks that I've missed.

Valuation Outlook

Given RioCan's resilience throughout the pandemic, and an improving outlook with 94.2% of 2020Q4 rent collected and vaccines gradually rolling out, I'd expect a continued gradual recovery in the share price.

For sake of argument, one could suppose that 5% of 2020 rent remains uncollected, 10% in 2021, and another 5% in 2022 (maybe as it takes time to re-lease closed stores, etc.). Relative to 2019 rental revenues of C$1.09B, this works out to about C$218M in rent that would be "lost" to the pandemic. That's only ~2.5% of RioCan's ~C$8.6B market cap prior to the pandemic.

To justify the roughly 27% share price drop since early 2020, I think one would have to assume a more permanent impairment in value. But as I've argued in the section on shopping behaviour, retail sales growth has mostly been positive or flat in non-lockdown periods, while there continues to be NAV creation opportunity in residential development. A few other factoids relating to valuation:

• 5-year average FFO multiple is 13.2. Using 2020's depressed FFO of C$1.60, that would put the share price at C$21.12.
• Despite the pandemic, new development has continued "unabated". Whether RioCan retains ownership or recycles capital by selling interest in its properties, eventually FFO will return to growth.
• Net book value per unit was C$24.34 in 2020, after write-downs from 2019's C$26.14, mainly in 2020Q2, related to Alberta and enclosed centres.
• Forward yield of ~4.8%, so if getting back to NAV happens in a couple of years that would put total return in the neighbourhood of 15% annually, as the sector recovers.
• In recent years, RioCan was stymied by the exits of Target and Sears; these are no longer headwinds.
• Monetary policy is expected to remain at near-zero levels until at least 2024 as the economy recovers from the pandemic, which should help support real estate values.

REITs traditionally attract dividend investors, so the share price might not fully recover until a higher dividend is re-introduced. The new CEO, Jonathan Gitlin, has not made any promises about restoring the dividend to its previous glory of C$0.12/month - he has instead stated he wants to create "total unitholder return", which could include buybacks.

Apart from RioCan, I think there continue to be other opportunities in the Canadian REIT sector, although that is beyond the scope of this article. While the return opportunity now is not as great as earlier in 2020, we at least have more visibility on vaccines, and how the sector is holding up.

Final Words

Sentiment could take a while to recover, but I'd expect the situation to look better in a number of months. The vaccine rollout could take another ~6 months to reach everyone with the first dose, but infection rates and the need for lockdowns should diminish, before then. Retail will face ongoing e-commerce headwinds, but it's not clear to me that this will be enough to offset long-term population and economic growth in RioCan's major markets.

The focus on mixed-use and residential development provide an avenue for continued value creation. The booming housing market in Canada took a short breather in 2020, but has shown signs of picking up again. While a downturn is a risk as always, RioCan's level of NAV creation relative to cost, and other factors, should give some buffer.

Please feel free to share your thoughts in the comments below.

Analyst’s Disclosure: I am/we are long RIOCF, CWYUF, CDNAF. 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.

I'm not a financial adviser/advisor, and this post is only intended to express my own opinions. I could have overlooked key facts and/or risks, and my views could change at any time, not least because of new information that might become available. The suitability of an investment depends on your own personal circumstances and risk tolerance. You are responsible for your own due diligence.