Description

THESIS: 

SmartCentres’ biggest advantage is the quality of its existing portfolio. Its strong tenant profile (virtually 100% of portfolio has full line grocery, ~70% with a Walmart) makes its rental income generation stable - as evidenced by the Trust’s resiliency during COVID - but not particularly high growth. The largest opportunity comes the plans to develop prime sites on lands they already own. Debt is high at 10.0x net debt/EBITDA, but not apocalyptic - interest is well-covered and management seems committed to reducing leverage. Distributions have remained stable at $1.85/unit since COVID, albeit relative to many peers who had to cut their distributions. Although I don’t expect distributions to increase materially as management focuses on reducing leverage, SRU.U’s current yield of 7.15% pays you to be patient while the company works to capitalize on new developments. Moreover, management – specifically Mitch Goldhar – owns 10.5% of the units, helping align incentives. I think the value of the stabilized existing portfolio is $19/unit and the new developments are worth $17/unit, amounting to a fair value of $36/unit. Put another way, at the current price, you're getting the existing portfolio of $19/unit and paying ~$6/unit for the new development pipeline, amounting to a cap rate of 50% on the present value of expected rental income from development.

SmartCentres is one of the largest owners of retail malls in Canada, owning 185 properties and 35.2 million sqft. of gross land available (GLA) at key intersections across Canada. The company currently has a 98% occupancy rate. Almost all the REIT’s revenues come from open air centers, which are often anchored by Walmart (114 of the 185 sites Walmart-anchored open air shopping centers). While new initiatives are underway to increase exposure to mixed-use properties, SmartCentres is still primarily a retail REIT, with mixed use and office still making up a very small percentage of the total income. At present, only 0.9 million square feet of the total 35.2 million square feet of GLA is dedicated to office, self-storage, or apartments. Over 60% of total revenues are attributable to large, creditworthy, “essential service” tenants, including Walmart (25%), Loblaws, Canadian Tire, Lowe’s, Dollarama, and others. FY22 tenant retention was high at 88% (+290bps YoY) and in-place rents remains table at $15.53/sqft (+1% YoY). As of 1Q23, committed occupancy rates are back in-line with pre-COVID levels and 100% of deferred rents during the pandemic have been collected. 

SmartCentres traces its roots back to the late-1980s when its Founder & CEO, Mitch Goldhar, worked with Walmart to bring their concept to Canada. Over the following two decades, Goldhar and SmartCentres developed 265 shopping centers in Canada. From 2001-2015, the growth of SmartCentres came principally from the acquisition and earnout of completed & fully leased open-format retail shopping centers, predominantly with the anchor/shadow anchor being Walmart. In 2015, Calloway REIT acquired SmartCentres from Goldhar for $1.2bn ($640m assumption of debt, $160m issuance of shares to Goldhar at $28.70, the balance cash) and renamed itself as SmartCentres REIT. Following the acquisition, SmartCentres expanded to mixed-use initiatives, leveraging lands already owned by the Trust. In 2018, Goldhar was elected Executive Chairman of the new REIT and in 2021 he was named CEO. He currently owns 10.5% of SmartCentre’s units outstanding and is personally responsible for leading the REIT’s $14.9bn development program.

SmartCentres’ existing tenant portfolio consists of 168 income-producing properties (the remaining 17 properties are either developments not yet sold for a profit or new builds that are not yet income-producing). Of those properties, ~73% are based in the greater metropolitan areas of Toronto, Vancouver, Edmonton, Calgary, Ottawa and Montreal.

SmartCentres’ 25 largest tenants accounted for 60.8% of their portfolio revenue as of 1Q23. These tenants are comprised of “blue-chip” names like Walmart & Lowe’s. Over 25% of the entire portfolio by annualized gross rent is made up from “essential service” tenants who include in-store grocery and pharmacies. Given the nature of SmartCenters’ portfolio and mix of tenants, their occupancy rate has been exceptional through-the-cycle and industry-leading when compared to its comps (98.2% vs. peer average of 96.0% over the past decade). During COVID, these tenants proved remarkably stable for the portfolio. 60% of the tenants were deemed “essential services” in Canada and remained open during the pandemic. Even in Jan 2021, the REIT had managed to collect 89.6% of its rents owed in the 9mo that were impacted by COVID, with the remainder under the CECRA program from the Canadian government. As of 1Q23, 100% of deferred rents have been collected.

Having a high concentration of large, prominent tenants helps provide significant stability to the REIT’s portfolio, as demonstrated by the experience during the pandemic. However, the flip side of these large, stable tenants is the relative negotiating power they have. This is true for terms – e.g., Walmart has exclusive covenant on food sales on many properties – as well as over rent increases – same-property NOI has grown at an average of 0.5% per annum since 2009 and renewed rents (ex. anchors) have grown at an avg. of 3.5% per annum since 2015. As such, while the existing portfolio should continue to grow steadily and produce stable cash flow (+3% growth YoY), it is unlikely – in itself – to be a large driver of growth in the future. 

More recently, SmartCentres’ stake in Premium Outlets in Montreal and Toronto, a JV with Simon Property Group, has been a material tailwind for top line, helping drive a +3.8% YoY increase in 1Q23. These properties are fully leased, with tenant sales in Toronto “well over” $1,000 per sqft and 2023 EBITDA trending over 10% higher than 2022. 

Currently, SmartCentres' properties cover nearly 35m sqft. of Gross Leasable Area (GLA), spread across all ten provinces in Canada. Increasingly, the REIT is leveraging its 3,500 acres of land to capitalize on a intensification program, led directly by Mitch Goldhar.  SmartCentres has embarked on an ambitious $14.9B, five-year redevelopment program, encompassing 274 individual projects spread over 95 properties, with the aim to enhance recurring income from two-thirds of these projects.  It is important to note that these proposed developments are on lands that SmartCentres already owns, located in highly populated communities in every major market across Canada. 

Currently, 59 projects are either in progress or projected to commence in the next 24 months, while an additional 67 projects are expected to be activated within the next five years. 84 other properties are currently under review for intensification/redevelopment. According to management, these development programs will result in an additional 56.1m sqft. of GLA – 27.2m sqft (~50%) of which has already started or will begin construction within the next 5yrs. Of this amount, SmartCentres owns 18.5m sqft. These projects consist of 110 apartment buildings, 88 condos, 7 townhomes, 8 office & industrial projects, 33 self-storage facilities, 3 hotels and 25 senior-living facilities. Moreover, their SmartStop self-storage joint venture aims to develop and operate 15,000 units of storage over 1.3 square feet. With 8 sites open and 3 more currently under construction, the project is projected to reach its initial 15 locations by 2024. In 1Q23, the Trust achieved residential zoning approvals on 3 projects, adding another 3.4m sqft. to the future pipeline. A total of 6.1m sqft. of new mixed-use permissions were approved during 2022.

SmartLiving & SmartVMC

As part of its expansion initiatives, SmartCentres launched a segment called SmartLiving to focus on mixed-use residential & commercial leasing and development in city-centers. The largest and most ambitious of these projects to-date is the Vaughan Metropolitan Center (SmartVMC), located in the municipality of Vaughan within the greater Toronto metropolitan area. In 2021 SmartCentres invested $513M to expand its ownership in its SmartVMC project, doubling its ownership in SmartVMC. This investment made SmartCentres the largest landowner in the Vaughan Metropolitan Centre and set the REIT up for a significant wave of residential development partnerships.

1,763 condos + townhomes have been closed since the commencement of the project. Construction is nearing completion on Transit City condo towers 4 & 5 at SmartVMC, comprising 45-stories and 50-stories, respectively, and 1,026 units. The buildings are 100% presold and occupancy is expected throughout 2023.

In 3Q22 SmartLiving initiated building of its 67%-owned, Park Place phase one project with 1,094 rental units across 2 towers and 960,000 sqft.

In 4Q22, the REIT commenced the first phase of ArtWalk a 627-unit residential tower across 550,000 sqft. in which SmartCentres has a 50% ownership stake. 320 condo units have already been pre-sold. Construction is anticipated to begin this year (2023) and deliveries of these sites are expected in 2026-2027. When the full ArtWalk project is built out, it’s expected to consist of 12 buildings across 12 acres, 4 million sqft. and 4,600 residential units.

Additional Opportunities for Expansion

Out of the 185 total properties under SmartCentre’s current portfolio, only 6 have been intensified/redeveloped. 95 properties have been marked for intensification while the remaining 84 are currently under review for redevelopment. Perhaps most importantly, <24% of the lands owned by SmartCentres are currently being utilized, presenting significant opportunity for redevelopment and contribution to the REIT’s FFO.

Debt

Given the SmartCentres’ high level of development activity in recent years, the REIT has taken on more leverage. As of 1Q23, SRU had a Debt / EBITDA ratio of 10.0x, having increased from 8.0x at YE19. Despite this, interest coverage ratios have remained robust >2.5x (1Q23: 2.9x) and a far away from their financial covenant requirement of >1.65x. The Trust has presciently structured most of its debt (82%) to be fixed rate across staggered maturities (weighted avg. term of 4.0yrs), providing some flexibility and relief from the pressure of a rising rate environment. Management has indicated their intention to reduce Trust’s debt and has focused on deploying excess cash flows to paying down the leverage. According to Goldhar, the Trust has ~$200m-$400m of assets (e.g., zoned surplus land) that they recycle to pay down the existing debt balance. The timing, however, depends on market condition and developers’ appetite for new projects. 

Management is very focused on maintaining a pool of unencumbered assets - $8.7bn as of 1Q23. Using a 65% loan-to-value ratio, this amounts to an additional ~$5.5bn of gross financing proceeds available. This is an additional lever that management could pull – especially since 78% of their total debt is unsecured. That said, the amount of financing they could theoretically obtain tells us nothing about the cost or terms of that financing. In my view, management points to this fact to soften the relatively high leverage of the business on a Debt / EBITDA level. I do think, however, that management can explore changing the unsecured/secured mix when large financings come due if it allows for better debt pricing and/or terms. They claim they’re not “super excited” about current rates and locking them in for 10 years. They can afford to wait out refinancing for another year or two, but I would think it prudent to lock in a bit. 

Distributions

The Trust has paid $1.85/unit in distributions each year since 2020. Prior to then, annual distributions increased each year from 2014-2019 at $0.05/unit. Although SmartCentres has kept their distributions flat since the pandemic, this is relative to the some of their closest peers – including RioCan & First Capital – cutting their distributions and the others also keeping their distributions flat since COVID. While distribution/unit growth is certainly something for management to aspire to – especially as new developments begin contributing to FFO – I expect the company to focus on paying down some of its debt before it materially increases distributions. Management reiterated this intention in their 1Q23 call. 

Moreover, payout ratios have gotten increasingly tighter in recent years, reaching 93.0% of AFFO in 1Q23. When you adjust AFFO for one-time gains from closings of townhomes + condos the payout ratio is 99.9%. I don’t expect there to be a need to cut these distributions, especially as FFO continues to grow from new rentals entering the portfolio and development sales produce one-time, but real cash. That said there’s little wiggle room at the moment and no capacity to raise distributions. Given my projections of cash flows, I believe SmartCentres can return to its pre-COVID “normalized’ payout ratio as a percent of Adj. Cash from Operations (ACFO) in the mid-80% by 2024.

Given the importance of the SmartCentre’s development pipeline on its future earnings, I valued the Trust’s existing portfolio and development initiatives independently and combined them to reach a valuation per unit:

Development initiatives are differentiated between rental income and development projects. Rental projects are meant to be held and generate NOI for the Trust. Development projects are meant to be sold on completion for a profit margin. To value these, I took management’s figures of sqft. under development and estimated costs and applied assumptions about rentals’ yield on cost and developments’ profit margin.

I valued the current “stabilized” portfolio by applying a cap. rate to my projection for 2023 NOI.

Catalyst