Introduction

I have been keeping an eye on SmartCentres REIT (OTCPK:CWYUF) for about two years as the REIT was a good buy right when the COVID pandemic pushed the share price lower to just C$21/share. The REIT’s share price has been hovering around C$30 for almost a year now, but has recently dropped below C$29 on the back of higher interest rates, which made investors in REITs trim their positions. I think the REIT is still priced quite attractive at the current levels. Walmart is the largest tenant, occupying almost 41% of the Gross Leasable Area and accounting for just over 25% of the gross rental revenue.

As you can see above, there are plenty of Tier-1 names in the list of tenants, but having Walmart as your core tenant is what made me very interested in SmartCentres REIT. Not only does this provide a reliable income stream from a Tier-1 tenant, I was also attracted by SmartCentres’ development pipeline, which includes the development of residential units.

SmartCentres has its primary listing on the Toronto Stock Exchange, where it’s trading with SRU (or in some cases SRU-UN or SRU.UN) as the ticker symbol. The average daily volume exceeds 300,000 shares and the current market capitalization is just under C$5B. I will use the Canadian Dollar as base currency throughout this article, as SmartCentres reports all its financial results in CAD.

The REIT Continues To Perform Strong In The First Quarter Of The Year

In the first quarter of this year, SmartCentres was able to increase its net rental income by almost 4% as the REIT saw its revenue increase from C$199M to C$202.5M while the property operating costs slightly decreased.

Looking at the breakdown of the received rental income, we see the gross base rent increased by about 2.5%, but we also see the amortization expenses related to tenant incentives decreased by a few hundred thousand Canadian Dollar and this helped to increase the net base rent by about 4%.

You can also clearly see the REIT was able to recover about C$0.6M in additional operating expenses in Q1 2022 compared to the same quarter in the previous year and the combination of this higher net revenue and the slightly lower operating expenses provided the boost to the net rental income.

Thanks to this strong performance, SmartCentres was able to increase its FFO by about 10%, to C$93.2M on an adjusted basis (the C$0.9M adjustment is related to the COVID-19 vaccination centres) that had a slightly negative but (hopefully!) non-recurring impact on the FFO result.

SmartCentres REIT does not publish an official AFFO, but adheres to the Canadian accounting principles for Real Estate Investment Trusts and provides an ACFO: the Adjusted Cash Flow from Operations. And as you can see below, the ACFO came in at almost exactly C$86M on an adjusted basis.

The FFO and ACFO per unit came in at C$0.52 and C$0.48 respectively. This means the current distribution rate is still fully covered by both the FFO and ACFO as the monthly dividend currently stands at C$0.15417 per share (for an annualized dividend of C$1.85). While it’s commendable SmartCentres continues to provide a healthy yield for its investors, we should not forget the REIT is in full development mode and will need more cash to fund that pipeline. And SmartCentres is looking beyond commercial real estate.

The Development Pipeline Still Looks Robust

So if the payout ratio based on the ACFO is in the mid-nineties, how will SmartCentres be able to fund the completion of its development pipeline. The answer should likely be found in the combination of the development pipeline, containing projects in the ‘complete to own’ and ‘complete to sell’ categories. Have a look below at SmartVMC (Condos), number 3 in the overview.

In the next two years Transit City 4 and 5, wherein SmartCentres has a 25% stake, should be completed and readied for a sale. As you can see, the required contribution from SmartCentres is about C$104M with an anticipated profit margin of 20-25% which means SmartCentres will likely book an equity profit on those development investments.

But more importantly than actually making that profit is the ability to ‘recycle’ capital. If the buildings indeed get sold in 2023 (the only question is the effective delivery date, as the assets have already been pre-sold. SRU does NOT need to find a buyer), SmartCentres will immediately be able to reinvest the C$125-130M in capital elsewhere. For instance in the Artwalk project which will require C$192M in capital and should result in similar profit margins when that project gets completed in 2025-2026.

Yes, there will for sure be spikes in debt levels and working capital required to complete the development pipeline, but this will ebb and flow and as SmartCentres has a pretty full pipeline, it will always be able to recycle capital from one project into another while the ‘build to own’ projects will further increase the ACFO and reduce the payout ratio. This year, for instance, the Mascouche North apartment building with 238 units should be completed. This was a C$72M development and SmartCentres contributed about C$57M as it owns an 80% stake in the development project. The estimated rental yield on this project is 4.5-5% and even if I would apply the lower end of that range, the net rental income will increase by C$2.5M per year. This will be followed by an additional net rental income increase of C$1.25M in 2023 when the Mirabel development will be ready.

So these two near-term apartment development projects require very little capital to complete but will immediately increase the ACFO per share by 1% or C$0.02 per year and allow SmartCentres to retain more cash if it doesn’t hike the dividend.

And talking about the Mirabel development, the image above shows how this development is just the very first phase in the densification planned by SmartCentres. This Phase 1 building is likely just the very first step towards the development of the entire land plot with a combination of residential, commercial and hospitality assets.

Investment thesis

SmartCentres is aggressive. Perhaps a little bit too aggressive for my liking but as the REIT delivers on its targets I for sure should not complain (as long as the financial puzzle continues to match). The REIT has an impressive land bank ready for development, and I like the diversification approach to slowly reduce the contribution from commercial real estate in the portfolio.

The current dividend yield is approximately 6.4% and is fully covered by the ACFO (albeit barely). More capital will be needed to complete all the development projects but with a relatively low debt ratio of 42.5% SRU should have plenty of financial flexibility to use debt to fund the completion of development projects while recycling the cash invested in the ‘build to sell’ projects.