Escalating economic shutdowns are increasing pressure on Canada’s retail-focused real estate investment trusts to slash their payouts, putting investors at risk of losing out on monthly income that used to be considered sacrosanct.
Retail REITs have suffered since the COVID-19 pandemic erupted, largely because the sector’s rent collections have been hit harder than office buildings or industrial warehouses. Some cut their distributions early in the pandemic, but most hoped to ride out the storm.
By fall there seemed to be a rebound across the sector as retail sales roared back, yet in December, RioCan REIT, one of the country’s largest retail landlords, cut its payout by one-third. There has been speculation since that some rivals will soon be forced to do the same, especially now that a new wave of shutdowns is likely to hit rent collections.
“We believe there is a chance select retail REITs could follow [RioCan’s] lead to preserve some cash, particularly for those with high distribution yields, payout ratios, and leverage profiles,” BMO Nesbitt Burns analysts wrote in a note to clients in December.
Not only are revenues likely to drop again because of growing shutdowns, many retail REITs have also committed to funding new developments of condos and rental apartment buildings in order to diversify their property mix as more shopping moves online. These projects require a lot of up-front spending, often worth hundreds of millions of dollars.
The potential for retail REIT distribution cuts “is the top question that we are getting asked,” Michelle Wearing, an associate portfolio manager at Starlight Capital, said in an interview.
“All boards are having this discussion right now, I guarantee you,” she added.
Last week, Brookfield Asset Management announced plans to buy back the 38-per-cent stake of its real estate arm, publicly listed Brookfield Property Partners LP, that it does not currently own. Brookfield Property is one of the largest retail and office landlords in the United States and was expected to pay out more than 100 per cent of its annual cash flow. BAM’s repurchase is seen by some as a way of side-stepping a payout cut because the company will be absorbed into a parent with a bigger balance sheet.
First Capital REIT and SmartCentres REIT are often cited as two companies whose payouts are at risk because they have large development pipelines. At the same time, First Capital has elevated debt levels after it borrowed hundreds of millions of dollars to buy back some of its shares from a large shareholder, while SmartCentres currently pays out around 100 per cent of its cash flow.
First Capital did not return a request for comment, but in an e-mail SmartCentres executive chair Mitch Goldhar touted his REIT’s liquidity and its relationship with Walmart Inc., which comprises 25 per cent of rental revenue. “Our cash flows from leases and profits from development activities are strong and sufficient to conservatively maintain our current distribution,” he said.
“Barring any extraordinary, unexpected events, we do not foresee changing our unit distribution level,” he added.
REITs have touted their redevelopment potential for the past five years, with plans to increase density on multiple properties – especially those in suburban locations with sprawling parking lots. RioCan, for one, created a new division to build high-end rental apartments and SmartCentres has been building condos, such as its Transit City project in Vaughan, Ont., just north of Toronto.
The expectation is that these projects will help to offset digital disruption in the retail sector, but their development requires a lot of cash. And in some cases, even when the new properties are operational, the payback period can take decades, particularly in the case of rental apartments where monthly rent cheques are collected.
With so many REITs trying their hands at development – including office owner Allied Properties REIT and industrial warehouse owner Granite REIT – the nature of the sector is changing. REITs emerged as investment vehicles in the late 1990s after widespread developer bankruptcies, and their goal was to create stable, income-producing real estate ventures that paid dependable monthly distributions to investors.
Yet many REIT risk profiles have changed. To limit the impact, REITs have promised measures such as capping development projects to a small percentage of their total assets. But the pandemic has exposed some fault lines despite this caution, suggesting investors may need to rethink the way they view the sector.
“Canada and Australia are the two markets where people buy REITs for the income,” said Corrado Russo, head of global real estate securities at Hazelview Investments. “That needs to change.”
In many other countries, payouts often hover around 55 per cent of adjusted funds from operations, an industry measure for cash flow, he said. Before RioCan cut its distribution, retail REIT payouts in Canada averaged around 92 per cent of AFFO.
Despite the risks, development projects don’t always dramatically change a REIT’s profile. Choice Properties REIT, for one, has plans to increase density on its properties, but the REIT also earns 57 per cent of its annual rent from grocer Loblaw – and grocers have performed well during the pandemic. Office landlord Allied Properties REIT has been adding development projects as well, and it raised its payout in December.
But for REITs testing the limits of their balance sheets, Starlight’s Ms. Wearing suggested using RioCan’s move as an air cover of sorts to address investor concerns. “You have the opportunity to have a kitchen sink quarter,” she said. “Throw in as much as you can.”
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