I first wrote about RioCan with the post cash for life, until it doubles in price! on August 20th 2020 at the time RioCan was priced at $15.60 and I had estimated the true value at $24/share and the annual funds from operations for 2020 at approximately $1.60/share.
The company has managed to successfully navigate the pandemic with a 95.7% committed occupancy for 2020 and was able to generate the $1.60/share in funds from operations.
A lot has happened since August, including a 2nd/3rd virus wave, vaccines, new lockdowns, a CEO succession, and a dividend cut. Despite this turbulent environment RioCan’s share price has risen 25% to $19.38.
The share price moved up in two primary moves, first at the vaccine announcement in November and more recently alongside the market rotation from growth to value.
I believe RioCan is still significantly undervalued, offers an attractive and safe 4.9% dividend yield and will deliver investors premium returns as it recovers to its pre-pandemic value and shifts into growth mode.
Valuation Price to NAV: $24.50 Net Asset Value - (CIBC) $24.50 NAV / $19.38 Share Price = current share price represents a 26% Discount to Net Asset Value
FFO Yield: This looks at the yield of funds from operations relative to the share price. $1.60 2020 Annual FFO / $19.38 Share Price = 8.25% FFO Yield An 8.25% FFO Yield reassures me that capital invested has a strong and direct relationship to earnings. Price/FFO: This looks at the price relative to the funds generated by the business. $19.38 Share Price / $1.60 2020 Annual FFO = 12.11 P/FFO The average Price/FFO ratio for RioCan since 2001 is 13.96 P/FFO This means the current share price represents a 15% discount to the average RioCan price/ffo valuation ratio.
In the chart below the blue line represents RioCan at its average price / ffo multiple of 13.96. The black line represents the share price for RioCan. RioCan can trade at a discount or a premium to its average valuation multiple.
When the price is below the blue line it is trading at a discount to its historical average and above the blue line represents a premium to its historical average.
If we look at how RioCan responded to the Great Recession in 2009, it hit a P/FFO low in March 2009 at 8.84 and then recovered fairly quickly hitting a premium P/FFO ratio of 19.32 by July 2012.
If RioCan was currently valued using this premium 19.32 P/FFO valuation ratio $1.60 2020 Annual FFO x 19.32 P/FFO Ratio = $30.91 This is a 59% increase from the current share price.
As we move through the pandemic I believe RioCan will follow a similar pattern to the 2009 recession and transition to a premium P/FFO valuation over the next two years. RioCan is set to benefit from a low interest rate environment, an increase in immigration to major city centres, a return to normal for retailers, a strong residential real estate market and inflation.
We can see a breakdown of P/FFO ratios by real estate sector below highlighting current valuation levels relative to the post GFC average and post GFC range. This highlights the room retail reits have to grow relative to past valuation levels. It also reinforces RioCan’s strategy to diversify into residential as the residential sector enjoys a much higher valuation ratio than the retail sector.
Vaccination Progress = Near Term Catalyst for Canadian Retail Reits “Assuming that vaccination progress differentials between Canada and the U.S. diminish over the near term, we reiterate our view that the Canadian retail focused REITs should trade at comparable valuations to their U.S. peers — as they did pre-pandemic At 14.9x P/AFFO and 81% P/NAV, the average Canadian peer valuations are still low by historical standards. In addition to higher valuations, we also see potential for increases in both AFFO and NAV estimates as economic restrictions are relaxed. All of the above give us higher conviction today on the relative near-term upside for unit prices of Canada's retail-focused REITs, particularly as our vaccination rollout progresses and catches up with the pace of the U.S.”- Sam Damiani TD Equity Research Industry Note March 8th 2021
Dividend Cut + Strategy Change RioCan announced a dividend cut in December 2020 reducing its payout ratio from 90%+ to 61.5%. This dividend cut was not just due to the impact of the pandemic but was designed to be a major strategy shift from primarily an income based shareholder compensation approach to a balanced growth and income approach.
As part of this strategic shift, Jonathan Gitlin succeeded Ed Sonshine as CEO with Mr. Sonshine becoming chairman of the board. Jonathan has been working towards this new approach for many years through the strategic cultivation of the urban development pipeline as well as a transition into the residential sector through RioCan Living.
If you look at the 20 year RioCan chart below the white line represents the dividend payout ratio and below it the payout ratio is written in black. Typically, RioCan has paid out 80-90% of the funds from operations to shareholders as dividends and only invested 5-20% of FFO back into the business. The transition to this growth strategy began gradually in 2011 as the allocation of funds from operations to growth increased from 10% in 2011 to 23% in 2019 and now to 38.5% in 2021.
61.5% FUNDS FROM OPERATIONS -> DIVIDEND INCOME 38.5% FUNDS FROM OPERATIONS -> RETAINED FOR INVESTMENT/GROWTH
The Growth and Income Flywheel at RioCan The 38.5% of FFO that is retained by RioCan will be reinvested in the business/development pipeline to generate additional FFO and increase the net asset value of the business. As FFO increases RioCan will be forced to raise dividends to maintain the 60% minimum REIT dividend payout ratio.
This creates an interesting Growth/Income Flywheel in which FFO growth will be maximized and the majority (60%+) of future FFO increases should be passed on directly to shareholders through dividend increases.
The chart above also indicates that the FFO Growth Rate has been historically 1.67%. The future growth rate should be significantly higher with a shift towards the new growth strategy. For example, the current FFO Yield is 8.3% with 5.04% going to dividends and 3.26% going to growth. This means the retained earnings represent almost double the historical FFO Growth Rate.
Valuing the Development Pipeline Investors typically focus on the future cashflow a real estate investment trust will generate when estimating value. When using the P/FFO method you are comparing the current share price relative to the cash flow the investment generates. This is a reasonable and fairly standard method of valuation in the real estate investment trust asset class but it does not fully consider the hidden value in land and the development pipeline. The shift from a primarily income-based return to a combination of both growth and income increases the importance of valuing the development pipeline going forward.
RioCan’s competitive advantage in the marketplace is the strategic land it owns across major Canadian cities including 3.7M SQFT of real estate under development right now and an additional 10.3M SQFT of real estate with approved zoning plus 7.7M SQFT of real estate with applications already submitted in the long term pipeline.
Currently RioCan has 38 Million SQFT of leasable property. If we take the extremely conservative assumption that the future square footage created will generate an equal amount of value to the existing 38 Million Sqft of space:
In development 3.7M SQFT (10% Increase to NAV) Zoning Approved 10.3M SQFT (25% Increase to NAV) Zoning Applications Submitted 7.7M (20% Increase to Nav)
This basic back of a napkin approach ignores future potential development and highlights the value creation potential with a conservative 55% increase to NAV in the medium term development pipeline.
In reality the value creation should be much higher with new development SQFT delivering higher returns than existing sqft. Prime commercial real estate land is a scarce asset that can be leveraged through intensification and development projects to unlock this hidden value and increase FFO through recurring revenue or development income (transactional ffo).
Measuring the Spread between REIT FFO Yields and Bond Rates
The Spread between REIT Yields and Bond Rates is one metric that can help estimate the total performance of REITS moving forward. The higher the spread the more likely REITS outperform and the lower the spread the more likely REITS underperform.
For example, if Government of Canada 10 Year Bond Yields are 1.5% and RioCan’s FFO Yield is 8.25% the spread is 7%. The median spread between REIT Yields and GOC 10 Year Bonds is 4.62% with the median following year return at 12.2%. A higher spread is correlated to outperformance. This is because the higher spread encourages investors to invest in REITS over fixed income alternatives and compress the spread.
“We do note that in years in which yield spreads were above 450 bps at the beginning of the year (such as 2021), the REIT sector has averaged ~20% total returns over the following 12 months” CIBC Canadian Reits Monthly
Bottom Line
RioCan offers investors a durable income stream and reliable growth at a significant discount. Its strategic land holdings and massive development pipeline in prime urban locations are a competitive advantage and a reliable way to generate value. It offers investors a great alternative to bonds with a high reliable bond-like income, capital appreciation and the ability to absorb inflation through rents and property values. This is a great contrarian investment that benefits from the economy reopening through vaccine distribution and still has lots of room to run.
Thanks for reading and good luck to all.
Disclaimer: Both Taylor and Drew own RioCan. This is for informational purposes only and is not investment advice.
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