For most investors, the main reason to invest in real estate investment trusts (or REITs) is the income they pay out.
Canadian REITs typically pay out a high percentage of their cash flow to unitholders. There isn’t much cash flow left after paying the distribution to grow the business, most REIT investors are looking for yield first and capital gains second.
Because the unitholders are so focused on a REIT’s yield, REIT managers take distribution cuts seriously and they are usually a sign of trouble.
Since Riocan REIT (TSE:REI.UN) just cut its distribution by 33%, should investors be worried?
What does Riocan (TSE:REI.UN) do?
Riocan is one of Canada’s largest real estate investment trusts. The company has 221 retail and mixed-use properties, including 16 developmental properties with aggregate net leasable space of just over 38.5 million square feet.
The REIT has leases with some of the largest companies in North America, including Best Buy, Bed Bath and Beyond, Canadian Tire, Dollarama, Loblaws, and Costco.
However, the company also does have some tenants that are struggling in a big way this year, including EBGames, Cineplex, Galaxy Cinemas, LA Fitness, Goodlife Fitness, and Indigo.
Which leads us to the most important question, why did the company cut its distribution? Is it a sign of troubling times ahead?
Did Riocan cut its distribution because its assets are in trouble?
In 2019, Riocan’s funds from operations (FFO, the equivalent of a REIT’s earnings) payout ratio was 76.9%. Adjusted funds from operations (AFFO, the equivalent of a REIT’s free cash flow) is a better indicator of a distribution’s safety, and the AFFO payout ratio was 84.3%, suggesting the distribution was safe.
The COVID-19 pandemic hurt Riocan’s tenants tremendously though, and 2020 has been a tough year for the REIT.
However, even during the pandemic Riocan’s AFFO fully covered its distribution and the payout ratio was under 100%. In the second and third quarters this year, with many tenants shut down by the government, Riocan’s payout ratio was 97.2% and 97.7%, respectively.
With a payout ratio above 97%, the safety of Riocan’s distribution was questionable
If over the winter Canada imposes more lockdowns on retail tenants, or if more tenants went out of business, Riocan would have been at risk of paying out more than it earned if it didn’t reduce its distribution.
The market could sense this risk. When a REIT or stock has a high yield, it’s because the market is saying there’s a risk of a distribution or dividend cut. Even though the unit price went up a lot in November, Riocan was still yielding around 8% before it cut its distribution.
The payout ratio suggests that Riocan was in a little bit of trouble, but it probably could have kept the distribution the same and been fine. Riocan has the liquidity to survive a few quarters with a payout ratio above 100%.
If Riocan could afford its distribution why did management cut the payout?
Riocan knows most investors hold this company for its yield. So if it could afford the distribution, why is it cutting it?
It’s because the payout ratio doesn’t tell the whole story. Even though the payout ratio was less than 100%, Riocan’s debt increased from 8x EBITDA last year to 9.3x on September 30th this year. Both debt-to-EBITDA and debt-to-assets (which is 44.8%) are above Riocan’s targets.
The reason debt has gone up even though Riocan has cashflow left over after paying its distribution is because Riocan is investing so much into developments. The development pipeline is the reason Riocan needs to reduce its distribution.
Riocan has probably the most impressive portfolio of development projects of any Canadian REIT. It has 59 projects underway that will add over 42 million square feet of leasable space to Riocan’s assets, more than doubling the size of the REIT.
Riocan has invested a lot into these developments, spending well over $1 billion to date, but there is a lot more money to be spent. Management expects to spend over $800 million by 2024, over $200 million a year.
The distribution cut is expected to save Riocan roughly $150 million every year. With these savings and by selling some assets where values are still high, Riocan can comfortably afford its development plans.
In fact, Riocan should be in a position to pay down debt as well.
Should you sell Riocan?
There’s no one size fits all answer. Whether you should sell Riocan depends on why you own it in the first place.
If you bought Riocan entirely for its income, it likely makes sense to sell it. Riocan is going to be spending a lot of cash on developments, and it needs to get its debt below its targets, so it won’t be raising its distribution for a while. Investors shouldn’t expect a raise in the next two years.
On the other hand, if you thought Riocan was undervalued and you were counting on capital gains, you should hold on, and maybe buy more. As Riocan completes its development projects, its FFO will go up and so will its net asset value.
The development plans include a lot of residential projects, which the market will value more highly than Riocan’s retail properties and result in Riocan’s FFO multiple going up. And if Riocan pays down debt, the market will see the REIT as less risky.
These factors will likely cause Riocan’s unit price to go up in the next few years and Riocan will be a good REIT to own for capital gains.