Canadian NET REIT Offers A 7% Yield With A ~60% Payout Ratio (OTCMKTS:CNNRF)

Introduction

Canadian NET REIT (OTC:CNNRF) (TSXV:NET.UN:CA) is a commercial REIT in Canada with a specific focus on triple net leases and management-free leases. The triple net status of a rental property is quite easy to explain as pretty much all expenses including taxes and insurance are covered by the tenants. The management-free type assets are assets where the tenant covers the small maintenance capex but where taxes and insurance in most cases remain with the landlord.

A very satisfying performance in 2023

What I like most about Canadian NET REIT is its diversified tenant base as the REIT traditionally leases to strong tenants with nationwide brand recognition. As you can see below, the largest four tenants (based on the NOI) are grocery chains, representing about 55% of the total NOI.

As the interest rates are increasing, I wanted to make sure the REIT is able to hike its rental income accordingly to avoid the net result to be hit too hard. As you can see below, the REIT reported a total rental income of C$7.25M in the final quarter of 2023, resulting in a NOI of just under C$4.9M. That’s a pretty stable result compared to the previous few quarters and the end of 2022 although the REIT sold three properties as it ended 2023 with 98 properties, mainly based in Canada’s Quebec province.

While the net income isn’t important for REITs, the FFO and AFFO are definitely the most important metrics to figure out a REIT’s financial performance. As you can see below, Canadian NET REIT reported a flat FFO of C$3.33M during the fourth quarter of 2023 and this represented an FFO of C$0.162 per unit. Looking at the full-year performance the C$0.635 in FFO per unit was pretty flat compared to the preceding year as well.

As the majority of the leases are triple net leases, there is hardly any capex that has to be covered by Canadian NET REIT. As you can see below, the total capex was just under C$1M for the year, while the main element that weighed on the AFFO was the C$ 347,000 in straight-line adjustment), of which the majority was incurred earlier in the year.

The total AFFO per share was C$0.57 in FY 2023, with C$0.152 per share generated in the final quarter of the year. And as Canadian NET REIT currently pays a monthly distribution of C$0.02875 per share, the distribution of C$0.08625 per share is very well covered as it represents a payout ratio of less than 60%. Looking at the full-year results, the payout ratio was just over 60% which is obviously still totally fine.

About the balance sheet, distribution and interest rate risk

In today’s era, I also want to make sure the balance sheet of a REIT is strong enough to cope with the high interest rate environment. While the distribution appears to be very safe based on the past few quarterly results, I also need to be certain the risk to incur capital losses is as low as possible.

As you can see in the image above, Canadian NET REIT’s real estate assets are valued at C$278M with an additional C$18M invested in joint ventures. The REIT had C$1.8M in cash which, in combination with the gross debt level of C$173M results in a net debt of C$171M. Compared to the C$278M in book value of the assets, this represents an LTV ratio of 61.5% of the fair value of the assets and approximately 57% if you include the book value of the joint venture assets. The REIT also had C$5M in assets held for sale on the balance sheet which had a C$2.8M mortgage on them. I haven’t seen any update on the sales process of that asset but if/when the transaction goes through, the LTV ratio will decrease even further.

Of course it is important to see what the used capitalization rate was to determine the fair value of the real estate assets. According to the footnotes to the financial statements, the capitalization rate remained virtually unchanged at approximately 6.4%. Using the annualized Q4 NOI, the cap rate is closer to 7%.

This also means the almost C$130M in equity, which represents a NAV/share of C$6.30 is pretty realistic. Additionally, you should expect the NOI to increase throughout 2024 as the Canadian NET REIT management has already dealt with most of the lease expiries in 2024 and reported an average lease spread of 5.2% on those leases, according to a recent broker’s note. That would be lower than anticipated as management was guiding for a double digit lease spread at the end of Q3. In any case, I like to err on the side of being cautious and don’t mind using 5.2% for now as even that lower number provides an excellent margin of safety.

And this brings us to my final question mark. Canadian NET REIT has played the debt game very well in the past few years and it has reduced its refinancing risk by staggering the maturity dates of its mortgages. As you can see below, it will have to refinance just C$20M in mortgages in 2024 and 2025 combined.

The total weighted cost of debt across all mortgages is approximately 3.86% which is pretty low, but fortunately the impact of higher interest rates will only be gradually incurred.

Other commercial REITs were able to secure financing in the mid-5% range (just last week, RioCan, a larger commercial REIT closed an unsecured (!) debenture offering at a cost of around 5.30%.). If I would assume a refinancing at 5.50% across the board (I expect interest rates to go down between now and 2028), the total interest expenses would increase by just around C$2.5M on the mortgages. And again, almost half of the total mortgage debt only has to be repaid from 2028 on, so there is a zero percent chance such a sudden interest rate shock will actually occur.

In the same worst case scenario where I assume no rental income growth (notwithstanding the 5.2% lease spread for 2024), the AFFO per share would decrease by C$0.12 to C$0.45. And in that case the distributions would still be very well covered. In fact, the REIT is retaining approximately C$4-4.25M per year in AFFO it doesn’t spend on distributions. Which means that in the 2024-2027 time frame it will likely retain C$16M in earnings which it could easily use to reduce its debt (saving C$0.9M in annual interest expenses) and/or acquiring properties at attractive capitalization rates.

Risks to the thesis

Of course this doesn’t mean Canadian NET REIT is a risk-free investment. The main risk to my thesis would be to see the interest rates and mortgage rates spiral out of control. If the average refinancing rate would jump to, say, 7%, Canadian NET REIT’s AFFO would likely decrease by about a third. Although the distribution would still be fully covered, it would make an investment less appealing.

A second risk would be the re-leasing risk. Fortunately Canadian NET REIT has already secured extensions for its 2024 lease expirations and perhaps the REIT can already start to focus on addressing the 2025 lease maturities.

A final risk I see is closely related to the interest rate risk. A sudden shock in the capitalization rates would result in an LTV ratio increasing to uncomfortably high levels.

While I don’t think the odds of any of the three risks are very high, this REIT, like most real estate companies, will see its performance fluctuate depending on market interest rates.

Investment thesis

The relatively high LTV ratio has always been bothering me but I am no convinced Canadian NET REIT is taking the right steps to keep the balance sheet and leverage ratio under control. The REIT retains approximately C$4M in annual AFFO which by itself reduces the LTV ratio by 150 bp per year. So even if the earnings stagnate and the property values don’t increase, the REIT is slowly walking its LTV ratio down.

The current dividend yield is very appealing as the almost 7% yield represents a payout ratio of just around 60%. The payout ratio will likely decrease towards the mid-50% ratio based on the full-year AFFO result for 2024.

I currently have no position in Canadian NET REIT, but I will likely go long before the end of the week.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.