Slate Grocery REIT

TSX:SGR.UN

Earnings Call Transcript

[Operator]

Good morning, ladies and gentlemen, and welcome to the Slate Grocery REIT Second Quarter 2023 Financial Results Conference Call. [Operator Instructions] This call is being recorded on Thursday, August 3, 2023. I would now like to turn the conference over to Paul Wolanski, Senior Vice President of National Retail Sales and Investor Relations. Please go ahead.

[Paul Wolanski, executive]

Thank you, operator, and good morning, everyone. Welcome to the Q2 2023 Conference Call for Slate Grocery REIT. I am joined this morning by Blair Welch, Chief Executive Officer; Andrew Agatep, outgoing Chief Financial Officer; Joe Pleckaitis, incoming Chief Financial Officer; Connor O'Brien, Managing Director; Allen Gordon, Senior Vice President; and Braden Lyons, Vice President.

Before getting started, I would like to remind participants that our discussion today may contain forward-looking statements, and therefore, we ask you to review the disclaimers regarding forward-looking statements as well as non-IFRS measures, both of which can be found in management's discussion and analysis. You can visit Slate Grocery REIT's website to access all of the REIT's financial disclosure, including our Q2 2023 investor update, which is now available.

I will now hand over the call to Blair Welch for opening remarks.

[Blair Welch, executive]

Thanks, Paul. Our Q2 results highlight our team's continued operational excellence and ability to drive consistent organic growth across our portfolio. Our team achieved a record 1 million square feet of total leasing at attractive spreads that drove occupancy and revenue growth. New deals were completed at 23.7% above comparable average in-place rents and nonoption renewals at 10.9% above expiring rents. New leasing drove a 70-basis point occupancy gain from the beginning of the year.

Our occupancy at the end of the quarter was 93.9%, with no grocery expiries for the remaining of this year. Our strong operational performance continues to drive same-property NOI growth, which has increased 2.7% on a trailing 12-month basis. Throughout the quarter, we further strengthened the REIT's balance sheet to create liquidity and financial flexibility. To maintain our fixed debt that helps keep our cash flow strong, we entered into a $175 million forward swap and amended an existing $137 million swap that was set to mature in July of 2027. At the close of the quarter, 96.6% of the REIT's total debt is fixed and no debt maturities remain for the remainder of this year. Year-to-date, the REIT has repurchased nearly 1 million units at a significant discount to our net asset value.

We have a strong conviction of the value of our grocery-anchored real estate. Fundamentals for grocery-anchored centers remain strong. Limited availability, coupled with the lack of new supply coming into the market, is creating a favorable dynamic for owners to grow rents. As consumers continue to spend more on goods and services that are close to home, tenant mix has become increasingly important. Centers like ours with a strong anchor tenant that drives foot traffic, and a high proportion of the central tenants are benefiting.

We believe our portfolio is well positioned for continued stable growth. At $12.29 rent per square foot, average rent in our portfolio remains well below market. This provides significant runway for us to increase rents and grow the overall value of our business. We also continue to actively underwrite compelling single-asset portfolio opportunities that would be accretive to unitholders to enable us to grow further strategically through high-quality acquisitions.

On behalf of the Slate Grocery team and the Board, I would like to thank the investor community for their continued confidence and support.

I will now hand it over for questions.

[Operator]

[Operator Instructions] First question comes from Sairam Srinivas with Cormark Securities.

[Sairam Srinivas, analyst]

Congrats on a good quarter. Just looking at the renewals for next year, should we be thinking -- how should we be thinking about any options that are there in those leases? And how would those options impact our spreads next year?

[Blair Welch, executive]

Sairam, could you repeat the question? So I didn't hear the -- on the options, sorry.

[Sairam Srinivas, analyst]

Just looking at the renewals for next year, I noticed that you say you had some of the renewal options come in. Are there similar options coming in next year as well? And how does that impact leasing spreads on renewals next year?

[Blair Welch, executive]

Yes, sure. So I'll take a stab at it. So I think the biggest thing, most leases obviously have options, and most of them are done at market. And that's why we keep on driving home the fact that our rent across our entire portfolio at $12.29 is significantly low. So we feel at the lease expiry when the town has the option and resets to market, there will be continued growth as we performed in the last bunch of quarters. I think we'll remain consistent. And we're optimistic actually because in the entire space, there's a lack of space available. So I think there's going to be more continued pressure on rents, which is a good news story for Slate Grocery.

[Sairam Srinivas, analyst]

Just following back on that. So in terms of, let's say, proportion of leases that are probably heaviest, would you say all of the major leases -- the grocery-anchored leases have the options next year?

[Blair Welch, executive]

No, no, no. I just -- in general, I mean, like next year, I don't know how much of our space's grocers are renewing next year. It's probably...

[Braden Lyons, executive]

8% of GLA.

[Blair Welch, executive]

80% of GLA. But they would all go -- most of them would go to market and there will be a negotiation on that. So I think we're really seeing significant growth in what we call the in-line or shop space. I think you'll get more consistent steady growth from our anchors when they come up, and it's -- 8% isn't a big number. But we're seeing very significant rental spreads in the shop space. And because the occupancy is strong, there's not many options for the tenants to go anywhere else. And it is still at a significant discount to new construction or new build. So they can't build new and pay these rents, and there's no space to go in other space, in other malls or other shops. So it's really kind of a perfect storm for rental growth.

[Sairam Srinivas, analyst]

Actually, that's a great segue to my next question. I know you mentioned lack of supply. And as you said, no new builds coming into those markets. How does the new supply cost come in, in terms of build cost per square feet? And what does that mean for implied rents?

[Blair Welch, executive]

I'll let the guys talk about that.

[Connor O'Brien, executive]

Yes. New construction costs for kind of blank shell would be roughly $275 to $300 per square foot, depending on the market, and that does not include kind of tenant inducements or the cost of land. So that would translate to a grocer needing to pay $15 to $20 per square foot, which really emphasizes the value of our portfolio and the under-market rents that we can offer our grocers to be profitable in our locations.

[Blair Welch, executive]

I also think if -- correct me if I'm wrong, the Green Street says market rents for these kind of centers is $23 or $24.

[Connor O'Brien, executive]

And that would be across both existing supply and new supply. And I would say when you look at the in-line rents for new construction, it's probably $25 to $35 for in-line space, and that's going to be market dependent as well.

[Operator]

Your next question comes from Brad Sturges with Raymond James.

[Bradley Sturges, analyst]

I guess, in the theme of acquisition environment or transaction environment, I guess curious to get your updated thoughts on whether or not you're starting to see bid-ask spreads start to narrow any [ green shoots ] in the transaction market that we're starting to see a little bit more pricing discovery in the market at this stage?

[Blair Welch, executive]

Yes. I'll do a high level, and I'll pass it off to the team again. But I think that what we're finding in this space, the real estate specifically, if you didn't have any debt on these assets, the fundamentals from the real estate are extremely strong. Rental growth is strong. Performance of the tenants is strong. You can still finance a positive leverage, all that stuff. But what we're feeling and what we think will happen is -- there's 40,000 of these types of assets in the U.S., but there's no really big owner. It's a lot of, I'd say, onesies-twosies, moms and pops. And a lot of those have been financed to regional banks or securitized CMBS or what have you. And we are finding that the capital structure on some of these assets is going to need to be reset. So we think there's going to be compelling opportunities because of capital structure, not the underlying real estate fundamentals. So we're excited about that. But Connor, maybe you can provide some color on the market.

[Connor O'Brien, executive]

Yes. I think you mentioned the bid-ask spread, and that was certainly the theme for the first half of this year. Transaction volume were substantially down. But as you alluded to, I do believe that the bid-ask spread is starting to narrow, and we would expect more transaction volume in the second half of this year.

In terms of kind of where positive leverage is, you can finance grocery-anchored real estate at roughly 5.5%. And you're seeing well above 100 basis points of positive leverage from there. So both our kind of in-place IFRS values is where -- as well as new acquisition opportunities are quite compelling at this point in time.

[Bradley Sturges, analyst]

Okay. So it sounds like there could be -- I don't know if you want to use the term distress, but there could be some sort of balance sheet-related or leverage-related opportunities as we go forward from here. I guess, from the opportunity set now that you're seeing, it's more of an expectation than what you're seeing specifically in the market right now. So I would -- I guess, is that a fair characterization?

[Connor O'Brien, executive]

Yes. I would say we're certainly trying to identify those motivated sellers and provide a solution that would be compelling for us at an investment opportunity today and going forward.

[Bradley Sturges, analyst]

Would you think that there could be some better portfolio opportunities that come about to? Or would it be more the onesie-twosies that you alluded to?

[Connor O'Brien, executive]

I would say we've had a lot of success buying great portfolios historically and are continuing to try and identify those opportunities. And the competitive set from a purchase standpoint, when we're looking at a portfolio is certainly more limited than a one-off. So I could certainly see that being an area we focus on in the second half of this year, if possible.

[Operator]

Your next question comes from Gaurav Mathur with iA Capital Markets.

[Gaurav Mathur, analyst]

Congrats on the strong quarter. You mentioned the retail supplier that's coming into the market at about 11 million square feet in 2023. Could you -- could you provide some color on how much of that would -- could be potentially grocery anchored related versus some of the other asset [indiscernible] types?

[Blair Welch, executive]

Sure. [indiscernible] maybe to put it in a context, just the size of the market and how little of the spaces would be helpful for him.

[Connor O'Brien, executive]

Yes. I think if you look at that 11 million square feet, that represents kind of roughly 50 basis points of total inventory. So it's quite limited. And while I don't have the breakdown between grocery and kind of non-grocery development, the vast majority of that new development is associated with kind of residential growth, where a new subdivision would be built, and there will be additional retail supply to serve that new market as well as additional intensification on existing sites through pad development. Our team has done a great job identifying those pad development opportunities, and we continue to add GLA to our existing sites across our portfolio.

[Braden Lyons, executive]

Yes. And just one additional point, Gaurav. It's really just single-tenant and small multi-tenant builds we're seeing, we're really not seeing like net new grocery-anchored centers going up.

[Gaurav Mathur, analyst]

Okay. Fantastic. So that does lead me to my next question, and you may have touched upon this earlier, but as you're looking at the product and some of these portfolios that you could start thinking about, is there a chance that you also bring in the North American fund to go after larger portfolios here?

[Blair Welch, executive]

Yes, I think we will look at all sorts of ways to look at doing accretive acquisitions for the REIT. I think we're a creative group at Slate. So if there's a compelling deal, I think we need to do what's in the best interest of unitholders, that's first and foremost. But if there's large deals, we can call on other investing partners the REIT has to look at things. But at this time, there's more enough stuff that the REIT can do. And I'd also like to point out that we have been active in buying our own units back because we traded a discount to the market, but we're extremely comfortable with our NAV, and we trade that discount. So we can look at other external ways of growth, but we also think we're pretty attractive and cheap, so we have to balance all that when we do stuff.

[Operator]

And next question comes from Jenny Ma with BMO.

[Jenny Ma, analyst]

Why don't you get a sense on how inflation may be changing, how you approach leasing negotiations? I think we mentioned that you're going to see some of the anchor leases go to market next year. So could you talk about how leases are being structured, if that's changing? And maybe the -- also the mark-to-market gap that you would be seeing on that 8% for next year.

[Blair Welch, executive]

Sure. Thanks, Jenny. It's great to have you back. I think that what we believe is real estate is pretty simple. We try and buy cheap rents. And there hasn't been a lot of inflation, but there is now. That being said, our grocers pay on average around $9 a square foot. And as Connor mentioned earlier, a new build will require $15 to $20 rent. So when you think of a $9 rent, and we look at grocery as food logistics, think about what the main warehouse rent would be in industrial. So we actually own the spoke of the hub at $9. It's pretty much an industrial rent in an infill location around the rooftops. So that is a very, very important piece of real estate and logistics for these grocers. And I think we will see growth. It could be significant growth in those rents over time.

That being said, what we try and do is balance the grocer rent with the shop space rent. Because the shop space and other nationals want to be around the anchor that provides that traffic. So we're seeing good growth and we -- because we're at $9 rents for our grocers, that's significantly cheap real estate for them, and it's a tight margin business, so we will get growth there as they come up. But we're also seeing significant growth from the shop space. So I think it's really -- inflation is important, and we'll see it. It almost makes the conversation easier with the tenant for rental growth, but the reality is they don't have many options and that they don't have many options at this rent.

[Jenny Ma, analyst]

So I guess the question is I'm trying to triangulate what the opportunity would be for you then because your occupancy is fairly healthy, there's rent -- rent inflation, there's higher construction costs. So when you go to negotiate these renewals, how far are you going to push on this growth?

[Connor O'Brien, executive]

So first off, given the lack of new supply, there's very few options. So our view is we have the ability to be aggressive on these lease negotiations. And I think that's represented in that kind of 11% nonoption renewal spread. And how that ties into inflation. If you look back at kind of our renewal spreads historically, we have kind of outperformed inflation in a high inflation environment as well as had positive rent spreads even in a lower inflation environment. So I think that just speaks to buying under-market rents and being able to create that mark-to-market going forward. I think as an asset management team, we plan to be aggressive on all renewals going forward and are hoping to maintain these really attractive rental spreads on all leasing going forward throughout the rest of this year and into next year.

[Jenny Ma, analyst]

Okay. So when you look at your renewal options, how much of them would be going to market versus how much of them have fixed terms that you would just renew for as it would be the proportion of your portfolio?

[Connor O'Brien, executive]

Roughly half of our portfolio is grocery anchored. So often, they like to be able to control their sites long term. That being said, when a grocer has say, 10 years of term left, they come to us with a conversation around potentially how they can control the site even longer. And often, that leads to the ability to push rents. So we'll certainly have those conversations with limited grocers. But where a lot of the rental growth will occur is in the non-grocer shop spaces where we can have outsized rental growth year-over-year.

[Blair Welch, executive]

I think just to add to that, Jenny, like, if our grocers are at $9 a foot, if you add $0.50, that's not a lot for them, but it's still on a percentage basis, a pretty big increase. I mean, I think that's -- I would say that that's kind of how we think about it. You're not going to -- the rents aren't going to go $9 to $16. What you do is you kind of increase the grocer rent over time so you can keep them so you -- most of grocers when they go to market on an expiry, they have a 5-year option at market. So you increased that 5% or 10%. And then 5 years is another 5% or 10%, you try and get steps in the rent every year. That's kind of how we look at it. That's the deal. It's a fine balance. And I think one of the benefits that we have is, we have multiple locations with these grocers. So we do think of every asset in isolation. However, it's a bigger conversation when you own like 20 Krogers because you think about -- like, hey, I got you here, and I'm going to put you over here. So -- but it's like -- I would say that's sort of -- like that's kind of how we think about it. Like at $9 rent you get $0.50. That's significant on a percentage basis but not that much in nominal dollars for the time, and you just increase it over time.

[Jenny Ma, analyst]

Okay. Well, to the latter point about not being that much of a nominal, I'm just trying to figure out to your point from $9 to $9.50 or from $9 to $10.50, right, which would be a meaningful difference. So...

[Blair Welch, executive]

Well, I mean we're trying to go to $16, but I mean it's just [indiscernible] yes.

[Jenny Ma, analyst]

Well, I think you'd be there somewhere in the middle. But okay, that's fine. So during the pandemic, you talked a lot about the grocers using the grocery space and sort of more future-forward ways in terms of maybe carving out some of it to distribution or have you -- "with the world having gone back to normal", has that chatter continued at the same pace? Are these efforts still going ahead? Or do you find it sort of reverting back to where things used to be and it's quiet a down? Like are your grocer tenants looking to still evolve the space towards the future of grocery as opposed to traditional grocery?

[Blair Welch, executive]

Sure. I'll let Allen talk about a bit more. But I think what's really important, and it's a very good question. We provide the grocer, a shell or a box or industrial shed 20- to 30-foot clear heights with loading [indiscernible]. What they do inside is what they do. And so depending on the local neighborhood, they will change what they offer inside, like maybe they do 2 rows of prepared foods in a higher income market or maybe they do -- do 2 rows of click and collect. 100% of our grocery stores is like grocery, every grocer has invested capital to do click and collect or other types of things in the box. So they pivot their use depending on the local demographic. And that cost is cheaper for them, changing [ 2 aisles ], in my example, and having to go in new real estate because they're that $9 rent, they can change those [ 2 aisles ]. It's not that much square footage, and they respond to the local demographics. But I'll let Allen talk about it a little bit more.

[Allen Gordon, executive]

Yes, I think simply said, and as Blair was alluding to, you're close to the rooftops. And that's our main advantage. It's the last mile logistics, and that's where our grocers -- it's cheaper for them to operate, cheaper for them to deliver food and closer to the rooftops.

[Blair Welch, executive]

The biggest cost for a grocer is transportation. It's about 45% to 55% of their cost. So when you think about a grocery store, if that's the spoke to the hub, if there's 3,000 people that live around that grocery store, a food drop gets dropped by truck from the main warehouse to these spokes. If you actually had individual drivers and that would increase the cost so much they can't do it. So it's almost like how they do it, they know how much food or what the locals are doing because they load that store every day. So they'll change the offering depending on what they're seeing, but they don't -- from a Slate Grocery perspective, it doesn't change the need for the box. They kind of pivot to what the consumer is demanding.

[Jenny Ma, analyst]

Right. So are those efforts still going ahead at the same pace?

[Blair Welch, executive]

Yes. I mean it's always been that way. It's never changed. But I would say that I think the biggest change we've seen in the last decade is the second biggest cost buying transportation is labor. So we've seen and you've seen it here, way more self-checkout. And that really just means less humans. So mix increased margins. So I don't -- I think we'll continue to see the evolution of the box. I mean most of our grocers are 30,000 to 50,000 square feet. We like that size of box because it is important and if they can kind of pivot it, it's not like the 500,000 square foot box, you got to repivot. So I mean I think we like the optionality of our portfolio and the grocers do too.

[Braden Lyons, executive]

And maybe just anecdotally, Jenny, we are seeing grocers in our portfolio sort of retrofit either expand or sort of reallocate existing square footage within stores with an omnichannel lens. So they might allocate 5,000 square foot -- square feet, sorry, just for cold storage, robotic sorting for their omnichannel pickup and click and collect at stores, right? So we're seeing that. They're investing significant capital in the stores, which is obviously good for the value of our real estate as well.

[Jenny Ma, analyst]

Okay. And that doesn't require any capital commitment from you, right? You just...

[Braden Lyons, executive]

Correct. Yes. That's [indiscernible] funded within their 4 walls, yes.

[Operator]

There appears to be no further questions. I will return the conference to Paul Wolanski for closing remarks.

[Paul Wolanski, executive]

Thank you, everyone, for joining the Q2 2023 conference call for Slate Grocery REIT. Have a great day.

[Operator]

Ladies and gentlemen, this concludes your conference call for today. We thank you for participating and ask that you please disconnect your lines.