What to Buy: RioCan REIT (TSX: REI-U, OTC: RIOCF)

Why to Buy Now: With crude prices taking a major hit over the past month, we need a breather from the energy sector. Beyond that, as evidenced by the market’s recent selloff, which was just shy of formal correction territory, there’s considerable uncertainty hanging over the global economy.

So we decided to go lower on the yield spectrum than we normally do in a bid for higher quality. With a market capitalization of just over CAD8 billion, RioCan is Canada’s largest real estate investment trust (REIT).

The retail-oriented REIT manages a portfolio of 340 properties in the US and Canada, most of which are shopping centers, with tenants that are among the top retailers in each country.

RioCan typically has a high occupancy rate, which most recently stood at 96.9 percent at the end of the second quarter. In fact, even at the height of the Global Financial Crisis, the firm’s occupancy rate remained near 97 percent.

The REIT trades about 10.3 percent below its all-time high, which it hit in late April of last year. At current levels, RioCan trades at a price to funds from operations per unit (P/FFO) ratio of 16.4, a moderate discount relative to an average of 18.2 among its peers.

RioCan pays a monthly distribution of CAD0.1175, or CAD1.41 annualized, for a current yield of 5.3 percent. For the second quarter, the REIT’s FFO payout ratio came in at 86 percent, down from 94 percent a year ago.

RioCan REIT is a buy below USD27.

Ari: We’re admittedly chastened after the broad-market correction over the past month. As such, for this month’s pick, we decided to go lower on the yield spectrum for a somewhat more conservative play than our usual recommendations.

As we noted in the special email alert that we sent to subscribers on Oct. 16, though we didn’t think crude prices had finally bottomed as of the last issue, we certainly weren’t expecting the sharp selloff that occurred earlier this month.

The universe of investable high-yield equities is relatively finite compared to other niches, and that means our Portfolio will necessarily have greater exposure to certain sectors than a newsletter that has a broader mandate.

Indeed, there are three main categories of high-yield equities that dominate our proprietary screen: corporations and master limited partnerships (MLPs) engaged in energy exploration and production (E&P), highly leveraged specialty financials such as buyout firms and business development companies (BDCs), and mortgage REITs, which use multiple layers of leverage to boost their yields.

There are also closed-end funds that offer high distribution rates, though all employ leverage, while many engage in destructive returns of capital. Then there are busted companies whose high yields are a function of depressed share prices. Finally, there are some Canadian firms that operate in various sectors and persist in offering high payouts as a result of their earlier incarnation as income trusts.

While we’ve steered clear of busted companies and mortgage REITs, we’ve dabbled in all of the other areas for the sake of diversification.

But because E&Ps really dominate the high-yield space, our Portfolio remains heavily tilted toward the energy sector.

So this month, we sought a non-energy sector play to tide us over until there’s greater clarity on the trajectory of the global economy, as well as the direction of crude oil prices.

Although the selloff in crude oil appears to be overdone, we need to get a better sense of the true supply-demand balance, which is currently being obscured by factors ranging from unrest in the Middle East to the fact that we’re in the midst of the period when refineries routinely go idle for scheduled maintenance.

Khoa: Now that you’ve offered some insight into our view of the Portfolio, let’s dig a little deeper into this month’s recommendation. Tell me more about RioCan’s holdings.

Ari: Well, as we mentioned earlier, RioCan largely specializes in shopping centers across several different categories. The single largest category is “new format retail,” at nearly 44 percent of the firm’s property mix. New format retail is just an industry term for the big-box shopping centers that started to spring up everywhere over the past 15 years or so.

Shopping centers anchored by a grocery store account for nearly 20 percent of the portfolio, while enclosed shopping centers, otherwise known as malls, comprise almost 18 percent of the portfolio. The balance of RioCan’s holdings consist of urban retail, non-grocery-anchored shopping centers, and office space.

While the REIT has a foothold in the US, it still derives the vast majority of revenue–recently about 84 percent–from its Canadian properties. RioCan owns 44 million square feet of retail space in Canada across 293 properties, with holdings concentrated in the country’s six major markets.

In fact, the concentration of RioCan’s rental revenue in these key Canadian markets increased to 73 percent in the second quarter, up from 71.7 percent at year-end.

The REIT’s US holdings encompass 9.9 million square feet across 47 properties situated in Texas and the Northeast, particularly Pennsylvania.

RioCan’s tenants are a veritable who’s who of North American retailing, including Wal-Mart, Target, Canadian Tire, and Loblaws, among others. The top 10 tenants accounted for 27 percent of annualized rental revenue during the second quarter, with no single tenant accounting for more than 4.1 percent of revenue.

At the end of the second quarter, RioCan had ownership interests in 16 properties under development that will, upon completion, comprise approximately 9.7 million square feet (5.1 million at RioCan’s interest), all located in major markets in Canada.

Lease expiries are roughly evenly staggered over the next several years, at an average rate of 10.8 percent for its Canadian properties and 7.2 percent for its US holdings. Among RioCan’s top tenants, none has a weighted-average remaining lease term shorter than 5.5 years.

A strong balance sheet should support continuing growth via property acquisitions and development on both sides of the Canada-US border.

Khoa: I see there was some turnover in the C-Suite this week.

Ari: Yes. While founder and CEO Edward Sonshine remains at the helm, CFO Raghunath Davloor was promoted to president and chief operating officer, after former president and COO Fred Waks stepped down.

Davloor will also serve as interim CFO until a replacement is found for this position.

While executive turnover always makes me nervous, during his career Davloor has previously served in both a financial capacity and an investment capacity at other commercial real estate firms. So he should have the expertise necessary to perform well in his new role.

Khoa: What does analyst sentiment look like?

Ari: RioCan currently enjoys moderately bullish sentiment, though with a strong neutral component, at five “buys” and four “holds.”

In fact, the stock’s bullish status is a recent development after several months in which the consensus rating was essentially a “hold.” Earlier this month, BMO Capital Markets upped its rating to “outperform,” which is equivalent to a “buy,” from “market perform,” or “hold.”

The consensus 12-month target price is currently CAD29.67, which suggests potential appreciation of 12.0 percent above the current unit price.

For full-year 2014, analysts project funds from operation (FFO) per unit, which is the relevant metric of a REIT’s profits, will grow 3 percent year over year, to CAD1.68. And next year, FFO per unit is forecast to grow 4 percent year over year to CAD1.75.

Both projected performances are running slightly ahead of the REIT’s average growth in FFO per unit over the preceding five-year period that ended on Dec. 31, 2015.

Khoa: How are the distributions taxed?

Ari: First, it should be noted that we’re not tax professionals and, therefore, you should consult your tax advisor or accountant for clarification regarding how taxation of any securities we recommend will affect your particular situation.

Unlike US REITs, whose distributions are taxed as ordinary income, distributions from Canadian REITs are taxed at a maximum rate of 15 percent.

Our understanding is that thanks to the tax treaty between the US and Canada, the Canadian government withholds just 15 percent of the payout (as opposed to the 25 percent rate that would prevail without the agreement).

Depending on their individual tax situation, most investors should be able to avoid double taxation by filing IRS Form 1116 at tax time to claim a credit for the tax withheld by the Canadian government, which can then be applied against any tax on the payout that would normally be owed to the US government.

While dividends paid by Canadian corporations are exempt from taxation when their shares are held by US investors in a tax-advantaged account such as an IRA, the same situation does not apply to Canadian REITs.

The Canadian government will withhold 15 percent of a REIT’s distribution even when it’s held in a US investor’s IRA. And that amount cannot be recaptured at tax time via tax credits from the IRS. The rationale for this treatment is that because REITs are not taxed at the trust level, their tax liability is passed along to unitholders.

The Canadian Revenue Agency (CRA) implemented a new rule in 2013 that requires US investors to file Form NR301 through their brokers in order to receive the reduced rate of withholding. Follow this link to learn more about the form and its requirements.

RioCan REIT is a buy below USD27.

Portfolio Update

Exchange Income Corp (TSE: EIF, OTC: EIFZF) announced that it has completed the sale of WesTower Communications, the US arm of its WesTower subsidiary, to MasTec Network Solutions, a subsidiary of MasTec (NYSE: MTZ), for USD199 million in an all-cash deal.

WesTower is a telecommunications services firm that builds and maintains wireless network infrastructure throughout the US.

The divestment disposes of a problematic asset that will allow EIF to retrain its focus on its high-margin Regional One subsidiary, an aftermarket aircraft and aircraft parts distribution company.

EIF is expected to announce a $0.55 per share to $0.66 per share gain on the transaction. The company said it intends to use the proceeds from the sale to pay down its long-term senior bank debt.

More important, the deal is a solid rebuke to the absurdly bearish report issued over the summer by Veritas Investment Research, whose subsequent amplification by a columnist for The Globe and Mail caused an alarming selloff in early August.

Management also announced that Regional One has entered into an agreement to acquire 12 Bombardier aircraft from Lufthansa CityLine within the next 12 months to 15 months. EIF expects to receive one aircraft per month starting as soon as November. The deal will allow Regional One to generate revenue from aircraft sale, lease or selling the component aircraft parts.

Exchange Income Corp remains a buy below USD22.