Slate Office REIT: Sector Headwinds, Dividend Coverage Concerns, And Overstated NAV Demonstrate Potential Value Trap In REIT (OTCMKTS:SLTTF)

Thesis

Slate Office REIT (OTC:SLTTF) has been promoted as a value REIT that has been overlooked by the market. On the surface, the company trades at a large NAV discount, has a well-covered and high-yielding dividend, and owns a stable portfolio of office properties. However, a closer look at the details shows that Slate is not nearly as attractive as it appears on paper. Cap rates are higher than management estimates, and adjusted funds from operations (AFFO) is not a proper measurement of the company’s cash flow. The office sector also faces potential headwinds in response to COVID-19’s long-term impact due to work from home shifts by businesses.

Portfolio Overview

Slate Office REIT has a portfolio of 33 office properties and 3 non-office properties that is geographically concentrated throughout Canada and Chicago. Slate’s Canadian markets include the Greater Toronto Area (GTA), Atlantic, and Western region. Canadian markets contribute around 82% of Slate’s annual NOI, while Chicago contributes the remaining 18%.

Market

NOI Contribution

Atlantic

35.50%

Ontario

40.50%

Western Canada

6.10%

Chicago

17.90%

Slate is well-diversified throughout Canada, giving it exposure both to its over-performing and under-performing markets. Given recent investment performance and prospective population trends, Slate’s GTA and Western Canada portfolio appear to be better positioned than their Atlantic portfolio.

Source

While the GTA and Western Canada consist of Ontario, Alberta, and Manitoba (high population growth projections), the Atlantic region consists of New Brunswick, Newfoundland and Labrador, and Nova Scotia (low population growth projections).

NAV Discount

On paper, Slate appears to be greatly undervalued due to its significant discount to net asset value mentioned by management. Given that Slate is a Canadian company and uses IFRS accounting standards, management is required to report its estimated fair value of assets. Management values its properties using a 6.07% cap rate. This is on the low end of the range it provides in its Q2 Management Discussion and Analysis, as management provides a weighted average cap rate of 7.28% in its Q2 report. Additionally, it is much lower than CBRE estimates for some of Slate’s markets. The weighted average cap rate of Downtown and suburban class A and B Canadian office properties from CBRE is 6.44%.

Average Canadian Office Cap Rates

Class

Location type

Cap rate

A

Downtown

5.63%

B

Downtown

6.50%

A

Suburban

6.41%

B

Suburban

7.23%

Source

I would put this figure closer to 7%, given Slate’s suburban focus. The chart below demonstrates the degree to which Slate’s fair value fluctuates based on cap rate changes. Each is still well below the current stock price level of $3.69 (Toronto Stock Exchange).

Cap rate

NAV

6.07%

$8.51

6.44%

$7.28

7.28%

$4.93

High Leverage

Slate’s potential fair value fluctuations show another concern facing the company – its high leverage levels. Higher leverage levels cause the massive changes in Slate’s fair value based on the different levels of cap rates, increasing the company’s exposure to risk.

Company

Debt/EBITDA

SLTTF

10.6

FSP

8.1

CIO

5.9

CUZ

4.4

HIW

4.87

Source- Company quarterly financial reports

Slate carries much higher leverage than its peer REITs, as it had a Debt/EBITDA ratio of 10.6 in its most recent quarter. While management reports its leverage ratio (debt/fair asset value) at 58.3%, this figure is also calculated using the extremely optimistic 6.07% cap rate. Using a cap rate closer to 7% would increase this closer to the 70% range.

AFFO Overstated

Slate’s greatest risk in my view is the prospect of an additional dividend cut in the coming years. Slate previously cut its dividend in early 2019 from $.1875 per quarter to $.10 per quarter. Given that Slate reported AFFO per unit of $.65 in the most recent year, the payout ratio appears to be safe at around 62%. However, I take issue with how Slate’s management team uses to calculate AFFO, as shown below.

A screenshot of a social media post Description automatically generated

Source

One of the key elements listed above is “Normalized direct leasing and capital costs.” Such is defined as being, “Normalized direct leasing and capital costs are determined as 10% of the net of rental revenue less property operating expenses and represents the normalized on-going costs required to maintain existing space of a stabilized property. Actual amounts will vary from period to period depending on various factors, including but not limited to, the timing of expenditures made and contractual lease obligations.”

I would be fine with this definition, so long as “normalized direct leasing and capital costs” was a similar amount to actual direct leasing and capital costs. However, the amounts greatly differ, which is consistent with the office sector’s rising need for higher capex and tenant improvement spending. As the chart below demonstrates, Slate’s direct leasing commissions and capex costs have been much higher than reported on the AFFO calculation. Were they reported as actually stated, not only would the dividend be uncovered, but the company would have had negative AFFO per share for some years.

Item/Year

2016

2017

2018

2019

2020

Direct leasing commissions and capex

39,763

64,416

39,230

56,710

18,752

Normalized direct leasing and capital costs

5,613

7,021

10,416

10,291

4,371

Source- Company financial statements

Rising leasing commissions, tenant improvements, and capex costs have been a trend for the office sector that will likely continue for years to come. Given that occupancy rates will be tamed due to reduced demand from COVID-19, I anticipate that office landlords will have to make increased accommodations to attract tenants and keep their properties competitive. Such will keep heavy pressure on earnings. Though management claims the dividend to be well-covered and sustainable, high levels of direct leasing commissions and capex spending could potentially result in another dividend cut over the next few years. Unless Slate changes its definitions for AFFO, I would not deem this figure an adequate measure of cash flow.

Suburban Strength, Work From Home Trend

Management describes the portfolio as being 85% in suburban regions or urban locations in secondary markets. Thus, the company’s properties are in a better position to come out of the COVID-19 pandemic and economic recession in better condition than its primary market peers. Slate’s suburban and secondary markets have seen higher levels of utilization (around 30-40%), illustrating that businesses are returning to the office at a faster rate than those located in downtown primary markets. Given that Slate’s markets are less densely-populated than its primary market peers, the company’s portfolio is potentially in a position to benefit from trends emerging due to the coronavirus. Such is with the exception of its Chicago properties, which are located in downtown.

Many speculate the virus will accelerate the movement of millennials from the urban core to the suburbs. Most millennials are now over or approaching 30 years old. With the median age to purchase a home being around 33, the shift to the suburbs may just be beginning. Consequently, office space in the urban cities may lose relevance. Businesses may seek to expand to suburban satellite offices to accommodate for shifting employee preferences, potentially increasing demand for Slate’s class of properties.

Potentially working against the suburban shift catalyst is the work from home movement. COVID-19 forced many businesses to shift to work form home operations, which may have lasting effects on office space demand. Offices will always exist and play a role in the economy. Studies have shown that a large percentage of workers miss the human connection and personal culture that emanates from working in an office with peers. However, businesses may seek to downsize to reduce costs as employees work part-time from the home and office.

A recent Colliers International survey showed that 47% of businesses anticipated their office space would decline due to COVID-19. Colliers mentioned they expected office space occupied to be reduced by 8.5% due to working from home. Some businesses may seek to expand their office use to accommodate for increased social distancing, counteracting the potential trend of reduced office demand. Recent surveys just show that this likely will not have a greater impact than the reduced office use that will result.

It is important to note that no massive changes or instability has occurred in the office sector yet. Rent collections remain above 95% for most companies, and Slate mentioned that they have not seen any tenants seeking to downsize yet. However, it should be noted that new leasing for Q2 was extremely low, as businesses focus on renewals over any potential office location changes. Just four leases totaling 13,000 square feet were signed in Q2. It will be important to watch how occupancy and lease durations trend over the next few quarters, indicating how businesses may plan to use office space going forward.

Conclusion

Slate’s stock price has fallen tremendously since the start of the COVID-19 pandemic, potentially making it a value stock at current prices. Given that cap rates are likely higher than estimated and leasing commissions and capex spending put the dividend at risk, I do not foresee much stock price appreciation going forward. While I like the company’s forward-looking strategy of focusing on sunbelt acquisitions, investors seeking to invest in the sunbelt can find REITs with exclusive focus on the sunbelt region, such as Cousins (NYSE:CUZ) or Highwoods (NYSE:HIW). Slate has seen its stock price decrease so much since going public and is trading at a discount to fair value of its properties. However, the large discount to NAV also exists for nearly every office REIT. Thus, I would not short the company. However, there are much better investment opportunities, both in the office sector and other real estate sectors.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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