Slate Grocery REIT

Thank you, operator, and good morning, everyone. Welcome to the Q2 2022 Conference Call for Slate Grocery REIT.

I am joined this morning by Blair Welch, Chief Executive Officer; Andrew Agatep, Chief Financial Officer; Connor O’Brien, Senior Vice President; Allen Gordon, Vice President; and Braden Lyons, an Associate. Before getting started, I'd 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 2022 Investor Update, which is now available. I will now hand over the call to Blair Welch for opening remarks.

Thanks, Paul. Today, I'm pleased to share Slate Grocery's strong second quarter results which highlight our team's continued operational excellence and underscore once again the resiliency of grocery real estate.

This quarter, Slate Grocery achieved significant growth through the acquisition of a $425 million grocery-anchored real estate portfolio. We acquired 14 high-quality properties, adding 2.5 million square feet or 18.6% of gross leasable area to the REIT's portfolio.

The acquisition increases our exposure to leading markets for population growth in the U.S. and a top-performing -- with top-performing national and regional grocers.

Importantly, the REIT's acquisition basis of $174 per square foot implies that in-place rents in this portfolio are well below market. We believe there is an opportunity to grow organically over the long term with this portfolio.

The REIT also entered into a strategic joint venture with the Slate North American Essential Real Estate Income Fund, or the North American Essential Fund. This partnership with the North American Essential Fund, which includes a leading sovereign wealth fund, provides institutional validation of the REIT's platform.

It also establishes the structure for a consistent source of private capital in addition to the REIT's public funding strategies. As part of the joint venture, the North American Essential Fund made $180 million cash investment into the REIT's assets at a valuation in line with the REIT's Q1 2022 IFRS value.

This once again validates the value of the REIT's real estate. The REIT allocated the entirety of the investment by the North American Essential Fund toward the $425 million acquisition which was completed in July.

Importantly, after the period, the REIT amended its existing revolving credit facility and term loans, totaling $608 million. The amendments enhanced the REIT's liquidity position and financial flexibility through improved pricing terms and covenants.

The REIT's debt profile mitigates near-term rising interest rate risk as 91.4% of the REIT's debt is fixed. Finally, our operational performance continues to trend positively, even amid a broader economic slowdown.

Our asset management team completed 440,000 square feet of leasing, renewals were completed at a 5.9% rate above expiring rent, and new deals at 26.6% above in-place rent. On a 1-year to-date basis, the REIT's total leasing spread is 12.4%, providing protection in an inflationary environment.

Occupancy has increased 20 basis points over the past quarter with net positive leasing expected through the second half. Additionally, our in-place average rent rate for the portfolio is only $11.82, which is significantly below market.

We believe that limited supply of new construction and neighborhood centers in the market, coupled with increasing the cost of construction, will continue to drive demand at our location, which gives us the ability to push our rents over time. Slate Grocery is uniquely positioned to benefit from the current macroeconomic environment as grocers continue to be the focus where people are spending their money, discretionary -- this is -- nondiscretionary items.

With inflation rates at all-time highs, consumers are pulling back on discretionary purchases and spending more on groceries and essential goods. We also continue to see a deep pipeline of accretive opportunities.

Our strategic joint venture with the North American Essential Fund, together with our recently upsized credit facility, gives us the flexibility to pursue strategically and opportunistically during challenging times. On behalf of the Slate Grocery team and the Board, I'd like to thank the investor community for their continued confidence and support.

I will now hand it over for questions.

So given that interest rates have risen quite materially, investment spreads have presumably compressed, especially when you consider that cap rates for your asset type have been flat or also saw a little bit of compression. I'm just wondering what your thoughts are, would be, in terms of what the minimum investment spread would be for the market, and maybe for Slate Grocery in particular.

I mean, there's obviously a lot more wiggle room with the going-in cap rates where they're at, in that high 6% to low 7% range. But at what point do you start to see, I guess, the market flatten out or slow down?

Yes. Thanks, Jenny.

I think, since you and I have talked about this a bunch, I think a cap rate is somewhat useless if you don't know what rent you're capping. So we believe, at Slate Grocery, with our rents at $11.82, we estimate that's probably half of market.

At our existing cap rate, there is tons of room to run. So effectively, what we're saying is, I would compare our rents, because we do, to any U.S.

peer or any Canadian peer, and we'd be below all of them, and yet we still have a wide cap rate. So I think investors get the benefit of our positive financing spread, which I think your question was.

Which -- we estimate right now, I think that the U.S. 10-year is well below 3%, it's kind of volatile.

But when you're buying in the mid-6s, I think that's positive leverage, which is nice. But more importantly, you're buying a significantly discounted rent that should grow your top line revenue.

Because last time I checked, the only way to make money in real estate is compression of cap rates or growing your rents. And I think we all know that cap rates are going up.

But Slate Grocery REIT has positive leverage because we can still buy wide cap rates, but we can get significant revenue growth because of our low in-place rents. And I think people need to start focusing on where rents are compared to market and where new supply is.

And I think the neighborhood-anchored grocery space is extremely compelling because of that. So we think, Jenny, we can buy positive leverage right now, and we have a lot of room.

But it's really more because of our low in-place rents.

So I mean, in that sense, when you look at the Slate Grocery portfolio, do you think that, that rent grows over time as leases roll? Or do you think you'd have to put some material capital to bring it up to market rent?

Well, I'll ask you the question. We've done 12.4% positive leasing spreads this year.

So I mean, I think that's pretty good. So I mean, it's happening, and our capital spend hasn't changed because Slate Grocery shows actual cash spend on a quarter-to-quarter basis.

So I think that's pretty positive growth. I think if you break that number out, is that a forever number?

Well, if inflation stays like this, maybe. And I think the next question could be, can our tenants afford it?

Well, our grocers are some of the biggest retailers in the world with great balance sheets, and the tenants need to pay for nondiscretionary items like food. I think where people are going to get squeezed is the nondiscretionary spend, and they might have issues.

But we feel very confident that our tenants can pay modest increases in their minds, going from $11.82 to $12, $13, $14, and that's huge growth. It's still less than a newbuild that would cost in the low to mid-20s.

So we feel confident that we are a great inflation kind of protected bet. And I think we love that play because Slate Asset Management always focus on low bases because you buy low rents.

Right, okay. So when we talk about continued growth through acquisition.

So in the last deal that you did, you were able to get financing from the North American Essential Fund at IFRS NAV for Q1. That's great.

Just given where, I guess, the public equity cost of capital is, it doesn't seem like it's necessarily a viable source of capital over the very near term. So I guess my question is, you've got these additional sources of capital now.

Would you be willing to issue in the public markets to fund acquisitions if the math works? Or is IFRS NAV kind of that line in the sand that determines whether or not you would issue public equity?

And if you're not able to maybe lean more heavily on your alternative sources of capital to get deals done.

I think that we're -- we do what's best for the investor, and we will only do accretive deals and deals that make sense. And I think right now, in the public markets, that's a little bit challenging.

But I can't comment on like deals in the future. And like if -- so you said here, Blair, here's a deal at a 50% return.

Like I might look at it, but it needs to make sense. We're not going to rush out to dilute the equity.

That's not what we do. We've never done that.

We try to focus on total return for our investors. And I think we feel really, really proud that we have some of the largest investors in the world supporting this strategy and supporting Slate Asset Management.

They came in with a real cash bid for our NAV. It wasn't a stock-for-stock trade.

It was real cash injected. They believe in the strategy.

I think global investors want assets that earn U.S. dollars that are defensive, that are inflationary protected.

And I think the market in the U.S. -- the grocery market is -- grocery real estate market is extremely fractured.

There's almost 40,000 grocery stores, and we estimate the largest portfolio is only like 500. So I think in a tougher financing environment, when the average asset size is $20 million to $30 million, when syndicators and privates typically use CMBS financing, I think well-capitalized buyers will see great opportunities.

But we're not going to rush out to issue equity to be foolish. I think we're going to do what we've always done and be prudent.

And I think the deals we've done historically at Slate Grocery show that.

So, I have two quick questions on my end, and I'll begin with the first. Now just staying with the acquisition line, there seems to be a healthy appetite for grocery-anchored assets in the U.S.

Just a question here on how that's affecting your capital deployment strategies, especially in terms of the buyer pool that you're facing, from maybe 6 to 12 months ago.

Yes. I mean, I'll start.

And Connor, if you're on, you can jump in. But I think that the market is kind of in 2 groups.

One is, I'll call the onesie-twosie market. I know that's a very scientific term for it, but buy 1 grocery store, finance 1 grocery store.

Usually a group of privates. That market is tough to get financing on individual assets.

As we all know, the financing market in North America, and Europe for that matter, has tightened. So I think you can find good one-off deals that come up to refi, or we're a well-capitalized buyer.

So that's how we've traditionally grown Slate Grocery REIT, with the exception of the deal we did this year and the deal we did on the Annaly deal. So we're constantly looking at that.

And then on the portfolio side, I think there are portfolios of grocery stores that are mixed together in portfolios of other assets, similar to the Annaly deal we did. And sometimes, they sell grocery -- the grocery assets because they can and get liquidity, and we get good pricing.

So we're looking at both, Gaurav. And I think there's no shortage of pipeline.

But we will only do deals that make sense. And really, what we do is that means can we buy cheap rents?

We believe buying cheap rents in this kind of environment make all the sense in the world. Well, we believe it makes all the sense in the world all the time.

But right now, in an inflationary environment, that's what we're looking for. And there's no shortage of pipeline.

Connor, I don't know whether you want to add to that.

Yes. I think right now, it's kind of a wait and see right now.

There's still been a lot of pricing tension in the grocery-anchored space. A lot of that has been from the 1031 exchange buyers, where they have the opportunity to take down an asset and not pay taxes on a previous trade.

So I think that will be interesting to see how that plays out over the next 3 to 6 months. But then also just speaking to kind of our brokers in the business.

You go back 6 months ago, a grocery-anchored deal, you would have a very deep buyer pool of qualified groups at very competitive pricing. The number they referenced is you'd average 12 qualified buyers around the purchase price.

Whereas now, that's shifted down, and pricing really hasn't moved much on good-quality grocery-anchored. But you're really seeing closer to maybe 5 to 7 qualified buyers close to the purchase price.

And there's a lot more discipline with choosing a group that is well capitalized that doesn't have to have financing contingencies. So I think we're still in the early stages, but we're going to continue to monitor and try and seek out interesting opportunities and be there to pounce when the opportunity is right.

Okay. Great.

And just that leads into my next question. Look, we've seen the rental spread, that 12.5% year-to-date.

But what kind of rental spreads can investors expect going forward, both on renewals and new leases, especially when you bifurcate the portfolio between the Sun Belt and the non-Sun Belt region?

Yes. I'll let Allen go in for detail, but I'll start by saying it's really -- we focus on the rents wherever we are, and we want to focus on the #1 or 2 grocer.

But we really break the portfolio into the grocer rental spread and then what we call the national or the junior anchor or the shop space spread. And what we have found is tenants move from enclosed malls because they want to be around the traffic that the anchor generates.

And they also believe, if you think of our portfolio, we can offer a much cheaper rent for those tenants coming out of the enclosed malls. We're also seeing tenants that we usually have, whether it's a Ross or a typical pad buyer or a user like an Aspen Dental, will go in an in-line now because they can't afford to construct space.

So I think traditionally, we have seen -- before the inflationary environment of last year. So we've seen grocer rents probably go to 1% to 3%, and we were doing shop space growth, probably 3% to 5%.

You mush that together, we would do, in the 2010 to 2018, like 3% to 4% growth. Well, now what we're seeing is the grocers, probably from 1% to 2%, maybe that's 2% to 5% because you want to keep them.

But like this is rough math. But then the shop space rents are growing much higher.

So when you blend that out, I think we could do, in the next little bit, 6% to 9%. Kind of bumpy, it's hard to tell, but we're beating that right now.

We're very conservative in what we do, but I just think there's no place for them to go. But you got to do the fine balance of keeping your anchor.

And then there's no space being constructed. But Allen, maybe you can jump in and correct all the math I just said.

No, I think that's very well said. I -- this past quarter, we had, on new leasing alone, the 26.6% spread.

And quite candidly, we do not see that slowing down on the new leasing side.

Just looking at the leasing trends and given the current environment, all the concerns around a slowing economy. Can you maybe just talk about what you're hearing from your tenants in terms of demand for new space?

Maybe where you're seeing strength versus weakness?

Yes, I'll start. And then Allen, you jump in.

We're seeing it across the board, but maybe you can give more detail Allen, on like -- say you had a pad user, they're deciding to go into in-line space. That's an amazing decision because of costs.

And so -- or when you see a tenant that, usually, you have to spend a lot of money on facade work or whatever. And again, we're talking grocery centers, so that's more like our below-line capital isn't like a normal enclosed retail or [ high-shell ] retail, it's cheaper.

But they're even scaling that back. So we're seeing demand into built-out space like we've never seen, and that's a good thing.

But I think, moreover, historically, if you look at the neighborhood grocery-anchored strip center or market in the U.S., I think it's always bounced around the low 90s, even in bad times. So the portfolios we purchased recently, the Annaly deal, which was below 90%, and the most recent deal we closed that was in the low 90s.

We feel that there's leasing upside because we think the market, like all the space in the next short term, I believe, could go to 100% full. Do I think that's sustainable forever?

No. But I think you can look back historically, it's always in the low 90s.

I think you're going to get full utilization of space, pressure on rents, in the short to medium term here. And it's demand from across the board.

But Allen, maybe talk about like what you're seeing from tenants and what you're hearing from what they need.

Absolutely. And in this environment, as Blair stated, it's very costly to build.

Timing is an issue as it relates to construction and getting projects completed. And that's what we have to remember, is across our portfolio, we typically have white or vanilla shells and some second-generation boxes.

So tenants are able to come into our shopping centers and open quickly, and at a significant discount to new construction. And so that's where we see our real advantage.

Got it. So I guess if I were to sum up, is it fair to say that you really -- it doesn't sound like you're really seeing any signs of weakness between, whether it's -- certainly not the grocer as it seems, but whether it's the juniors or some of the smaller shop, independents space, it all seems to be fairly healthy.

Is that fair, or...

Yes, I think that is exactly right. We know a lot of our tenants reported, whether you're a Walmart or -- I think the squeeze on them is the discretionary spend items.

So their higher-margin items, sales are going down, but the grocery spend is going up and it's just a lower-margin business. So what does that mean?

They're making money, but not as much. But the grocery sales are going up.

But our tenants, the grocers, are very well capitalized. They're still making money, but it's the food business, and that's good.

As it relates to the other tenants in our space, we still offer cheap rent. And I think -- and compared to other options.

So it's like are they going to stay in business or not? We feel very confident that our tenants that are in our space are healthy.

But we also are the low-cost provider because our weighted average rent is lower than any other retail and any new construction. So the question is, are they going to -- do they want to be in business?

Do they not? Where do they go?

And they want to be around the activity of the grocer. And the grocer's fulfilling an omnichannel strategy: Shop in the store, click and collect or online delivery pickup with the vans in the parking lot.

And I think that activity is where all the other retailers want to be. So I think we see activity across the board.

We offer the best rent in the street, and I think that's why demand is pretty strong. And why we called this as essential real estate.

Like in the COVID lockdowns, people still went to their neighborhood center. And that's -- I don't think that's changing.

Right. Just you mentioned the Annaly portfolio and some of the leasing there.

Can you just give an estimate of just how much the occupancy in that portfolio has risen since -- or if it has, sorry, since the closing of the acquisition?

Yes. So leasing has been positive.

We're probably -- we came in at about 88% on the portfolio. I'd say it's about low 90s right now, so 91%, 92%.

And we still think that there's traction there. Speaking to Blair's point of just the demand we see in our space, the in-place rents are really attractive to drive sort of the in-line sort of shops.

Got it. Just lastly, maybe just putting all those comments together on the gap between in-place and market rents.

Looking back, I think Slate's historical organic growth has averaged maybe around 1%. It sounds like the next, call it, 1 to 2 years, I mean, should we start to see some numbers that are closer to 2%?

In the 2% to 3% range? Particularly on the -- with some of the rental spreads that you are getting.

Or is it -- should we sort of stick with kind of this 1%, maybe a bit higher?

No, I think it should increase. When we started in this space over a decade ago, I think there was rental growth.

And then if you want to pull out 5 years ago or when Amazon bought Whole Foods, people thought it was the end of bricks and mortar. We didn't -- for grocery.

We don't think so. And I think there was a pullback or a flattening, and then maybe that's the growth you're referring to.

There was no new space built. People still used the bricks and mortar because it's the spoke to the hub of the distribution, it's last mile distribution.

And now I think we're seeing significant rental growth because we actually look at the grocery store as logistics, and that's how the grocers use it. And when you think of their rents in place, it's almost cheaper rents than their industrial hub.

So I'd like to say it, I'll put it in the Canadian context because I think most people on this call are Canadian. If I live in Midtown, Toronto and I want my groceries delivered, Loblaw's doesn't go to the Mississauga warehouse with 100 vans to deliver to 100 homes in Midtown.

They drop a couple of trucks in the main store, and then they do short trips because the biggest cost to the grocer, about 45% to 65%, is transportation. And so you need to be more efficient on your distribution, and the next is labor.

So I think what we're seeing now is the value of the spoke to this logistics hub has become -- like if you think of industrial rents, and we love industrial, don't get me wrong. But when you think of a grocery box as just part of that distribution chain, I think you're going to see extreme or really good rental growth.

So I -- to answer your question, Pammi, would I think we can bump that up a couple of percent and feel pretty comfortable about that.

So something closer to 3%.

Yes.

I'm not sure if I missed this earlier, but just on the recently closed portfolio, what is the mark-to-market on rent there? And the time line or, I guess, the average lease term you have to capture that spread?

So the in-place rents for that portfolio is close to $13. So again, it's still below market, especially compared to our peers in the U.S.

space. The average lease term is kind of what we see in our portfolio.

So it's not too different from what we have across SGR.

Okay. And then just on cap rate spread.

So obviously, you made a big move into the Sun Belt states recently. Just wondering, how does pricing compare there versus other markets for a similar product?

Connor, do you want to talk about some of the large portfolio deals and that stuff? Cool.

Yes. I think the grocery-anchored space kind of across the country has really, over the last 18 to 24 months, become more and more competitive, with large institutional groups coming in and making kind of big portfolio and platform acquisitions.

We've seen cap rates kind of as low as the low 4% caps, kind of with several deals between kind of low 4s into the low 5s. So there's a lot of kind of comps in there and capital looking for the stability of the grocery-anchored space.

And in terms of the spreads between kind of Sun Belt market to other markets, it is more competitive. There is a lot of money coming into, specifically, the state of Florida.

And I think the nuance of the acquisition we just made, it was a little bit of a fragmented portfolio. It was across 7 different states.

So there was lots of group bids and pricing pressure on just the Florida assets from multiple groups focused on that particular region. But because we have a national platform with a lot of assets in a lot of these markets, it fit really well for us and probably limited the amount of competition we should see there.

So I think simply put, more cap rate compression has been occurring in the Sun Belt markets. I think we've done a good job focusing on real estate fundamentals, continuing to buy at a discount to replacement cost with strong grocer performance.

And there's been a little bit less competition in some of the, call it, Northeast or Midwest markets. But that's not to say the fundamentals aren't still strong.

There's probably just a thinner buyer pool that is driving pricing.

Thank you, everyone, for joining the Q2 2022 Conference Call for Slate Grocery REIT. Have a great day.