Retail Estates: A Fully Covered 7.2% Yield With Commercial Real Estate (OTCMKTS:RETTF)

Introduction

Retail Estates (OTCPK:RETTF) is a Belgian commercial real estate REIT focusing on retail parks. The REIT originally focused on Belgium but has since expanded into The Netherlands. I like the REIT because of its relatively conservative capitalization rate it applies to calculate its NAV (which means the independent appraisers are more conservative than with for instance high-end malls which are still valued at a capitalization rate of less than 5%).

As Retail Estates is a Belgian REIT, I would strongly recommend you to trade in the REIT’s securities on its primary exchange. The ticker symbol on Euronext Brussels is RET and the average daily volume is 9,000 shares. There are currently 14.1M shares outstanding, resulting in a market capitalization of 920M EUR.

The financial year started well

Retail Estates has a financial year that ends in March which means the most recent available financial statements are the H1 results which discuss the REIT’s performance between April 1 and Sept. 30 of 2022. That’s before the world economy got a little bit shakier, but it also means that none of the inflation-related rent hikes are taken into account just yet. Those hikes usually occur at the beginning of each calendar year.

During the first half of the financial year, Retail Estates reported a 60.8M EUR rental income, which resulted in a 60.6M EUR net rental income. The vast majority of its property-related expenses was covered by the tenants and the “property result” was approximately 59.6M EUR. The operating property result, which we can likely assume to be the NOI-equivalent, was 54M EUR, an increase of approximately 5% compared to the first half of FY 2022.

The EPRA earnings for the first half of the year came in at 2.84 EUR per share. While that is a 4% decrease compared to the 2.95 EUR per share in H1 2022, keep in mind the average share count increased by approximately 8% as Retail Estates issued new shares during the first half of its financial year. Those new shares were priced at 64.00 EUR per share.

While Retail Estates did not provide a full-year EPRA earnings guidance, I think it’s safe to assume we will come in at around 5.8-6.00 EUR per share as the majority of the EPRA earnings will be weighed toward the second half of the year. Retail Estates completed a 35.7M EUR acquisition in July, which means the contribution from that new asset was less than half the H1 period and this means the full-year contribution of that sole retail park asset alone will boost the EPRA earnings by about 5 cents per share.

Additionally, Retail Estates completed yet another 22.4M EUR acquisition in January 2023. That new acquisition consists of 13 retail units in a 55 unit complex with almost 1,000 parking spaces on the roof. I was pretty pleased when I saw the metrics of this acquisition as the annual net rental income of 2.25M EUR indicates the property was purchased at a 10% capitalization rate. There’s one caveat: The equity portion of the acquisition was co-funded with a private equity group. This means that the net attributable investment in the asset was about 4.5M EUR (with about 7M EUR in debt on a 50/50 basis. I’m not sure of the asset will be consolidated but even if it doesn’t we should see an increase in the value of the investments in associates and/or joint ventures.

The book value should hold up, even at a higher capitalization rate

As of the end of September, Retail Estates’ properties were valued at 1.82B EUR based on a 6.77% capitalization rate. Notwithstanding the recent purchase at a 10% capitalization rate, I think using 6.77% is actually pretty decent.

Keep in mind though the capitalization rate is applied to the rental income and not to the net operating income. That’s pretty standard for Europe, while in North America capitalization rates are usually applied on the net operating income. Looking at the H1 results and including the pro forma result of the July acquisition, the capitalization rate based on the NOI is approximately 6.1-6.15% which isn’t very high.

But even if I would use a 7% capitalization rate on the NOI (adjusted for the July acquisition but excluding the January acquisition), the fair value of the real estate assets (adjusted for vacancy levels) would be approximately 1.6B EUR. Assuming a 4% increase in the NOI throughout 2023, the NOI would increase to 113M EUR resulting in a fair value of 1.66B EUR.

We also know the net debt is approximately 859M EUR. Which means that in the 7% capitalization rate scenario, the fair value of the equity is approximately 800M EUR. And divided over the 14.1M shares outstanding, this means the NAV/share is approximately 56.7 EUR.

It’s also important to note that even in this scenario using a 15% higher capitalization rate, the LTV ratio will remain limited to just under 52%. That’s pretty high, but it does mean Retail Estates remains in the safe zone. And considering the REIT should be able to retain about 14-16M EUR per year in earnings that it doesn’t distribute as a dividend, the LTV ratio could easily decrease by about 100 basis points per year so as long as Retail Estates keeps its occupancy level at the current level and doesn’t see a spike in defaults, I don’t anticipate any issues on the balance sheet front.

Retail Estates also has locked in its effective cost of debt thanks to swaps. In excess of 90% of its gross debt has a been fixed. This will only provide a temporary shield as the average term of the debt is just around four years (and potentially even lower now as we are getting close to the end of the financial year). So we will see a gradual increase of the interest expenses (as the average cost of debt is just around 2% right now) and an increase to 5% would have a negative impact on the EPRA earnings of approximately 1.5-1.7 EUR per share. Of course Retail Estates should be able to 1) hike the rent so it increases its earnings and 2) reduce its net debt a little bit by retaining some of its earnings. A 4% NOI increase in CY 2023 followed by three years of 2% increases should increase the NOI should add about 12M EUR in annual NOI and thus mitigate about half of the impact of a 5% cost of debt.

Investment thesis

Retail Estates is not cheap based on the NAV using a 7% capitalization rate but based on the EPRA earnings multiple of 11 and the anticipated dividend yield of 7.2% based on the prognosis to pay 4.70 EUR per share as a dividend over FY 2023 (subject to the standard 30% dividend withholding tax in Belgium), the stock is still somewhat attractive.

I was lucky enough to pick up some shares in the high-50 range then the entire REIT sector was hurting at the end of September but I’m not “averaging up” at this moment. I may decide to expand my position but I’m in no rush.

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.