Ivelin Radkov

Thesis: Risks are assessed

Whitestone REIT (NYSE: WSR) is a retail real estate investment fund that owns need-based shopping centers in fast-growing, high-income areas of five Sunbelt hot markets: Phoenix, Dallas/Fort Worth, Houston, San Antonio and Austin.

However WSR’s centers aren’t primarily anchored in a grocery store, they feature staple retailers and service-oriented or experienced tenants, making them largely e-commerce resistant.

WSR’s portfolio occupancy and rental rates are increasing rapidly, but the REIT is also highly leveraged, with much of the debt maturing in the next few years.

When it comes to retail REITs, WSR is above average risk. But in the balance between risk and reward, I would argue that the market has largely priced in WSR’s risks while overlooking its strengths and future growth potential. With a payout ratio of around 50%, the 4.6% yield dividend looks safe. And at an FFO price of 10.4x, the market appears to be far too pessimistic about WSR’s future growth prospects, setting virtually no price.

I don’t believe the REIT has to be a growth monster in order to generate strong total returns for investors from current stock prices. If the REIT can deleverage while continuing to increase FFO per share, that should be enough for WSR to get an upward revaluation in market share, giving it a 30-50% upside.

Mid-Year Update on Whitestone REIT

The first thing you need to understand about WSR is that the REIT has an attractive array of neighborhood shopping centers in its five core markets. Here’s COO Christine Mastandrea describing WSR’s top real estate locations on the Q2 conference call:

…[I]n Phoenix, we targeted key neighborhoods in the aftermath of the 2009 financial crisis and acquired the base of our centers [there] well below replacement cost. Our strategic focus on the East Valley in North Scottsdale has paid off due to outsized gains in job growth and out-of-state relocations, which have boosted traffic in our centers well located.

In Houston, the majority of our NOI comes from the main retail district known as the Uptown District or Galleria, and the affluent western suburbs. In Dallas, we were early investors in northern suburbs that have been magnets for corporate relocations and are among the fastest growing zip codes in the nation.

In Austin and San Antonio, we purchased centers in prime locations in both cities before the migration from coastal towns really took hold. Often the reason we are able to secure these prime locations in cities is that we are very much in tune with concentrations of educated talent that attract employers.

This year’s performance figures demonstrate the quality of WSR’s portfolio.

Total revenue was up more than 14% year-over-year, although FFO per share was up only 4.2% due to share issuance as well as the increase in operating expenses and interest.

WSR Metrics

WSR Presentation

In the far right column, you can see WSR’s second quarter rental spreads (straight line, which takes into account future rent increases), which have more than doubled from their level a year ago. On a straight-line basis, leasehold rent growth was 17.4%, while spot rental rate growth was approximately 9% in the quarter.

Retailer demand for smaller spaces averaging around 2,000 square feet has increased as goods providers find that they simply need less space in the omnichannel era than they did during the heyday of the physical shopping.

The same is true for many service providers. For example, smaller, niche fitness centers like F45 and Orange Theory are gradually taking market share from traditional, large-footprint health clubs with their giant locker rooms and saunas.

These trends are a tailwind for WSR, as most of the available REIT space is already around this smaller size.

We can see the post-pandemic boost that WSR has enjoyed over the last year or so in the annual growth in base rents across its portfolio as well as the surge in linear same-store rent growth.

Growth in WSR rents

WSR Presentation

For the full year 2022, management expects the same store NOI to increase 3-5% from the 2021 number, and they expect to further increase occupancy to 91.5 % in Q2 to 92-93% at year end.

Unfortunately, even as rental income increases at WSR’s properties, its operating expenses also increase. Operating and maintenance costs and property taxes have actually increased at a faster rate than revenues, eroding margins.

Q2 2022 Q2 2021
(O&M + RE taxes) / Revenue 32.0% 31.4%

This demonstrates the double-edged sword of inflation for property types that don’t lock in their costs for long periods of time or force their tenants to pay or repay them.

On the other hand, management has made great strides in reducing general and administrative expenses, both on an absolute basis and as a percentage of revenue. They did this primarily by reducing executive salaries from the inflated levels present under the former CEO to more reasonable levels. Total G&A fell by around 10.6% between the first half of 2021 and the first half of 2022.

1H 2022 1H 2021
G&A to turnover 11.9% 17.4%

As you can see above, WSR could make further progress on this front, as G&A still accounts for nearly 12% of revenue, which is quite high. I would like it to go down to 8-9% in about a year. This should come from a combination of rising revenues and flat or falling G&A costs.

In the second quarter, management reaffirmed guidance for 2022 FFO per share of $0.98 to $1.02.

WSR Tips

WSR presentation

Despite the tailwinds of rising occupancy rates and rents, interest charges are also rising. Additionally, management plans to divest approximately $50 million of properties and recycle the proceeds into acquisitions or development opportunities, which could result in a temporary decline in FFO.

WSR’s annualized dividend of $0.48 represents a forward payout ratio of about 50%, given that management expects to generate only about $0.45 per FFO share in the second half.

After the dividend cut at the start of the pandemic, WSR’s payout appears to be on very solid ground, and the REIT’s FFO per share is expected to continue to grow in the coming years from its 2022 level. steady growth in future dividends, as long as the company’s balance sheet issues can be resolved.

Balance sheet

WSR’s main risk relates to its balance sheet, which is relatively highly leveraged. Total debt to total assets stood at just over 50% in the second quarter. And net debt to EBITDA remained high at 8.3x, although it fell 8.8x in the same quarter last year.

At the end of the second quarter, 82% of WSR’s total debt was fixed rate, while the remaining 18% was floating rate. However, much of this fixed rate debt is maturing over the next several years, which means that the REIT’s average interest rate will almost certainly rise.

As you can see below, nearly 3/4 (74%) of WSR’s debt matures by the end of 2024.

WSR debt maturities

RSM Q2 2022 10-Q

The weighted average interest rate on WSR’s fixed rate debt was 3.4% at the end of the second quarter. However, the 18% of variable rate debt currently bears interest between 5% and 5.4%, bringing the effective interest rate on the total debt to around 4%.

Q2 2021 Q2 2022
Outstanding debt $623,286 $629,114
Interest charges $6,143 $6,234
Implicit interest rate 3.94% 3.96%

However, the weighted average differential interest rate on WSR’s debt ended the second quarter at 4.5%, which means that interest charges will increase quite substantially in the coming quarters.

Between the rise in short-term interest rates due to the rise in the LIBOR rate and the rise in long-term interest rates due to the renewal of fixed rate loans, the current environment for rising interest rates is a serious headwind for WSR that cannot be ignored.

During the second quarter conference call, Chief Financial Officer Scott Hogan mentioned that he expects to complete the refinancing of the majority of debt maturing in 2022 and 2023 over the next few months. As such, shareholders should know what kind of terms the REIT has managed to secure by the time the third quarter results are released, if not sooner.

Conclusion

There are several issues surrounding WSR that should caution the REIT.

  1. What conditions will management be able to obtain on its refinancing of loans and credit facilities?
  2. Will planned capital recycling efforts be leverage neutral?
  3. Will the disposals be used to reduce debt? Will the acquisitions be used to re-leverage?
  4. How adept will the new CEO be at steering the ship and driving growth per share?

That said, these risks and uncertainties appear to be well priced in at this stage. A price/FFO ratio just above 10x reflects headwinds from rising interest charges, but not headwinds from rising occupancy and strong rental growth.

WSR will be must refinance the debt at higher rates, but these higher rates should not be too high to be prohibitive. Credit markets are always open. There is no liquidity crisis for the moment. As such, I think the market will absorb the news of higher rates on WSR debt when it comes, shrug its shoulders, and begin to take a more balanced view of the REIT.

This balanced view, in my view, will include not only the “known unknown” of rising interest charges, but also the “known unknown” of further growth in occupancy rates and rents, as well as benefits of capital development/redevelopment/retraining efforts.

Maybe I’m wrong and the results of WSR’s refinancing will turn out to be much worse than the market expected. But at such a low valuation, it looks like a pretty bad scenario is already priced in. This creates an attractive opportunity to generate strong upside if WSR manages to hold its own during this period of rising interest rates and “lives to die another day”, so to speak.

WSR can always be cheaper, and maybe it will be. But WSR’s long-term return outlook looks attractive at its current price, making it a “buy.”