Nexus Industrial: 9% Yield to 120% (NXR.UN:CA)

Note: All amounts discussed are in Canadian dollars and the share price refers to the TSX share price and not its over-the-counter counterpart.

We’d buy this here even if Nexus Industrial REIT cut its dividend by 50% tomorrow.

Source: Nexus Industrial: A look at the safety of the 8.5% yield.

This excerpt is from our coverage a few months ago of Nexus Industrial REIT (TSX:NXR.UN:CA). The reasons are many, and we have summarized them in this article. A NOI boost lies just around the corner due to below-market rents currently enjoyed by tenants, balanced lease expirations and debt maturities that protect the portfolio from a hard economic downturn, and shares trading at a discount of more than 40% to NAV in IFRS. Finance, to name a few. While the 8.5% return was an added incentive, it was the value that motivated us to add to our holdings position, effectively doubling it.

Fundamental value is more important to us than just a high dividend yield. We want to own quality properties at a great discount. Value has rarely been this cheap compared to growth stocks and you want to rally here. We have recently added to our position and effectively doubled it. We are maintaining our “Buy Under $7.50” approach. like before.

Source: “Nexus Industrial: A Look at the Safety of the 8.5% Yield.”

It hasn’t been a smooth ride since then.

On a total return basis, the dividend has stemmed some of the bleeding from lower prices.

The compelling discount on its tangible book value has deepened, and dividends are now more than 9%. With the dividend reaching 100% AFFO in Q4 2024, the sustainability of the dividend has been in question, but we put the potential for a cut at low.

We bought it for less than $7.50 in March. Let’s review the latest numbers to see if we should add more at this time or wait and see.

First quarter 2024

The first quarter of 2024 was a bit weak, as the REIT was impacted by a slightly higher vacancy rate and higher interest expenses. Funds from operations came to 16 cents versus 18 cents last year, and FFO (AFFO) fell to 13 cents.

We will note that these two numbers were lower than the agreed upon estimates. We generally don’t want to make excuses for a company when it fails, but there was an interesting commentary on this that investors should definitely read. Let’s see what they said about the first vacancy.

We have become aware of these vacancies in two properties. The first property was our 29,000 square foot specialty building and associated excess land located at 102 Second Avenue in southeast Calgary.

The tenant has outgrown the site and moved into another of our buildings, a newly acquired 83,000 square foot facility on High Plains Drive in Rocky View, northeast of Calgary. This left the property vacant for part of a quarter. However, we have leased this space to a new tenant of the building portion as of August 1st.

Since the excess land is in a good location and is not required by the new tenant, we have the opportunity to build a new 115,000 square foot small industrial building on the property, which is a highly desirable building in this location. At market rates, this would return approximately a 12% return on a $15 million investment, which we expect to complete in early 2025. Combined, this will put us ahead of where we were with Canada Cartage as the sole tenant.

Source: Nexus Q1-2024 conference call transcript.

This is a fairly strong result, and one that continues to indicate that high-quality industrial space is still in deficit. Let’s look at the second.

The second property was the 220,000 square foot Exeter Road building, a multi-tenant property in London, Ontario. During the quarter, a tenant vacated from 44,000 square feet to a 70,000 square foot space in one of our other buildings in a large rental elevator.

At the same time, we had a second tenant vacate a challenging office portion of the space adjacent to this, leaving us with a total of 68,000 square feet vacant. We are currently in final negotiations with a new tenant for the full 68,000 square feet of space with a significant rent increase for occupancy expected in August.

It is a testament to the strength of our portfolio that when our tenants were looking to grow, they looked to do so with us. Likewise, I’m impressed with how quickly and profitably we were able to fill the void

Source: Nexus Q1-2024 conference call transcript.

The real estate investment trust estimates that the current rent for the portfolio is still 24% below market rents. This is an easy one to get behind since the bulk of net operating income (NOI) comes from industry and a tiny amount comes from the office.

Significant leasing activity on the renewal front during the quarter showed something similar as well.

The REIT entered into additional interest rate swaps in the quarter that benefited from an inverted yield curve. This would reduce borrowing costs by about 1.6% on $100 million of borrowing. This was good timing, as Canada’s yield curve is now less inverted with the end of interest rate cuts.

By fixing this problem in the first quarter of 2024, Nexus has “locked in” expectations of a rate cut, even if it does not happen. The real estate investment trust purchased one industrial property for $35 million in Alberta during the quarter. It also stated that it plans to sell approximately $200 million worth of properties in the back half of 2024.

Prospects

If you are approaching a 100% return rate, you tend to worry about negative surprises. You’ve had one (negative surprise) this quarter and the payout ratio looks very uncomfortable. Management believes that the payout ratio has peaked. We generally ignore every promise of dividend continuity that comes from management. This is not Nexus specific. We have this opinion about each company individually. This disdain is amplified in REITs, where issuing shares is their lifeblood, and telegraphing a premature dividend cut is generally a bad political choice.

In this case, given the facts, we believe the payout ratio has peaked. This does not necessarily mean that profits are safe.

The AFFO payout ratio will only drop below 100% in 2025, and a lot can happen between now and then. The good news for Nexus is that it has other forms of buffer to get around the high payout ratio. Their expiring base rents are very modest and cumulatively well below market rents. So, chances are good that it will be able to sustain the payout ratio until it catches up with the underlying earnings strength.

Its debt maturities also look very easy, with just $110 million refinancing by the end of 2025. That represents half of the property sales it plans to do in 2024.

Nexus has plenty of its exposure to interest hedged as well. Some hedges continue until October 2028.

In other words, every other base is well covered and the odds of profits remaining unscathed are high. This was the REIT that maintained it during the coronavirus as well, and management may want to maintain that record if it aims to make it really big. So, at present, we give these low odds for the cut.

Judgment

The main reason to own this has nothing to do with whether it will pay 64 cents or 46 cents in 2025. If those 18 cents make a difference in your investment decision, then you’ve come to the wrong Seeking Alpha article. Dividend distribution is important to the extent that it conveys a message about the health of the company. We believe the underlying properties are worth far in excess of enterprise value and that an implied capitalization rate of over 7% is unfair given the quality of the portfolio. However, there’s a reason this REIT sold off near $12 in 2021 (trading at 1.2X NAV) and we didn’t issue a buy rating until it was below $7.50. You need a large margin of safety when the payout ratio is high and the REIT is relatively small. Nowadays, we have that.

We haven’t seen anything from Nexus Industrial REIT this quarter to change our view on the upside front. We are maintaining our “Buy Under $7.50” approach.

Please note that this is not financial advice. It may seem so, it seems so, but surprisingly it is not. Investors are expected to conduct their due diligence and consult with a professional who knows their objectives and limitations.

Editor’s Note: This article discusses one or more securities that are not traded on a major U.S. exchange. Please be aware of the risks associated with these stocks.