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Real estate activity has been very low for the last two years as macroeconomic uncertainty encouraged would-be participants to take a wait and see approach. During this time, demand was not shut off, it was just delayed, creating a large backlog. A slew of factors has been creating uncertainty:
Many companies, perhaps wisely, have waited for more clarity in the face of such uncertainty before pulling the trigger on new activity.
These factors are starting to clear up and with clarity, the backlog of repressed demand is starting to surge into actual activity. There is some impressive leasing volume across REITs, but the timing varies significantly across sectors.
It is the data centers and retail that are the focus of this article because the pacing with which leasing volume trickles through to earnings is not well known to the market.
In both data centers and retail, leases are often signed well in advance of commencement. These are referred to as SNO leases or Signed-Not-Open.
Leases signed in Q3'24 might not actually start until 2025 or even 2026 in some cases. It does, however, provide excellent visibility into future Annual Base Rent or ABR.
There are 3 topics we believe are particularly relevant to understanding how SNO leases will affect the growth rate of these REITs.
Retail REIT CTO Realty (CTO) has $6.5 million ABR in SNO leases. With 29.976 million shares outstanding, that is about $0.21 per share.
Brixmor's (BRX) CEO, James Taylor, described their SNO leases on the Q3'24 conference call:
Our signed, but not yet commenced pipeline sits at $59 million, even with the commencement of $18 million of ABR in the quarter[.]
[W]e've further replenished our SNO pipeline through our continued leasing success. It remains substantial today at 340 basis points and nearly $50 million of incremental base rent[.]
That represents 27 cents per share.
Similarly, large SNO leases could be found at just about every shopping center REIT. Data centers have even larger SNO leasing.
Jordan Sadler (investor relations) on the Q3'24 Digital Realty (DLR) conference call:
In fact, 3Q leasing was more than a full year's worth by previous standards as activity in the quarter exceeded the leasing completed in all of 2023, pushing our backlog of signed but not commenced leases up to nearly $860 million.
With 331 million shares outstanding, DLR's SNO leases are a whopping $2.59 per share in incremental revenue.
The market seems to be a bit frustrated with retail REIT growth, as FFO/share is just trickling up roughly 1 to 2 percentage points in 2024 for most of the sector. I think some view it as incongruous that the leasing activity has been so incredibly strong with 20%-50% roll-ups in rent as well as high leasing volume and yet, it has not translated into growth.
This is overwhelmingly a timing issue. Most of the leases signed in recent quarters commence in 2025, with a handful of starting in 2026. The way SNO leases work is that there is 0 cashflow until the start date, at which point the full cashflow of the lease kicks in.
It is already a contractual obligation of the tenant to pay the rent. The rent simply hasn't started yet, therefore the FFO growth has not yet appeared.
Data center SNO leases have similarly delayed timing, with many commencing 2025 and 2026. The market seems much more willing to wait for the growth in data centers, with DLR trading at 30X AFFO. I suspect the patience for DLR is due to its category.
The market knows AI means growth and that AI growth comes later. DLR was not shy about associating with the trend, as the term AI appears 16 times in Digital Realty's latest earnings call. It is an entirely fair association as DLR is one of the largest providers of AI data centers and is legitimately getting AFFO accretion from the build out.
SNO leases are a revenue figure corresponding to annual base rent. Thus, the impact to AFFO is going to be related to margins on that revenue. Some SNO leases come with large expenses, while others do not.
The retail REITs are positioned to have very high margin on their SNO leases due to the majority of these leases consisting of filling existing vacant space.
CTO, for example, has 90% current occupancy and 95.8% leased occupancy.
The SNO leases are essentially filling 5.8 percentage points of vacant space, which means they come with minimal expenses. CTO already owns and has already paid for the real estate, but now a higher percentage of that real estate will be cash flowing.
Thus, CTO's 21 cents per share of SNO leases should translate to almost 21 cents per share of AFFO accretion. That represents 10% growth.
Brixmor's SNO leases are similar, but not quite as much vacant space. James Taylor on the Q3'24 call:
We continue to see opportunity for upside in occupancy. I think a key differentiator of our growth strategy is that we're also driving spreads, so we're bringing in a lot of new ABR not just simply through gaining and occupancy, but by replacing lower rents with better rents and better tenants. That continues to drive, importantly, the momentum that we're seeing in the small shop space. And we fully expect that to continue to grow and have great visibility on its growth because of the drag of what we have in our reinvestment pipeline.
The other thing I would just highlight with respect to that SNO pipeline is it's stacking growth. As I mentioned in my remarks, we commenced $47 million of new ABR in the first 3 quarters. We expect that trend to continue in the fourth quarter, which we won't see the full benefit of from a growth perspective until '25 and '26. So it's both elements. It's not only driving better occupancy, but even more importantly, driving better rate. It's part of what gives us confidence in being able to outperform over the long term not simply through lease-up alone.
That description indicates a significant portion of the SNO leases are on vacant space, but there is also a portion that is lease roll-ups on formerly leased space.
The vacant space leasing would be close to 100% margin, while the roll-ups would be AFFO growth approximating the delta between the new lease and the old lease. Given BRX's substantial occupancy growth, I think a majority is vacant space, so I would estimate that of BRX's 19 cents per share in SNO leasing, about 15 cents will translate to AFFO/share.
Data center margins on SNO leases are going to be much lower because most of their leasing is closer to build-to-suit transactions. A hyperscaler customer requests DLR build an AI ready data center with a certain megawatt size. DLR builds it and when the facility is ready, rent commences. Most new data center builds are in the 11%-15% cap rate range, and DLR indicated similar cap rates on their developments.
That is still very accretive given DLR's low cost of capital, but it is nowhere near the margin of leasing up vacant space. Thus, DLR's $2.59 per share of SNO leases is unlikely to result in anywhere near that figure in AFFO/share growth.
Both retail and data center REITs are signing new leases at a pace that is faster than move-ins, so their SNO pipelines are still expanding.
The very high margin SNO leases for retail REITs are related to current vacancy, so I tend to favor lower occupancy retail REITs over those with already high occupancy. BRX and CTO are among the lower occupancy of their cohort, which provides the most leasing upside.
As occupancy gets closer to 96%-98% it will be much harder to fill vacant space, and growth will instead come from leasing at higher rates rather than BOTH higher rates and occupancy gains.
Data center leasing volume is clearly in a boom period at the moment and the duration of that boom will ultimately depend on the ROIC the hyperscalers are able to generate on the use of these data centers. Your guess is as good as mine.