CA - Dream Office: Become An Office Landlord On The Cheap

2024-01-02 12:19:13 ET

Summary

• Valuation distress after a poorly designed substantial issuer bid is likely to fade as investors take a fresh look at Dream Office REIT.
• Long duration property assets are a play on the interest rate cycle reversing course in 2024 as a decline in cap rates will likely pull property valuations higher.
• It has a well curated property portfolio in the Toronto business district with a very strong moat.

The Moat

The first thing that strikes me as soon as you look at Dream Office Real Estate Investment Trust ( D.UN:CA, OTC:DRETF ) is its well-curated property portfolio with a very strong moat, so much so that the management never tires of repeating this quality to investors. It owns a portfolio of difficult-to-replace mid-rise heritage office buildings in Toronto's central business district. The moat comes from a high barrier to entry against comparable new supply through a combination of location, size and well-targeted capital investments because:

1. It is very difficult to buy land in central business district areas like Bay Street where most prime locations have already been built up.
2. Its focus is on the mid-rise office space niche with average building size of ten or twelve stories or sometimes even lower. For a new player, this type of building is uneconomical to develop because of very high price per square foot to build.
3. Most such buildings were built back in the day and have acquired a heritage characteristic which appeals to a unique class of tenants.
4. Boutique companies generating high revenue with a small number of employees (i.e., high revenue per employee) looking for their own Bay Street address, who want to lease a whole floor with their own elevator do not have a lot of other options.

The Cheapness

The second thing that strikes you about Dream Office REIT is its cheap valuation. It trades at a trailing 12-month P/FFO of 7.33x, Price to reported IFRS NAV of 0.30x and implied cap rate of over 7%. Office REITs have been out of fashion for a long time now. Over the past four years, the traditional office-centric work model has been replaced with a hybrid work model which means that office occupancy has stabilized at a level lower than pre-COVID-19 levels resulting in erosion of profitability. Moreover, the rise in interest rates has eaten into profitability via higher interest expense and has also caused a dent in valuations which are driven by the level of risk-free interest rates. And lastly, investors have been fearful of an impending distribution cut with its payout (relative to FFO) creeping upwards from approx. 60% in 4Q-19 to around 70% in 3Q-23.

The bottom fell out after the substantial issuer bid (SIB) for 12.5 million units at C$15.5/share (total approx. C$194 million) was completed in June 2023. The timing and the manner in which this SIB was conducted have encouraged investors to sell out because:

1. The company's debt level relative to its assets has gone up after the company paid for the SIB by selling its holdings in Dream Industrial REIT
2. The largest shareholder, Dream Unlimited Corp, partially tendered its holdings to generate liquidity for its own investment plans, a move that may have harmed the confidence of many investors in the stock price

I don't expect Dream Office to remain this cheap for long. Its stock price may be headed higher either via a reduction of the deep discount versus NAV as investors move past the poor signaling effect of the recent SIB or via an increase in NAV as the interest rate cycle reverses course during 2024. I estimate that the SIB was conducted at a Price to NAV of 0.49x, based on the SIB offer price of C$15.50 and 1Q-23 IFRS NAV of C$31.50. Subsequent to the SIB, the market price touched a low of C$7.25 (P/NAV of 0.21x) in late October and is now trading around C$10.48 (P/NAV of 0.30x). Even if the P/NAV remains unchanged from current levels, the NAV itself is likely to go higher in response to declining Government of Canada bond yields which will pull cap rates lower. Some people may scoff at IFRS NAV as a number representing a lot of management judgment, which is true to some extent. However, as they say - you have to start somewhere and IFRS NAV is a number good enough to start with and then apply a discount of your liking.

The Future

I think the future of Dream Office REIT is likely to involve a combination of a token distribution cut during 2024 and some deleveraging via asset sales. I don't think a distribution cut will have much further negative impact on the stock price as the market is already pricing in this possibility.

A distribution cut is likely because the market has been expecting it for some time and the management will likely take advantage of these distribution cut expectations reflected in the price already to reduce the outflow of cash. At the same time, it's reasonable to assume that any distribution cut will be quite nominal, in the 10-20% range. Given a choice, I believe the management would much prefer to allocate surplus cash towards buying back shares versus distributing it as a dividend to shareholders because buy-backs increase NAV (if done at price below NAV) while distributions reduce NAV.

Management will likely justify a distribution cut as a step towards reducing the debt level of the company. Going by comments in recent conference calls, the management's preferred leverage (defined by the company as net debt to net assets) is in the low to mid-40s while their preferred debt-to-EBITDA level is below ten times. This translates into a target reduction in debt of approx. $94 million to bring the leverage metrics down to preferred levels. The company's annual distribution to unit-holders at a current rate of 8.33 Canadian cents per unit amounts to C$34 million. To illustrate the futility of a massive distribution cut as a leverage reduction tool, it will take around three years to bring the leverage and debt-to-EBITDA down to management's preferred levels even if the company scrapped its distribution altogether.

In my view, any meaningful deleveraging for Dream Office REIT is only possible through asset sales, an option management has summarily dismissed in recent conference calls. If management had to choose assets to sell, it would likely put on the block its properties earmarked for redevelopment (located on King Street West and Dundas Street West) because their current EBITDA contribution is low, and their sale will reduce the need for raising more debt.

What to Do?

I look at Dream Office REIT as a very long-term play on the disconnect between public market and private market valuations of office properties in downtown Toronto. This gap may never bridge given how inefficient markets can sometimes be. However, in the medium term, investors are likely to move past their disappointment with the 2023 SIB resulting in a reduction in the deep discount to IFRS NAV being seen now. Moreover, Dream Office REIT is a play on the interest rate cycle reversing course in 2024 as it will pull property valuations higher in tandem with a decline in cap rates in my view. It's time to build up a position in Dream Office REIT.

Take everything you read with substantial skepticism and a healthy grain of salt. Invest based on your own financial profile and your appetite for volatility. The information discussed here should not be considered as an "investment advice" or as a "recommendation."

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