HRUFF - True North Commercial REIT: Key Metrics From Q2 2023 Results

2023-08-08 07:43:18 ET

Summary

• We had previously upgraded True North to a hold rating after two consecutive sell ratings.
• Q2 2023 results show the stresses building up behind the scenes.
• We tell you why AFFO should drop further in the next few quarters.

All values are in CAD unless noted otherwise.

True North Commercial REIT ( TNT.UN:CA ) is a Canadian REIT that owns and operates a portfolio of 46 office properties across the country.

This predominantly Ontario based portfolio spanned approximately 5 million square feet of gross leasable area, and had a weighted average lease term of 4.5 years at the end of the second quarter. The top 20 tenants bring in two thirds of the revenue and close to 80% of the total revenue comes from government and investment grade rated occupants.

We have covered this REIT a number of times on this platform, moving from a sell to a neutral rating in our most recent piece after the Q1 results.

With the much anticipated dividend cut coming to pass and the stock price correcting to expected levels, we closed our short position and informed our readers of the same. To be clear, the debt levels and the relatively short lease terms made it hard to get excited about True North despite the correction. We also were of the opinion that the management was a tad optimistic on the capitalization rates and we suggested another office REIT for those wanting exposure to this sector.

Obviously, we are using different cap rates than management. That difference comes from what we are valuing these properties at when the current leases expire, rather than where they stand today. So we see a grinding path lower. But from a trading standpoint, it is not a slam dunk short as it was previously. We are hence upgrading it to a hold and noting that we have closed out our short position as well. We think anyone wanting office exposure should consider H&R REIT ( H&R Real Estate Investment Trust ( HR.UN:CA ) Stock Price Today, Quote & News), ( OTCPK:HRUFF ) as it has the best complementary assets to allow a chance of success.

Source: True North: Upgrading To A Hold After Brutal 3 Months

It's been less than 3 months since that call and while neither stock has made any earth shattering movements, our protagonist is slightly ahead in terms of total returns.

True North's investors could have done without the volatility that came with this outperformance though. Next we review the recently released Q2 results .

Q2-2023

The REIT did better in terms of new leases and renewals in Q2 compared to Q1. In the second quarter it had 30,000 square feet of new leases having a weighted average lease term of 7.2 years. It also completed 271,800 square feet of renewals having a weighted average lease term of 4.4 years and a leasing spread of 15.2%.

True North had three properties that it held for sale at the end of Q2, two of which were sold subsequent to it. The overall weighted average lease term excluding the properties held for sale was 4.5 years and the occupancy was 93%. The occupancy levels at the end of Q1-2022 was higher at 96% and that contributed to the lower year over year revenues in Q2-2023. This is a now familiar story of 2023 coming under the 2022 numbers, which we saw while reviewing the Q1 results and is also evident from the numbers below.

The interest expenses continued their upward trajectory with the weighted average interest rate increasing from 3.32% at the end of Q2-2022 to 3.64% at the end of June 30, 2023.

This 16% year over year rise in finance costs, along with the declining occupancy had the expected dampening impact on the FFO, with the year over year number for that metric being down by close to 26%. What is equally concerning is that the overall and per unit numbers would have been even lower without the input from termination income. The FFO per unit of 11 cents included a 2 cents contribution from termination income . At some point the well from this source will run dry leaving the finance costs to run amuck. Coming back to which, we can also see the cascading impact of the rising finance costs and lower revenues on the interest coverage ratio (3.09x in Q2-2022).

True North has more than 50% of its mortgages coming up for renewal in the next couple of years.

They will have to work some magic on the NOI numbers as the finance costs will continue to apply downward pressure on their FFO numbers. Subsequent to June 30, True North refinanced around $36.5 million of maturing mortgages for a weighted average fixed rate of 6.05% and an average term of 6 years.

On the liquidity front, True North had around $52 million in cash and undrawn credit facilities at the end of Q2. The sale of the aforementioned two properties subsequent to the quarter added to the liquidity by around $40 million. Lastly, the REIT expects to save $25 million annually as a result of the 50% reduction in the dividends that was announced earlier this year .

Verdict

While the price has remained flat since our coverage in May, the AFFO keeps falling quarter after quarter. With 36 cents in an annualized AFFO (after adjusting for the 2 cents contributed by the termination fees), True North is now trading at 13.6X AFFO. Investors bidding it up consider it cheap and its 11% yield (even after the dividend cut) does not hurt. But consider what will happen if that weighted average interest rate moves from 3.6% all the way to 6% over time. Just by itself, that move will chop off more than half of the AFFO from these dilapidated levels. Combine that with stresses in office occupancy levels and a relatively high debt to asset ratio. We were not ready to bite at a 6X multiple, so we will definitely stay away now. True North Gets an 8 on our potential pain scale.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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