CA - True North's Distribution Visits The Deep South

2023-11-14 12:54:14 ET

Summary

• Since our last article, the REIT has experienced a gut-churning negative total return of 44.60%.
• The REIT's Q3-2023 results and new strategy add another twist to the ongoing drama.
• We give you our take on the situation and tell you why risks remain incredibly high.

On our last coverage of True North Commercial REIT (TNT.UN:CA), we suggested that the key metrics were still due for more deterioration. That led to a negative bias and a 'very' rating on our "potential pain scale." Specifically, we said,

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.

Source: Key Metrics From Q2 2023 Results

While the "8" might have sounded a bit high, especially after the trauma the REIT had already suffered, the REIT did deliver a gut-churning experience for its holders. It has delivered total returns of negative 44.60% and that is over just three months.

The REIT released its Q3-2023 results late last evening and threw another unusual twist to this drama. We look at the numbers and this new strategy and update our loyal readers.

Q3-2023

With three properties less than last year, and a lower occupancy level (93% versus 95%) the revenues were set to be lower. Revenues dropped by about 11% and same property net operating income (NOI) dropped by about 12%.

Funds from operations (FFO) which is sensitive to both the NOI and changes in interest rates, dropped far more sharply (29%). Adjusted FFO (AFFO) did a similar drop. Some blame or credit (depending on your viewpoint), could be given to the lease termination fees from last year.

Q3-2023 FFO and AFFO basic and diluted per Unit decreased $0.04 to $0.11 over the comparable period. YTD-2023 FFO basic and diluted per Unit decreased $0.13 to $0.34 and AFFO basic and diluted per Unit decreased $0.14 to $0.33 compared to YTD-2022. Excluding termination fees, Q3-2023 FFO and AFFO basic and diluted per Unit were lower by $0.02 and $0.03, respectively, and YTD-2023 FFO and AFFO basic and diluted per Unit were lower by $0.07 and $0.08 compared to the same period in 2022.

Source: True North Q3-2023 Financials

We had harped about that as one of our early rationales for the distribution cut. But even excluding that impact, things were far from rosy. Besides the same property NOI drops, we saw that big jump in interest expenses once more. True North has walked into this interest rate hike cycle about as unprepared as the standard Canadian REIT. With short durations on their debt profile, they are constantly refinancing at higher and higher rates every quarter. This quarter we saw interest expense increase by another $1.0 million.

The current run rate is now approaching $36 million annually. We were at $24 million run rates at the trough in 2021. The REIT's key metrics show the end impact. Debt to gross book value is over 60%. The interest coverage ratio fell for yet another quarter and is now at 2.43X.

The refinancings have been for a short duration as well. The weighted average term to maturity is just 2.99 years. The REIT is likely betting on lower rates down the line rescuing it. But in the interim, these rates are pushing their weighted average rates up quickly. Note the 4.03% above relative to what was done in the quarter and subsequent to it.

During the quarter, the REIT refinanced $36,452 of mortgages with a weighted average fixed interest rate of 6.05% for five and seven year terms. YTD-2023, the REIT refinanced $67,573 of mortgages with a weighted average fixed interest rate of 5.65% (excluding one with a variable interest rate at prime plus 1.5%) and a weighted average term to maturity of 4.5 years, providing the REIT with additional liquidity of approximately $5,700. Subsequent to September 30, 2023, the REIT refinanced a $3,834 mortgage with a fixed interest rate of 6.62% for a three year term.

Source: True North Q3-2023 Financials

If you refinance the entire deck at 6.62% then your interest costs increase by another 55%. Your FFO drops another 50% from these levels. Investors might be taking comfort in the improved distribution payout ratio, but that was primarily the consequence of the first 50% distribution cut.

New Strategy

We have seen a few unusual things in REIT land and that's a consequence of having the fastest rate hike cycle in history. True North joined the "Stranger Things" cast with a pseudo-distribution suspension. We say pseudo as they have not clearly declared how much they will pay, but only that it will be substantially reduced and reallocated to buybacks.

On November 13, 2023, the board of trustees of the REIT ("Trustees") determined that the most effective use of available capital was to reallocate substantially all distributions paid to Unitholders ("Distribution Amounts") for the month commencing November 1, 2023 and ending April 30, 2024 to purchase the maximum number of Units available under the NCIB or through other acquisition programs, with the intention of revisiting the reallocation in approximately six months to reinstate a sustainable distribution to Unitholders. The Trustees believe that reallocating the Distribution Amounts to the NCIB, given the dislocation between the Unit price and the intrinsic value of the business will be immediately accretive to Unitholders and is the most compelling near term opportunity to increase Unitholder value and per Unit growth. As at September 30, 2023, the REIT's NAV per Unit was $4.97 resulting in the REIT's Unit price trading at a significant discount.

Source: True North Q3-2023 Financials

On the surface this makes sense. If the NAV is $4.97, then paying a 25% distribution yield on the current sub $1.50 price is pretty useless. In theory and practice may be very different, the REIT can buy 25% of its units over the next 12 months. That would mean that if the value of the properties stayed static the NAV would improve to about $6.50 per share. The assumptions here are the value of properties remains static and the price of the True North units does not move up in response to this measure. As we check the opening action, the units are actually down 8%, so the latter part is not even a distant threat. We're also assuming they extend this beyond the initial six months to a year. This all looks good if the value of the properties is static. As can be seen in the very picture that True North uses to make its case, the NAV has dropped over 10% since December 2022. Capitalization rates are still relatively optimistic here compared to where the market is.

True North sold its prime Ottawa office building for $17.5 million in July , and that was a big discount on its purchase price. What's more here is that True North is very heavily leveraged. So a small move in property values has a large effect on equity and hence NAV. We're skeptical this can work but it's worth a shot relative to just paying out the distribution. Allied Properties ( AP.UN:CA ) has a far lower debt-to-gross assets ratio and if they tried something like this in 2024, they might have a better chance of success.

Verdict

Alongside this terrible news for income investors, True North also announced a reverse split.

Total Equity (including Class B LP Units) (1) 94,440,415 $ 468,994 94,339,487 $ 536,766 NAV per Unit (1) $ 4.97 $ 5.69 Unit Consolidation On November 13, 2023, the REIT announced that it intends to affect a Consolidation of its Units, special voting Units of the REIT (the "SV Units" together with the Units, the "Voting Units") and the Class B LP Units on the basis of 5.75:1 Voting Units and Class B LP Units (together, the "Consolidated Units"). The Consolidation is expected to become effective on or about November 22, 2023 and is primarily intended to increase the REIT's per Unit trading price. As a result of the Consolidation, every 5.75 Voting Units and Class B LP Units will be converted automatically into one issued and outstanding Consolidated Unit.

Source: True North Q3-2023 Financials

While that does not change the numbers that matter, it prevents buyers who think low-priced stocks are "cheap."

The battle here will be fought in trying to preserve NAV while navigating the lease rollovers.

Alberta appears the most vulnerable in that regard as Calgary office property vacancies (28.6%) are very high relative to True North's portfolio (5% vacancy, 95% occupancy) and it will be tough to maintain tenants in there.

Leasing activity both in the third quarter and year to date remains weak. So far this year deals have been signed for around 430,000 square feet. The weighted average term on signed deals was slightly higher than True North's portfolio term.

But True North needs about 1 million square feet of deals annually to keep vacancy levels unchanged. We're running far below that and with a 60% debt to gross book value, risks remain high. While we applaud this unusual strategy, we don't believe it will materially change the end outcome for True North. We are giving this an upgrade on our potential pain scale as the 50% price drop has fixed that risk-reward a bit.

We still think this could go lower and for those that are smarting at the price action, remember it could be worse. Just see what Inovalis REIT ( INO.UN:CA ) is doing this morning after they stopped their distribution.

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