2024-01-10 23:39:22 ET
Summary
- Allied Properties REIT's Q3 2023 showed growth in rental revenue and net operating income, but caution is advised due to weak office demand.
- The overall office market in Canada is experiencing a rise in vacancy rates, which may impact Allied Properties' occupancy rate.
- While Allied Properties' balance sheet is improving, there is a significant amount of debt maturing in 2025 and 2026.
Introduction
We last covered Allied Properties REIT ( AP.UN:CA ) ( OTC:APYRF ) back in August 2020. It was during the midst of the pandemic and at that time we pointed out that Allied Properties had a strong balance sheet and its dividend was sustainable. It has been about 3.5 years since we last covered this stock, it is time for us to analyze the company again and provide our thoughts and recommendations.
Investment Thesis
Allied Properties invests in office properties in major cities in Canada. The office market has continued to experience weak demand since the pandemic occurred in 2020. It is very likely that 2024 is going to be another year of excessive supply of office properties in Canada’s major cities. Although Allied Properties has an improving balance sheet, and the future rate forecast appears to be favorable, investors should remain cautious. Weak office demand may eventually result in decline in its office rental rate. Therefore, we think investors may want to stay on the sidelines.
YCharts
Q3 2023 Highlights
Allied Properties delivered a good Q3 2023 thanks to continual growth in its rental revenue and same asset net operating income. As can be seen from the table below, its same asset NOI has increased by 5.7% year over year to C$86.4 million in Q3 2023. Although occupancy rate was down by 280 basis points, growth in its rental rate was more than enough to offset this decline. We will discuss the long-term occupancy forecast in our analysis section. Its adjusted funds from operation also increased by 3.6%. The reason that its AFFO growth was slower than its same asset NOI growth was primarily due to property disposition that happened in the past year.
(C$000') | Q3 2023 | Q3 2022 | Change (%) |
Rental Revenue | 138,455 | 131,823 | +5.0% |
NOI | 92,986 | 97,843 | -5.0% |
Same Asset NOI | 86,400 | 81,729 | +5.7% |
Adjusted Funds From Operations | 76,174 | 73,508 | +3.6% |
Adjusted FFO per share | 0.545 | 0.526 | +3.6% |
Occupancy Ratio | 86.8% | 89.6% | -280 bps |
Source: Created by author, Company Reports
Earnings and Growth Analysis
Office vacancy rate on the rise
Let us look at the overall office market in Canada. Canada’s national office vacancy reached 16.7% in the final quarter of 2024. This was 90 basis points higher than last year. As can be seen from the chart below, overall vacancy rate has increased significantly in the past few years from near 10% in 2020 to above 16% now. Fortunately, gross asking rent per square foot has also been on the rise. This helps to offset some of the decline in vacancy rate. However, it is very likely that higher vacancy rate may eventually result in stalling or declining rent price growth. In fact, we are already seeing signs in Q4 2023. As can be seen from the chart, rent price has declined quarter over quarter from the peak reached in Q3 2023.
Looking forward to 2024, about 5.7 million square feet of office space is expected to enter the market. This is significantly higher than last year’s 3.8 million square feet.
Will the market be able to absorb this growth in supply? According to stats from the past few years, the answer is likely not. As can be seen from the chart below, net absorption of new supply has been negative since 2020. Although the gap has narrowed considerably, net absorption was still negative 5.2 million square feet in 2023. Therefore, it is unlikely that 2024’s net absorption rate will turn positive unless the economy is very strong, an unlikely scenario in this current rate environment. Hence, we think overall vacancy rate will continue to rise. This may inevitably impact Allied Properties’ occupancy rate.
Allied Properties’ balance sheet is improving but significant amount of debt maturing in 2025 and 2026.
While declining occupancy rate may be a concern, Allied Properties’ balance sheet continues to improve. Its net debt to EBITDA ratio of 7.9x at the end of Q3 2023 is significantly better than Q2 2022’s 9.6x. This improvement was due to its effort to de-leverage by disposing some of its non-core assets.
One area investors should be aware of is Allied Properties’ debt maturities in 2025 and 2026. As can be seen from the table below, about C$893.4 million and C$936.4 million of debts (or 20.5% and 21.5% of its total loans/payments) will mature in 2025 and 2026, respectively.
Fortunately, Canada's core inflation measures have continued to trend lower in the past few months. Therefore, it is highly possible that future rates in Canada will be much lower than the rate today. This means that the company will likely be able to refinance its loans expiring in 2025/2026 at a much more favorable rate than today.
Management expects to continue with its developments
Allied Properties has about 1.8 million square feet of ground-up developments. This represents 12.7% of its total rental portfolio. The good thing about these development projects is that a significant portion of the developments are pre-leased already. This means that as soon as these projects reach completion, they will be able to receive rental revenue very soon.
Valuation Analysis
We think Allied Properties will be able to generate AFFO of about C$2 per share. This means that it is trading at a price to AFFO ratio of 10.4x. The company has typically traded between 15x and 25x from 2010 to 2020. Therefore, its current P/AFFO ratio is quite low. We believe a combination of weak demand for office properties and high interest rate likely put a lid on its share price. While some think that Bank of Canada’s eventual rate cut will result in Allied Properties’ share price growth, we think this only applies when there is a soft-landing of the economy. If a recession occurs, office demand will inevitably dwindle. Hence, its low P/AFFO ratio may be justified.
Investor Takeaway
Allied Properties may be trading at an attractive valuation relative to its past. However, demand for office market may continue to be weak for the remainder of 2024 and beyond, not to mention there may be an economic recession in 2024. Therefore, we think investors should wait on the sidelines.
For further details see:
Allied Properties: Future Is Still Uncertain