2023-04-24 08:25:54 ET
Summary
- Dream Office REIT's debt levels are too high.
- The office real estate market is currently in distress.
- The REIT's current valuation does not provide an adequate margin of safety to warrant investment at this time.
Although the valuation seems intriguing, there is no compelling argument for the safety of principal in an investment in Dream Office REIT ( D.UN:CA ) (DRETF). The company has a high debt load and operates in a currently troubled office real estate sector. They are heavily concentrated in Toronto office space, and should there be a further downturn in that market, it is difficult to see Dream Office REIT’s fortunes faring very well.
I won't predict future share prices here, but I would not suggest opening a position in Dream Office REIT at this time. There are always risks in any investment decision, and it may be that in the long run Dream Office does fine. However, D.UN is in a commercial office real estate sector that is facing falling asset prices. Falling asset prices coupled with a rising interest rate environment, with a high debt load: that is a recipe for troubled waters ahead. Thus there is not enough of a margin of safety to justify investing right now in my opinion. For those already owning Dream Office REIT who have a long-term buy and hold outlook, they may well do fine to hold on and weather the storm.
For those looking for a bullish entry-point, there is potential for the NAV of Dream Office REIT's Dream Industrial REIT units to appreciate in value to such an extent that it comes close to the market unit price of D.UN. Something for investors to keep their eyes on. More on that below.
High Debt Load
Currently most of Dream Office REIT’s debt ratios are uncomfortably high. I calculate their 2022 end-of-year total indebtedness at approximately 47%. They have more debt than equity, which is never a good sign, and they have 10-year worsts in Debt to EBITDA, Interest Coverage Ratio, and Debt Service Coverage Ratio. See the below chart to compare their interest coverage ratio over time.
2014 | 2015 | 2016 | 2017 | 2018 | 2019 | 2020 | 2021 | 2022 | |
3.5x | 3.4x | 3.5x | 3.2x | 3.2x | 2.75x | 3.2x | 3.2x | 2.96x | 2.5x |
Dream Office's interest coverage ratio was 3.5x in 2013 which was a 10 year high. Since then their interest coverage has withered away. In 2022 they had a 10-year worst 2.5x coverage. The chart clearly shows that Dream Office REIT interest coverage is lower now than it has been in the last ten years. Another chart that shows that their debt is reaching troubling heights is this Debt to EBITDA chart (which is actually something called EBITDFV in the company’s financial reports).
2018 | 2019 | 2020 | 2021 | 2022 |
8.4 | 7.2 | 8.7 | 10 | 10.7 |
I hope the visuals help to demonstrate that Dream Office REIT has a significant amount of debt, which has been rising. Neither the interest coverage, nor the Debt to EBITDA on their own is necessarily a screaming red flag, however the trend of rising debts is troubling. Also troubling is Dream Office's Total indebtedness of 47% ( 5% higher than the Canadian average for REITs ), and their Equity to Assets of 0.48 (which means Dream Office's equity is less than half its total assets).
Now debt provides strong leverage when assets are rising, which can be a good thing. Unfortunately for Dream Office REIT, office real estate assets are in the midst of a free fall, to the point where they have been highlighted by banks as a big worry due to an increased risk of defaults . There have already been some fairly prominent office defaults announced this year, and the sector should continue to experience stress in the near future.
Just over 5 years after Dream Office REIT sold off more than half their portfolio of assets , their debt load coupled with an office real estate market that looks to be evolving unfavorably may force office landlords like D.UN to offload more office properties soon. Debt is a problem right now for Dream Office REIT because with the current office real estate market, and the rise in interest rates, D.UN may face the possibility of declining revenues and growing interest payments, which could lead to the REIT losing assets or being forced to sell assets at an unfavorable time.
The NAV Trap
I want to briefly explore the net asset value problem with regards to office real estate at present. I mentioned in my previous article how I recommend ignoring the stated NAV of any office property at present. Now I say this not because I worry that REITs are purposefully misstating their values. I actually think the opposite, the values as printed are probably fairly accurate reflections of the estimated values at the time of printing. But that value will always be a backward looking estimate, and at present the office real estate market is in distress and is in the midst of a fair amount of turbulence. It seems fairly certain that the changes the sector is currently going through will affect some of the values going forward.
Given those realities, in my view it will be best moving forward to value office REITs as much as possible without referring to their net asset values. Focus instead on the health of the business that the REIT is using the buildings for. In the case of Dream Office REIT, aside from a P/NAV that's at a 10-year low, their other valuation metrics are not at an unprecedented level judging from their last 10-years. Add to that the somewhat perilous current position discussed above, and I think it's only prudent for investors to demand an even steeper discount, or just to avoid D.UN altogether.
2013 | 2014 | 2015 | 2016 | 2017 | 2018 | 2019 | 2020 | 2021 | 2022 |
10.4 | 9.0 | 6.3 | 7.6 | 9.0 | 12.5 | 18.0 | 12.2 | 15.3 | 9.7 |
Looking at this chart, it's hard to argue that Dream Office REIT is trading at a noticeable bargain, as their P/FFO is currently closer to being at their 10-year median.
The One Silver Lining of Dream Office REIT
Dream Office REIT has a large ownership share (9.4%) of Dream Industrial REIT ( DIR.UN:CA ) (DREUF). By my calculations, Dream Office REIT’s share of DIR.UN represents $7.70 CAD per unit at current market prices as of April 19 th , 2023 (I adapted the figures at p. 25 of the 2022 Dream Office REIT annual report ). Given that D.UN trades at $13.58 CAD as of that same date, 56% of the purchase price of each D.UN unit is actually the per unit ownership of Dream Industrial REIT at market prices. Industrial real estate is not suffering from the same stresses that office real estate is at this time , and so the large ownership of Dream Industrial REIT does provide some buffer for owners of D.UN.
For adventurous investors looking for a possible entry point to buy, keep an eye on the Dream Industrial REIT units that D.UN owns. Should Dream Office REIT slump significantly and Dream Industrial REIT units rally higher, this could provide an entry point where the NAV of the DIR.UN units owned by D.UN comes close to, or maybe even surpasses the market unit price of Dream Office REIT, in which case that would provide a healthy margin of safety for investing in Dream Office REIT units.
A possible second silver lining is that Dream Office REIT also owns a 25% stake in Alate, which is a real estate technology venture capital firm. It is certainly possible that over the long-term Alate finds a hidden gem that realizes some nice profits down the road. However, in the near-term it is not likely to help alleviate Dream Office REIT’s debt concerns.
Bottom Line
Dream Office REIT is in a bit of a tough space at the moment. They face the challenge of rising interest rates, coupled with an office leasing market that is anything but secure at the moment. They ideally would be able to lower their debt load, in order to provide a stronger balance sheet and to help bolster the company should hard times hit, but they do not appear to have a simple way to accomplish that. Eventually office real estate could be in strong demand again, but it isn't likely for that to happen this year. If you are a believer in office, it might be worth it to hold this stock, but I certainly would not recommend buying it until we know more about the fallout in regards to the office real estate market. My best guess is that this stock will see some periodic price declines over the next year under the weight of its debt and the difficult leasing environment in the office real estate market. It certainly doesn't seem to provide a large enough margin of safety to warrant investment at present.
For further details see:
Dream Office REIT: High Debt Will Continue To Be A Problem