2023-06-28 08:27:38 ET
Summary
- We gave Inovalis REIT our first review in December 2022.
- We noted that the NAV estimates were optimistic and crystallization of that value was improbable in the short term.
- We review where the REIT stands after losing its largest tenant.
Note: All amounts are in Canadian dollars unless noted otherwise.
When we last wrote on Inovalis Real Estate Investment Trust ( INO.UN:CA ) we noted that the NAV estimates might be on the optimistic side and distribution coverage was likely to take a hit in the quarters ahead. We suggested that only the intrepid and patient take on the long side as it was unlikely to bear fruits quickly.
So if push comes to shove, they can walk away from properties where they fail to refinance or vacancy levels get too high to salvage value. They can also possibly force banks to renegotiate a lower loan amount. If that long drawn out battle sounds appealing to you in return for the potential upside, go for it. Keep in mind that even that estimated NAV is possibly optimistic.
Source: A Look At The Safety Of The 10% Yield
Inovalis like every other Canadian listed office REIT, has moved lower since then. The performance has been middling. It has underperformed Allied Properties REIT ( AP.UN:CA ) and the iShares S&P/TSX Capped REIT ETF ( XRE:CA ). But it has outperformed the distribution cutters in this time frame, True North Commercial REIT ( TNT.UN:CA ) and Slate Office REIT ( SOT.UN:CA )
Northwest Healthcare Properties REIT ( NWH.UN:CA ) also did worse even though it has higher quality medical office buildings and it has not (yet) cut its distribution. We look at how the tea leaves read for Inovalis as it navigates extremely challenging times for its properties.
Q1-2023
We will skip the Q4-2022 numbers and go straight to the latest quarterly results for Q1-2023. The rental revenue numbers were quite strong at $7.3 million and net rental income (as in after expenses) more than doubled.
The key impact was from acquisitions done at the end of Q1-2022 which boosted the year over year comparatives. There were also two other factors.
For the IP Portfolio, NOI for the three months ended March 31, 2023, increased significantly to CAD$3,962 (EUR€2,730) compared to CAD$1,873 (EUR€1,318) for the three months ended March 31, 2022 (“Q1 2022”). The increase in NOI came from the contribution of the new property acquisitions, Gaia and Delgado in the amount of CAD$1,237 (EUR€853) that were completed at the end of March 2022, as well as from the lease renewals in the Metropolitan property fully effective starting Q2 2022 for CAD$215 (EUR€148) and the disposition of Veronese property that were negatively weighting on Q1 2022 NOI for CAD$555 (EUR€383).
Source: Q1-2023 MD&A
The strong property level income propelled adjusted funds from operations (AFFO) to 14 cents a share.
The REIT is trading currently near the $3.00 mark so it is easy to start thinking that the numbers make it look really cheap.
Outlook
Unfortunately, nothing could be further from the truth. As it stood at the end of Q1-2023 Orange S.A. ( ORAN ) was about to vacate the largest occupied single space that Inovalis had ever rented.
That 30% of the revenue base is going to sting hard over the next 15 months. Inovalis is trying to sell this building near its IFRS value and a lot of the total return profile over the next 2 years will hinge on whether this can be completed at or near expected book values.
The lease with Orange, the sole tenant of the Arcueil property, matures in mid-2023 giving the REIT the opportunity to redevelop this 335,000 sq.ft. asset located 5 minutes from the Paris southern ring road. Management of the REIT are engaging with a developer to sell this property near its actual appraised value (EUR65.6 million) with a building permit application. This could lead to a disposition by mid-2024 with a reinvestment of the sale proceeds.
Source: Q1-2023 MD&A
That is the primary challenge. There are three secondary challenges. The first being that even if you remove Orange out of the equation, weighted average lease term is just 2.6 years. That is a low number to be chasing office properties. The second challenge is that as tenants move out, Inovalis is likely to have more property level mortgage defaults. This has been an ongoing saga in the last year and the Baldi Property is the one that is currently in default stage. As mentioned below, banks have still not forced the issue but we cannot imagine there are very pleasant outcomes in such scenarios.
As at March 31, 2023, further to ongoing redevelopment scenarios or arbitrages anticipated on the Baldi property, the Debt Service Coverage Ratio covenant criteria has not been met. This arises because the REIT cannot simultaneously maintain minimum occupancy requirements of the covenants and vacate the building to fulfill redevelopment plans. Consequently, the Baldi mortgage loan has been classified as a CAD$5,906 current liability on the balance sheet . Throughout the periods in which the occupancy covenant has been breached, the REIT has been in communication with the lenders to refinance the loans and mitigate the breached covenants. Through correspondence with the lenders, there has been no evidence that would indicate that either of the lenders intend to call the principal on the loans, despite the breach of covenants.
Source: Q1-2023 MD&A
The final additional challenge is that weighted average loan/mortgage maturity is extremely low.
As we run through refinancings at likely double the current interest rates, the impact to AFFO will be substantial. So AFFO is likely to decline over the next 4 quarters and the REIT will have trouble generating value for its investors. As always your call comes down to whether or not you believe in the NAV (same as tangible book value per share under IFRS) and whether management can extract that for shareholders.
We think it will be a challenge and don't think upside will be material even if management gets everything right. On the flip side, it is also hard to envision big losses from here if management can sell a few properties at attractive prices. Inovalis gets a 6 on our potential pain scale rating.
Those looking for office exposure should consider H&R REIT ( OTCPK:HRUFF ), ( HR.UN:CA ) as it has the best non-office portfolio to support value extraction from the office side.
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.
For further details see:
Inovalis: Orange You Glad You Stayed Away?