Note: All amounts discussed are in Canadian dollars.
In investing, buying into the bull case is straightforward. In any case, there are all the time lots of slides that encourage you to accomplish that. Analysts by default, lean bullish. For those who take a look at most comments on articles, they’re also there in support of the corporate. But when all the pieces doesn’t line up, it’s okay to stay out. We did the identical within the case of Artis REIT (TSX:AX.UN:CA) on our last couple of articles, despite some extremely deep value surfacing.
This was our logic in February of this yr.
The corporate will still have challenges because the weighted average debt maturity even after this recent extension is about 2 years. Rents remain strong for now but we predict a recession will test the corporate’s mettle. Debt to EBITDA was still over 9.0X and we just cannot pull the trigger.
Source: 6.4% Yield With A 50% Discount To NAV
And here’s what we said in July.
The consensus NAV is closer to $13 with one brave soul pondering this is definitely price $16.80. We predict there’s likely more pain ahead as Artis tries to handle the ultra-short debt maturity schedule. We’re staying out.
Source: Now 8.5% Yield And 60% Discount To NAV
The REIT didn’t make us regret our stance.
Data by YCharts
Well in defense of the REIT, absolutely no company on this sector has made anyone regret staying out in 2023. But the corporate did throw in a latest wrinkle in the graceful investing case.
Artis also announced that its Board of Trustees (the “Board”) has established a Special Committee to initiate a strategic review process to think about and evaluate strategic alternatives which may be available to the REIT to unlock and maximize value for unitholders.
Source: Artis Press Release
For those who got Deja vu from that, you will not be alone. We had a special committee formed to explore strategic alternatives in May 2019. Well, still, let’s take a look at the Q2-2023 results and see if we are able to delineate a price creation pathway.
Q2-2023 results were quite strong from a net operating income (NOI) perspective, with same property NOI up almost 7%.
For those who wanted to present certainly one of the three segments credit, you probably did not must parse through very hard. Industrial was the clear leader with the US side showing same property NOI growth of 18%. Office was not too shabby with an overall increase of 8%. What drove this strong increase in NOI?
It wasn’t the occupancy levels, though it was nice to see committed occupancy tick up a bit, even within the office sector.
It was the rent increases and the foreign exchange.
Renewals that commenced within the quarter were renewed at a weighted-average increase of 4.6% – the tenth consecutive quarter of growth in renewal rents and a transparent reflection of the strong demand for high-quality, well-located space across all three asset classes.
Source: Artis Press Release
The weaker Canadian dollar added lots of extra oomph to the outcomes. This is analogous to what we saw for H&R REIT (OTCPK:HRUFF), (HR.UN:CA).
In order that was a powerful start, however it gets so much stranger after that if you have got not been following the corporate. Total funds from operations (FFO) were down 33%. FFO payout ratio bumped as much as 57.7%.
Normally, you’ll expect NOI gains to be amplified in the identical direction if you reach the FFO. Obviously, here we went in the opposite direction. Adjusted FFO (AFFO) was even worse with a forty five% drop and the payout ratio ballooned to 100%. What happened? Well, we’ve been harping about Artis having risked all the pieces by going for a particularly short debt maturity profile. It seems we were right. Interest expenses are going vertical.
Artis did unlock lots of liquidity with 13 property sales throughout the quarter.
None of those sales were within the office sector though.
Despite some aggressive paydowns and extensions, the debt maturity profile still looks incredibly short.
The nice part is that the rate of interest damage has now been fully felt. The asset sales are also helping and targeting the very best cost debt (after attached mortgages) where feasible.
The bull case rests on the NAV of $16.28.
The bear counter is that the cap rates on office remain unrealistic.
Even the large asset sales within the last quarter completely dodged the office sector. So Artis was not in a position to unload a single property, or perhaps selected to not. Regardless of the logic, the final result is that this increases the relative weighting of the REIT’s square footage dedicated to office and that in turn likely makes the market discount the NAV even further. But allow us to run some math here to see what the NAV could be.
On a distressed level, we could see a worst case of around a ten% cap rate on office. This is incredibly unlikely but allow us to run with that. So in case you blow out the cap rate that far, your $1.8 billion gross book value becomes $1.3 billion. Your total gross book value drops to $3.5 billion. In some individual cases, the drop in values can be buffered by the property level debt. Artis can just hand the keys back to the lender. But allow us to ignore that and keep on with the numbers above.
That drop from $4.0 billion to $3.5 billion doesn’t look so scary, but do not forget that the debt and preferred equity remain fixed, so common equity takes an even bigger hit. Total debt is $1.8 billion and preferred equity is near $200 million. So common equity valuation drops to $1.5 billion (with the ten% office cap rate) and that gets you to a NAV of about $13.30 (with about 113 million units outstanding). It is difficult to argue with those numbers, especially as Artis has shown the power to unload industrial and retail properties at or above IFRS values. This all suggests that there could be some value here for the investor able to go in with a long term outlook. Artis is taking a look at alternatives here but there really is none outside of selling some office properties at good values to point out that the market is mistaken.
An important defensive solution to play this may be the recently reset Artis Preferreds. The Series E (TSX:AX.PR.E:CA) were just reset at 7.198% every year. The reset is effective from October 1, 2023. That was based on a Government of Canada 5-year bond yield of three.898% on the time plus 3.3%. At the present price of $17.00, these yield 10.58%. We predict the NAV has loads of buffer for these they usually could be the safest way that you would be able to wade into these waters.
Please note that this just isn’t financial advice. It might seem to be it, sound prefer it, but surprisingly, it just isn’t. Investors are expected to do their very own due diligence and seek the advice of with knowledgeable who knows their objectives and constraints.
Editor’s Note: This text discusses a number of securities that don’t trade on a serious U.S. exchange. Please concentrate on the risks related to these stocks.