DBRS Confirms Exchange Tower Limited at A (low)

DBRS has today confirmed the rating of the 6.38% Series A First Mortgage Bonds, due 2012 of Exchange Tower Limited (Exchange Tower) at A (low) with a Stable trend. Exchange Tower issued the Bonds, but recourse is to the current owners’ interest in the Exchange Tower office complex: Exchange Tower Limited at 50%, HRI Exchange Inc. at 25% and PFS Exchange Inc. at 25% (collectively, the Owners).

Exchange Tower’s credit profile continues to benefit from strengthening office markets in downtown Toronto. Net operating income (NOI) grew by 11% in 2007, driven by a combination of lower vacancy and higher net rental rates from leasing activity in recent years. Interest coverage improved to 2.81 times from 2.48 times, while debt service coverage grew to 2.09 times from 1.89 times. These metrics are solid in the context of the current rating and Exchange Tower’s rating could improve looking forward if coverage ratios continue an upward trend and office fundamentals remain healthy. The main challenge to a rating upgrade is the impact of new office supply on market conditions over the next couple of years (discussed below) as well as the potential negative impact from an economic slowdown. For example, the current turmoil in credit markets could have a negative impact on demand for office space within the financial services sector.

The vacancy rate of the Exchange Tower office complex (the Project) declined to only 3.2% from 4.9% at the end of 2006, while in-place average office rental rates increased by 2%. The average increase in net rental rates for office space for new leases and renewals in 2007 was 14% more than the average in-place rent at the end of 2006. Although office leasing activity overall was modest at just less than 70,000 square feet (7% of office space), the higher net rents are expected to continue to result in growing NOI in 2008.
The Project’s vacancy rate remains below the overall vacancy level in Toronto’s downtown core office market, illustrating the strength of the property. Toronto’s office market showed further improvement over the past year, with core vacancy rates declining by 240 basis points to 3.9% currently from 6.3% at the end of Q1 2007, while the financial-core Class A vacancy rate improved to 3.9% from 5.7%. The stronger market and lack of any material new space drove asking net rental rates up by another 5% to 6% (to $27 to $29 per square feet), after an increase of 5% to 7% in 2006.

Looking forward, DBRS expects NOI growth to continue but to be somewhat more moderate in 2008, closer to 5% to 6%, driven by higher net rents from recent lease renewals as well as modest built-in rent steps on existing leases. Operating costs grew by 4.9% in 2007, which is higher than recent years but remains manageable given the high occupancy levels and results in most costs being recoverable.

The Project’s relatively long-term lease profile is expected to support stability in cash flows, given modest lease maturities averaging only 5.7% for the next four years, below the market average for office space. Re-leasing risk over the next two years is low, with only 6.9% of space expiring in 2008 and 1.8% in 2009. This to some extent limits the upside from higher rental rates but provides stability.

Over the longer term, DBRS expects that new supply could dampen downtown Toronto office fundamentals given the six projects that are underway in downtown Toronto, which will add 4.15 million square feet, most of which will be completed in the second half of 2009 (resulting in a a 6% increase in downtown space and 13% increase in financial-core Class A space). Although almost 60% of the new space is pre-leased, many tenants plan to move from existing properties. Recently, the lack of new space has driven vacancies to historic low levels in Toronto and the new space is expected to result in vacancies rising to closer to 7% or 8%, which is reasonable. However, the impact will depend on market conditions over the next couple of years, including the potential negative impact of an economic slowdown.

The Project’s location should allow it to continue to attract quality tenants and maintain solid occupancy levels. In 2008 and 2009, capital spending is expected to average $1.6 million to maintain and improve the building such as improvements to the common area appearance and elevator upgrades.

Note:
All figures are in Canadian dollars unless otherwise noted.