DBRS Confirms H&R Real Estate Investment Trust at BBB with a Stable Trend and Removes It from Under Review with Negative Implications

DBRS has today confirmed the Issuer Rating of H&R Real Estate Investment Trust (H&R or the Trust) at BBB with a Stable trend and has removed the rating from Under Review with Negative Implications, where it was placed on November 18, 2008. The rating confirmation reflects the fact that H&R has secured the following financing arrangements with respect to the Trust’s operations, including its significant development project, the Bow (or the Project), a two-million-square-foot, Class AAA office tower located in downtown Calgary:

(1) H&R has secured a $425 million construction facility for the Bow. This floating-rate facility has been swapped to a fixed interest rate at an effective rate of 6.90%, which is reasonable for the current credit environment.

(2) Fairfax Financial Holdings Limited and/or its affiliates (collectively, Fairfax) purchased $200 million of debentures from H&R on a private placement basis, with 28.6 million of warrants at $7 per stapled unit strike price.

(3) As part of these financing arrangements, H&R reduced the level of its annual distribution from $1.44 per stapled unit to $0.72 per stapled unit, which has resulted in a lower payout ratio. Cash retained from the lower distribution is more than $100 million per year.

(4) H&R secured an $85 million 6.5% five-year mortgage on its Bell Phase III office complex and $150 million in subordinated unsecured convertible debentures.

DBRS believes that these financings have resolved our previous funding concerns of the Bow (approximately $911 million over the next few years) and has enhanced the Trust’s financial flexibility position, which is more consistent with the BBB rating category. As a result, DBRS has removed the Under Review with Negative Implications status. DBRS estimates H&R’s pro forma debt level will increase momentarily to approximately 57.9% then decline modestly during the construction phase of the Bow. DBRS expects approximately $100 million per year in principal repayments, the Fairfax warrants, free cash flow, potential proceeds from the Trust’s recently announced At-The-Market (ATM) equity financing program, modest asset sales and the collection of mortgage receivables will assist in this de-leveraging process.

Nevertheless, DBRS acknowledges the risks in undertaking such a significant development project (accounting for more than 28% of current gross book value of assets) and the concentration risks associated with the Project, including potentially greater property and tenant exposure. Furthermore, the Bow is expected to pressure the Trust’s coverage ratios with increasing capitalized interest costs during the construction phase (i.e., when the Bow is not generating cash flow). DBRS estimates that the Project is expected to result in a decline in EBITDA-to-interest coverage ratios, including capitalized interest, to a low point in the 1.50 times to 1.60 times range in year 2011–2012, when interest from construction financing reaches its peak. While this is a fairly aggressive level for the current rating category, DBRS believes H&R has addressed a majority of the risks related to the Bow, particularly our previous financing and liquidity concerns as outlined above, and has enhanced its financial flexibility.

DBRS notes that there are several factors mitigating the usual risks of such a significant development. The Bow is fully pre-leased to EnCana Corporation (EnCana; rated A (low) by DBRS) under a 25-year triple-net lease, which significantly reduces the Trust’s exposure to real estate market risk in Calgary, including the current downturn in the energy sector and the risk of competing new supply coming on line in the next few years. In addition, the Trust has effectively locked 80% of the budgeted hard costs (before contingencies) associated with the Bow.

The Bow is expected to generate stable cash flows starting in 2011–2012, with rental rates increasing by 0.75% for office space and 1.5% for parking annually. DBRS expects cash flow contributions of approximately $94.3 million from EnCana during the first year of tenancy. As a result, DBRS expects coverage ratios to improve closer to 2.00 times when the Bow is completed and EnCana takes full occupancy in 2012. At that time, management may consider selling a partial interest in the Bow (if it hasn’t already done so) or obtaining long-term financing on the Project. DBRS notes that proceeds from a partial sale could be used to repay the construction facility, which would result in the Bow being free and clear of any debt.

DBRS also takes comfort in the fact that H&R’s portfolio exhibits very low cash flow volatility, which is supported by the following credit strengths:

(1) H&R’s large and diversified commercial real estate portfolio focuses on single-tenant buildings that have long-term leases (averaging 11.3 years), which provides underlying stability to cash flow and good protection from changes in market conditions.

(2) H&R has an above-average tenant base, with nationally recognized and high credit quality tenants.

(3) H&R’s debt profile is well staggered over the next five years, which limits its exposure to refinancing and interest rate risk. In addition, DBRS notes that 51.8% of H&R’s total debt is non-recourse debt.

Going forward, DBRS believes these credit strengths place the Trust in a better position to withstand the challenges of this significant development project since it is generally not as exposed to the normal operating risks experienced by real estate entities rated similarly by DBRS.

The overall credit risk profile of H&R is expected to remain consistent with the current rating category if it can remain within these parameters over the next few years. DBRS expects overall EBITDA and operating cash flow to remain relatively stable during the construction phase of the Bow despite the challenging broader economic conditions. A deeper or longer-than-expected economic downturn that affects H&R’s tenant base, more aggressive financial management and any delays to the construction of the Bow that deteriorate credit metrics beyond our expectations could result in negative pressure on the Trust’s credit rating.

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

The applicable methodology is Rating Real Estate, which can be found on our website under Methodologies.

This is a Corporate rating.