DBRS Confirms H&R Real Estate Investment Trust at BBB, Stable Trend

DBRS has today confirmed the rating of H&R Real Estate Investment Trust (H&R or the Trust) at BBB with a Stable trend. The rating confirmation reflects the fact that H&R continues to perform well with underlying support from its large and diversified commercial real estate portfolio, comprising over 38 million square feet of office space (accounting for 46% of net operating income (NOI), industrial 31% and retail at 23%). The portfolio mainly consists of single-tenant buildings with long-term leases (averaging 10.5 years) that are occupied by nationally recognized and high credit quality tenants. These features are highlighted by the portfolio’s consistently high occupancy rates (close to or above 99%) and very low cash flow volatility, which have provided good protection from the challenging capital and real estate market conditions over the past couple of years. In addition, DBRS believes these credit strengths place the Trust in a better position to withstand the challenges of its significant development project the Bow (or the Project) since it is generally not as exposed to the normal operating risks experienced by real estate entities rated similarly by DBRS.

The rating confirmation also reflects the Trust’s good progress in improving its financial flexibility and funding pressures associated with the Bow. As at Q1 2010, H&R had ample liquidity, totalling $256.1 million ($241.9 million available on its bank facility and $15.2 million of cash on hand and short-term bank deposits). In addition, H&R’s debt profile is well-staggered over the next five years, which limits its exposure to refinancing and interest rate risk. DBRS notes that H&R modestly extended its debt maturity profile with the issuance of senior unsecured debentures (due in 2015 and 2017) and the repayment of the Fairfax Financial Holdings subordinated unsecured debentures (due in 2014). DBRS also notes that H&R has adopted a plan to increase annual distributions from the current $0.72 per unit to $1.05 per unit (46% increase) in eight quarterly increases by the end of Q2 2012. Overall, DBRS estimates H&R’s payout ratio will still remain below 70%, which will ultimately reduce retained cash flow by $47 million per year. The Trust, however, is still expected to have an ample amount of liquidity to fund the remaining costs associated with the Bow. As at Q1 2010, H&R has incurred approximately $810.3 million of the Project’s $1.33 billion budget, excluding capitalized interest costs.

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 2011-2012, when interest from construction financing reaches its peak. While this is a fairly aggressive level for the current rating category, 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 online in the next few years. In addition, the Trust has effectively locked 84% 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.

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.