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’s (H&R or the Trust) Senior Unsecured Debentures at BBB with a Stable trend. The rating confirmation takes into consideration significant portfolio growth while improving asset quality, stable operating metrics and an expectation for coverage ratios to recover to levels more in-line with the current rating category in the near term. H&R’s BBB rating is supported by the following strengths: (1) long-term lease profile with an average term of 11 years, (2) large diversified portfolio with high-quality tenants and (3) very strong portfolio occupancy levels. The rating also takes into consideration the following challenges: (1) low coverage ratio for the rating category, (2) limited internal growth opportunities and (3) portfolio concentration in Alberta and Ontario.

Over the past year, H&R has achieved significant portfolio and cash flow growth driven mainly by the acquisition of four major office properties, including Hess Tower, Gotham Tower and Atrium on Bay in 2011 and Corus Quay in Q1 2012. These acquisitions had an aggregate purchase price of approximately $1.38 billion with capitalization rates ranging from 5.85% to 6.60%, and are expected to contribute $87.8 million of annual net operating income (NOI). In addition, DBRS believes these assets are of high quality with a majority of them having high credit-quality tenants under long-term leases, which should support cash flow stability going forward. Despite increased portfolio size and scale and corresponding growth in cash flow, same-property NOI growth (excluding straight-line rent) was slightly negative compared with the previous year, as both H&R’s Canadian and U.S. portfolio experienced lower income during the period. At the same time, occupancy levels for H&R’s portfolio continue to remain very strong at 99.1%.

H&R’s significant investment activity, mainly the aforementioned property acquisitions and capital expenditures associated with the Bow (a two million sq. ft. 58-storey Class AA office tower located in downtown Calgary, Alberta), were funded with a higher proportion of debt than equity. As a result, debt levels have increased to 51.5% (debt-to-fair value assets) as at Q1 2012 from 47.6% for the comparable period 2011. EBITDA interest coverage (including capitalized interest) continued to remain at a level (1.75 times for the 12-month period ended March 31, 2012) outside of the current rating’s parameters. DBRS, however, factored into the current rating the decline of H&R’s EBITDA interest coverage during the construction phase of the Bow with the expectation of a recovery when Encana takes full occupancy, expected in late 2012/early 2013.

The stable rating outlook takes into consideration DBRS’s expectation that operating income will continue to increase into 2013, mainly due to full-year cash flow contributions from recent property acquisition and the Bow, which is expected to generate approximately $93.5 million of annual NOI. In addition, subsquent to Q1 2012, H&R acquired a one-third interest in Scotia Plaza located in the downtown Toronto financial district for approximately $421.6 million representing a going-in capitalization rate of 5.2%. DBRS estimates Scotia Plaza to contribute $22.2 million (H&R’s interest) of annual NOI. As a result, DBRS estimates EBITDA to increase significantly above $600 million on annual basis.

From a financial profile perspective, H&R partially funded the purchase of Scotia Plaza with the issunace of $216.5 million (H&R’s share) of first mortgage bonds (see DBRS report SP Limited Partnership and SP1 Limited Partnership (Scotia Plaza), dated June 15, 2012). In addition, H&R issued $175 million of Senior Unsecured Debentures and two series of first mortgage bonds secured by the Bow aggregating $500 million (see DBRS report Centre Street Trust, First Mortgage Bonds, dated June 14, 2012). H&R used part of the proceeds from the first mortgage bonds secured by the Bow to repay bank indebtedness and to finance the remaining portion of the Trust’s one-third interest in Scotia Plaza. Although DBRS estimates that recent debt financing activity has increased H&R’s debt levels to 54.1% (debt-to-fair value assets), DBRS expects the Trust’s total debt-to-fair value assets ratio to decline to 53.9% with the potential conversion into equity of the Trust’s outstanding 6.65% convertible debentures maturing June 30, 2013, and 6.75% Series B convertible debentures. In addition, DBRS estimates H&R’s EBITDA interest coverage (including capitalized interest) to increase to 2.20 times in 2013 mainly due to cash flow from the Bow, recent acquisitions and interest expense savings on convertible debenture conversions into equity. Overall, DBRS believes this level of EBITDA interest coverage is more in-line with the current rating category.

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

The applicable methodology is Rating Real Estate Entities (April 2011), which can be found on our website under Methodologies.