DBRS Confirms H&R REIT at BBB

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.

H&R’s rating continues to be supported by underlying stable cash flows from its large-scale, diversified, real estate portfolio which benefits from long-average lease maturities averaging 12.1 years (the highest among its peers) closely matched with long term financing (averaging 10.2 years). H&R has maintained stable credit metrics with EBITDA interest coverage remaining at 2.1 times and debt-to-gross book value at 61%. Interest coverage improved to 2.2 times from 2.1 times excluding capitalized interest, mostly related to The Bow development in Calgary.

H&R’s risk profile has increased somewhat given uncertainty relating to its major development project, namely, The Bow, a two million square foot office complex in downtown Calgary. The cost of the project has risen to $1.4 billion (from $1.1 billion last year partly due to an increase in size from 1.84 million square feet) while construction costs have not been fixed, and specific construction financing has not been secured. H&R is currently financing ongoing construction through bank facilities and dispositions of non-core assets. At this point, DBRS views the risks as acceptable within the current rating given that there are several mitigating factors against the usual risks of such a significant development.

First, H&R has renegotiated the lease terms to compensate for the higher anticipated construction costs and H&R has recently entered into fixed cost supply contracts for a portion of the total costs (H&R is expected to provide an update in Q2 2008). The budgeted cost also includes a reasonable amount for cost over-runs which could potentially benefit H&R. As well, H&R has indicated that it is willing to consider the option of a significant equity partner to raise capital and potentially reduce H&R’s exposure to overall higher financial leverage.

Another mitigating factor is the fact that The Bow is 100% pre-leased to Encana Corporation (rated A (low) by DBRS) for 25 years, which significantly reduces exposure to real estate market risk in Calgary, including any potential downturn in the energy sector and the risk of competing new supply coming on line in the next few years. The Bow is expected to generate stable cash flows beginning in 2011 under a triple-net lease with Encana, which escalates by 1.5% annually.

DBRS notes that The Bow is expected to pressure coverage ratios during the construction phase. Based upon DBRS’s preliminary assumptions, the project is expected to result in a decline in EBITDA interest-coverage ratios to 1.7 to 1.8 times by late 2009 and into 2010. Excluding capitalized interest costs, interest coverage is expected to remain at 2.0 times, a level that is acceptable given H&R’s stable cash flow from its long-term lease profile. H&R’s overall leverage is likely to increase to 64% to 66% of gross book value, which is permitted under its Trust Indenture since it now excludes The Bow from its 65% debt to gross book value calculation (although debt related to the Bow does have recourse to H&R).

H&R has slowed its acquisition growth over the past year as valuations remained high and the turmoil in credit markets has reduced available financing. As well, H&R has increased focus on developments by investing $309 million mostly on The Bow and beginning Phase III of the Bell Mobility office complex in Mississauga, Ontario. In 2007, acquisitions totaled $261 million for 16 properties at an estimated average capitalization rate of 7.3%. The largest acquisition was $215 million for 12 refrigerated distribution facilities comprising 1.7 million square feet from Eimskip Atlas Canada Inc.

The rating also reflects the following: (1) Lease maturities are well spread out over the next five years averaging only 2.2% annually, the lowest for DBRS-rated REITs; (2) H&R has maintained consistently high occupancy rates of 99% or higher across its portfolio for the past five years. This, combined with minimal lease maturities, should contribute to stable cash flows looking forward. In terms of challenges, the Trust generates 46% of net operating income (NOI) from office assets, which have experienced weakness in net rental rates within certain parts of the Greater Toronto Area.

Notes:
All figures are in Canadian dollars unless otherwise noted.
For the definition of Issuer Rating, please refer to Rating Definitions under Rating Policy on www.dbrs.com.

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