DBRS Confirms H&R REIT at STA-3 (high)

DBRS has today confirmed the Income Fund rating of H&R Real Estate Investment Trust (H&R or the Trust) at STA-3 (high).

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).

In 2007, H&R’s payout ratio improved to approximately 89% of cash available for distribution, despite a 2.7% increase in cash distributions to $1.37, due to a reduction in leasing and maintenance capex which had been higher than normal in recent years to upgrade multi-tenant office space. In 2008, H&R’s payout ratio could increase to closer to 95% given another 5.1% increase in cash distributions to $1.44 and slower overall growth in cash flow. DBRS views this as manageable given the overall stability of H&R’s cash flows from long average lease terms and minimal lease maturities in 2008 of only 1.5%. As well, H&R has about 25% participation in the distribution reinvestment plan (DRIP) which reduces the actual cash payout ratio.

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 higher financial leverage to fund construction.

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.

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 close to 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 65% 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).

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 over 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.

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

The full report providing additional analytical detail is available by clicking on the link under Related Research at the right of the screen or by contacting us at info@dbrs.com.

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