H&R Real Estate Investment Trust (TSX:HR.UN) is trading at $18.70 per unit, 4% higher than its 52-week low and 22% below its 52-week high. Does that mean there’s more upside to the diversified real estate investment trust (REIT) than downside?
Why H&R REIT’s price refuses to go up
Since the start of 2015 H&R REIT’s unit price has been in a downtrend. That’s thanks (or rather, no thanks) to its exposure to Alberta. About 28% of the REIT’s adjusted same-asset property operating income comes from Alberta.
H&R REIT earns 49.6% of its rental income from its top 15 tenants. Four are from the energy industry, and they generate 20.9% of the REIT’s rental income.
Encana Corporation (TSX:ECA)(NYSE:ECA) is H&R REIT’s top tenant, and it generates 12.6% of its adjusted same-asset property operating income and 11.3% of the its rental income.
Encana experienced its fourth consecutive quarterly loss and is cutting its workforce by 20%, slashing its dividend by 79%, and reducing its capital spending by about 55% year over year.
Including this workforce reduction, since 2013 Encana has cut its workforce by 50%, and its dividend has been slashed almost 93% from an annual payout of $0.80 per share to $0.06 per share. These actions are expected to add $50 million of cash flow to the company’s pot this year.
Additionally, as of February 19 Encana has hedged close to 75% of expected 2016 oil, condensate and natural gas production.
All of these actions should help Encana navigate the challenging environment. Encana rallied 23% on the news.
Since Encana has 22 years of remaining lease terms with H&R REIT, any good news for Encana’s business is good news for H&R REIT.
Is H&R REIT’s 7.2% yield safe?
On December 31, 2015 H&R REIT’s occupancy was 95.9%, 1.8% lower than a year before. Interestingly, the decrease was mainly due to Target Corporation disclaiming its leases.
Since the REIT maintains a high occupancy, has remaining lease terms of about 9.5 years, and has an adjusted funds-from-operations payout ratio of about 85%, its rental income should remain pretty stable, and its yield of 7.2% is sustainable.
However, investors should be aware that even when distributions are sustainable, the board can still choose to cut them for other reasons.
Conclusion: Is there more upside than downside?
Since H&R REIT has sizeable rental income from Alberta, there’s a higher risk of vacancy if commodity prices remain low. However, at least a part of that risk is priced into the stock, seeing that its unit price has declined since the start of 2015. When commodity prices improve, so will H&R’s price.
Based on its normal multiple, H&R could trade at least at the $22.50 level, implying there’s some margin of safety, and there’s potential upside of 20%. In the meantime, unitholders can collect a 7.2% yield.