Does a Credit-Rating Downgrade Spell Doom for Cominar REIT?

Should the recent credit-rating downgrade of Cominar REIT’s (TSX:CUF.UN) senior unsecured debentures by the DBRS scare current investors?

A major credit-rating agency, DBRS Limited, downgraded Cominar REIT’s (TSX:CUF.UN) senior unsecured debentures credit rating from investment grade BBB (low) to a speculative rating, BB (high), on August 4, 2017. The REIT’s units responded by falling 4.69% during the day’s market trading hours.

It was a bad Friday for Cominar REIT investors, who were still digesting the news of a 22.45% monthly distribution cut from $0.1225 to $0.095 on August 3.

DBRS’s BB rating category is for speculative, non-investment grade credit quality issues from borrowers whose capacity for the repayment of financial obligations is uncertain. DBRS believes that Cominar REIT’s unsecured debenture-repayments capacity is now more vulnerable to future events.

The graduation to BB from BBB is not that much of a surprise, as it has been a way time coming, and we once discussed the issue recently here.

I was hoping DBRS would spare Cominar from a downgrade, as the REIT had taken some significant steps towards satisfying the required parameters for maintaining an investment grade rating by reducing the total debt ratio below 53% of assets by March 31, 2017.

Now that the downgrade has happened, what could be the worst-case scenario for Cominar REIT?

Increasing cost of debt

It is almost a given that Cominar REIT will face an increased difficulty in sourcing cheaper, unsecured debt financing in the capital markets as a result of the non-investment grade rating of its senior unsecured debenture offering.

The problem with assigned credit ratings is that they do not give precise numerical probabilities of default — a measure much more critical in assessing default potential.

Lenders will classify Cominar’s debt offerings in the same class as other “junk” issues just by applying the new rating and demand higher interest premiums due to the high perceived credit risk profile.

That said, Cominar’s probability of defaulting on its unsecured debentures has indeed been viewed as being higher by DBRS, and capital markets will require a higher default risk premium when lending to the organization.

Higher interest repayments would slow down the rate at which the REIT internally accumulates free cash flow for future developments, thereby hurting future growth.

Declining equity value

Cominar’s equity units’ valuation will be negatively impacted.

Most investors usually value REITs, real estate companies, and dividend-paying stocks using cash flow discount methods. The applied discount rates are significantly influenced by the REIT’s risk profile, and a credit-rating downgrade increases required return premiums.

Higher equity discount rates, a lower growth rate, and potentially reduced free cash flows will hurt the market value of Cominar’s equity units.

They have already taken a plunge.

Worst case

Increasing refinancing costs may not be severely felt in a generally low interest environment or during economic boom times, but serious problems may crop up when general interest rates increase or when the general economy enters a recession.

In a recession, the interest rate spreads widen between investment grade and speculative grade debt offerings, and Cominar’s income statement may be seriously hurt.

Cominar may be forced to refinance only through mortgages, limiting the amount of debt the REIT may be able to raise in financing future projects, thus limiting the rate at which the REIT will develop new properties.

The REIT may find it more feasible to cut the distribution further down from the $0.095 monthly payout to improve cash flow.

Investor takeaway

A credit-rating downgrade is not really the end of the road for Cominar REIT.

It should be noted that the REIT has no maturing debentures prior to June 2019, and Cominar has just $1.725 billion in outstanding debentures and an unencumbered property portfolio worth more than $3.6 billion. The REIT will simply switch to mortgage financing for the next six years as it has already advised.

It’s highly likely that the REIT’s credit rating will have improved by the time the last debentures mature in 2023, so investors may need not worry about the worst-case scenario.

On the contrary; it may be rewarding to capture the current 9.19% implied annual payout yield at the current heavily discounted unit price of $12.41, especially considering the REIT’s aggressive leasing program to improve occupancy levels and its new strategic developments in Quebec.

Happy investing.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Brian Paradza has no position in any stocks mentioned.

More on Investing


These 2 Stocks Carry a Lot of Risk, But Their Upside Is Huge

These two stocks have some significant risks, but they trade so cheaply that they offer unbelievable capital gains potential.

Read more »

Payday ringed on a calendar
Dividend Stocks

Boost Your Monthly Dividend Income With This TSX Gem

A high-yield TSX gem in the real estate sector can boost your monthly dividend income.

Read more »

Bank sign on traditional europe building facade
Bank Stocks

Bank Stocks Look Like a Steal: Here’s My Favourite for October 2023

TD Bank (TSX:TD) stock looks dirt cheap, as it continues to fluctuate in this rocky economic environment.

Read more »

little girl in pilot costume playing and dreaming of flying over the sky

Better Buy: Air Canada Stock or WestJet Airlines?

With the airline industry yet to recover fully from the pandemic, is Air Canada one of the top stocks to…

Read more »

oil and gas pipeline
Dividend Stocks

Is Enbridge Stock a Buy for its 7.6% Dividend Yield?

Enbridge stock is a TSX giant that offers investors a tasty dividend yield of 7.6%. Is this high-dividend stock a…

Read more »

Early retirement handwritten in a note
Dividend Stocks

Retire Early With These 3 Canadian Passive-Income Stocks

Three Canadian passive-income stocks are smart choices for people with early retirement goals.

Read more »

Businessperson's Hand Putting Coin In Piggybank
Energy Stocks

This 7 Percent Dividend Stock is My Top Pick for Immediate Income

Looking for a solid dividend stock that can provide an immediate income source? Consider this dividend gem now while its…

Read more »

man sitting in front of 3 screens programming
Tech Stocks

Shopify Stock or Microsoft Shares: Better Buy for the AI Revolution?

Shopify (TSX:SHOP) and Microsoft (NASDAQ:MSFT) are two of the most impressive growth stocks to watch, as tech slips further from…

Read more »