Canada averted a full-blown recession, but many small- and mid-cap stocks felt the heat of rising interest rates. Renewable energy and real estate sectors were the most affected by this rate hike. Canada’s housing prices slumped after ballooning for over a decade.
Canada’s real estate sector
There was an influx of real estate investment trusts (REITs) in Canada in 2011 when a law ended the tax privileges of other income trusts but retained them for REITs. As per the law, REITs pay distributions before they pay tax. That explains the high distribution yield of Canadian REITs.
True North Commercial REIT (TSX:TNT.UN) is a commercial property REIT that rents office space to several government offices and large and small corporations. It has been buying and selling office buildings with high occupancy potential. The REIT started trading on the exchange in 2013. Between 2013 and 2022, interest rates have been below 4%.
Hence, the REIT had difficulty coping with the Bank of Canada’s aggressive interest rate hike from 0.25% in March 2022 to 5% in July 2023. The rising interest rate even reduced business activity. Many companies reduced their office space or shifted to work from home to cut costs. It significantly affected the occupancy rate of commercial REITs like True North and Slate Office.
From here began the struggle to stay afloat.
Why I wouldn’t touch this stock with a 10-foot pole?
On one side, interest expense was rising, and on the other side, rental income was falling for commercial property REITs. In the 2023 mortgage renewal, REITs took a hit. To cope with increasing mortgage payments, True North Commercial REIT took several steps between April and December 2023, which reduced its stock price by 80%.
- True North Commercial REIT halved its distribution and discontinued its dividend-reinvestment plan in April 2023.
- The REIT sold three properties and used the proceeds to buy back 208,400 units.
- It consolidated its units in a 5.75:1 ratio, which reduced its unit count from 92,020,251 to 16,003,513 in November 2023.
- It even paused its distribution payment to unitholders for the next six months starting November 2023. The REIT will use that money to buy back as many units as possible. With fewer units, it will have to shell out a lesser amount on distributions.
While all the above restructuring efforts are in the right direction, its debt is a cause of concern that makes me stay away from this stock.
True North Commercial REIT has been refinancing its mortgage at a higher interest rate in the range of 5.65-6.62% for a term of three to seven years. As of September 30, 2023, 61.4% of its gross book value is indebted. Its weighted average fixed interest rate has increased to 4.03% from 3.54% a year ago.
Does the cigar butt theory hold true for True North Commercial REIT?
Value investor Warren Buffett coined the term cigar butt investing, in which you buy shares of a struggling company at a low price and sell them when the share price jumps. But this strategy only works when the company has more value to give.
Canada’s falling property prices and True North Commercial’s high debt are unlikely to add much value to shareholders. Debt holders will get a preference over unitholders. Moreover, no secular trends are in sight that could turn around the REIT’s fundamentals.
Consider this stock
If you are looking for value opportunities in the Canadian real estate sector, you could consider investing in RioCan REIT (TSX:REI.UN). It has a healthy balance sheet and a significant portion of assets in the Greater Toronto Area. It enjoys a 97.5% occupancy rate, with no single tenant accounting for more than 5% of rental income. Like all REITs, RioCan REIT’s stock price fell 26% throughout the central bank’s rate-hike cycle, creating an opportunity to buy the dip and lock in a 5.7% yield.
