What is your opinion of Allied Properties Real Estate Investment Trust AP-UN-T? The units are yielding about 10 per cent, and I am wondering if this is sustainable or if it is a trap.
When a yield climbs toward double digits, it’s usually a sign the business is facing substantial challenges.
In Allied Properties’ case, investors are right to be cautious.
As an owner of primarily low-rise urban office properties that cater to technology, financial, creative and other businesses, Allied has taken a direct hit from the work-from-home trend. The REIT’s in-place occupancy was 85.8 per cent in the second quarter, down from 94.5 per cent in the first quarter of 2020, before the COVID-19 pandemic upended the office REIT sector.
As its occupancy was falling, Allied’s borrowing costs were rising as central banks hiked interest rates aggressively in an effort to tamp down inflation.
The one-two combo of falling occupancy and surging interest rates has taken a heavy toll on Allied’s unit price. In February, 2020, three weeks before the pandemic was declared, Allied hit a record high of $60.14. On Friday afternoon, the units were trading around $18.50 – a drop of 69 per cent – and the yield had climbed to 9.7 per cent.
Even after that substantial decline in the unit price, analysts are still advising caution.
“Given a challenged outlook for office fundamentals, a restrained growth profile, some wood to chop on deleveraging, and an elevated payout ratio, we believe the units will remain range-bound until signs of a sustained recovery begin to surface,” Pammi Bir, an analyst with RBC Dominion Securities, said in a note in August after the release of Allied’s second-quarter results.
Mr. Bir, who cut his rating on Allied to “sector perform” from “outperform,” estimates the REIT’s payout ratio at 94 per cent for both 2024 and 2025, calculated as Allied’s annualized distribution of $1.80 per unit divided by estimated adjusted funds from operations (AFFO) of $1.91 per unit for both years. For 2026, he sees the payout ratio falling to about 88 per cent as Allied’s AFFO – a real estate cash flow measure – rises to an estimated $2.03 per unit.
Allied’s balance sheet is another concern. In the second quarter, its ratio of debt to EBITDA (earnings before interest, taxes, depreciation and amortization) rose to 10.9, which is “outside our comfort zone,” Mr. Bir said. Allied is aiming to reduce debt to 8.4 times EBITDA by the end of 2026 through a combination of non-core property sales, organic growth, development completions and other initiatives.
Still, Allied wasn’t able to stave off a credit downgrade by Moody’s Ratings, which in June cut the REIT’s senior unsecured debt rating to Ba1 – one notch below investment grade – and maintained a negative outlook. Although Allied’s properties “have largely outperformed the broader markets over the last few years, the difficult leasing environment has weakened its portfolio occupancy,” Moody’s senior credit officer Ranjini Venkatesan said in dropping the REIT’s debt to junk status.
When a credit rating agency starts turning the screws, it’s often a sign that a company’s distribution could be in jeopardy.
For its part, Allied has insisted that its distribution is safe.
“We’re very confident in our distribution. It’s sustainable. And so it’s not something that we’re discussing in terms of changing it. It will be supported by our growing and improving operating metrics and it’s something that we intend on maintaining,” Cecilia Williams, Allied’s president and chief executive officer, said on the second-quarter conference call.
However, given the challenges Allied is facing, some analysts question the wisdom of maintaining such a high yield.
“While we do appreciate management’s commitment to the distribution, we do not believe that the REIT is best served with such a high payout in the current environment,” Mark Rothschild, an analyst with Canaccord Genuity Corp., said in a note to clients.
“In our view, reducing the distribution would offer a variety of benefits to the REIT, all of which would grow unitholder value,” added Mr. Rothschild, who cut his rating on Allied to “hold” from “buy” after the second-quarter results.
For instance, slashing the distribution in half would save $126-million annually, which Allied could use to reduce debt, acquire high-quality assets from distressed sellers, or repurchase units that are trading at a discount to the estimated net asset value of Allied’s properties.
It’s telling that Allied’s units have lagged the recent rally in the REIT sector, which is rebounding thanks to falling interest rates. Year to date through Thursday, Allied posted a total return, including distributions, of negative 4 per cent. The BMO Equal Weight REIT Index ETF, by comparison, gained 15 per cent on a total return basis. Allied’s units have, however, strengthened of late, gaining in each of the past five sessions through Friday.
If you believe Allied’s distribution is secure and that demand for urban office space will eventually rebound, buying the units now could pay off long term. But given Allied’s elevated payout ratio, its stretched balance sheet and the structural challenges in the office sector, there are probably safer places to invest your money.
Editor’s note: (Sept. 16, 2024): This article has been updated to correct the title of Cecilia Williams, president and chief executive officer of Allied.
E-mail your questions to jheinzl@globeandmail.com. I’m not able to respond personally to e-mails but I choose certain questions to answer in my column.