The investment case for beaten-up office real estate investment trusts took another hit this week after Slate Office REIT (SOT.UN-T) acknowledged that it might not make interest payments on some of its debt.
For anyone already worried about the dismal environment for office real estate, Slate offered an example of just how bad things can get. But is it typical of other office REITs?
The answer is no – for now – which is why office REITs remain an alluring prospect for anyone with a steel-lined stomach.
Slate isn’t a big player in this space. Even when times were good – say, five years ago, when most of us left home for work and office occupancy rates were high – the REIT was worth just over $400-million, based on the total value of its outstanding units.
Now, with Slate unlikely to make interest payments on its debt, the units traded at 21 cents on Thursday, giving the REIT a market capitalization of just $18-million.
Even that value looks a bit rich, given the circumstances.
CIBC Capital Markets analyst Sumayya Syed slashed her target price on the units, or where she believes they will trade within a year, to zero from 75 cents previously. Her expectation, she said in a note this week, is that “the REIT ceases to be a going concern.”
Meaning: Investors could be wiped out.
The stock market, which has done an admirable job of identifying weak players in this space over the past couple of years, tagged Slate as a particularly troubled entity early on.
The unit price fell 84 per cent over the two-year period from the start of 2022 through the end of 2023, as office occupancy rates fell and interest rates climbed to multi-year highs. Rising rates increased borrowing costs and undermined the appeal of dividend-generating investments such as REITs.
While most other REITs also suffered over this two-year period, their declines weren’t as precipitous. Dream Office REIT (D.UN-T) fell 57 per cent, Allied Properties REIT (AP.UN-T) fell 47 per cent and the diversified S&P/TSX Real Estate sector fell 20 per cent.
There are a few reasons why Slate stuck out from the crowd. It is virtually fully exposed to the office sector, with less desirable Class-B buildings where more offices are sitting empty right now and not collecting rent. The REIT’s occupancy rate was 77.7 per cent in the first quarter, compared with 81.6 per cent for the Canadian office sector, according to consultancy CBRE.
Slate also has a lot of floating rate debt, at 26 per cent of the total, which has made the REIT vulnerable to rising borrowing costs. Interest paid in the first quarter increased by 25 per cent over the same period last year.
Lastly, while stronger real estate players – such as Brookfield Corp. (BN-T) – have been flexing their financial muscles in anticipation of scooping up additional properties at fire-sale prices, Slate has been selling into the current mayhem to reduce debt pressure.
Slate, which currently pays no distribution, doesn’t look investable. Other office REITs, though, may be worth a closer look.
A good place to start: Allied Properties REIT.
Yes, it has its challenges as well. Though the occupancy rate is better than most, at 85.9 per cent, it has declined by 3.7 percentage points since the end of 2022.
The decline contributed to a credit rating downgrade from Moody’s on June 11. Allied Properties’ unit price has fallen 7.5 per cent since then, driving the dividend yield toward a troubling 12 per cent.
But there’s a case to be made that investors are being too pessimistic.
The Bank of Canada recently cut its key interest rate after inflation subsided. Additional rate cuts should bolster the appeal of dividend-paying REITs, ease pressure on borrowing costs and support economic activity that will generate jobs and demand for office space.
Stephen Brown, deputy chief North America economist at Capital Economics, estimates that lower rates should drive Canadian economic growth to 2.2 per cent in 2025 and 2.8 per cent in 2026, up from just 1 per cent this year.
Hybrid work is a threat, but the trend may be levelling off as fully remote work loses its appeal and more companies demand workers return to the office.
Allied Properties’ occupancy rates reflect some moderation. The rate declined 0.5 percentage points in the first quarter of this year, compared with a more severe 1.4-percentage-point decline in the first quarter of 2023 and a 1.6-percentage-point decline in the same period in 2022.
Down is down. But the end of this difficult period could be in sight.
David Berman