Dream Office REIT SIB

An interesting financial gamble just commenced yesterday evening.

Dream Office REIT (TSX: D.UN) owns 28 properties (2 under construction), and currently about 63% of the square feet is lease-able in downtown Toronto. The consolidated portfolio is 80% occupied (84% with commitments), with the Toronto segment at 88%.

Just like other office REITs, D.UN’s unit prices have gotten killed over the past year for well-known reasons.

On D.UN’s balance sheet, their primary assets are $2.39 billion in investment properties, and about 26 million (effective) units of Dream Industrial REIT (TSX: DIR.UN) (fair market value: $383 million at March 31, 2023). There is also about $1.27 billion in debt. Some of the debt is secured with the DIR.UN equity. The net equity is $1.5 billion, and with 52.2 million diluted units outstanding, gives a net asset value of about $29/unit.

They announced they will be selling about half (12.5 million units) of their DIR.un for $14.20 a piece ($177.5 million gross) and then commence a SIB for 12.5 million of their own REIT (24% of diluted units outstanding) for $15.50/unit. This is $194 million gross.

A typical bought deal would cost about 4% of the gross, so D.UN is paying about $7 million for this transaction, plus another amount for the legal fees for the SIB, so let’s round it to a $200 million dollar transaction.

D.UN shot up from $12.61 to around $15.00 per unit today in response – clearly some arbitrage potential being priced in.

The $200 million dollar question is (and this applies to all of these office REITs) whether the $2.4 billion in properties on their balance sheet is actually worth $2.4 billion.

If so, Dream is trying to buy dollars for half-dollars.

If the properties are worth 71% of the stated value, then the proposition is break-even at best (not factoring in the leverage factor and lost income from the ownership of DIR.un).

If the properties are worth less than 71% of the stated value, then this is a value-destroying proposition.

Another interesting factoid is that Artis REIT (TSX: AX.UN) and related entity Sandpiper jointly own about 6.8 million units of Dream Office REIT. Will they tender?

This will be interesting to watch. I have no skin in the game here – in general, I am adverse to deeply leveraged entities in our existing macroeconomic environment.

How not to sell an ETF

If you ever wanted to liquidate $2 million dollars of the CASH.to ETF in the last four seconds of trading, look what happens!

I could not imagine went on in the mind of somebody punching this order into the computer. Reading the tape, those sitting at around $49.75 on the limit would have received a reasonable fill and this is the financial equivalent of picking up the freest half a basis point on the planet.

Office REITs

Those of you that tuned into the last episode of Late Night Finance will know that I took tiny positions in a couple office REITs, which I took the liberty to dump out subsequent to that zoom-cast (no, not a pump-and-dump, I promise).

Traditional valuation methods of real estate can use cash flow methods, capitalized costs of land/building, and gut instinct on where future market demand lies, but there is one universal truth and that is when vacancy rates are high, it is not a good sign of how much cash flow you can dredge out of a property.

We are starting to see downward pressure on various office properties (WSJ article), at least in San Francisco.

While the specific example in this article may be an extreme case (a mark-down of 80% or so from pre-Covid pricing), because mortgage and other secured financing is collateralized by real estate asset values, it stands to reason that many other office REITs are going to face issues with trust covenants of specific debt-to-asset ratios going forward.

Since real estate loans are a slow-moving process, it will take a sustained credit-tight environment to trigger more and more financial stress on these entities, but just like how Silicon Valley Bank and Signature Bank New York were the first canaries in the coal mine, it will be inevitable that we will see the first office REITs start to fall – the trigger will be forced liquidations of office properties.

Processing the entrails of First Republic Bank

In highly anticipated news, First Republic (NYSE: FRC) went bye-bye over the weekend.

As long as the yield curve remains inverted and quantitative easing continues, financial institutions are going to receive continued pressure and the “too big to fail” institutions will be the ones to vacuum up the money.

Think of it this way – behind each bank asset (a customer loan) is a bank liability (a customer deposit). If the asset to liability situation goes out of regulatory proportions (e.g. you took your customer loans and invested in them in high-duration government debt and suddenly your customer wants their deposits back and you can’t pay it), you get FDIC’ed. However, when the FDIC process occurs, it is not as if all of that capital goes away – it has to go somewhere. It doesn’t end up as paper banknotes inside the safe or underneath the couch, but rather it goes to another financial institution. The assets and liabilities go somewhere else within the financial net – they do not vanish!

In this case, it appears destined that the assets in this digital financial world (where assets get transferred with mouse clicks) will bubble up to the systemically important banks.

I’ve been trying to pick away at the entrails of the lesser banks within the USA, but I don’t have a clue how to project who will survive and who will not. So I’ve given up.

I will leave this post with one amusing note. Financial releases go through plenty of review cycles within management, but if they can’t spell the word “average” correctly, it is trouble:

Costs matter – a brief look at coal

There is a paradoxical rule in investing that when you anticipate the underlying price of whatever a company sells to rise, you want to be invested in a higher cost producer. The reason for this is embedded leverage. In a flat to declining price environment, you want to be invested in the low cost producer.

An example will suffice.

Say the market rate for widgets is $100. Company A (high cost producer) can make widgets for $90 a piece, leaving $10 of profit per widget. At a 10x multiple, the company would be worth $100 a widget. If the price of widgets goes up to $200, the company would be worth $1,100 a widget, 11x your money at the same multiple.

Company B (low cost producer) makes widgets for $50 a piece, leaving $50 of profit per widget. At the same multiple, it would be worth $500. If the price of widgets goes up to $200, Company B would be worth $1,500 or a mere 3x. Not bad, but nowhere close to the high cost producer.

The reverse is true – especially if the price of widgets goes below the costs of some producers. If the price of widgets goes to $70, Company A will suffer (they will have to dig into their balance sheet), while Company B will still make a living.

Markets can anticipate these leverage effects and compensate valuations accordingly – in particular price to earnings multiples decrease as prices increase. But over market cycles, costs matter.

I’m looking at earnings of coal companies, and the contrast between ARCH and BTU is quite striking.

In Q1-2023, ARCH produces its metallurgical coal at a cash cost of US$82.66 per short ton, while BTU is $151.13. In Q4-2022, HCC was $123.40, while AMR was $112.97. Teck reported US$103 per metric ton, which is about US$94 per short ton. (In the case of Teck, there is a bit of an accounting fudge factor as some of this cost is the amortization of “capitalized stripping”, which creates unevenness in cash flows, a technical matter well beyond the point of this discussion).

As met coal prices come back down to earth (they were as high as US$450 per short ton last year and are roughly US$260 or so presently), low cost producers should start to feel the pinch on their cash flows.

It leaves the question why one would want to invest in a company producing a commodity in a lowering cost environment, and that is where some market skill comes into place – there is an anticipation of cyclicality in these companies. You can also play expectations against each company by engaging in pair trading – long one, short another (and pray that your short doesn’t get bought out).

However, there is one raw number that really counts – cash dividends. If you’re going to get paid a reasonable return on equity, it still might be good enough.

In this respect, ARCH’s 50/50 plan (which is giving 50% of free cash flow directly off as special dividends and the remaining 50% for debt/capital/remediation/buybacks) has a certain elegance to it. As more shares get repurchased, the amount of the dividend that gets distributed will rise over time. It is like a very strange version of dollar cost averaging except the company is deciding to do it for you.

In 2022, ARCH gave out about $25/share in dividends. I do not anticipate this level of distribution will continue. For one, they will start paying significant cash income taxes which will reduce the dividend stream. However, there is a reasonable chance that the cash payouts will continue being in the double digit percentages, coupled with share appreciation through buybacks. Another paradox about having high amounts of cash flows is that you want to see the stock price lower, not higher – the reason is because reinvestment (in the stock) can compound at higher rates when done at lower prices.

It would not shock me in the least to see some more consolidation in the sector. We’re already seeing Teck trying to avoid one.

Also, for reference, read my December 2019 post on Arch. Even after Covid-19, this write-up is aging pretty well.