It was announced today that Dundee REIT (TSX: D.UN) and H&R Reit (TSX: HR.UN) will be purchasing 2/3rds and 1/3rd, respectively, the Scotiabank headquqarters in Toronto, for a price of $1.266 billion. This was a classic sale-and-leaseback transaction by Scotiabank.
The salient press release is here. Specifically, this line caught my attention:
Highlights:
Going-in capitalization rate of 5.2% – The $1.266 billion purchase price reflects a 5.2% going-in cap rate.
$650.0 million of 7-year first mortgage bonds, provisional A (high) rating, to be issued – To provide partial funding of the purchase price, $650.0 million of first mortgage bonds (100% interest) will be issued with a 7-year term at an effective interest rate that will not exceed 3.45%. Dundee REIT and H&R REIT have entered into an underwriting agreement with Scotia Capital Inc. and TD Securities Inc.
…
The current weighted average in-place office rent is approximately $31.45 per square foot, more than 10% below estimated current market rates of $34.49 per square foot.
The company is also issuing $300M in equity at $35.90/unit. Their annualized yield at that price is 6.12%.
A cap rate of 5.2% basically means you invest $100 to get $5.20/year back. The income figure is usually net operating income, which excludes the depreciation and interest expense associated with owning the property. The figure also implies that it is calculated with the present occupancy rate (99.5%).
So Dundee is receiving a fairly slim return. Let’s just assume that they exclusively purchase this building with debt financing and ignore the more expensive equity. Also, let’s generously assume they can flick a switch and charge the “market rate” for their leaseholders (which is unlikely since Scotiabank is their majority tenant in the building and presumably negotiated a bulk discount associated with the sale of the building!). Their cost of debt is 3.45%, and they anticipate receiving 5.7%, so a spread of 2.25%.
When you do factor in the other attributes (e.g. the true cap rate of the building, depreciation, real estate pricing risk, state of the Toronto economy, occupancy, cost of equity) there is not a heck of a lot when it comes to a margin of error. One predominant question is what happens when interest rates rise to the point where you are paying 200 basis points more on everything? A lot of the higher levered REITs are going to get killed on two fronts – financing expenses and balance sheet write-downs when others are trying to liquidate exactly the same assets. Your compensation as an equity investor is amazingly small.
My conclusion here is that the Bank of Nova Scotia (TSX: BNS) made one hell of a deal.