Northern Property REIT announced plans to buy True North Apartment REIT, hoping to create a broader, geographically diversified REIT focused on apartment units.Hemera Technologies/Getty Images
At long last, deal flow for real estate investment trusts is catching fire. After two painstakingly slow years in Canada, the sector's seeing everything from initial public offerings to mergers and acquisitions to strategic reviews again.
This is supposed to be good news for investors. Most Canadian REITs have traded poorly since May, 2013, when bond yields went wild because of an expected Federal Reserve rate hike. Recent deals, such as RioCan REIT's review of its U.S. portfolio and Health Care REIT's acquisition of Regal Lifestyle Communities, suggest the sector is coming back to life. All of this is supposed to translate into better valuations.
But that logic only works if the new deals are sound for all investors. The latest one, proposed Monday, struggles to tick this box.
Surprising investors, Northern Property REIT announced plans to buy True North Apartment REIT, hoping to create a broader, geographically diversified REIT focused on apartment units. The major wrinkle: Rough math suggests Northern's earnings per share will drop by double-digit percentage points if the deal goes through.
Currently, Northern owns a portfolio of properties that are heavily skewed toward the North, with apartment units in places such as Iqaluit and Yellowknife, as well as Alberta, which makes up one-quarter of its operating profit. That isn't the best news in an energy downturn. Fort McMurray alone accounts for 10 percentage points of Northern's operating profit, and the REIT's vacancy rate there soared to 24 per cent last quarter, up from only 4 per cent two years ago.
As Northern struggled to keep investors, Daniel Drimmer appeared. The founder of True North Apartment REIT, which is focused on apartment units in Ontario, struck up a conversation in March. The two REITs eventually agreed to a deal that will see Northern buy True North, as well as acquire $535-million worth of properties co-owned by Starlight, Mr. Drimmer's private real estate vehicle, and the Public Sector Pension Investment Board.
If the deal goes through, the combined company is supposed to have an enterprise value of roughly $3-billion, making it Canada's third-largest apartment REIT, behind Boardwalk and CAP REIT.
But it has to get approved first, and there's a decent chance it doesn't.
First there's that double-digit dilution. Northern trades at a discount to net asset value, but it's buying True North for roughly its net asset value. That's confusing many people, which is partly why Northern's units fell 8.4 per cent on Monday. Paying full price goes against Northern's recent acquisition strategy. Recently, the REIT's management team had said it was frustrated that apartment units were too expensive to buy in Canada, so it started developing its own units instead.
Northern's also known for its low debt profile. By absorbing the new properties, its debt to gross book value, a measure of leverage, will climb to 59 per cent, its highest ever.
All of these concerns were aired on a conference call, and Todd Cook, Northern's chief executive officer, pushed back, arguing that building a bigger, diversified REIT is hard to do bit by bit. This deal with True North lets him do it instantly.
"This gets us significant diversification in one piece, which is something you can't do on a transaction-by-transaction basis," he repeated in an interview, adding that this advantage "clearly outweighs any nominal dilution."
That sounds nice, but his own unitholders don't seem to be buying it. As for True North's, they have to consider whether they want to pair with a REIT that's been struggling and has heavy exposure to Alberta. Sure they're getting a premium for it, but this bonus will disappear if Northern's units keep sinking, because the acquirer is paying all in stock.
The REIT sector is bound to see more deals. Too many trusts have traded at discounts to their net asset values for too long, and management teams are starting to get creative. While they weigh their options, they should remember that bulking up for the sake of security isn't always necessary. Sometimes sticking to your original strategy is all investors want.