Allied Properties slashes distribution by 60%

Key Concepts

• Distribution Cut: A reduction in the regular payments made by a company to its shareholders, typically from its profits.
• Occupancy Rebound: The process of increasing the number of tenants or people occupying a property.
• Return to Office (RTO): The trend of employees returning to their physical workplaces after a period of remote work.
• Class A Plus Properties: High-quality, modern office buildings in prime locations, often with premium amenities and services.
• Class A Vacancy: The percentage of available office space in Class A buildings that is not currently leased.
• Implied Cap Rate: A metric used in real estate to estimate the rate of return on an investment property, calculated by dividing net operating income by the property's market value.
• Distribution Yield: The annual distribution per share divided by the current market price per share, expressed as a percentage.

Allied Properties: Distribution Cut and Market Challenges

Urban office space developer Allied Properties has implemented a significant 60% reduction in its monthly distribution to address its debt situation. Lauren Calmer, VP and Institutional Equity Research Real Estate at Dejardan, discusses the implications of this move and the broader challenges facing the company and the office real estate market.

Rationale and Permanence of the Distribution Cut

Calmer views the distribution cut as a "prudent move by management and the board," albeit "arguably a little bit later than it should have been." While acknowledging it as a step in the right direction, she operates under the assumption that this cut is permanent, unlike temporary reductions seen in the past (e.g., First Capital during COVID-19). She has not received explicit clarification on its permanence but believes the company is setting a distribution policy for 2025 and 2026.

Underlying Problems in the Office Real Estate Market

The primary issue for Allied Properties stems from "persistent weakness in the office real estate market." The catalyst for the distribution cut was a "slower than anticipated rebound in occupancy." This challenge is not unique to Allied but affects all office properties outside of core Class A+ buildings.

Phased Recovery of the Office Market

Calmer outlines a three-phase recovery model for the office market:

1. Return to Office (RTO): This initial phase is driven by companies mandating employees to return to the office. While some banks and large users are returning, the majority of this recovery is concentrated in core Class A+ buildings, typically occupied by financial institutions. These are often large, modern skyscrapers connected to transit infrastructure, as seen in Toronto.
2. Economic Outlook and Business Sentiment: A more comprehensive recovery requires an improvement in Canada's economic outlook, business sentiment, and office-using employment. Calmer believes the market is still "a ways out" from this stage.
3. Demand Cascade: Even as the economic outlook improves, significant Class A vacancy (around 14-15% in Toronto) needs to be reduced to high single digits before demand "cascades outside of the core" and into the types of assets that Allied owns.

Allied Properties' Development Projects and Challenges

Allied Properties has been involved in significant real estate projects in Toronto, including "The Well." While hindsight might suggest they "bit off more than they could chew" with such large developments, especially with the advent of COVID-19, Calmer credits them for achieving 98% lease-up of their office property at The Well, even completing leasing during the pandemic.

A key challenge arose when Shopify, their anchor tenant occupying approximately 350,000 square feet, shifted away from an office-centric model and put their space up for sublease. Finding a replacement tenant for this substantial space has been difficult for Allied. However, they have reported "a lot of interest" and expect further updates, with "decent progress" made recently.

Investment Outlook and Valuation Metrics

Calmer maintains a "sell" rating on Allied Properties, believing there is "a little bit more risk to the downside than there is upside to the name right now." She anticipates further headwinds and potential negative capital allocation catalysts.

Key Valuation Considerations:

• Distribution Yield: At current levels, the revised distribution yields a "sub 51.5%" yield. Calmer considers a 6-7% distribution yield more appropriate, implying a stock price of approximately $12 (for 6%) to $10.20 (for 7%). She would become more constructive on the stock if it reaches the $10-$11 range.
• Implied Cap Rate: Allied Properties is currently trading at an implied cap rate of approximately 6.8%. Based on limited market transactions, Calmer believes this still appears "a little bit expensive" given the geography and type of properties Allied owns.

Market Stabilization

While the office market has "certainly come off its bottom" and is "in the process of stabilizing," Calmer reiterates that the initial RTO phase is underway. However, a broader recovery hinges on improvements in Canada's economic outlook and office-using employment, suggesting continued challenges for the Canadian office market.