Dream Office REIT: Stock & Dividend Analysis

I’ve held Dream Office REIT (TSX:D.UN) a couple times over the years, buying in when it gets into trouble and selling once it extracts itself.

The first time was back in 2016. Dream was overexposed to the Calgary office market, which imploded when oil tanked. Calgary has recovered somewhat in the intervening years, but its downtown is still a shadow of its former self — which, in turn, is a shadow of most Canadian downtowns. Toronto, Vancouver, and Montreal all have diverse downtowns with people living there, chic restaurants, and all sorts of amenities. Calgary’s downtown is deserted by 6pm and all the interesting places to hang out are in other neighbourhoods.

To its credit, the company recognized it had a problem and immediately changed its strategy. It put the Calgary properties up for sale (along with some other non-core assets). Once buyers came along — and it didn’t take long, either — the company then took the proceeds and cycled the cash into debt repayment and share buybacks. Your author took his 60%+ gain in about a year and moved on.

Then the pandemic happened, and Dream got into trouble again.

I took a closer look at the portfolio and liked what I saw. The new Dream had most of its assets in Toronto, specifically downtown all near the financial district. The location alone made these all irreplaceable assets, an extremely good thing if office use is permanently impaired after the pandemic. Couple that with a balance sheet I thought was well prepared to survive even the worst storm, and I thought I was in pretty good shape. I bought shares in 2020 and have held ever since.

Unfortunately, my second foray into Dream Office REIT hasn’t quite worked as well as the first, and I’m a little underwater on my position that was acquired in the $19 per share range. Let’s take a closer look and I’ll explain why I still like the company today and why I’m happy to hold.

The skinny 

As mentioned, Dream Office REIT is a pure-play on office real estate, with most of that real estate in Downtown Toronto. It owns approximately 5.3M square feet of gross leasable area, with 3.4M square feet located in Canada’s largest city.

Of the 1.9M square feet of space not located in Downtown Toronto, some 40% is located in Scarborough and Missasauga. The rest is a smattering of buildings in Calgary, Saskatoon, Regina, and, for some reason, Kansas City.

Ultimately, Dream is a Toronto play. 4.2M of a total 5.3M square feet of space is located in the GTA.

Before the pandemic, these Toronto properties were consistently full. Nowadays, leasing is much weaker than it used to be. Current occupancy stands at just over 85%, with many investors thinking that number will slowly head lower over time. Downtown Toronto is a bright spot at least, with occupancy at 89%. The rest of the portfolio is under 80% occupancy, however. Some quick time with Google and its obvious the non-Toronto properties are nowhere close to the marquee status enjoyed by the Downtown Toronto properties. In other words, the Calgary/Saskatchewan/etc. assets are kinda crappy.

Dream also has a few properties it has labeled with big development potential, which would eventually add another 4.3M square feet of space in Downtown Toronto. Construction has not started on any of these projects.

Dream has a diverse list of top tenants, with the 10 largest renters accounting for a little less than 40% of all rents. Federal and provincial governments are the largest tenants, combining for about 20% of all space.

Renting to governments has advantages and disadvantages. On the plus side, you know the rent is going to be there every month. There’s no bankruptcy risk there. Governments tend to get bigger over time, too. Others view the government as a risky tenant today, pointing out most government employees have been working from home for 2+ years now, and most government services haven’t missed a beat. If that’s the case, why would they keep that office space?

(Aside: I’ve mentioned this before, but I had a very illuminating talk with someone who works in real estate for the feds a couple years ago and was told the average person would be amazed at how much real estate various levels of governments end up with, for various reasons. She added the mandate during COVID was to get rid of this excess space, but haven’t really seen the evidence of it.)

Here’s a shot of Dream’s largest tenants. You can see how the government dwarfs everyone else.

(WeWork. lol)

Obviously, lease renewals are a huge risk going forward. There are penalties to get out of leases early, but tenants can do whatever they want when the lease expires. I’ll speculate a little more on lease renewals going forward later on, but 2022’s numbers on that front have been pretty solid.

Dream renewed 98% of its expiring 2022 space with most of these renewals at prices more than 30% higher than previously, which is much better than I certainly would have expected. It comes with a bit of a caveat, however:

What about that other 32,000 square feet? Why not just average that into the total number and say you increased rents by 25% or whatever? The only reason I can see for not disclosing it that way was those other 32,000 square feet got some pretty significant incentives to re-up.

Overall, however, leasing activity is much stronger than you’d expect considering the narrative out there. That’s the beauty of having such good assets.

Finally, let’s talk about Dream’s balance sheet. The debt-to-assets ratio currently stands at 42%, which gives Dream a more conservative balance sheet than many of its peers. Total debt stands at $1.26B at the end of the last quarter (Sept 30th). Approximately a third of that debt is variable, with a 2025 renewal date. And about $300M of that debt comes due in 2023 or 2024. Put it all together and Dream has a pretty significant amount of debt renewing in the next 3 years.

On the plus side, the company still has over $200M in liquidity remaining on its current credit lines.

One thing Dream bears are quick to point out is the 42% debt-to-assets level is based on Dream’s internal valuation of the real estate, something that is very different than the market’s valuation. Look at it this way. Dream’s current NAV, at least according to management, is $33 per share. The current price is a hair under $17 per share. That’s a big difference, and it all comes down to the value of equity in these buildings.

As Charlie Munger put it: “the liabilities are always 100% good. It’s the assets you have to worry about.”

Why I like Dream today

Let’s go through the bull case for Dream Office REIT.

First, let’s talk about earnings. Through the first three quarters of 2022 — full year results won’t be out for a couple weeks — FFO came to $1.15 per unit. Annualize that and we get full-year 2022 FFO at $1.53 per unit.

That puts shares at 11x trailing FFO, which is a solid valuation.

There are a few reasons why I think Dream can at least maintain that number in 2023. First, there are the lease renewals, which were stronger than expected. Add on increased rent for most of these renewals, and that goes a long way to at least maintaining current earning power. Analysts also see forward FFO coming in at around the same number. Finally, Dream is still a share buyback machine. If earnings stays the same but the number of shares outstanding goes down, that’s a good thing for FFO per share.

Let’s talk a little more about Dream’s buyback program, which gets heavily utilized when the unit price is depressed. Dream started buying back shares aggressively in 2020 and haven’t really stopped in 2+ years.

In two years shares outstanding went down approximately 10%, or 10M shares. That’s not a bad result anytime, never mind during a pandemic.

Share repurchases will continue in 2023, too. Dream renewed its share repurchase plan in August, which gives it authorization to repurchase some 3.3M shares until August, 2023. It purchased approximately 300,000 shares from September to December, 2022.

Then, just last week, something interesting happened. Dream announced it had sold 720 Bay Street for $135M. The unencumbered building is 100% leased to Ontario’s Attorney General, a lease that comes up for renewal over the next couple years.

Dream was quick to point out it sold the property for over its internal value for it, and its filings seem to agree with that assessment. Dream listed *all* its unencumbered property being worth $111M on Sept 30th. 720 Bay Street sold for $135M. Even if there are no additional unencumbered buildings — a safe assessment — it's still proof Dream is being conservative in valuing its assets.

Proceeds from the sale will go towards paying down Dream’s credit line — which had a current average annual interest rate of 5.4% as of Sept 30th — and repurchasing shares.

This disconnect between public and private valuations comes up often in the REIT world, with publicly traded REITs able to sell assets at a much higher valuation than they’re currently valued by the wisdom of the market. Artis was also able to do this in 2021/22 as well, selling off chunks of the portfolio for far higher than expected.

Say Dream spends $100M paying down debt and buys back an additional 2M shares at $16 each. That’s a savings of $5.4M in interest alone, which should translate into an additional 3-5% in FFO. Subtract the share buyback from the denominator and I can easily envision how this one transaction increases FFO per share in 2023.

The share buyback is a big part of the bull thesis here. If you buyback undervalued shares for long enough, good things are bound to happen.

Another thing I like about Dream Office is its ownership stake in Dream Industrial. Office owns a 9.7% stake in Industrial, a stake worth approximately $325M today. It’s not an inconsequential position considering Office’s market cap today is a mere $760M. I’m bullish on industrial real estate over time, and Office is a nice way to get cheap exposure to the sector.

Next, let’s take a closer look at some of Dream’s biggest shareholders. I mention this because these entities are some of the smartest real estate investors around.

Let’s start with Dream Unlimited and Michael Cooper. Together, these two connected parties own or control some 38% of Dream Office. Sandpiper Group (who you might remember from the Artis piece I did a few weeks ago) owns an additional 15% if you include the 3% or so portion of the company Artis owns. These two main shareholders effectively have control of the company. This is incredibly rare to see in the world of REITs, where equity gets issued for seemingly every transaction.

A quick note on Michael Cooper, Dream’s CEO. He is one of Canada’s finest real estate investors, and if he’s not a billionaire he’s damn close. This 2018 Globe and Mail profile is a good place to start (subscription required) if you want to learn more. The TL;DR version is Cooper is smart, hungry, and doesn’t back down from a little adversity. There are certainly worse guys to have in your corner.

Dividend safety

Dream currently pays a $1 per share annual dividend, which translates into a 6.1% yield today.

I think the payout is sustainable. The stock will earn approximately $1.50 per share in FFO in 2022. That gives us a payout ratio in the 65% range.

The share buyback will help 2023’s dividend payout ratio, too, since there should be fewer shares outstanding while the payout per share stays the same. This translates into fewer dollars out the door. Plus, the company is relatively cash rich after the sale of 720 Bay Street. I wouldn’t worry about the dividend until at least 2024, which gives management the opportunity to improve operations a bit more.

The bottom line

You’ll notice I didn’t delve much into the future of the office much in this article, mostly because I don’t have a damn clue. Most people reading this don’t either, although it won’t stop them from having an opinion.

Here’s what I do know. Property close to the subway in downtown Toronto will always have value, whether that real estate exists as offices, retail space, condos, or some combination of all three. You can put up a building anywhere you want, but you can’t replace location. Dream Office REIT has perhaps the best-located portfolio in Canada, which is a major advantage over its peers.

Combine that with a solid balance sheet, what I view to be a reasonable valuation of NAV, a nice dividend while I wait, and one of the best managers in the business, and I think it adds up to a pretty solid value opportunity. I own a medium-sized position today and I’m happy to hold and wait for these assets to recover. I think there’s serious upside when they do.

Disclosure: Author holds Dream Office and Dream Unlimited shares.