Inovalis: A Look At The Safety Of The 10% Yield (TSX:INO.UN:CA)

All values are in CAD unless noted otherwise.

Inovalis Real Estate Investment Trust (TSX:INO.UN:CA) is a Canadian entity that owns properties in Europe, namely France, Germany and Spain. Not sure which is the fourth country that they allude to on their website. We think the graphic probably predates the East Germany-West Germany unification.

The 14 properties are located in major urban areas, close to public transportation, city centres and shopping areas. The kicker is they are office properties, which makes the magnitude of the 2023 maturities a bit more concerning.

Most of the upcoming vacancy comes from the tenant that makes up 28% of their rental revenue. Orange S.A. (ORAN) will be exiting the Arcueil property.

Inovalis is showing a positive attitude about it.

But still, that is a stunning portion of their total rental income.

Predictably, the market is not too happy and the stock has breached even the pandemic lows.

Despite the recent 50% cut to the dividend, the yield is now over 10% (stock price $3.98) beckoning the courageous amongst the income crowd. The REIT is externally managed by Inovalis S.A., and the two are considered related parties as they share top executives.

The contract with the manager expires on March 31, 2023 with an option to extend for another year depending on the mutual agreement between the two, which to reiterate have the same decision makers. Does this take the term “mutual agreement” to a transcendental level?

Having introduced the REIT with some peripheral information, lets get down to the weeds and see if we think the investors getting a piece of this are on to something or simply simple.

Q3-2022

Inovalis was setup for the dividend cut for a long, long time. Anyone having a cursory glance through the financial statements would have seen the ridiculous payout ratio.

In Q4 2021, the REIT reported FFO and AFFO of CAD$0.10 and CAD$0.07 per Unit respectively, versus CAD$0.17 and CAD$0.15 for the same period last year The AFFO payout ratio, a non-GAAP measure of the sustainability of the REIT’s distribution payout, is 198.1% for the year ended 2021.

Source: Inovalis Q4-2021

The whole of 2021 had a 198.1% payout ratio so the big drop after the announced cut was a blow in the face of efficient market hypothesis. Still, with that bad news out of the way, Inovalis had room to surprise on the upside. The adjusted funds from operations (AFFO) came in at 17 cents and the dividend cut brought the payout ratio back in line to just under 100%.

But there are a couple of nuances here. The first being that the dividend cut was announced earlier in the year but implemented effective September 2022.

So this quarter reflected only one month of the lowered number. That should help the payout ratio even more in the months ahead. The other nuance though is that the baseline run rate of AFFO is a lot lower. One can get sense of this by seeing that the AFFO presented above, is almost as much as the net rental income. The reason is explained as follows.

In Q3 2022, the REIT reported FFO and AFFO1 of CAD$0.18 per Unit, up $0.06 from the same period last year as a result of the gain on the partial sale in September 2022, of the exchange forward contracts. The REIT reduced its forward exchange contracts to align with the reduced monthly value of distributions.

Source: Q3-2022 Financial Statements

This amount of gain on sale was almost $2.0 million. Adjusting for this, the baseline forward (as in Q4-2022) AFFO would be close to $0.12 a quarter and the payout ratio close to 85% (on new dividend schedule). That does not give the REIT any breathing room as we enter 2023.

Outlook

As Orange exits the property mid-2023, the REIT is once again going to feel the pressure. With almost 30% of rental income falling off the books, things will be extremely difficult. Remember, a lot of property operating expenses don’t go away when the tenant leaves. So we would expect 70%-80% of this drop in rental income to lower the AFFO. At the point of exit, we would look for about 8 cents of AFFO per unit per quarter, pushing the payout ratio once again past the 100% mark. That likely means that unless a tenant is found quickly post the redevelopment being proposed, we are going to see another dividend cut.

We wish those were the only challenges that this REIT is facing. Alongside perhaps the shortest weighted average lease maturity that we have seen, it also has the shortest debt maturity profile we are aware of.

Two mortgages were pushed up further for payments as occupancy rates dropped.

As at September 30, 2022, due to the lenders’ right to repayment upon breach of the covenant on the Baldi, Courbevoie and Sablière properties, these three loans have been classified as current liabilities for a total amount of CAD$29,436, with maturities in December 2022 (Sablière and Courbevoie) and June 2023 (Baldi). The Bad Homburg mortgage loan, on which a one-year extension was obtained in March 2022 with a 1.45% rate (vs.1.43% in the previous agreement), is maturing in March 2023. Management is studying various opportunities to refinance this property, including a collateralization with other German financing in the portfolio, notably Stuttgart and Neu-Isenburg.

Source: Q3-2022 Financial Statements

So there will be some more exciting times ahead as the REIT balances redevelopments and refinancing. If the distributions are maintained at the current rate, we will be extremely surprised.

Verdict

If you want European office exposure and who amongst has not wanted that, Inovalis will give you that pleasure alongside some nausea. If you are thinking of buying, collecting distributions and saying “La vie est un beau rêve, mais ne vous réveillez pas”, then this is not the REIT for you. The reason you may want to buy this, is if you believe in the NAV. Inovalis still thinks that the NAV is well above the current price as reflected in the price to tangible book value of 0.41X.

Inovalis also has a good chance of crystallizing that NAV. The reason is that all their loans are at a property level.

So if push comes to shove, they can walk away from properties where they fail to refinance or vacancy levels get too high to salvage value. They can also possibly force banks to renegotiate a lower loan amount. If that long drawn out battle sounds appealing to you in return for the potential upside, go for it. Keep in mind that even that estimated NAV is possibly optimistic. Inovalis has lowered the tangible book value per share over the last three years but one has to wonder whether that drop accurately states the likely sale prices today.

We rate this a hold/neutral now while noting that anyone purchasing should use some of the upcoming distributions for domperidone purchase.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints. We strongly recommend you have a Merry Christmas and a Happy New Year.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.