Description

Inovalis REIT ($10.05)

Inovalis REIT (INO.UN) is a modestly priced Canadian small-cap REIT that is focussed on the ownership and management of office properties in Germany and France. Due to its small market cap approx. C$250 million and its low trading volume, this idea is best for small funds and personal accounts.

Investment Summary

Inovalis has a distribution yield of 8.2% and is trading at a slight discount to NAV using a 5.5% cap rate generating a NAV of $10.50 versus a $10 stock price (trades at a 5% discount to NAV). Given its geographic focus, Inovalis is a potential beneficiary of Brexit. In addition, ownership of European properties offers a higher cap rate/interest rate spread than what is available in North America due to lower European interest rates. On the less attractive side, as a result of spending on capital expenditures to improve its buildings requiring vacancies to rise, the payout ratio is 110%, but should fall below 100% over the next two years as occupancies and revenues increase and vacancies fall (and capex falls) due to the improvements. The second issue is the external management structure which merits a discount. There are options to internalize the REIT.

Description

Inovalis has 15 properties with 1.4 million square feet of gross leasable area (GLA). Its properties are located in France and Germany, the two largest GDP countries in the EU. Specifically, the French properties are located in the Greater Paris Region whereas the German properties are in the “Big 7” German office markets.

From 2014 to 2018, vacancy rates in office properties in Paris fell over 200 bps to just over 5% while rental rates increased 12%. Similar dynamics were present in the “Big 7” office markets in Germany where vacancy rates fell 450 bps to 3.5% from 2013 to 2018 whereas rents increased over 12% in that period.

Portfolio

Inovalis has a portfolio of 15 office properties totalling 1.4 million square feet of gross leasable area. Eight of these properties are held in joint ventures. The partners of the REIT in these JVs are sovereign wealth funds, pension funds, private banks and family offices. The upside of the JV structure is that Inovalis can buy larger buildings with its partners and/or in more desirable areas.

Fifty-seven percent of Inovalis’s properties are in France whereas 43% are in Germany.

Property details are as follows:

Tenants

The REIT’s five largest tenants, diversified by industry, occupy over 50% of the GLA. The top two tenants, including Orange S.A., which has an investment-grade credit rating, occupy one third of the REIT’s GLA.

Occupancy

From 2016 till the middle of 2018, occupancy rates have been between 95% and 97%. However, due to tenant departures, Inovalis seized the opportunity to re-develop the space. In 2018, Inovalis spent C$3.9 million on capital improvement projects compared to less than half of that amount in 2017 (C$1.6 million). Given the low vacancy rates in both Paris and the “Big 7” cities in Germany, Inovalis’s occupancy rates should rise to the mid to high 90% range once the capex has been completed.

Lease Maturity Profile

For the overall portfolio, the REIT’s average remaining lease term is 3.8 years. There are material lease expiries in 2021 representing over a third of the portfolio. Given the strong office dynamics in Inovalis’s core markets, even these lease expiries will offer the opportunity to improve the space and capture higher rents.

Debt Maturity Profile

Inovalis doesn’t have any near-term debt maturities.  The weighted-average term to maturity is 5.4 years with a weighted-average interest rate of 2.1%. Fixed-rate debt comprises 83% of total debt.

Inovalis has a debt to book value ratio of 52.5%.

Given Europe’s below zero interest rates, the long debt maturities aren’t ideal. However, they do assist in forecasting future cash flows.

External Management Contract

As investors, internal management contracts are preferred to external ones. Given its small size, Inovalis does benefit from the external manager’s (Inovalis S.A.) regional real estate experience. With a staff of over 500 and significant experience in development and repositioning in Europe, Inovalis S.A. provides the REIT with strong support.

There can be a vote of the Board of Trustees to internalize the management contract at the earlier of the REIT achieving a market cap of $750 million or April 1, 2023.

Pertinent details of the management contract

REIT Growth Potential

Inovalis has spent significantly on capital projects over the last 2 years (C$5.5 million). The company continues to spend on redevelopment of its properties. This should result in rent increases above market where the rates are growing in the low single digits.

Also, given its real estate ownership partners including its management partner, Inovalis S.A., Inovalis has access to opportunities to grow its portfolio.

Share ownership

Management and the board plus the external manager (Inovalis S.A.) own 11% of the total units outstanding. Institutional investors own approximately 17% of the units with the rest owned by retail investors.

Valuation

Inovalis trades at a cap rate of 5.7%. Given the continued fall in interest rates (especially in Europe), cap rates should stay stable or fall. At a 5.5% cap rate, Inovalis would trade at $10.50. On a cash flow basis,  Inovalis trades at 13x 2020E AFFO, a significant discount to Canadian office REITS, but also at a discount to Dream Global, a larger European-focused Canadian REIT (15x).Given the capex spend and the resulting rent increases with increased occupancy, Inovalis represents a modestly-priced small cap European REIT opportunity with some upside and an 8.2% yield in the interim.

Risks

• Higher interest rates in Europe

• Larger capex spend than anticipated

• Opportunity to capture rent increases disappears due to slowing Eurozone economy

Catalyst

• Releasing space at higher rents once redevelopment is complete

Catalyst

• Releasing space at higher rents once redevelopment is complete