Morguard REIT is a publicly traded closed-ended trust whose units are traded on the Toronto Stock Exchange. Morguard REIT is an externally advised REIT that is 44.8% owned by Morguard Corp. (unrated). We ascribe no support from Morguard Corp. in our credit assessment of Morguard REIT. The REIT owns a portfolio of 53 properties, including 20 shopping centers, 24 office buildings, and nine mixed-use properties aggregating 8.5 million square feet. Slightly more than half of the properties are in Ontario, and the balance is located in Alberta, Quebec, and three other Canadian provinces. There is single asset concentration in the portfolio, as the largest property (St. Laurent Centre in Ottawa) accounts for 10% of total square feet and, by our estimate, more than 20% of the total portfolio value. This concentration could contribute to cash flow volatility. While the portfolio remains very well occupied (96% on March 31, 2012), some increased vacancy during the first quarter of 2012 in the office and retail portfolios contributed to a same-property NOI decline of 2.4% relative to the first quarter of 2011.
Morguard REIT's C$2.2 billion asset base (under International Financial Reporting Standards {IFRS}) consists almost entirely of commercial real estate holdings and was 43.1% leveraged at March 31, 2012. However, we expect Morguard REIT is likely to eventually increase leverage to about 50% of assets, through largely debt-financed future acquisitions. Debt totaled C$926 million on March 31, 2012, and included C$798 million of mortgages and first mortgage bonds. Related principal amortization contributed to the company's below-average debt service coverage (about 1.7x for the quarter ended March 31, 2012). We expect coverage to gradually improve as higher rents contribute to growth in funds from operations (FFO).
Scenario analysis
Our scenario analysis contemplates macroeconomic and credit-specific conditions that influence our opinion of Morguard's credit quality. Our base-case scenario for Morguard REIT assumes a 4% increase in FFO in 2012, due primarily to moderate same-property growth in rents and occupancy. Under this scenario, we expect debt service coverage to gradually improve to 1.8x by year-end 2012, which is closer to the company's historical average (1.8x over the past three years and nearly 2.0x over the past five fiscal years). Under an alternative downside scenario, if FFO dropped 10% in 2012, perhaps due to unforeseen tenant defaults, debt service coverage would decline to 1.6x and total coverage would dip below 1x, which would prompt us to lower the corporate credit rating. However, we currently ascribe a low probability to this downside scenario occurring.
Liquidity
We view Morguard REIT to have an adequate liquidity profile because its cash position (C$8.5 million on March 31, 2012) and expected FFO appear sufficient to meet maturities, distributions, and capital expenditures over the next year. We estimate that FFO (roughly C$78 million in 2012 and C$81 million in 2013) will be sufficient to cover interest, principal amortization, and trust distributions. Morguard REIT faces no balance maturities in 2012, and we expect the REIT to preemptively refinance a portion of its C$287 million 2013 mortgage maturities (including a mortgage bond related to St. Laurent Center) during the second half of 2012 with new secured debt given our estimated low loan-to-value ratios for the maturing obligations.
We do include the company's C$70 million of revolving credit facilities as sources of capital; although Morguard REIT's credit facilities renew annually (at year end), we consider them as a source of capital because we believe that the company has a credible plan to renew them at maturity. Further, we note the company's standing in the capital markets as the price performance of its publicly traded trust units has marginally surpassed the common stock price performance of U.S. REIT peers over the prior year. As of March 31, 2012, Morguard REIT was in compliance with the covenants governing its credit facilities, as well as with a 60% debt-to-gross asset limitation under the REIT's declaration of trust. The mortgages and property-specific mortgage bonds payable (not rated) are not subject to restrictive financial covenants.
Outlook
Our stable outlook reflects our expectations that Canadian commercial real estate markets will continue to hold relatively steady and that Morguard REIT's occupancy and rent revenues will remain firm over the next 12 months. We also assume that the company pursues growth in a leverage-neutral manner. We would raise our rating on Morguard REIT if debt service coverage improves to 2.0x and dividend coverage improves. We would lower our rating one notch if our downside scenario materializes--although we ascribe a low probability of this occurring--and debt service coverage falls below 1.6x, or if FFO were no longer sufficient to cover interest, principal amortization, and trust distributions.
