What to Buy: Dream Industrial REIT (OTC: DREUF, TSX: DIR-U)

Why to Buy Now: We’re attempting to dial back the risk somewhat this month with a real estate investment trust (REIT) whose properties have a high occupancy rate, at 95.6 percent across the overall portfolio, and generate solid cash flows.

Dream Industrial REIT owns and operates a portfolio of 205 high-quality light industrial properties comprising approximately 15.6 million square feet of gross leasable area located in primary and secondary markets across Canada.

The REIT enjoys solidly bullish sentiment on Bay Street. And it boasts an ample monthly distribution of CAD0.05833, or CAD0.70 annualized, for a current yield of 7.2 percent.

With a market cap of CAD491.2 million, Dream Industrial is just on the cusp of being a small-cap stock. As such, the trading volume of its OTC listing can be pretty thin. While daily trading volume has risen as high as 122,000 shares recently, most days total volume is just a couple thousand shares.

As such, investors should absolutely use buy limits to build or exit their position. Set your buy limit at or below the current price to avoid moving the market.

Dream Industrial REIT is a buy below USD10.

Ari: While there’s no such thing as a low-risk, high-yield equity, we’re attempting to dial back the risk somewhat this month with a real estate investment trust (REIT) whose properties have a high occupancy rate and generate solid cash flows.

Although expectations for unit price appreciation in the near term are modest, Dream Industrial REIT (OTC: DREUF, TSX: DIR-U) offers an ample, well-supported distribution.

Khoa: Correct me if I’m wrong, but didn’t this REIT used to operate under the Dundee name?

Ari: Indeed, Dream Industrial was spun off from Dream Office REIT (OTC: DRETF, TSX: D-U) back in October 2012, and until earlier this year in May, both entities operated under the Dundee name. Dream Office still holds a 29.1 percent stake in Dream Industrial.

While I believe Dream Industrial is a solid investment, I personally think the name change is atrocious. At least, the notion of a “dream office” exists. But I don’t believe anyone would ever use “dream” as a modifier for an industrial space.

Khoa: What was the company’s rationale for adjusting their brand?

Ari: It was a bunch of feel-good nonsense about how the name change aligns with the REIT’s core belief that it’s creating better communities for Canadians in which to work, which will result in a better investment for unitholders.

While I trust the executive team’s judgment when it comes to acquiring and managing properties, creative branding is clearly not their strong suit.

Khoa: Maybe the “Dream” brand will overcome our collective cynicism and provide an additional boost for unitholders.

Ari: Let’s hope so! I’m all in favor of any performance edge for our recommendations, even one that’s derived from a silly, though memorable, name change.

Khoa: Frivolity aside, tell me more about Dream Industrial’s portfolio.

Ari: Dream Industrial describes its portfolio as consisting primarily of high-quality light industrial properties comprising approximately 15.6 million square feet of gross leasable area located in primary and secondary markets across Canada. These properties tend to generate stable and predictable cash flows and produce high yields.

At quarter-end, the portfolio held 205 properties located in Calgary, Edmonton, Regina, Toronto, Montréal and Halifax. These properties are leased by 1,265 tenants, and the weighted average remaining lease term across the portfolio is 4.5 years.

Dream Industrial also boasts an above-average occupancy rated of 95.6 percent. In fact, management’s approach emphasizes renewals of existing tenants to reduce tenant improvements and leasing costs and to maintain current occupancy without interruption.

The REIT characterizes the industrial real estate sector as a fragmented market that offers significant opportunities for consolidation. Indeed, Dream Industrial has made five acquisitions since it first went public not quite two years ago, more than doubling its asset base to CAD1.5 billion, with the latest two portfolio additions announced just last week.

Dream Industrial is acquiring two portfolios of 14 geographically diversified properties, with one portfolio from Dream Office, totaling 248,000 gross leasable square feet, and the other from KingSett Capital, totaling nearly 1.1 million gross leasable square feet.

The weighted average remaining lease term for the acquisitions as a whole is 6.3 years, with an occupancy rate of 97.2 percent.

The CAD128 million deal will be funded through the issuance of new equity units as well as new and assumed mortgage debt.

The acquisitions are expected to close in September and are immediately accretive to adjusted funds from operations, by CAD0.015 on an annualized basis.

The deal will also improve the portfolio’s already strong characteristics, increasing the overall weighted average lease term to 4.7 years and boosting the occupancy rate by a tenth of a percentage point, to 95.7 percent.

Khoa: What does analyst sentiment look like?

Ari: Dream Industrial has enjoyed solidly bullish sentiment since its spinoff from Dream Office. Though the number of analysts tracking it has risen over time, at no point has it been rated anything less than a “buy.”

The REIT is currently rated “buy” by all eight analysts who track it. The consensus 12-month target price is CAD10.36, which suggests potential appreciation of 6.3 percent above the current unit price.

The modest expectations for future price appreciation are likely the result of the REIT’s strong run over the trailing year.

However, that performance followed a protracted decline that accelerated in sympathy with the broad selloff that occurred in the middle of last year among REITs and other dividend stocks.

Dream Industrial fell from an all-time high of CAD11.70 in late January of last year to a low of CAD8.23 by mid-December. Although the units are up 18.5 percent since their bottom, they’re still down about 16.7 percent from the aforementioned high.

You may recall that the REIT selloff was precipitated by the US Federal Reserve’s announcement at the time that it was planning to curtail its extraordinary stimulus. Traders jumped the gun by punishing income-oriented equities with the expectation that yield-starved investors would abandon them in a rising-rate environment.

While dividend stocks will eventually face stronger competition for income investors’ dollars from fixed-income securities, that hasn’t happened quite yet.

Beyond that, traders were betting that REIT fundamentals would deteriorate once they could no longer borrow cheaply to expand their portfolios of properties.

But that analysis could prove short-sighted. Both the Fed and the Bank of Canada have pegged rate hikes to an improving economy, so unless we’re suffering a period of stagflation (i.e., a slow-growing economy wracked by high inflation), then rising rates will presumably accompany robust economic growth.

And from the standpoint of REITs, a growing economy usually translates into rising rents. So while growth via acquisition will necessarily slow as financing becomes more expensive, REITs will simply shift to organic growth.

According to management, two-thirds of Dream Industrial’s properties are leased to multi-tenants, which means it should have greater opportunities to raise rents. And renewals should yield moderate gains, since market rates are 6 percent above in-place rents.

There are also opportunities to pursue intensification, a real estate term that means increasing the density of an existing property so that it can support a larger tenant base.

During this interim period, Dream Industrial’s near-term growth prospects could be subdued. But the REIT’s monthly distribution of CAD0.05833, or CAD0.70 annualized, which currently yields 7.2 percent, is ample compensation while we see how it adjusts to the changing operating environment.

The payout ratio, which is based on adjusted funds from operations, is 89 percent, which is solid coverage for a REIT.

For full-year 2014, analysts forecast FFO per unit will rise 5 percent, to CAD0.95, on revenue growth of 17 percent, to CAD167 million.

The REIT has beaten estimates for FFO per unit in three of the past five quarters, so it has a decent record of managing analysts’ expectations.

Khoa: What about tax considerations?

Ari: Unlike US REITs for which distributions are taxed as ordinary income, distributions from Canadian REITs are taxed at the more favorable dividend tax rate of 15 percent. Of course, that rises to 20 percent if your taxable income is in the top bracket.

However, the Canadian government will withhold 15 percent of the payout, though that amount can be recovered as a credit at tax time by filing Form 1116. This withholding rate has been reduced from the usual 25 percent rate for non-resident investors as the result of a tax treaty between the US and Canada.

While Canadian companies that are organized as corporations are exempt from this withholding when held in a tax-advantaged account such as an IRA, Canadian REITs held in IRAs are still subject to this withholding, and it cannot be recaptured via a credit at tax time.

The Canada Revenue Agency (CRA) implemented a new rule in early 2013 that requires US investors to file Form NR301 through their brokers in order to receive the reduced rate of withholding. Follow this link to learn more about the form and its requirements.

With a market cap of CAD491.2 million, Dream Industrial is just on the cusp of being a small-cap stock. As such, the trading volume of its OTC listing can be pretty thin. While daily trading volume has risen as high as 122,000 shares recently in the wake of its acquisition, most days volume is just a couple thousand shares.

As such, investors should absolutely use buy limits to build or exit their position. Set your buy limit at or below the current price to avoid moving the market.

Dream Industrial REIT is a buy below USD10.

Expect a separate update via email later this week, with a slew of earnings updates for existing holdings.