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Income from Residential Real Estate Development Opportunities

The Canadian dollar has been caught in the crosswinds of the recent liquidity flight to U.S. greenbacks, giving us good reasons to scour the Canadian bond market this week looking for the best high yield debt instrument to increase the loonies in our clients Foreign and World Fixed Income portfolios. To overcome the difficulty in finding suitable high yield investment opportunities in bonds denominated in loonies, we turned to one of our neighbor to the north's numerous convertible debentures. Tricon Capital (TCN.TO), which we first reviewed last September, has continued to improve and is delivering excellent results. In fact, we so like Tricon's business model and the direction the company is moving in, that we began to consider whether it might be reasonable to acquire more of its 2017 bonds at a significantly higher price (and lower yield) than our earlier purchase. Fortuitously, this occurred at about the same time that Tricon announced that it was planning a new (second) convertible debenture due March 31, 2020. Similar to its earlier 2017 note, this bond is also "unrated" by the popular credit rating agencies. However, in the following updated review of Tricon Capital, we present how it meets and exceeds the strict criteria that we have previously developed and found highly successful for evaluating lower rated bond issues.

Denominated in Canadian Dollars, this Canadian company's Convertible Unsecured Subordinated Bond has a coupon of 5.6% and currently trades near par. While the debentures are redeemable at the option of the company at par after March 31, 2018, the bondholder has the option to convert this debenture anytime (up until its maturity in 2020) to common equity stock at the conversion price of C$9.80 ($9.60 in USD) per share. This gives this instrument the potential for much higher returns and added protection against higher inflation should the stock price of Tricon Capital appreciate significantly in value. Tricon Capital Group currently trades for about C$6.83 ($6.68) and has been paying a quarterly dividend that amounts to C$0.24 ($0.23), or about 3.51% annually.

Given the possibility of significantly increasing this already very respectable 5.6% yield through the added capital gains its conversion to stock option allows for, as explained further in this review, we find it timely and appropriate to include these seven-year Canadian dollar Tricon Capital convertible notes in our Foreign and World Fixed Income holdings.

Tricon Capital Group

Founded in 1988, Tricon Capital Group Inc is one of North America's asset managers focused on the residential real estate development industry. It has participated in the development of residential properties in Canada and the United States by acting as the manager of a growing series of limited partnerships that provide financing for residential land development, single-family homebuilding, multi-family construction and retail developed in conjunction with residential projects. Tricon is focused on four major geographic markets in Canada (Toronto, Vancouver, Calgary and Edmonton) and five major geographic markets or regions in the United States (Southern California, Northern California, Phoenix, Atlanta and South Florida). It currently manages 7 active funds with about $1.07 billion in assets under management and a growing portfolio of U.S. single-family rental homes. Over its 23 year history, Tricon has financed about 150 transactions valued at roughly $9.8 billion and has an outstanding track record of investment performance and fund raising.

Tricon is an asset manager and principal investor focused primarily on the for-sale housing sector. As an asset manager, it manages private funds and separate investment accounts for investors participating in the development of real estate in North America by providing financing (generally in the form of participating loans which consist of a base rate of interest and/or a share of net future cash flow) to developers. As a principal investor, it co-invests in its private fund and separate account business, and most recently has established a U.S. single-family rental platform whereby it can acquire, renovate, lease and manage distressed single-family homes through a network of "best in class" local operating partners. The Company believes that U.S. single-family homes can be purchased at meaningful discounts to peak pricing and replacement cost and even to current retail pricing through foreclosure, short and bank REO (real estate owned) sales and that the Tricon will generate attractive risk-adjusted yields from the rental, sale and future appreciation of these properties.

A Bloomberg article that appeared this week indicates that Tricon is not alone in the pursuit of distressed homes. One of the largest asset managers in the world, the Blackstone Group (NYSE:BX), recently increased a line of credit from $600 million to $2.1 billion to pursue a similar rental strategy. Blackstone has invested $3.5 billion in 20,000 single family homes over the past year. This reinforces our opinion that Tricon's current strategy and timing in the real estate is very sound.

Tricon completed its Initial Public Offering in May of 2010 (at C$ 6.00/share), and in April of 2012 completed a C$51.75 million ($50.7 million) equity offering priced at $C4.00/share. Its asset management business derives its revenue principally from Contractual Management Fees, General Partner Distributions, Performance Fees, and Investment Income. Tricon's total Adjusted Base Revenues for the quarter ended September 30, 2012 increased by 277% from $2.63 million to about $9.93 million when compared to the quarter ended Sept. 30, 2011, primarily as a result of the contribution from Tricon's new single-family home strategy, the sale of warehoused investments to new U.S. distressed fund Tricon XI, increased investment income and increased contractual management fees. Adjusted Base EBITDA for Q3 2012 increased by 210% from $1.065 million to about $3.3 million, and Adjusted Net Income for the quarter ended September 30, 2012 was $1.655 million, approximately $1.076 million or 186% higher than the $0.579 million earned for the quarter ended September 30, 2011. Interest expenses for Q3 2012 were $0.564 million, indicating a coverage ratio greater than 6 times.

The company's U.S. single-family platform has generated net operating income of about $815,000 since its inception in Q2 2012, primarily from the sale of Inventoried Homes designated for sale; which amount is expected to ramp up through Q4 2012 and beyond since there is a 60- to 90-day time frame required to renovate, lease and stabilize the recently acquired rental properties. AUM for the quarter ended September 30, 2012 was $1.076 billion -- approximately $136.7 million lower than June 30, 2012, and approximately $87.2 million higher than December 31, 2011. This decrease resulted from the run-off of old funds and was partially offset by increases in AUM from the initial close of Tricon XI and higher capital deployed to the U.S. single-family rental strategy

During Q3 2012, the company's assets and liabilities increased as a result of the C$51.75 million ($50.6 million) debenture offering completed in July 2012. Cash and cash equivalents at the end of Q3 were about $55.9 million, while debt was $53 million. On Dec. 4, 2012, the company and Mandukwe Corp. ( a company controlled by Geoff Matus, cofounder and a director of Tricon) completed an offering of 11,097,500 common shares at a price of C$5.70/share, for aggregate gross proceeds of about $61.86 million. On Jan. 3, 2013, the company announced the acquisition of a 550-unit portfolio of homes in Charlotte, N.C., for approximately $26 million. The portfolio was assembled over several decades by a private individual and has an occupancy rate of approximately 95%. Based on current rents in place and historical operating expenses, the purchase price equates to a capitalization rate of over 12.5%.

Tricon continues to successfully deploy capital into its new U.S. distressed single-family for rent platform; however, no meaningful income is expected until Q4 2012 as it generally takes 60 to 90 days to renovate, lease and stabilize recently acquired rental properties and to renovate and harvest the flip properties. The company views the single-family home rental strategy as an opportunity to invest in a deeply undervalued asset class which the company believes offers investors strong downside protection through stable rental income and meaningful upside potential should the U.S. housing market recover. The company believes there may still be several additional U.S. markets with economic conditions that create attractive investment opportunities for the distressed acquisition and rental of single-family home (and, if the opportunity arises, for smaller multi-family dwellings). In time, Tricon may explore expanding its platform into other markets in an effort to further its U.S. national presence, with the objective of becoming one of the larger owners of U.S. single-family rental properties in the United States. Tricon continues to pay equity holders a quarterly dividend of six cents, or about $0.24 annualized, to its shareholders.

With this second convertible offering, it was announced this week that with the additional underwriter purchases Tricon has added about $84.1 million to their cash holdings. Tricon appears to have very little difficulty maintains strong balance sheet flexibility and good access to the equity capital markets. Along with strong insider ownership and buying support, Tricon has the approval to the Toronto Stock Exchange to buy back up to 5% of its common shares should it believe it to be an appropriate use of available cash and to be in the best interest of Tricon and its shareholders.

The Convertible Note

In addition to the 5.6% coupon (paid semi-annually) that they offer, a very important feature of this bond to consider is the holder's option to convert it at anytime prior to maturity to common stock at the conversion price of C$9.80. This strike price represents a mere 5.25% annualized appreciation from the C$6.83 price TCN is currently priced at on the Toronto exchange, and it is our belief here at Durig Capital that there is very strong upside growth potential remaining within this company that may significantly exceed the 5.6% yield to maturity (at par) in 2020 that is indicated in the bond's current price at par. While both of Tricon's convertible debenture represent an intriguing opportunity, we see this longer maturing issue as being more conservative and having less downside risk due currently due to the high premium that the shorter issue commands. We also think that because the conversion feature allows bondholders to participate in a significant rise in the stock price, the longer maturity can be viewed as advantage. However, we would also like to point out that the shorter maturing issue will capture more of the capital gains appreciation of the stock should the stock price rise to conversion price of C$9.80 prior to August 2017.

Being a smaller issue, Tricon's debt is not covered by the major credit rating agencies and is therefore classified as "unrated." However, this appears to be a very astutely managed, well financed company with reasonably low debt, ready options for additional funding if necessary, and a prudent use of existing cash flows.

Risks

The default risk is Tricon Capital's ability to perform. Considering their historical and recent performance, their flexible balance sheet, their sound cash position, and the excellent cash flow that is projected to service their interest bearing debt, as outlined above, it is our opinion that the default risk for this short to medium term bond is minimal relative to its more favorable return potential. An option that further reduces the default risk of this convertible bond, should at its maturity the company decide not to pay off or roll over the debt, is a conversion of the principal (at par) to TCN common stock at a 5% discount to stock's valuation at maturity on March 31, 2020. As a result of being denominated in Canadian dollars, the currency exchange risk will affect the returns of these bonds and possible in a negative way as it exposes investors to the Canadian economy.

Tricon's investments focus on the North American housing industry, with primarily attention to previous home bankruptcies. Even though this appears to be an industry that has been gaining strength since we first reviewed Tricon, the industry is fraught with unknown and uncontrolled industry related issues, such as changes in interest rates and/or building cost of new housing. Furthermore, the overall supply and demand for housing in a particular region can greatly affect the profitability within the housing market. Any and all of the above could affect the future profitability of Tricon Capital.

Any fast growth company in developing markets, such as Tricon Capital, also has execution and market risks, as companies often encounter unforeseen issues. This is a common risk associated with younger, fast growing companies.

Tricon Capital convertible debentures have similar risks to the previously reviewed TransGlobe Energy (NASDAQ:TGA) convertible bonds, Brigus Gold (BRD) convertible bonds, and Neo Corp. convertible bonds, which were subsequently acquired by Molycorp (NYSE:MCP). TransGlobe Energy's convertible bonds. Tricon Capital's 6% convertible debenture, which was added last fall to our Foreign and Global fixed income portfolio, has become one of the portfolio's top performing issues.

Conclusion

We applaud Tricon Capital's successful and intelligently leveraged approach to the currently distressed North American real estate market. This relatively small and less well known issue appears to be a savvy investment risk offering solid returns from a company that has good management, a good cash position, good interest coverage, and a strong and flexible balance sheet. Its convertible bond appears to be an exceptional opportunity for obtaining a very respectable 5.6% yield, with significantly lower default risk than is typically associated with an unrated (or low-rated) medium-term bond. The additional capital gains return potential that its conversion at any time feature allows gives us further reason to add this Canadian dollar denominated debenture to our Foreign and World Fixed Income Portfolio

Ticker: TCN.TO
TSX: C$6.97 March 6, 2013

Convertible Debenture:
Coupon: 5.60%
Maturity: March 31, 2020
CUSIP: 89612WAB8
Conversion Price: C$9.80
Rating: None
Pays: Semi-Annually
Price: 100
Yield to Maturity: ~5.6%

Disclaimer: Please note that all yield and price indications are shown from the time of our research. Our reports are never an offer to buy or sell any security. We are not a broker/dealer, and reports are intended for distribution to our clients. As a result of our institutional association, we frequently obtain better yield/price executions for our clients than is initially indicated in our reports.

Source: U.S. Real Estate Opportunities Yield 5.6% With Tricon Capital's Convertible Debentures