Artis REIT: Building Value That Will Eventually be Unlocked

• Artis 3/15 unit price is a 31% discount to IFRS Net Asset Value of $15.55 per share
• Artis trades at 8X 2019 FFO, well below the 14X average for Canadian REITs and 19X average for US REITs
• The strategic initiatives announced in November 2018 have been aggressively implemented
• Shares may not trade at fair value until further corporate actions are forced by an activist shareholder (Sandpiper) and a strong independent shareholder (Joyce)

Artis REIT units have risen 19.6% in 2019, but are still slightly below where they traded prior to the 11/1/18 announcement of “New Initiatives To Deliver Improved Value to Shareholders“.  The company’s satisfactory 4Q18 results featured aggressive share repurchases and marketing of assets for divestiture.

The company’s projection of Year3 Net Asset Value of $17.50 can be easily achieved and likely exceeded through development projects (long-term company target of $3.80/unit) retained cash flow (about $1.50/unit) and accretive share buyback (about $1/unit).

A significant risk is that the company could continue to trade at a large discount to Net Asset Value that might not be eliminated without more aggressive reorganization.  Activist investor involvement is likely to ensure that steps are taken to deliver fair value to shareholders over time.

Topics:

• 4Q18 Operating Results
• Relative Multiples
• Strategic Initiative 1: Divestitures
• Strategic Initiative 2: Buyback
• Strategic Initiative 3: Development
• Activist Involvement
• Investment Considerations

Background: Artis is a diversified Canadian REIT with Office (53%) Industrial (27%) and Retail (20%) assets in Canada (55%) and the United States (45%).  Additional information is available at the company website, investor presentation, financial reports, conference call transcripts and a prior Koneko article (12/31/18).

4Q18 OPERATING RESULTS

Artis 4Q18 results (press release) were in line with expectations and largely overshadowed by the strategic initiatives.  Key data:

The key trends affecting the value of the company are managing the weakness in certain Canadian markets and maximizing the value of the thriving US industrial assets.

Part of the Canadian office weakness is attributable to 360 Main (profile) in Winnipeg where vacancy is temporarily high during a substantial renovation for a new tenant who will take a large block of space.

RELATIVE MULTIPLES

Artis trades at a large discount to the valuation of REITs in every sector where it owns assets:

The large valuation gap shows that Artis valuation is held back by the excessively diversified scope of its business.

STRATEGIC INITIATIVE 1: DIVESTITURES

Artis is rapidly executing its plan to sell $800-1000mm of property within three years.

• $320mm of properties were classified as “held for sale” at 12/31, most are expected to sell by 3Q19, and $100mm are already under contract.
• Another $100mm to be added to “held for sale” during 1Q19
• A similar volume of sales is expected in 2020 and would reach the proceeds goal in 2 years (ahead of schedule)
• Management sees good demand and the pace of sales is currently only restrained by the capacity of the company to manage so many simultaneous transactions.

Artis noted that buyer inquiries have been from opportunity funds, private family offices, and operators seeking to convert a building to hotel or residential use.  There has been no interest from public REITs.  Investors pay high valuations for REITs with steady income with low perceived risk, but Artis and others (e.g. Dream Office) have shown that the market is very unforgiving  of holding distressed assets within a REIT.  7.7% of Artis 4Q18 NOI was from the severely depressed Alberta office market and the company hopes the current sale program will reduce the weighting to 5%.

STRATEGIC INITIATIVE 2: BUYBACK

Artis intends to repurchase $270mm of shares within three years at an estimated average cost of $11.50.  The REIT bought 3.5mm shares in 4Q18 at an average price of $9.77 and has repurchased an additional 4.1mm shares in 2019 (to 3/8) at an average price of $10.39.  Total purchases of $77mm in just over 4 months put the company well ahead of the promised pace of execution and at better than projected cost.  Artis has drawn on its credit line to buy shares when they were at a very attractive discount to NAV.  The borrowing will repaid in coming months with proceeds from properties currently held for sale.  Conference call comments were vague about whether there was any ceiling on the unit price that the company might be willing to pay for repurchases.

STRATEGIC INITIATIVE 3: DEVELOPMENT

Artis plans to invest about $200mm over the next three years in multi-phase new industrial developments in the US:

Phased construction allows Artis to defer capital investment to match tenant commitments for the completed space and limits exposure to the risk of a market downturn.  The company expects to achieve rental yields about 150-200bps above market cap rates which could improve IFRS Net Asset Value by $0.49/share.

Artis will earn additional profits by preparing certain existing properties for residential conversion and then selling to third parties after zoning approvals have been received.  The 4Q18 conference call included discussion of 415 Yonge Street (profile)  at a fantastic downtown Toronto location and the Concorde Corporate Center (profile) in suburban Toronto:

“We think by the second-half of this year we’ll launch the sale of [415 Yonge]. We’ve been at this for two years with the city planners, and we feel optimistic that we’re going to be getting a positive report and support from the planners in the near future. And because of that — and again, you can’t quote me on this, but we just feel good about the momentum, we’re getting the progress, and that is a bit of a game changer in terms of getting the actual entitlements after that. So, we’re plugging away, and the more visibility we can get on the re-zoning, I think the higher — the more value we get when we sell. So, that’s the balancing act right now for 415 Yonge. But meanwhile, it’s a great asset.

If we don’t re-zone that site, Mike, in the next 10 years, that NOI will double. That’s just the way it is, it’s just a great asset to hold right now. And so the same applies to Concord. Concord, we’re being well received [indiscernible] we’ll have some entitlements, and we’ll look to launch Concord in the second-half of this year as well.”

The 4Q18 financial statements provided additional detail:

Artis is exploring opportunities for a densification project at 415 Yonge Street in Toronto, Ontario. 415 Yonge Street is in a prime location in downtown Toronto, across from the College Station subway stop and in close proximity to the University of Toronto and Ryerson University. Preliminary plans to build 375 apartment units above this 19-storey office building are underway.  Artis is exploring opportunities for a densification project at Concorde Corporate Centre in the Greater Toronto Area, Ontario.  The site provides direct access to Don Valley Parkway and convenient access to other major thoroughfares in the Greater Toronto Area. Preliminary plans are underway to build approximately 600 apartment units on the site.  Development plans are underway to rezone the Stampede Station II site on Macleod Trail in Calgary, Alberta, from the original plan for a 300,000 square foot office project to a 30-storey multi-family project with 300 suites.  Artis is exploring opportunities for a densification project at Poco Place in Port Coquitlam, British Columbia. The site provides
access to major transportation routes and frontage on four streets, including Lougheed Highway, an east-west arterial corridor.  Preliminary plans to build 600 to 900 apartment units are underway.  These projects will be planned for sale once rezoning and densification entitlements are achieved.

The IFRS carrying values of these redevelopment properties are based on current usage and rents so sales after successful rezoning with increased density should result in significant gains.

ACTIVIST INVOLVEMENT

Artis has a clear path to increasing asset value over time through development, however it may be unable to deliver an improved shareholder return without more significant corporate actions because its diversified business model is unpopular with investors.  For comparison Brookfield Property Partners (BPY) has a diversified portfolio and trades at a 30% discount to book value despite an excellent reputation and superior long term performance.  Dream Office traded at a large discount to NAV while it held underperforming Alberta assets and eliminated the discount by shrinking the company to a core portfolio of prime assets mostly in Toronto.

The strategic initiatives announced by Artis can each build value, but they do not address the excessive diversification which is the fundamental reason for the share price undervaluation.  The potential to capture that value attracted the attention of activist investor Sandpiper Group which disclosed a 4.5% stake last Spring and agreed with Artis on the selection of a new independent director.  Sandpiper’s public record with Canadian real estate companies has been:

• Dream Alternatives (10% stake disclosed 3/6/19) – “Sandpiper has engaged, and intends to continue to engage, in discussions with DAT leadership and looks forward to further dialogue with regards to, among other things, capital allocation, corporate governance and board composition, corporate strategy and opportunities to maximize unitholder value.”  Shortly prior to public disclosure of Sandpiper’s investment DAT announced a “strategic plan to enhance unitholder value” featuring repurchase of up to $100mm of shares (about 20% of market cap).
• Pure Multi-Family (2% stake disclosed 4/30/18, current ownership unknown) – Sandpiper supported the sale process initiated by the Board of Directors following receipt of an unsolicited merger proposal.  No firm offers were received, the process closed, and Sandpiper has not taken further public action or made any comment.
• Artis (4.5% stake disclosed 4/4/18, current ownership unknown) – Artis agreed to add an independent Director recommended by Sandpiper.  The Director is not a Sandpiper employee and therefore Sandpiper is not an “insider” required to report all transactions in Artis shares.  Sandpiper has not taken further public action or made any comment about Artis.
• Agellan Commercial (10% stake disclosed 9/19/17)– Sandpiper protested a $15mm payout to the REIT’s external manager, received support from 35% of outstanding shares in calling a special shareholder meeting to replace certain directors, reached a settlement agreement which included appointment of three new directors, and the REIT was recently acquired at a 15% premium to its IFRS Net Asset Value and at a substantial increase over the price at which Sandpiper became involved.  Like Artis, Agellan was a Canadian REIT with Industrial (50% of NOI) and Office (50% of NOI) properties in the US (75% of NOI) and Canada (25% of NOI).  Due to its diversified business model the price of its units in the Canadian market did not fairly reflect the value of its assets, particularly the US industrial properties.  Sale of the company provided the best outcome for shareholders.

• Granite (6.2% stake disclosed 5/26/17) – Sandpiper launched a proxy fight to replace the Board of Directors that led to a settlement agreement and appointment of three directors selected by Sandpiper.  Sandpiper promised that it’s plan provided “a clear path to a $60 share price” which has recently been surpassed:

Artis sticks out on Granite’s Fall investor presentation as the most undervalued peer.

A Globe & Mail profile of Sandpiper mentioned it is raising an additional $200mm for investment in undervalued Canadian real estate companies.  Comments in the article by Sandpiper’s CEO seem highly relevant to Artis:

Mr. Manji would not provide names or identify the type of real estate he is pursuing, but he said companies with more than one type of real estate (such as office buildings, apartments and warehouses) or those that are heavily invested in retail or properties in Alberta would come under pressure.

“The only way to bridge the value gap is by taking the tough medicine and making the fundamental changes, whether it is by divesting an entire portfolio that represents one asset class, or possibly even doing something more significant than that,” he said.

Each step of Artis strategic plan is building value for investors, but if that value is not fairly reflected in the share price then I expect a push by Sandpiper for bolder corporate actions would be broadly supported by the company’s investors including the family of Ron Joyce which owns 12% and has one seat on the Board.  Management built the company as it is now and might prefer to get away with doing less, but insider ownership is low and the company does not have an outstanding long-term record that it could point to in its defense.

INVESTMENT CONSIDERATIONS

Investors punished Artis for reducing its dividend rate, but dividends simply transfer value rather than creating value.  Any change in the dividend does not affect the underlying value of the company and its assets so this article does not offer any detailed commentary about past present or future dividends.  The distribution (currently C$0.54/year) gradually returns a portion of the full NAV which we can now acquire in the market at a discount.

Artis shareholders will be rewarded if corporate actions succeed in narrowing the NAV discount so investors should be attuned to board membership, the shareholder roster, and developments at peer companies that may hint at the path that Artis will follow.

Disclosures

The author is a shareholder of Artis REIT.  The author does not make any recommendation regarding any investment in any company mentioned in this article.  Investors are encouraged to check all of the key facts cited here from SEDAR filings and other sources prior to making their own investment decisions.

“Art is anything you can get away with” is from the Canadian philosopher Marshall Mcluhan’s 1964 book Understanding Media, but on the internet it is often attributed to Andy Warhol because it seems so appropriate.  Artis REIT may keep trying things until it finds a form that people like.