Artis REIT: Liquidation Sale?

• Artis 3/3 unit price is a 16% discount to IFRS Net Asset Value of $15.56/unit
• Artis trades at 8X 2020 FFO, well below the 15X average for all Canadian REITs
• The strategic initiatives announced in November 2018 have been aggressively implemented and the benefits are fully reflected in the unit price
• The share price now includes optimism about sale of the company

Artis REIT (TSX:AX/UN)(ARESF) has provided a 53% total return since my December 2018 article (LINK).  Strong 4Q19 operating results were led by a 40% yoy increase in NOI from US industrial properties.  Since announcing its strategic initiatives in November 2018 Artis has provided a higher total return than most diversified REIT peers:

1. Cominar (TSX:CUF/UN)(CMLEF)+42%
2. Artis +39%
3. iShares S&P/TSX REIT ETF (TSX:XEG)(IUSPF) +27%
4. Morguard REIT (TSX:MRT/UN)(MGRUF) +14%
5. H&R REIT (TSX:HR/UN)(HRUFF) +9%
6. Brookfield Property (TSX:BPY/UN)(BPY) +7%

The benefits of the 2018 plan are now well understood by the market and the unit price is what it is.  The formation of a Special Committee and activist investor involvement should increase confidence that additional steps will be taken.  BNN-Bloomberg reported on 2/28 that takeover discussions have taken place with several parties.  A successful transaction should deliver at least CAD$15/unit while failure to reach an agreement could cause the units to fall back below CAD$12.

Topics:

• 4Q19 Operating Results
• Relative Multiples
• Strategic Initiative 1: Divestitures
• Strategic Initiative 2: Buyback
• Strategic Initiative 3: Development
• Special Committee & Activist Involvement
• Investment Considerations

Background: Artis is a diversified Canadian REIT with Office (49%) Industrial (33%) and Retail (18%) assets in Canada (52%) and the United States (48%).  Additional information is available at the company website, investor presentation, financial reports, conference call transcripts and prior Koneko articles.

4Q19 OPERATING RESULTS

Artis 4Q19 results (press release, MD&A, conference call transcript) beat expectations.  Key data:

Artis has substantially reduced its exposure to the weak Calgary office market (only 6% of 4Q19 NOI and expected to be just 2% after 1Q20 sales).  Results benefited from increased rents at US industrial properties which reported same property NOI +6% yoy.  Total NOI from US Industrial properties rose from $9.8mm in 4Q18 to $13.7mm in 4Q19 (+40% yoy) due to a 23% increase in GLA.

Net Asset Value suffered from depreciation of the USD from CAD$1.324 at 09/30/19 to CAD$1.300 at 12/30/19.  A $32mm fair value loss on investment properties was partially offset by a fair value gain of $12mm on US properties held through joint ventures.

Overall it was disappointing that NAV increased by only $0.01/unit for the full year despite accretion from the unit buyback and value created by new industrial developments.  These benefits were offset by $0.67/unit of fair value losses and $0.50/unit of FX depreciation.

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 and the lack of exposure to the most valuable markets.

STRATEGIC INITIATIVE 1: DIVESTITURES

Artis is aggressively executing its plan to sell $800-1000mm of property within three years.  As of 12/31/19:

• $602mm sold
• $222mm held for sale (includes $118mm sold in Jan-Feb 2020)

Artis boasted that aggregate proceeds from completed sales were at a premium of $13mm over IFRS carrying value, but this is quite misleading because:

1. IFRS values were measured as of the quarter-end prior to disposition so they were already marked down close to the expected sale prices, and
2. It includes a $29mm gain at 415 Yonge Street in Toronto reflecting a development premium not factored into IFRS valuation.

The $95mm fair value losses on investment properties recognized by Artis in 2019 is a better indication of the softness in the company’s NAV.

During the 4Q19 conference call  CEO Armin Martens suggested that further sales at a pace of $200-400mm per year would be recycled into new investments, but added that “the board will take a good look and see what the next step is, it could be we’ll double down on our strategic initiatives.”

STRATEGIC INITIATIVE 2: BUYBACK

Artis intended to repurchase $270mm of units within three years at an estimated average cost of $11.50.  The company aggressively executed the buyback and purchased $173mm of common and $6mm of preferred through 9/30/19.  Management suggests that redemption of $79mm preferred units at par also counts to the buyback plan.  The Normal Course Issuer Bid approved by the TSX in December 2018 was fully utilized and the company renewed its authorization in December 2019.

Management indicated on the conference call that proceeds from additional asset sales will be allocated to debt reduction with a goal of reducing Debt/GBV to a range of 45-48% from 52% at 12/31/19.  Artis has not purchased any units since September.

STRATEGIC INITIATIVE 3: DEVELOPMENT

Artis planned to invest about $200mm over three years in multi-phase US industrial developments.  The company completed a large Denver area project in 4Q19 (Tower Business Center) which was 69% committed as of 12/31/19.  The company expects developments to generate a yield of 7% on cost and then have a stabilized fair value with a 5.5% cap rate.  Most of these industrial developments are held through the joint ventures responsible for a $32mm fair value gain during 2019.  These projects under planning should lead to gains in future periods:

Artis will earn additional profits by preparing certain existing office properties for residential conversion and then selling to third parties after zoning approvals have been received (4Q19 MD&A excerpt):

Rezoning and Densification Initiatives
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 500 apartment units on the site.  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.

The IFRS carrying values of these redevelopment properties are based on current usage and rents so sales after successful rezoning with increased density should provide significant gains as happened at the 415 Yonge Street property in Toronto.

SPECIAL COMMITTEE & ACTIVIST INVOLVEMENT

Artis has a path to increasing asset value over time through development, however its diversified business model is unpopular with investors and the company does not have assets in the most highly valued markets (e.g. Toronto, Vancouver, US Coasts).  There has been a risk that the strategic initiatives announced last fall would be insufficient to improve the company’s appeal.  Indeed management appears to believe that it delivered its commitments and the units continued to trade at a large discount to fair value.

Prior Koneko articles suggested that Artis could be pushed towards further strategic actions by an activist investor (Sandpiper Group) who has a successfully pushed for changes other companies including Agellan Commercial REIT and Granite REIT (see 03/19/19 article for background on Sandpiper’s record) .

In May Artis announced the formation of a “Special Committee of Independent Trustees to review and evaluate additional strategic alternatives that may arise”.   The 4Q report and conference call included no meaningful disclosures, but the BNN-Bloomberg article said:

Artis Real Estate Investment Trust has drawn takeover interest from prospective suitors including Morguard Corp. and Slate Asset Management LP, as well as an affiliate of TPG, according to people with knowledge of the matter.  Artis Chief Executive Officer Armin Martens has also held discussions with prospective partners and lenders regarding a takeover offer of his own, said the people, who requested anonymity because the matter is private.

Artis diversified portfolio may not be a good fit for any single strategic buyer, but it’s possible that the company could realize the highest value by selling itself in several pieces.  Looking at the entities mentioned in the article:

• Slate Asset Management  is a deep value buyer that seeks out of favor assets at bargain prices.  For example in 2017 Slate acquired buildings in Calgary from Dream Office.  In addition to private funds Slate manages two listed REITs: Slate Office (TSX:SOT.UN)(SLTTF) and Slate Retail (TSX:SRT.UN)(SRRTF).  Slate does not own any US industrial property.  On the recent Slate Office 4Q19 conference call  the company said it is evaluating acquisitions with cap rates around 7%.  At 12/31/19 Artis’ Office portfolio had an IFRS valuation at a 6.8% cap rate.
• Morguard Corporation is a long-term value buyer (for interesting background see

  Rai Sahi: A Canadian Outsider CEO).  Morguard owns a lot of Retail and Office properties, but only a small amount of Canadian Industrial (1.5% of its portfolio) and no US Industrial.

• TPG Real Estate has a portfolio of loans and minority equity interests rather than direct ownership of properties.  It is unlikely that TPG would buy all or a significant part of Artis, but it might provide financing for a third party purchase of some Artis assets.
• Armin Martens could be involved through the Marwest Group, the Martens family business that created Artis REIT and served as its external manager until 2011.  A Marwest unit has served as “capital advisor” to Artis REIT on its US industrial investments.

Artis shares have been undervalued because the diversified business does not suit the objectives of most retail and institutional investors.  The Special Committee faces the same challenge in evaluating strategic alternatives, there is not a logical buyer for the entire company.  One possible way to maximize value for shareholders would be to sell the Office and Retail assets to Slate and/or Morguard and to either leave the Industrial assets as an ongoing public business or sell them to another entity, possibly Marwest with a financing package from TPG.

Artis Industrial properties were valued at a cap rate of 5.8% at 12/31/19.  CBRE’s 2020 Outlook provided these valuation ranges for Artis significant Industrial markets:

A strategic transaction should deliver at least the carrying value of Artis Industrial properties and possibly more to reflect the development pipeline.  Artis Office and Retail assets might sell at a discount to their carrying value because fair value losses were incurred ahead of the sales made during 2019.

INVESTMENT CONSIDERATIONS

Investors punished Artis in 2018 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.

The Special Committee could face a dilemma if the best bid received for the company (in whole or in parts) is less than C$15.  In that case there might be a temptation for Artis to continue as an independent entity and build value over time, but the stock would probably drop back under C$12.  The Special Committee and management might decide to increase the scope of the 2018 initiatives, i.e. more asset sales and more unit buybacks.

Disclosures

The author is a unitholder 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 any investment decisions.