H&R REIT: This Blue Chip Canadian REIT Has Never Been Cheaper

• Unit price has fallen 51% since 2/28, much worse than peers
• Trading at a 60% discount to its IFRS Net Asset Value ($25.79) and  7.3 X 2020 AFFO (C$1.40) estimated prior to the impact of the coronavirus
• Diversified business model is unpopular with investors, but includes high quality assets that should sustain their value through the bear market
• Long-term growth prospects from residential development in the US and redevelopment of mature Canadian retail and office properties.
• Monthly distribution of C$0.115 provides a current yield of 13.5%, but it would  be prudent to cut the payout due to uncertainty this year.

Since 2/28 the unit price of H&R REIT (TSX:HR/UN) (HRUFF) has fallen much more sharply than peers in every sector where it has assets and does not fairly reflect the high quality of the company’s assets, stable financial condition, and strong long-term shareholder returns.

H&R’s business has built value for shareholders over time and and the unit price is likely to recover without any significant change in the company’s strategic plan.  The peer performance shown above suggests that H&R units should have only declined in a range of 10% ($17.46) to 20% ($15.52).

Topics:

• Profile and Net Asset Value
• Historical Returns
• Financial Review
• Growth Potential
• Coronavirus Impact
• Investment Considerations

Background: H&R is a diversified Canadian REIT with Office (49% of 2019 Property Operating Income) Industrial (8%) Residential (8% ) and Retail (35%) assets in Canada (70%) and the United States (30%).  Additional information is available at the company website, investor presentation, financial reports, and conference call transcripts.  All amounts in this article are in Canadian dollars unless otherwise indicated.

Profile and Net Asset Value

H&R was a business founded in 1952 by Jewish refugees from Hungary (Sandor Hofstedter and Bill Rubinstein) and H&R REIT has been listed in Canada since 1996.  Current Chairman Thomas Hofstedter and other insiders hold approximately 6% of the company’s units.  Directors have bought $941,522 of shares on the open market since 2/28.

Significant Historical Transactions:

• 2007 – Acquired The Bow tower development project in Calgary from Encana (now Ovintiv) for $70mm.  Encana signed a 25-year lease agreement for the entire tower, the largest in Canada went of Toronto, which began when construction was completed in 2013 and runs to 2038.  Ovintiv has since moved its headquarters to Denver.  27 floors of The Bow are occupied by its former oil sands subsidiary Cenovus and some of the remaining space is being offered for sublease.
• 2013 – Acquired Primaris REIT which owns Class B Malls in Canada with average sales of C$545/sf in 2019.  Unfortunately Primaris owned 0.7mm sf (attributable) occupied by Target Canada which filed for bankruptcy in 2015 and 0.6mm sf occupied by Sears Canada which filed for bankruptcy in 2017.
• 2013 – Acquired 1/3 ownership of privately held ECHO Realty which mostly owns grocery-anchored shopping centers in Pennsylvania and Ohio connected to the Giant Eagle supermarket chain.
• 2014 – Founded Lantower Residential which has grown to 24 properties with 8443 rental units, mostly in US sunbelt cities.

H&R’s investor presentation includes helpful disclosure about the composition of the company’s IFRS Asset Value:

H&R has emphasized large long-term leases with creditworthy tenants which provide protection from real estate market cycles:

H&R has 13% of its asset value in the Calgary Office sector where vacancy rates are over 27%, but H&R’s space is 100% leased to Ovintiv (at The Bow) plus pipeline operator TC Energy, and electric company Altalink (a unit of Berkshire Hathaway).

Historical Returns

H&R has generated an annual return (NAV appreciation plus dividends) of 13.6% for shareholders since 2003:

The lack of NAV growth in the last few years resulted from the burden of low occupancy at the Canadian malls following the Target and Sears bankruptcies.  By 12/31/19 it looked like the company might finally have digested those vacancies with committed retail occupancy of 94%, but COVID will certainly have an adverse impact in 2020.

H&R’s unit price has never been cheaper in its 20+ years as a public company.  The price was slightly lower in late 2008, but asset value was 55% lower than now.

Financial Condition

H&R’s income has been roughly unchanged over the past 5 years, however the company improved its financial condition and future earnings potential by selling mature assets and investing in promising new developments.

The company has a BBB investment grade credit rating and significant borrowing capacity to fund its development pipeline.

In January the company sold two US properties for proceeds of US$90mm and received a $256mm payment of a mortgage that it supplied to a buyer of one of its properties.  In February and March it paid off $337.5mm of maturing debentures.  The company has no other bonds due until 2022.

H&R sold $1.8Bn of property in 2018-2019, but additional asset sales would be difficult in the current market.  I believe the company is likely to take the prudent step of reducing its dividend by about 50%, as it did in 2009.  The retained $198mm could fund projects under development and redevelopment while also giving management flexibility to repurchase some units while they are trading at such a low valuation.

H&R is internally managed and trust expenses (excluding property operating costs) were a modest $27.3mm in 2019 (including $10.1mm of equity compensation).  That works out to about 0.4% of equity.

Growth Potential

H&R should be able to deliver growth in income and asset value in coming years:

Development:  H&R’s significant properties currently under development are:

• Industrial – Caledon ON.  Deutsche Post has leased 343,000 sf at the 526,000 sf Phase One of this 144 acre site near Toronto which will be completed in 2020.    Future Phases will expand the project up to 2.7mm sf.
• Residential – H&R currently has 7 US residential projects under construction and 5 in planning.  The company often works with local partners in larger markets.  For example, Tishman Speyer is 50% owner of the Jackson Park residential rental complex in Long Island City which was completed in 2019.  The owners expect to earn a 6% yield on the project cost. A new mortgage financing last year allowed H&R to recover almost all of its capital investment.

Redevelopment:  H&R has submitted plans for redevelopment of several existing properties to take advantage of strong demand for residential and office space. 

• The Dufferin Mall (lovingly celebrated by thedirtyduff instagram account) currently has 589000sf of retail space anchored by a Walmart.  Part of the open parking lot would become “Dufferin Grove Village” with 1135 residential units in 4 towers.

• At 145 Wellington Street in Toronto H&R has submitted plans to replace the existing 13-storey office building (above left) with a 65-storey tower (above right) holding 13 office floors and 52 residential.
• H&R has identified redevelopment opportunities at many other existing properties including 55 Yonge Street and 310-320-330 Front Street in the Toronto CBD.

Coronavirus Impact

The table of peer returns suggests that H&R’s unit price has been severely impacted by the coronavirus market crash while peer prices in each operating segment suggest the impact will be manageable.

The impact of the virus on the sectors where H&R has assets will be:

• Residential – limited impact because it serves an essential need.  There may be a short-term impact from rent deferrals and other concessions.  Leasing may slow.
• Industrial – limited impact.  E-commerce customers are benefiting from high volumes but industrial and retail customers are suffering.
• Office – CBD office demand has moderate economic sensitivity.  H&R’s revenue is protected by its long-term leases (average 12.4 year remaining term) with large tenants.
• Retail – necessity-based retail (grocery/pharmacy-anchored) will hold up relatively well.  Discretionary retail (e.g. apparel electronics, and entertainment) will obviously suffer.  All of H&R’s US retail properties provide essential services.  H&R’s Canadian mall properties include essential businesses like grocery stores, pharmacies, restaurants (take-out only), liquor stores, and medical services.  Depending on their tenant mix some malls are entirely closed and some are partially open.

H&R has not made any corporate statement about the virus, but press releases from Canadian peers generally indicate they will work with tenants on a case by case basis:

• Cominar (Cominar Provides COVID-19 Business Update and
  Withdraws 2020 Guidance)
• Choice (Choice Properties Real Estate Investment Trust Assisting Tenants Confronting Challenges from COVID-19)
• Artis (Statement on COVID-19)
• Morguard (Morguard Responds to COVID-19)
• Brookfield (Brookfield Property Partners Provides Update on COVID-19)
• Crombie (Crombie REIT Announces Small Business Support Program)
• CT (CT REIT Provides Business Update Related to COVID-19)
• First Capital (First Capital REIT Announces $30 Million Small Business Support Program )
• Smartcentres (A COVID-19 UPDATE FROM SMARTCENTRES REIT EXECUTIVE CHAIRMAN MITCHELL GOLDHAR)

Dream Office CEO Michael Cooper was quoted in the media pushing back against rent concessions for office tenants in strong financial condition:

Hypothetically a 20% reduction in H&R’s 2020 income from retail properties would cost the company about $50mm which is very manageable.  The share price decline implies a much worse outcome which seems unrealistic based on the company’s revenue mix.

Investment Considerations

Dividend: H&R has been paying a dividend of C$0.115/month for a current yield of 13.5%.  The cost of $396mm/year has been covered by Operating Cash Flow, but it would be prudent for the company to cut the dividend by 50% as it did in 2009.  The retained cash could be applied to:

• Shortfall in income from coronavirus impacts such as rent concessions and increased vacancies
• Ongoing capex for development projects.  It would be difficult to raise funds through asset sales in this suddenly depressed market
• Share buyback – H&R has an authorization to purchase up to 15mm shares.  The company bought 6.6mm shares in 2018, none in 2019, and none so far in 2020.  A lower dividend would provide more financial flexibility to buy shares if they remain severely undervalued.

Diversified Business Model:  Diversified REITs (including H&R as well as Brookfield, Artis, and Morguard) have been trading at lower valuations than companies operating in a single segment.  Prior to the coronavirus crash H&R traded at a discount of 15-20% to Net Asset Value and that is unlikely to change without significant management actions to demonstrate greater internal growth and to deliver more value to shareholders.  Fair Value for H&R is therefore about 80% of NAV (0.8 X $25.79 = $20.54).

The Bow:  The downtown Calgary office had a vacancy rate of 27.2% last year so the value of this asset is almost entirely attributable to its lease with oil and gas producer Ovintiv.  That company was recently downgraded by S&P to BBB- so it’s far from failing, but if it did go bankrupt then the carrying value of the Bow could be significantly impaired.  H&R offered the building for sale last year, but did not conclude a transaction.  The investor presentation says Ovintiv provided 11.7% of H&R’s rental income in 2019.  That works out to about $135mm.

Toronto:   H&R has significant exposure to the Toronto market and will increase its investment through redevelopments.  The office sector had a vacancy rate of just 2.2% in 2019 and residential prices have risen for many years:

The overall population of the Toronto metro area grew 35% over the past 20 years .  The number of tech jobs in the city grew 54% in the past 5 years which is driving demand for premium downtown office space and condos.   Toronto real estate has been been extremely strong, but still provides excellent value for businesses relative to other global metropolitan areas. For example, the average technology sector salary in Toronto is only 1/2 of San Francisco and Seattle and office occupancy costs are also 40-50% lower.

Strategic Initiatives:  The persistent gap between H&R’s unit price and asset value might lead to pressure for corporate actions to reduce or eliminate the discount.  The company might sell mature assets more aggressively and repurchase its units as was done by Dream Office and Artis.  However any such plan is unlikely during the disruption from the virus.

Brookfield Comparison:  H&R has many similarities with Brookfield Property Partners (BPY).  They both have diverse portfolios of high quality assets in the US and Canada and their unit prices fell sharply over the past month.  Brookfield has delivered a higher long-term NAV return, but also has higher risk due to higher leverage, higher retail mall exposure, higher New York City office exposure, larger development spending, and private equity investments.  Brookfield also has much higher overhead expense (about 2% of equity per year).  Investors with a taxable loss on units of Brookfield might consider switching to H&R.

Disclosures

The author is a unitholder of H&R REIT.  Investors are encouraged to check all of the key facts cited here from SEDAR filings and other sources prior to making any investment decisions.

HR Pufnstuf was a kind dragon serving as the mayor of Living Island on a 1969 TV series created by Canadian brothers Sid and Marty Kroft.  (theme song)

The table of peer returns in the article published on 4/13 included several errors.  Corrections were made 4/15.