H&R REIT: Fading Risk Should Be Reflected In A Higher Price

• Unit Price has sharply underperformed the sector since the onset of COVID
• Trading at a 44% discount to IFRS Net Asset Value (C$22.11) and less than 9X 2020 AFFO which has been temporarily depressed by COVID
• Retail and energy tenants are performing better than feared

H&R REIT (TSX:HR/UN)(HRUFF) units have fallen sharply this year due to fears about its Canadian malls and office exposure to energy tenants.  Favorable news in both areas has not been reflected in the price.  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.  Peer comparisons suggest that H&R units should currently trade around C$16.

Topics:

• 3Q20 Operating Results
• Investor Concerns
• Peer Returns
• Investment Considerations

Background: H&R is a diversified Canadian REIT with Office (40% of 3Q20 NAV) Industrial (9%) Residential (23% ) and Retail (28%) assets in Canada (57%) and the United States (43%).  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.  The company’s history was described in prior Koneko articles.

3Q20 OPERATING RESULTS

H&R Operating results were in line with expectations, but included several developments which provide optimism about future performance. The company recorded a $13mm bad debt provision with about $5.5mm attributable to tenant concessions, about $5.2mm attributable to tenant bankruptcies, and $2.8 mm concessions to tenants under the CECRA program.  The provision was almost entirely in the retail division where stores have reopened and business is gradually recovering.  Excluding bad debt the run rate for FFO/AFFO is ahead of last year.

The fair value increase was attributable to lower cap rates applied to Sunbelt residential properties. Stability in other segments demonstrates that H&R promptly recognized the impact of COVID, unlike some peers (Brookfield, Morguard) which have reported further losses in each quarter of this year.

Most of H&R’s rental apartment buildings are in markets (Texas, North Carolina, and Florida) which have benefited from population trends that accelerated with COVID. The only residential property at risk is the 50% owned Jackson Park complex in New York City where rents in its Long Island City neighborhood are down about 14% compared to a year ago (MNS Real Estate Queens Market Report). H&R believes weakness at Jackson Park is temporary and that the property’s extensive amenities including a private park provide a lasting competitive advantage. H&R has begun leasing its River Landing rental apartments in Miami and says “leasing velocity” is better than expected. I believe H&R will report a modest fair value increase (about $50mm) when River Landing is reclassified as an Investment Property in coming quarters. H&R reported good progress at other residential properties under development and I believe could report fair value gains of about $65mm over the next year.

H&R classified one US Office property as “held for sale” at 9/30 with a carrying value of US$219.5mm. It could be one of two buildings in Dallas 100% leased to Texas Health Resources, a building in Tampa 100% leased to Coca Cola Enterprises, or a building in Culver City 100% leased to Sony Pictures. The strong tenant profiles should make it easy to find a buyer even in an office market that is weak overall. Sale of this property would largely meet the $285mm debt paydown that H&R expects to make in 2021.

Risks in the retail segment and recent developments are described in greater detail below under “Investor Concerns”. 

INVESTOR CONCERNS

H&R has exposure to several areas of heightened concern to investors, but where news has been better than feared.  Overall rent collections have remained high (95% in October) and the trend has been positive.

Energy Tenants:

• Ovintiv (f/k/a Encana) pays 12% of H&R rents and has 18 years remaining on its lease at The Bow tower in Calgary.  It’s an excellent building, but the contracted rent is far above current market rates in a market suffering from over 27% vacancy.  If Ovintiv went bankrupt then it would presumably break the lease and H&R would suffer declines in rental income and asset value.  In September Fitch provided this commentary when it downgraded Ovintiv’s credit rating to BB+. Encana 2037 bonds which have about the same maturity as The Bow lease spiked to a yield over 15% in March.  One could argue that a similar cap rate should be applied to The Bow rent payments.  The bonds have subsequently recovered to a 6.7% yield, but I believe H&R equity investors and analysts still believe the risk requires a cap rate of 8-10% or even higher. After seeking buyers for The Bow in 2019, H&R indicated last week that “there’s nothing new at this point in time“. The stabilization reflected in Ovintiv bond prices suggests that a stake in The Bow might be a reasonable acquisition for a large pension fund at a price that would likely be above where H&R is currently valuing the asset. H&R analysts and investors would welcome the reduction in concentration risk.

• Hess (6% of rents) occupies the Hess Tower in Houston.  H&R faced potential risk to occupancy and rents upon expiration of the lease in 2026, however the company disclosed with 3Q results that the lease for 2/3 of the space was just extended for an additional 10 years. H&R did not disclose the terms, but conference call comments suggested that the extension would not affect the IFRS carrying value of the asset.
• TC Energy (2% of rents) is an energy midstream company that should not be of any concern.

The energy sector has substantially recovered from the supply crisis caused by the temporary Saudi production surge in March and the demand crisis caused by COVID.   H&R’s unit price has lagged prices of oil, gas, and share prices of its energy tenants.

Malls: H&R receives 21% of rents from enclosed retail (i.e. malls) in Canada.  Management made these comments about the pace of recovery during the 3Q conference call:

• Leasing showed notable progress with 3 large pharma tenants occupying 80000 sqf of new space in 3Q20 and an additional 3 tenancies of 72000 sqf will begin in 4Q20. Commitments have been received for an additional 75000 sqf in 2021 and H&R is in “final stages of negotiation” for 55000 sqf. Leasing interest in malls for smaller spaces has been “primarily electronics, some food, some home goods“.
• Tenant sales in September had recovered to 86% of prior year levels. Stores selling goods associated with office workplaces (dress apparel and cosmetics) are suffering while casual apparel and household goods are doing better.
• Releasing of the large format spaces left from the Target/Sears bankruptcies has been occurring at higher rents. H&R said that excluding the impact of bankruptcies, same property rents in malls were +10.4% yoy.
• H&R’s MD&A includes detailed disclosure of the estimated impact of retail tenant bankruptcies. The company estimates permanent closures will affect only 47 retail spaces (1.8% of total) covering 109142 sqf (0.8% of total).
• Vaccine news is starting to provide confidence that COVID will not last forever and investors can begin to anticipate recovery of severely affected sectors like retail.

PEER RETURNS

H&R’s diversified business model should protect it from weakness in particular sectors and markets, but since February H&R units have underperformed broad US & Canadian indices and also sector returns weighted according to the sources of H&R Fair Value.

If H&R had dropped 18% in line with the Canadian index then it would trade at C$15.99.  If it dropped 19% in line with a weighted measure of peers then it would trade at C$15.80.

INVESTMENT CONSIDERATIONS

Dividends: H&R prudently reduced its dividend by 50% earlier this year to conserve capital.  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$0.69/year) gradually returns a portion of the full NAV which we can now acquire in the market at a discount.  The distribution is amply covered by AFFO and strong rent collection so it is very unlikely to be cut.  The company can apply its retained cash flow to development, redevelopment, and share repurchase. The company’s dividend policy following the 2008 crash suggests that payout will gradually return to prior levels over 3-4 years.

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 COVID 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 $22.11 = $17.69).

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.

Long-Term Value Generation:  H&R delivered a 13.6% IRR (NAV appreciation + dividends) from 2003-2019.  The unit price implies a degree of distress which is not evident in the financial statements or real estate operations.  Malls may continue to disappoint, but the company has an attractive growth pipeline through new developments, and redevelopments.  If NAV returns to growth and the unit price discount shrinks then investors at the current price will earn high returns without any dramatic corporate catalysts.

Unit Repurchase: Management spoke favorably about unit buyback during the 2Q conference call, but didn’t mention it in 3Q and none of the analysts on the call asked about it.

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.

“Dufferin Mall Really” was a 2009 marketing campaign to inform consumers that the mall (at that time owned by Primaris REIT which was acquired by H&R in 2013) was “No longer a post-apocalyptic consumer experience“. @thedirtyduff is an instagram account which shares valuable first person insights about the Canadian retail landscape.

Diversity Our Strength is the official motto of the City of Toronto.