- H&R recognizes that its diversified business model is out of favor and that higher valuation can be delivered through “pure play” entities
- H&R disclosed intensification plans for several prime downtown Toronto sites and a huge site in Vancouver
- Very low yields on H&R’s unsecured debt suggest the AFFO yield of H&R units is far too high
Canadian REIT 4Q20 earnings have had an optimistic tone as companies have survived the recession in sound financial condition and look forward to recovery in 2021. COVID imposed a severe stress test on tenants – those who were able to pay rent and expenses through the crisis are not going to fail as soon as activity normalizes. The most significant development for H&R was the disclosure in its Chairman/CEO Annual Letter that spin-off of operating segments was under consideration:
H&R units have persistently traded below the value of their underlying assets and suffered an exaggerated impact from the COVID crash. Unbundling would provide better visibility and valuation for those parts of the business with strong performance and hidden value that can be realized through future development. Spin-offs will take time to execute. If the plan is successful then H&R units could appreciate to reflect their fair value of about C$22 at some point in 2022-23.
With 4Q earnings, H&R reviewed many non-recurring and transitional factors affecting near-term results including: COVID disruption and recovery, costs related to large leases, transition of property under development to investment property and then time to stabilize occupancy, and conversion of an interest bearing mortgage receivable into a property ownership. Earnings will be a bit harder than usual to forecast in 2021 and it will not be meaningful whether the next few quarters are better or worse by a few pennies. Instead the increased importance of new developments and potential strategic actions should make NAV realization the primary focus for investors.
- The Valuation Problem
- Segment Highlights
- Intensification Plans
- Toronto Risk
- Low cost of debt
THE VALUATION PROBLEM
H&R units have long traded at a discount to their book value (which reflects investment properties at their fair value determined in accordance with IFRS).
H&R’s unit price decline of -33% since the onset of COVID (market impact from 2/28/20) was significantly worse than the -16% drop of the Canadian REIT index. It fully reflects the uncertainty of its Malls (similar to Riocan) and Offices (similar to Allied and Dream) while ignoring the resilience of Industrial, Residential, and US Grocery-Anchored Retail.
Other Diversified REITs have also struggled with undervaluation and have been under shareholder pressure. Cominar and Artis are reviewing strategic alternatives while Brookfield Asset Management has offered to privatize Brookfield Property.
H&R’s Industrial and Residential segments are already well positioned for potential success as independently listed companies. H&R’s Offices are performing well, but they are out-of-favor with REIT investors – some asset sales would make the business more appealing. H&R’s Retail business likely needs further restructuring to improve its position in the market and potential appeal to investors.
Comments on recent developments and the prospects for each business:
Residential (Lantower) – Management comments on H&R’s 4Q20 conference call focused on new construction: “The expected development yields [close to 6%] relative to historically low Class A cap rates [close to 4%] provides strong value creation and risk-adjusted returns”. Lantower acquired two more development sites in recent months and may buy more while also possibly selling newly completed developments “at a very, very low cap rate and quickly redeploying that capital into more accretive investments“.
Management is pleased with the “leasing velocity” at the newly completed River Landing project in Miami where occupancy has reached 28%, however the expected initial yield of the project has further declined to 4.4% (was 5.7% at 12/31/18).
Management anticipates a rebound at the Jackson Park complex in the New York City where recent occupancy is “a tad over 60%“, but “we are seeing a ton more traffic than we have seen in the last 6 months. And obviously, our conversion rate from traffic to actually lease signing has been doubled in the historical average“. H&R did not provide detailed comments about rent and concessions, but the latest monthly report from MNS Real Estate shows average Long Island City rents -16% from a year ago.
H&R acquired a large site in Jersey City for $162mm (on which the company had previously issued a mortgage) and indicated that it was working on a mixed-use development combining residential with office space designed for the booming Life Sciences market.
Lantower is a “vertically integrated multifamily investment platform and operating company” that appears well-positioned to succeed as an independent entity. It currently has about C$3.3Bn (US$2.6Bn) of assets. Spin-out might provide the opportunity for Lantower to raise more equity for accretive investments,
Industrial – H&R completed the first building of its Caledon ON project occupied by Deutsche Post and recognized a fair value gain of $44mm in 4Q20 above the construction cost of $55mm. The company will resume construction of Buildings 2&3 this year with returns now expected to be higher than initially budgeted. The company made two land acquisitions for industrial development in Mississauga ON in recent months and has 118 remaining acres in Caledon which could support an additional 2.2mm sqf of development.
H&R’s Canadian industrial portfolio has a total of C$1.2Bn of assets. As an independent company it would be the smallest in the sector, but has an appealing development pipeline and could grow more quickly by issuing equity for accretive investments. 78 of H&R’s 87 properties are held through an institutional JV with Crestpoint and the Public Sector Pension Investment Board. If those partners were willing to exchange their private partnership interests for units of the new industrial REIT then it could launch with a cleaner property ownership structure and larger market capitalization.
Office – Operating results from H&R’s office portfolio are extremely predictable due to the long-term leases (WALT > 12 years) with large high quality tenants (>99% occupancy and 86% investment grade tenants). However equity investors currently perceive office assets as high-risk due to the uncertain long-term impact of work-from-home and possible pandemic induced population movements. Private buyers have more current interest in properties like those held by H&R because their long lease term and high occupancy makes them similar to a high yield credit asset.
In January H&R closed the sale of a Culver City CA property 100% occupied by Sony Pictures. The building was acquired in 2004 for US$60mm and sold for US$165mm. With regard to potential further sales CEO Tom Hofstedter said: “we obviously have some target office buildings that we want to sell, but I don’t necessarily think that 2021 is the right year to do that until there is some light at the end of the office recovery tunnel, even though we have long-term leases, quite frankly, so our assets can wait and be sold if we want to sell later on to generate cash. So I can’t give you clarity on what assets are going to be sold to when. We’re looking at it when the markets — when the time is right, we will do so, but I don’t think the time is right now“.
Any discussion of H&R’s Office portfolio continues to be dominated by The Bow tower in Calgary which provides 12% of H&R overall rents and 24% of rents in the Office segment. The building is fully leased to Ovintiv for another 17 years so rents are very predictable, but the concentration of exposure has been a concern for investors. H&R examined sale of the building in 2019 and CEO Tom Hofstetder mentioned that The Bow would be one of his top priorities in 2021 without disclosing whether sale was once again on the table. H&R significantly marked down the carrying value as of 3/31/20. The long-term lease at a rent far above current market rates makes the value of the building heavily dependent on Ovitniv’s credit quality. Ovintiv unsecured bonds with a similar maturity as the lease briefly traded at a yield over 16% in March 2020, but have since recovered all the way to 4.7%. I think it’s very likely that H&R could find a buyer for all or part of the building at a price higher than where it has been carried since 3/31. If H&R retains all or part of the building then it would be too large and too much of a distraction to be placed within an independent Office REIT.
Of H&R’s remaining 32 Office properties, 22 are in Ontario, and 18 of those are in or near Toronto, a very strong market. The transition to a “more narrowly defined mandate” suggests that the single properties held in Dallas, Houston, Tampa, and New York City might not be a strategic fit. The portfolio features long-term leases with strong tenants including Corus, Bell Canada, and government agencies, but the low current valuations of Dream Office and Allied Properties suggest very limited current investor appetite for Office REITs regardless of asset quality.
Retail – Despite extended COVID closures, H&R was able to raise its retail occupancy and rents during 2020. The company enjoyed positive momentum from releasing of former Sears and Target anchor spaces and extended a Walmart lease at the Dufferin Mall in Toronto with a 55% rent increase. Canadian government assistance programs provided substantial support to rent payments by smaller tenants. H&R estimates that large tenant bankruptcies will result in permanent closure of only 49 stores (out of 2,658) using only 109,568 sqf (out of 13,704,000).
The fair value losses recorded by H&R in 2020 appear to value its Retail portfolio quite conservatively relative to average cap rates estimated by CBRE research:
Transition to a “more narrowly defined mandate” raises the question of the role of the remaining US retail properties. In 2013 H&R paid $296mm to acquire a 33% interest in ECHO Realty which owns grocery and convenience anchored retail properties, many operated by Giant Eagle. At 12/31/20 the equity interest was carried at $471mm. It has been a good investment, but it operates independently, does not have a strategic fit with other H&R business, and the large minority stake would be an awkward holding for an independent H&R Retail REIT. H&R also owns 17 auto service centers, gas stations, and convenience stores in the Western US.
H&R’s non-mall Canadian properties are predominantly grocery stores, Wal-Marts, home improvement stores, and similar essential retailers. Overlap with the markets and tenant base of the malls makes them a reasonable strategic fit.
Investor concerns have transitioned from the near-term impact of closures to the uncertain long-term impact of increased ecommerce and home delivery on physical stores. H&R explained that it is developing “an e-commerce platform exploring innovative technology that facilitate the seamless online purchase and delivery of real-time inventory directly from our shopping center real estate. The digital strategy that Primaris is exploring will soon be a prerequisite to attract new bricks-and-mortar locations, retailers and direct-to-consumer brands to our center.” The current H&R mall websites (e.g. Orchard Park Mall) are unattractive and uninformative compared to those from Simon Property (e.g. Anchorage 5th) and Riocan (e.g. Burlington Center).
The fair value of H&R’s Retail assets was C$3.9Bn at 12/31/20. Investor interest in a new standalone Retail REIT with high mall exposure is likely to be extremely limited. Even in the much larger US market the only significant remaining Mall REITs are Macerich and Simon (following the privatization of Taubman and Brookfield). The best approach is probably to concentrate on improving operating results, selling non-core assets, and think about the corporate structure later.
H&R revealed exciting new details about four of its intensification projects (Investor Presentation pages 27-30):
- Burnaby BC (Vancouver Metro) – 4 new towers with 1.8mm sqf residential space and 44,000 sqf commercial
- Wellington Street (Toronto) – New 13 floor office building (replacing existing 13 floors) topped by 52 residential floors (square footage not specified)
- Yonge Street (Toronto) – New 66 storey tower with 158,000 sqf commercial and 283,000 sqf residential
- Front Street (Toronto) – New 69-storey tower with 120,000 sqf commercial and 463,000 sqf residential
Site plan approval is expected for all four locations by the end of 2022 and then construction could take several more years. The Toronto projects are in prime downtown locations:
If an approved Toronto development is valued at $200/ft and Burnaby is worth $100/ft (WAG) then these newly disclosed projects could add as much as $500mm of value for H&R by 2023. Further appreciation would be realized as the buildings are completed and occupied or sold. The company also has development potential at Mall sites such as Dufferin in Toronto, but the individual locations are not as valuable.
H&R’s largest exposure and its most exciting opportunities are in the Greater Toronto Area. Observers have warned for many years that rising Toronto real estate prices were on the verge of collapse (see for example, Canada’s Real Estate Bubble: An accident Waiting to Happen – published in August 2010).
Pessimists failed to appreciate that real estate demand was a natural consequence of a strong economy. Excellent local universities provide a strong talent pool boosted by migration of domestic and international skilled workers. This CBRE analysis shows that Toronto remains a bargain relative to other major centers for technology employment:
CBRE describes certain major markets as “Gateway Cities” which have lasting appeal for real estate investment due to presence of corporate headquarters, associated professional services firms, educational and cultural institutions that attract talented workers, international transport infrastructure, and diverse economies.
Over the past 20 years Toronto has shown the strongest growth among the North American Gateway Cities. The government of Ontario currently projects the city’s population to reach 9.5mm by 2046. The real estate market will undoubtedly experience cyclical ups and downs, but prime downtown locations are likely to provide owners with substantial long-term appreciation in addition to rental income.
LOW COST OF DEBT
H&R’s unsecured debt pricing signals that credit investors are very confident in the company’s cash flow and asset value:
In contrast, the consensus forecast for 2021 AFFO is $1.38/unit which provides a yield of 10.3% implying that equity investors are being compensated for a degree of great uncertainty even though the COVID shock and deep recession led to only a 3% drop in 2020 AFFO and a 15% drop in NAV.
On 2/17 H&R just issued another unsecured debenture with a 6 year term and 2.633% coupon.
H&R’s recognition that the excessive breadth of its business depresses its valuation and the new commitment to restructuring increase the probable return for unitholders. Prior to now I assumed the units would be fairly valued at a 20% discount to NAV, consistent with how they traded prior to the crisis. That would suggest a target price of C$17.54. The diversification made H&R similar to a holding company valued with a “holding company discount”. Splitting H&R into simpler and more narrowly focused entities could allow the full undiscounted value of the units to be reflected in their market price, but investors will need more details to gain confidence that the strategic plan can succeed.
Some factors to keep in mind:
Future Structure – The valuation of future H&R entities will depend on the investor appeal of the structure the company adopts. Some public benchmarks:
- Dream has been the most successful with Dream Unlimited as an Asset Manager receiving reasonable compensation while owning non-controlling minority interests in the managed companies, each of which has a narrow mandate. Dream Office shrank its portfolio to a tight focus on Toronto downtown offices and appreciated to a premium over NAV prior to the COVID crisis. Dream Industrial has delivered growing NAV supplemented by accretive investment of multiple secondary offerings. Dream Global was extremely successful as it grew NAV, accretively invested capital raises, and was acquired at a premium to NAV by Blackstone. Dream Impact struggled to define itself, but may find success through its new “Impact Investing” mandate.
- Morguard manages, co-owns properties with, and holds controlling interests in Morguard REIT and Morguard North American Residential REIT. The complexity and conflicts of interest limit investor interest in all three entities and they all trade at large discounts to NAV, although Morguard may have been more aggressive than peers in estimating its NAVs so the size of the discounts is uncertain.
- Brookfield manages and holds controlling interests in several public companies, including Brookfield Property REIT. The REIT traded at a substantial discount to NAV for years due to the complex breadth of its business and above average operational and leverage risk. The manager recently made an offer to privatize the REIT at a substantial discount to NAV.
These examples suggest that entities spun out of H&R are more likely to be successful if they have a clear mandate and operational independence from an H&R parent company, but external management is OK.
Legal Constraints – H&R has no preferred units so a major restructuring would require approval only from common unitholders. This would avoid the problem that occurred at Artis where a large preferred holder opposed that REIT’s Retail spinoff plan. H&R’s unsecured debt has a few financial covenants which are not very restrictive (EBITDA/Interest > 1.65, Debt/Assets < 0.65, and Unitholder Equity > $1Bn), but will require substantial assets to remain at the parent company level.
Dividends – H&R prudently reduced its dividend by 50% last 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. With access to debt on extremely attractive terms the company could raise its payout, but it’s reasonable to defer a decision until there is greater clarity about the broader strategic plan.
At the time of publication the author was 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. At the time of publication the author was also a holder of Artis, Allied Properties, Cominar, Dream Unlimited, and Dream Impact. These disclosures should not be interpreted as recommendations and they could change at any time.