H&R REIT: Transform & Roll Out

H&R REIT announced that over 5 years it will transform from a diversified REIT into one focused on its thriving Lantower Residential business:

• Accelerated residential development will deliver meaningful NAV appreciation
• Specialization will enhance investor appeal and eliminate the substantial discount at which units currently trade
• Spinoff of H&R’s malls into a new well-capitalized independent entity positions that business for potential success as a contrarian recovery play
• H&R has significant insider ownership and insiders have purchased an additional $2.4mm of units in the past 90 days.

Primaris REIT units distributed to current H&R investors began trading on Wednesday January 5. I estimate an initial fair value of about $17/unit (value of $4.25 per existing H&R unit). Primaris should be an attractive investment if the units trade at a large discount to this value.

The Primaris spinoff will remove the distracting retail narrative that has kept investors from recognizing the high value-creation potential of H&R’s residential development pipeline. As H&R becomes recognized as a Residential REIT I believe units should rise over 1-2 years to their NAV following the Primaris spin ($17.27 using 9/30/21 valuations). Over 5 years I believe the development pipeline could create $10/unit of additional value.

Topics:

• H&R Background
• The Strategic Repositioning Plan
• H&R’s Multifamily Business
• Housing Market Risk
• Primaris
• Investment Considerations

BACKGROUND

My April 2020 Koneko article summarized H&R’s history from its founding in 1952, the formation of the REIT and its 1996 IPO, and major corporate milestones. Investor attention in recent years was dominated by concern about the REIT’s exposure to Calgary Offices and Canadian malls while the company’s many strengths were obscured by its diversified business model. Units have consistently traded at a discount to Book Value (which includes investment properties at fair value according to IFRS accounting).

As the REIT managed through COVID disruptions it also disclosed in February 2021 that management was evaluating a restructuring that could include spinoffs of operating segments:

The plan announced in October 2021 will result in 2 independent pure-play REITs with significant competitive advantages in their respective markets.

THE “STRATEGIC REPOSITIONING PLAN”

Key elements:

• Spinoff Primaris REIT as a new independent public company that will own all of H&R’s enclosed malls in Canada. Primaris will launch with a strong market position in an unpopular segment and will be led by Alex Avery who was head of REIT research at CIBC prior to joining H&R in 2016. His capital markets expertise suggests that Primaris will try to build value through transactions using its underleveraged balance sheet.

• Sell remaining Retail Properties. H&R owns 56 primarily single-tenant retail assets in Canada anchored by essential services companies including Lowes, Metro, and Walmart. H&R owns a 33% stake in ECHO Realty which owns 236 US locations associated with Giant Eagle Supermarkets. Strong performance of essential services retail over the past two years should ensure that H&R can realize the estimated current fair value of these assets ($1.1Bn).
• Exit Office Property through sale of $2.3Bn of properties and residential redevelopment of $1.4Bn of properties. Sales are achievable due to the very high occupancy and long-lease terms of H&R assets. In October CEO Tom Hofstedter said: “They’re high-quality properties, and we’re very confident that we’ll be able to exceed our IFRS values or at a minimum retain — sell them at that IFRS values.” The redevelopments will unlock considerable hidden value from older properties in prime locations.

• Invest in Residential and Industrial development pipeline. H&R has an exceptionally robust project pipeline with potential to generate $9.92/unit of value accretion over a 5-7 year period. H&R provided guidance for capex and returns on projects breaking ground in the next 2 years. The fair value cap rate for these projects upon stabilization might be as low as 3.5% in the current market. If the later projects have the same capital intensity and yields then they could create over $2Bn of value, but I believe the capital investment and returns could be higher because they are highrise developments in prime locations.

H&R MULTIFAMILY BUSINESS

H&R has achieved impressive success since founding its residential business in 2014 using capital reallocated from sales of office properties.

The residential development business is generating yields of 5.5-6.0% on development costs in markets where new stabilized Class A multifamily properties are valued at cap rates below 4.0%. H&R has been achieving IRRs as high as 50% on its equity contributed to these projects.

H&R has not provided budgets for its longer-term projects (in most cases permits are still pending), but these projects are at prime locations in major markets and should be able to achieve very attractive returns.

Further details are available on the websites available for most of the projects:

• The Cove, a mixed use project on the Jersey City waterfront with 1.6mm sqft of lab/tech office space and 1.6mm sqft of residential (1544 units)
• 55 Yonge Street, a 66-storey tower at a prime downtown Toronto location
• 145 Wellington West, a 52-storey residential tower at a prime downtown Toronto location (476 units)
• 310 Front Street W, a 69 storey residential tower at a prime downtown Toronto location (560 units)
• 3777 Kingsway, a proposal to add 2200 residential units at a prime location in Burnaby, 12 minutes by train from downtown Vancouver
• 69 Yonge Street, a historic early 20^th century skyscraper in Toronto will be converted into 67 luxury condos

In addition to the disclosed pipeline, on the 3Q21 conference call H&R said: “we have additional owned and under contract land sites that we expect to soon join the Lantower active development pipeline.”

H&R’s portfolio will transform over 5 years from being 22% Residential at 6/30/21 to 80% Residential.

HOUSING MARKET RISK

Residential real estate markets in the United States and Canada have been extremely strong over the past two years. There is an uncomfortable combination of nearly universal optimism and unprecedented valuations.

Developers, landlords, and lenders argue that there is a US housing shortage due a drop in new supply after the 2008-2009 financial crisis.

A possible “shortage” of new homes is evident from the sharp decline in construction from 2009-2015. However, construction has now surged to the highest level since 1973. Some caution is warranted.

Demand is at risk from weakening affordability in the US (Housing Affordability Conditions Decline in October) and Canada (‘Grim’ outlook as housing affordability hits 31-year low). The growth narrative for Austin TX is well understood, but home prices have also surged in markets with falling populations and employment like Flint MI and Rochester NY.

Investment demand from institutions and individuals may represent 18% of current US demand and my guess is that this is understated because the methodology does not capture investment purchases by individuals.

I believe investment demand pushed prices higher and contributed to a bubbly mindset where consumers feel more confidence and urgency in buying. The overall growth of the US population has been turned minimal. The housing shortage implied by rapidly rising prices may rely on demand dependent on financial market and consumer psychology.

H&R’s residential property assets are concentrated in attractive markets including Austin. Dallas, Florida, and Toronto, however a broad housing market downturn would slow the pace of development and reduce the potential for value creation.

PRIMARIS

H&R released an investor presentation to introduce Primaris. Key elements of its business plan will be:

• Primarche – an omnichannel ecommerce offering that will facilitate fulfillment of ecommerce orders from mall premises. It should provide consumers with fast delivery from stores they know well. It should provide mall tenants with an efficient logistics solution by consolidating orders and deliveries from multiple retailers at the same locations. It could provide a competitive advantage in attracting and retaining mall tenants. It could strengthen corporate relationships between Primaris and tenants operating at multiple malls.
• Strong Market Position – coincident with the spinoff from H&R, Primaris is acquiring 8 additional properties from Healthcare of Ontario Pension Plan (HOOPP). Enhanced scale will improve corporate efficiency and deepen major tenant relationships. Primaris positions itself as a leading operator of malls in secondary markets. Tenants are essential services and mass-market value-oriented retailers such as TJ Maxx and Best Buy.
• Strong Financial Position – Primaris targets low Debt/EBITDA (4-6X) and low Debt/GBV (25-35%) and at least $60mm/year of retained free cash flow for reinvestment. Financial strength will enable Primaris to withstand market downturns and make opportunistic investments.

• Mixed Use Redevelopment – everybody’s doing it. Malls have large underutilized land footprints and good transportation access. Primaris identifies development potential at 8 of its malls, but probably has less development upside than some peers (Riocan, First Capital, and Smartcentres).

• Mall Acquisitions – nobody’s doing it. Alex Avery (Primaris CEO) described the REIT as a “consolidator in the enclosed shopping center space in a market with limited institutional competition for assets”.

Primaris historical financial results are distorted by the COVID disruptions over the past 2 years and H&R provided only very limited future guidance. Available data is summarized below:

The initial distribution payments of $81mm/year would be 59% of Forecasted 2022 Net Income. Perhaps the payout ratio will initially be above target. Perhaps management expects Net Income to be above the disclosed target.

Retail REITs in Canada and the US provided strong investor returns in 2021 and are trading at close to normal valuations.

• Choice, Crombie, and CT trade at premium valuations due to the stability provided by their strategic partnerships with anchor tenants.
• Riocan and Macerich probably are the best comps for Primaris.

Putting it all together, I estimate an initial fair value for Primaris of about $16.67/unit.

Primaris has long been considered a problem asset within H&R due to the impact of ecommerce on its retail tenants and the bankruptcies of Sears Canada, Target Canada, and many others. Primaris units may initially be weak due to typical spinoff dynamics, but appointment of Alex Avery, formerly a leading REIT analyst, as Primaris CEO suggests that the REIT should be able to successfully develop relationships with major investors and capital market participants.

INVESTMENT CONSIDERATIONS

The transformation plan had limited impact so far on H&R’s unit price because its ambitious scope makes it complex to analyze and several of the firms covering H&R served as advisors on the plan so their analysts have been restricted from commentary. I expect that H&R will be able to release planning updates on several of its most exciting residential developments in the next few months and draw investor interest to their value creation potential. I expect that Primaris will be able to establish an identity with the investment community as a well-capitalized contrarian investment.

Insider Buying – H&R has disclosed that insiders and family members control approximately 6% of the units. Since announcement of the transformation plan (to 1/5/22) Alex Avery (Primaris CEO) purchased an additional $1.4mm of units and Ronald Rutman (H&R Chairman) purchased an additional $0.9mm of units. Primaris announced that Alex Avery and other senior executives plan additional purchases of its units.

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 Primaris distribution rate of $0.80/unit may be a source of support during initial trading when investors are unsure about the REIT’s value.

Industrial properties will be retained by H&R and the company will continue to develop its valuable pipeline. Industrial is projected to be 20% of H&R assets in 5 years and could be spun off as an independent entity, but separation is not part of the near-term plan for tax and regulatory reasons. I don’t believe that any investors will see H&R’s industrial exposure as a negative factor.

Development may represent a much larger percentage of assets for H&R than most multifamily REIT peers. Several analysts tried to ask about this on the October conference call and H&R was unprepared to provide clear guidance. H&R explained that development timelines were flexible and that some projects could be sold or developed in joint ventures.

I believe that brokerage analysts have focused too much on this development as a % of assets metric and not enough on the actual value of H&R’s development assets. Permitted residential development in the core of downtown Toronto is valued over $250/sf prior to construction. Separation of the Primaris narrative and redevelopment permitting progress is likely to lead to higher expectations for H&R’s NAV over the next year.

DISCLOSURES

At the time of publication the author was a unitholder of H&R REIT and Primaris 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.