H&R REIT - Dirt Cheap and With A Catalyst

After taking last week off to visit his family/do his taxes (gettin’ a refund, baby!), your favorite Substacker is back this week with potentially the best idea I’ve had in months. I’m really that excited about it.

Let’s get right to it.

H&R REIT (TSX:HR.UN) has underperformed for years. Despite checking off many of the boxes REIT investors want — including high rates of insider ownership, a diversified portfolio spanning both Canada and the United States, a solid dividend, and many others — the REIT has been a laggard in many portfolios. Including mine.

The hatred really started in 2008. H&R was one of the few Canadian REITs to cut its dividend during that crisis. The payout eventually recovered, but the damage was done. It seemed like everything H&R touched turned into a turd shortly thereafter. The company bet hard on Calgary downtown office space right before oil tanked, taking Canada’s most lifeless downtown with it. It acquired a portfolio of regional shopping malls right as buying stuff off the internet took off. And, more generally, it had too much of its portfolio in retail and office assets while residential and industrial space outperformed.

More recently, the company was hit hard during COVID, using the pandemic as an excuse to cut its dividend for the second time. Management finally bit the bullet and started making real tangible changes, including getting rid of albatross assets in Calgary’s downtown and a bunch of other stuff. It also plans to continue to expand its residential and industrial portfolio.

The transformation plan really began a few years ago. Instead of buying more retail and office space, H&R expanded into the U.S. apartment market, developing luxury properties (with partners) in markets like New York, Miami, Austin, San Fransisco, Long Beach, and Seattle. H&R would own a chunk, manage the property, and finally get access to parts of the market investors were actually excited about. These days, nearly a third of the company’s portfolio is in residential, which is a pretty big transformation considering the company was barely in the residential market just five years ago.

Other aspects of the portfolio have been drastically changed as well. The marquee transaction saw H&R basically exit The Bow, Calgary’s largest office tower and the company’s largest asset. It sold the tower and its interest in the big Encana Ovintiv lease and it also retained an option to buy the building back in 2036, which it’ll surely exercise if the Calgary office market continues to recover. The city is working hard to diversify itself away from oil, but those efforts might slow if crude remains above $100 per barrel.

H&R also spun off its regional shopping malls into Primaris REIT (TSX:PMZ.UN), which I covered a couple months ago. Those assets combined with similar properties (plus a robust development portfolio) from the Ontario Healthcare Pension Plan created a pretty compelling investment opportunity, one I purchased back in January.

H&R also took a machete to the rest of its portfolio, basically selling off most everything that wasn’t located in the GTA (and even a few things that were). Transactions of note included:

• Sold 1.1M square feet of office space at the Bell Campus in Mississauga

• Sold its share of the San Fransisco apartment development

• Sold an office tower in Culver City, CA

• Sold its 50% stake in a 14 property industrial portfolio

Including the Bow and Primaris transactions and the ones listed above, H&R either sold or spun out some $2 billion worth of real estate. That’s a busy couple of years.

The company isn’t done yet, either. It plans to sell its grocery-anchored portfolio of properties, which are located primarily in Ontario. These should go for around $600M. It also plans to exit its stake in Echo Reality, which owns grocery-anchored property in the United States. This should net the company $500M. It also plans to sell any non-core office buildings, an overall portfolio that is 98.5% leased and offers an average lease term of nearly a decade. These are all good assets, and all should attract strong interest. And remember, all the prices I’m quoting come from the 2021 annual report. Cap rates have moved up since then, meaning H&R should be able to get a little more than what’s quoted here.

What’s it going to do with all that cash? The company plans to double down on residential and industrial space. It has 11 development projects earmarked on the residential side, with a big emphasis on U.S. sunbelt cities. When completed, these developments are slated to provide 5,300 residential units and nearly 400,000 square feet of industrial space.

Despite all this (and there really is a lot!), H&R’s shares have languished since spinning off Primaris. Let’s take a closer look at the financial side, which is what really makes this a compelling opportunity.

How cheap it is…

We won’t spend too much time on H&R’s past profitability, since the company has already said it’s going to sell a bunch of those assets. But it’s still worthwhile to look at.

In 2021, H&R generated $1.53 per share in FFO and $1.21 per share in AFFO. Shares trade at around $13 today. The math is easy and comes to an easy conclusion. H&R is cheap on a trailing earnings perspective. Even if H&R sells 20% of the company and doesn’t reinvest those dollars into anything, shares are still reasonably valued on a trailing earnings perspective.

H&R’s management team also wants investors to know the company is undervalued from a net asset value perspective. NAV was $17.70 per share at the end of 2021. The gap between the current price and NAV is close to 30%.

Management is putting its money where its mouth is, showing investors what they think of the gap between the current price and NAV. The company has started an aggressive share buyback program for the first time in years (hell, maybe ever!). It has authorization to repurchase up to 28 million shares this year. It has already repurchased more than 10 million shares since December, a decent amount for a company with some 280 million shares outstanding.

The NAV should increase with interest rates pushing cap rates higher across the real estate world. Look for it to be easily above $18 when H&R releases quarterly earnings in May.

A $5 gap on an $18 NAV translates into nearly 40% potential upside, plus a 4% dividend as you wait. There are far worse opportunities out there.

The bottom line

H&R REIT is in the middle of a transformation and it appears your author is the only one who’s noticed. There should be some point where the market picks up on what’s happening and the stock pops nicely higher in a short period of time. And if it screws it up (like H&R has done so many times in the past), the stock is cheap enough here that downside should be limited.

In five years, I can see H&R completing its transformation, increasing earnings as the newly developed assets add to the bottom line, boosting distributions, and trading at 17-20x FFO as the market appreciates its pivot to residential/industrial. Shares could easily double. But the market doesn’t give it any credit because of its history and because everyone just remembers the trash it used to own.

Those are exactly the kinds of assets I want in my portfolio, which is why I’m so excited about H&R today.

Disclosure: I own some already and plan to buy a bunch more next week