The Curious Case of H&R REIT

If you stopped paying attention to H&R REIT (TSX:HR.UN) back in about 2018, nobody would have blamed you.

Geez, even that logo is uninspiring. Give me an hour in some editing program and *I* could come up with something better. And I don’t have a lick of artistic talent. This job went to someone’s nephew, didn’t it?

For those of you unfamiliar, here’s the skinny. Here’s a summary of H&R’s last decade in a single paragraph.

H&R bet heavily on Canadian malls (not good ones, either) and Calgary office space, riiiiight before each segment of the market went to shit. They had a bunch of better assets, so overall the company muddled along. It started to expand into residential apartments (with partners) in the United States in a rare good move. Then, starting in 2020 or so, the company got serious about selling off the crap.

The last year has been marked by a couple substantial moves. First, the company sold the Bow, its marquee property in the Calgary office market. Then it spun out a large portion of its retail properties into a new entity called Primaris (TSX:PMZ.UN), the same name of the company it acquired a decade ago to bring these retail properties into the fold in the first place.

The more things change the more they stay the same, I guess.

Much more on Primaris later.

The transaction gave H&R shareholders one Primaris share for every four H&R shares held, and became official the first trading day after January 1st when the new company would trade on the TSX. H&R traded sharply down on the news, falling from a close of $16.25 per share on December 31 to ending the week at $13.29 per share.

That’s a decline of just 18%, well under the 25% you’d expect from such a transaction. In other words, if you spin out the crap it’s beneficial to the rest of the company. Who woulda thunk that?

In fact, the remaining part of H&R looks to be pretty promising. Right before the spin-off, H&R was extremely focused on office and retail property, with a little industrial and residential mixed in. Office and retail accounted for 70% of assets.

And here’s where management would like the portfolio to be five years from now:

Management plans to achieve these plans by focusing on office tower redevelopment, selling off much of the remaining office/retail left in the portfolio, and then cycling the proceeds into either new builds or existing assets in the U.S. (and Toronto area). As they sell the crap nobody wants (at least until the next cycle, anyway), the discount to NAV will shrink.

H&R estimates their current NAV at about $17 per share. The stock currently trades hands at $13.29 per share. There’s some upside there, assuming H&R can get a good price for its remaining assets, an outcome that is shrouded in uncertainty.

The good news for H&R shareholders is they get a nice dividend while waiting for everything to go down. The current payout is 5.8 cents per month for each share, a payout just north of 5%.

In a world where discounted REITs are few and far between, H&R is one of the more interesting opportunities in today’s market. It’s easy to see the company finding a way to bridge that gap to NAV in the next 18-24 months, all while investors get paid to wait. And, the company’s valuation should go up as spare cash is invested in residential real estate.

Now let’s take a closer look at the second part of this transaction, Primaris.

Primaris is cheap with redevelopment potential

Primaris wasn’t your normal spin-off. There are a few important details to go over.

Essentially, H&R combined its retail properties with the Healthcare of Ontario Pension Plan’s (HOOPP) retail properties to create a $3.2 billion behemoth that owns 35 properties and 3.2 million square feet of gross leasable area across Canada. Occupancy is approximately 90% and 75% of the portfolio is located in so-called “secondary” markets, with 25% in larger centers.

These secondary markets are places like Kelowna, Medicine Hat, Kingston, Saint John, and, perhaps Winnipeg. The website isn’t super clear on that last one. The primary market assets have a big Calgary weighting, with scattered properties in the Toronto area, as well as a couple in the Vancouver area.

Primaris’s first week of trading was volatile, and it’s easy to see why. H&R basically screamed from the rooftops these assets were hot garbage. A portfolio of shopping malls in secondary markets isn’t something most people want to own in 2022, either. As much as Primaris tells investors these assets are well positioned in an online retailing world, it’s pretty easy to be skeptical of such analysis. So the stock sold off the $14 opening price.

But we don’t care about any of that. Because Primaris is pretty damn cheap with nice downside protection.

The company is in fine shape post-spinoff. It has a 29% debt-to-total assets ratio, which is incredibly low. It has a 90%+ occupancy rate and its top tenants are a who’s who of Canadian retailers. Many of its top assets have recently been renovated and are in a good spot coming out of the pandemic, too.

The portfolio also has development potential. Lots of it.

I used to live in Calgary, so I know those properties well. And I remember thinking living right next to a shopping mall would be appealing. It’s close to transit, you have all sorts of food options right there, and many have grocery stores as anchor tenants. And those malls all have way too much parking.

It’s also cheap from a NAV perspective. The company estimates its net asset value to be around $22 per share. The stock trades at $13.27 per share as I write this. You don’t even need to do the math. The cheapness basically leaps off the page.

It also looks to be a good deal on an earnings perspective. Management hasn’t provided earnings guidance for 2022, so we have to dig a little deeper and do a little creative math. First, the distribution is $0.80 per share. The payout ratio is in the 45-55% of earnings range, so let’s double the distribution to figure out approximate cash flow from the assets. That works out to $1.60 per share, or a little over 8x earnings. That’s cheap, kids.

One thing to note - that valuation is even cheaper than it seems. Most REITs that cheap traditionally have too much debt - often in the 55% or even 60% of assets range. The market tends to punish most REITs that go above 50%. But Primaris is less than 30% debt-to-assets.

It’s easier if we look at it from an enterprise value perspective. Let’s assume we have REIT A and REIT B. REIT A is worth $10 at a 60/40 debt to equity mix. So $4 is equity. If it earns $1, the organization has a EV/earnings ratio of 10x and a P/E ratio of 4. REIT B is also worth $10, but $7 is equity and $3 is debt. It earns $1 as well. The EV/earnings ratio is the same, but the P/E ratio is 7.

In other words, Primaris can easily stack some leverage on the balance sheet and increase earnings. Which should happen once it starts building apartments on its shopping mall properties.

One word of caution, however. H&R identified the same potential years ago, and never executed. If the potential was so great, why didn’t H&R just do it themselves? Remember, the company has pushed into residential in a big way over the last few years.

The bottom line - what to do with H&R and Primaris

I’ve owned H&R for years now and thanks to the spin-off I now hold Primaris as well. I also watched the price action on both stocks closely this week.

At this point, I’m not going to do anything with H&R. It’s a smaller position for me that has struggled for years. And I really hate averaging down. The discount to NAV is decent, but not that exciting.

Primaris is a whole different animal. It is incredibly cheap. Yes, malls aren’t a great asset class in 2022. But these malls are sitting on prime pieces of real estate in the middle of various cities. There’s value in that land, and I think Primaris can redevelop it well enough to provide a nice return.

I intend to take a much bigger position in Primaris on Monday.