A New Investment Opportunity [CEO Interview]
Important Note
Before going into today's article, I wanted to let you know that we will soon conduct interviews with the management teams of the following REITs:
Farmland Partners (FPI)
Easterly Government Properties (DEA)
Safehold (SAFE)
Cibus Nordic (CIBUS)
Canadian Net REIT (NET.UN:CA)
Let me know if you have any questions for them and I will make sure to ask them for you. You can put your questions in the comment section below.
Thanks!
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Interview with H&R REIT [Watchlist]
Following the recent rally, I have been looking for some new opportunities to recycle some of our capital and that's how I recently came across H&R REIT (HR.UN:CA).
It never recovered from the pandemic crash of 2020 and still trades at just about half of its previous peak:
As a result, its valuation is today heavily discounted.
Its latest share price is $11 per share, but its net asset value is $20 per share, meaning that it is priced at a near 50% discount to its NAV. Moreover, we think that the REIT is using conservative cap rates to estimate its NAV and that it could enjoy further upside, especially now as interest rates return to lower levels.
Why is it so cheap?
Well, it is a bit of complex story.
First off, it trades in Canada, but most of its assets are in the US. This, on its own, is not a major issue, but it can explain part of the discount because Canadian investors may not be as familiar with US real estate markets.
Secondly, the REIT is diversified, investing in residential, industrial, retail, and office properties. Historically, the REIT market has punished such REITs that aren't specialized with a lower valuation. You cannot be a 'jack of all trades' and expect to earn exceptional returns.
Thirdly, it has had more leverage than your typical REIT, further depressing its market sentiment as interest rates surged to higher levels.
But here's why we think that this is an opportunity.
The REIT is now rapidly transforming itself. In just three years, it has significantly reduced its exposure to office and retail and reinvested those proceeds into residential and industrial:
As a result, the REIT now generates 46% of its revenue from residential properties, and this will increase to 52% once it has finished redeveloping the "rezoning" assets from office to residential. It also now generates an additional 20% from industrial properties.
So the REIT went from generating 35% from residential and industrial properties in 2021 to generating 70% from them. That's a major transformation and it appears to have been overlooked so far.
In the same process, it also paid off a bunch of debt and bought back some stock at a steep discount, proving to shareholders that the management is truly trying its best to unlock value for them.
I agree with the market that the H&R from 2021 deserved to be heavily discounted as interest rates surged and the office sector vacancy rate hit a new all time high.
But the REIT is far better positioned today and yet, its valuation is still as low as it has ever been.
We reached out to the management to learn more about the story and their plan for the future. Below, we share our transcript of the interview and conclude with our takeaways.
In short, we are adding H&R to our watchlist, give it a Strong Buy rating, and may invest in it in the future if it remains discounted when new capital becomes available. We will keep researching the opportunity and make a decision later.
Interview Transcript:
1) Multifamily vs. Industrial Focus:
Jussi: You are currently undergoing a significant portfolio transformation to emphasize multifamily and industrial properties. At present, 46% of your rental income comes from multifamily, a figure that is expected to surpass 50% as you convert some office properties into residential units. Given that the market tends to favor REITs that specialize in a single property sector and historically rewards them with higher valuation multiples, why not concentrate solely on multifamily rather than splitting focus between multifamily and industrial? You already have a substantial allocation in multifamily assets compared to industrial. Would you consider gradually divesting your industrial holdings to reinvest more heavily in multifamily properties, especially if you continue to trade at a significant discount?
When we announced our Strategic Repositioning Plan in October 2021, we were clear that our goal (within roughly 5 years) was to position H&R towards higher growth and the way we planned to do that was by focusing on residential and industrial properties. We are proud of our progress to date whereby we have completed the spin-off of the REIT’s 27 enclosed shopping centres to a new publicly-traded REIT (on a tax-free basis), Primaris REIT, as well as sold ownership interests in 56 properties totalling approximately $5.2 billion. As of June 30, 2024, 65% of our real estate assets, based on fair value, are residential and industrial. If you add our office properties going through the rezoning process, that takes us to 71%.
In summary, our goal remains the same as it did in October 2021, when we announced the plan. Once we are successful in achieving the goal, we would still have the ability at that point in time to re-assess how to further position H&R with its remaining residential and industrial properties. Our Canadian Industrial portfolio is solid with ownership interests in 66 properties encompassing 8.1 million square feet at H&R’s share. It’s further worth noting that the weighted average rent per square foot in H&R’s Canadian Industrial Portfolio was $8.97 as at June 30, 2024, which is well below market rent which bodes well for our industrial portfolio continuing to deliver strong results... We are not considering selling our Canadian industrial portfolio.
2) Cap Rates and NAV Expectations:
Jussi: Typically, REITs use relatively aggressive cap rates for property valuation. However, in your case, a high 8.6% cap rate is applied to your office properties, despite their appealing features such as long leases, investment-grade tenants, and urban locations. The cap rates for your other property types also seem reasonable. Do you anticipate that your NAV will stabilize at these levels and potentially begin to increase as interest rates are lowered and rent growth accelerates in the coming years?
Firstly, just to further breakdown our Office cap rates. For our remaining 9 Canadian office properties that are not slated for redevelopment, those were valued at an average cap rate of 7.90%. Our remaining 3 US office properties were valued at an average cap rate of 9.02%. Our Canadian office properties advancing through the rezoning process were valued using a comparable sales approach, which estimates fair value based on the market value per unit which is established by recent sales activity in the same or similar markets. For these properties located in downtown Toronto, we wrote them down to $140 per square foot as at June 30, 2024, from $170 per square foot previously. We did take some large write-downs during Q2 which reflects what’s going on in the market today. Although interest rates have started to come down in Canada, as well as it now appears the US will follow suit in September, we are still dealing with a challenging economic environment along with volatility in the capital and real estate markets. Therefore, we do think our NAV will stabilize in the short-term and when we start to see some improvement in the real estate markets over the medium to longer term, we are hopeful to see some NAV growth as interests rates come down and stabilize.
3) Share Buybacks and Deleveraging:
Jussi: Your shares are currently trading at a 50% discount to your net asset value, which seems to be conservatively estimated. Why not use the proceeds from asset sales to reduce debt, but also repurchase shares at these discounted prices? This strategy could be highly accretive and send a strong positive signal to the market.
Since the announcement of our Strategic Repositioning Plan and spin-off of our 27 enclosed shopping centres, H&R has bought back over 27 million units for a total cost of $340M.
Given the challenging economic environment over the past few years, our first priority is to protect our balance sheet. We have had and currently have 3 industrial and 2 US multifamily developments that are under construction so we need to allocate sale proceeds to these developments. Also keep in mind that if we used disposition proceeds to buy back shares without balancing a portion for debt repayments, that would have a negative impact on certain ratios such as Debt/EBITDA which is critical for us in order to maintain our BBB credit rating with DBRS. For larger asset sales or sales of properties to be developed we would use a portion of the proceeds to repurchase units.
4) Third-Party Capital and Fees:
Jussi: Your business model includes utilizing third-party capital to fund some development projects, earning fees for managing these investments. Could you provide more details on the types of fees you receive and explain how this capital-light approach benefits the REIT?
Our third party property fee business has grown over that last several years as we’ve sold partial or full ownership interests in many of our properties. The largest bucket is property management fees for sold properties such has The Bow, Bell Campus, 100 Wynford, Corus and our 50/50 industrial portfolio owned with Crestpoint and PSP Investments.
We also earn leasing, construction and financing fees mainly from our Crestpoint/PSP JV. Lastly and most recent, we created the Lantower Real Estate Development Trust earlier this year which will allow H&R to earn development fees on two residential developments currently under construction in Florida as well as a possible asset management fee upon completion.
5) Retail Property Sales Strategy:
Jussi: You plan to sell your retail properties, which are currently valued with a 7.04% cap rate. Given their strong performance and rising demand for retail assets, with notable interest from investors like Blackstone, are you waiting for a more favorable interest rate environment before aggressively marketing these properties, or do you expect to potentially make some larger announcements soon?
As far as our Canadian retail portfolio, these properties are solid income producing properties, which are primarily tenanted by grocery stores or are grocery anchored. In short, there’s no urgency to sell these. They are highly liquid to sell anytime, so we will wait and re-assess once interest rates come down further. We have two automotive tenanted properties in the US which we expect to sell. That leaves us with River Landing and Echo. River Landing is a core holding for H&R as it is a mixed use property with 502 residential units.
In the case of ECHO, we would sell if we get our price. Having said that, we are in no rush, as ECHO is predominately grocery anchored shopping centers. The portfolio has strong cash flows and provide good FFO. We can wait for interest rates to come down further.
Takeaways:
In the next phase of the transformation, the REIT will finish selling the remaining office and retail properties and reinvest that into residential and industrial properties.
The good news here is that both, the office and retail properties, are valued with conservative cap rates in the 7-9% range, and selling them at such high cap rates should be doable, especially as interest rates return to lower levels.
That would then complete the transformation, leaving H&R with primarily residential and industrial properties, potentially in just a few years from now.
These are two of the most popular property sectors and REITs that own such assets typically trade at much closer to their net asset values.
Therefore, completing this transformation should be a strong catalyst for the stock. Even if they only closed half of the NAV gap, that would still result in ~50% upside from here.
While you wait, you also earn a 6.4% dividend yield, and the REIT still retains 40% of its cash flow to reinvest in its development projects and further deleveraging.
The balance sheet is not great, but it is not dangerous either. They have a 44% LTV, which is right in the middle of their target range of 40-50%. They have significant maturities in 2026 and 2027, but interest rates should have come back down by then, leaving H&R plenty of time to pay off some of it and refinance the rest.
In closing, I think that H&R has a great plan to unlock value for shareholders. The market does not like diversified REITs, especially those with high exposure to office properties and higher debt, but this is changing rapidly, and should eventually result in a lower NAV discount.
Repricing at a 25% discount would result in 50% upside. That's how cheap the REIT has gotten. And patience is rewarded with a 6.4% dividend yield, paid monthly, and further value will be created in the meantime since they retain 40% of their cash flow as well. There is also additional upside potential if they can sell properties at lower cap rates than what they are valuing them at. This seems quite plausible to me, especially as interest rates now return to lower levels.
The risk-to-reward seems asymmetrical to the upside and we may initiate a position in the near future.
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Analyst's Disclosure: I/we have a beneficial long position in the shares of all companies held in the CORE PORTFOLIO, RETIREMENT PORTFOLIO, and INTERNATIONAL PORTFOLIO either through stock ownership, options, or other derivatives. High Yield Landlord® ('HYL') is managed by Leonberg Research, a subsidiary of Leonberg Capital. All rights are reserved. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. The newsletter is impersonal and subscribers/readers should not make any investment decision without conducting their own due diligence, and consulting their financial advisor about their specific situation. The information is obtained from sources believed to be reliable, but its accuracy cannot be guaranteed. The opinions expressed are those of the publisher and are subject to change without notice. We are a team of five analysts, each contributing distinct perspectives. Nonetheless, Jussi Askola, the leader of the service, is responsible for making the final investment decisions and overseeing the portfolio. We do not always agree with each other and an investment by Jussi should not be taken as an endorsement by other authors. Past performance is no guarantee of future results. Our portfolio performance data is provided by Interactive Brokers and believed to be accurate but its accuracy has not been audited and cannot be guaranteed. Our portfolio may not be perfectly comparable to the relevant index. It is more concentrated and may at times use margin and/or invest in companies that are not typically included in REIT indexes. Finally, High Yield Landlord is not a licensed securities dealer, broker, US investment adviser, or investment bank. We simply share research on the REIT sector.
