RioCan Likely To Bid On Primaris REIT

| About: Primaris Real (PMZFF)
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In early December I wrote about Canadian private equity firm and real estate specialist KingSett Capital's joint $26/unit bid with the Ontario Pension Board for retail mall operator Primaris REIT (OTC:PMZFF) here.

RioCan REIT (OTCPK:RIOCF), Canada's largest, agreed to take $1.1 billion of the Primaris assets as part of the KingSett consortium's plan.

But the hostile bid from KingSett was rejected out of hand by the Primaris Board of Trustees as "financially inadequate and opportunistic" and they hustled to find other offers and revamp the standard poison pill.

Primaris units have traded over the $26 deal price consistently since it closed at $23.04 the day before the KingSett offer was launched. Slowed down by the holiday period, competing circulars to unitholders arrived in the mail over the last two weeks, with the bid set to expire on Thursday, unless extended.

On Wednesday night H&R REIT (HR.UN on Toronto) came in with a friendly cash and stock deal to buy Primaris in a friendly deal with a controversial and large $106.6 million deal termination fee. The new deal, sanctioned by the same Board of Trustees, barely moved the needle on the unit price (meaning it was equally financially inadequate and opportunistic).

H&R CEO Tom Hofstedter says the idea to buy the biggest Canadian enclosed mall owner was hatched by a couple of investment bankers from Canaccord Genuity.

According to the Globe and Mail, in an interview, Hofstedter said "we started to think about it, and putting two and two together it made beautiful sense."

Somehow, I think there is more to this than that. It's also about big executive acquisition payouts and bigger CEO egos.

Dundee REIT (OTC:DRETF) CEO Michael Cooper was featured in the latest edition of Report On Business Magazine as the wunderkind of Canadian real estate.

Dundee is the biggest pure play in Canadian office real estate, and valued at slightly less than H&R REIT.

This couldn't have sat well with Hofstedter. After all, H&R bought some of the Scotia Plaza tower, a prized property in downtown Toronto, just as Cooper's Dundee did.

Cooper wasn't the only guy making big waves in the Canadian REIT space.

Hofstedter had built H&R REIT into arguably the second largest public Canadian real estate firm, although others were bigger in specific segments such as retail First Capital Realty (OTCPK:FCRGF) or had assets outside of Canada such as Brookfield Office Properties (NYSE:BPO).

Hofstedter had built the tallest building in Calgary (The Bow). This deal could put him on the top of the heap, and they'd be writing articles about him for a change.

On the loosey and goosey conference call announcing his coup to trump Jon Love's KingSett consortium move on Primaris, Hofstedter said the only thing he had to say about The Bow was "they had got rid of Randy Eresman," departed CEO of anchor tenant, Encana Corporation (NYSE:ECA). A low blow, because Eresman apparently left due to fatigue induced from fighting an uphill battle against falling natural gas prices.

I think real estate CEOs have something to prove. Bigger buildings and more land. Being the biggest cheese on the block.

You could argue testosterone was now driving real estate sky high in Canada as much as any rational discussion of Canada's economic growth prospects. The oil and gas sector, responsible for 20% of Canadian GDP, was hardly showing signs of life, and was even in a crisis mode.

On the conference call, Hofstedter characterized the Primaris deal as "game-changing" and a "once in a lifetime" opportunity.

Hofstedter said the combined entity would be the largest REIT in Canada. That must have felt good to say that.

But "The Bow" with its major tenant Encana selling natural gas at rock bottom prices and hiving off assets in joint ventures with Asian sovereign-controlled entities could easily become an albatross around Hofstedter's neck if they were to downsize.

So why Primaris? Weren't shopping malls with that cheesy piped in Muzak and bricks and mortar real estate so old.

Ask Amazon (NASDAQ:AMZN). Online was where it's at, been like that for awhile now. Online was taking share from real estate, leaving them less profitable for the tenants.

At the very least, retailers were having to integrate their online platforms with the hard assets, often subsidizing one via the other.

Ask the Bay, ask Sears Canada. These were/are failing retailers that hadn't made the transition to the online world, that had product lines that were just as easily purchased at home.

I recently asked Al Mawani, CEO of Calloway REIT (OTC:CWYUF), another major Canadian retail player, what the prospects for bricks and mortar were in Canada?

Coincidentally, Mawani was CFO of Oxford Properties during the 90s, and has special insight, having been Jon Love's Number 2 man, for a decade. Oxford owned some of the original Primaris assets before OMERS took out Oxford.

Mr. Mawani told me the key to retail mall success was the anchor drawing traffic, and one of the best draws was fresh food.

Even though enclosed malls were much more expensive to operate than open shopping centers (such as the kind he and Calloway controlling unitholder Mitch Goldhar operated) their desirability, longevity and hence value, were drawn from the strength of the anchor tenant.

Primaris had depended for a long time on their prime tenants Hudson's Bay Company and its subsidiary Zellers.

With Target (NYSE:TGT) coming in to take over most of the Zellers leases, Mawani stressed to me, there would be a significant draw of traffic back to some of those poorly performing properties.

Mawani and Goldhar's SmartCentres focus on Wal-Mart Canada as an anchor, and although not prohibited from renting to Target (they have two), would probably not please their main tenant by engaging in a battle for more Target locations.

Personally, I did most of my holiday shopping online this winter (with some research done in store for free advice as many do now). I did get a special sweater for my wife by shopping at RioCan's newly-purchased Georgian Mall in Barrie.

But having also been a frequent visitor to Dufferin Mall, (one of Primaris' 35 properties) when I lived in Toronto, I knew that on a cold blustery day in the winter as we have now, enclosed malls served more as a "town square" than just a place to drive up to, and shop.

You have to figure those malls, with no potential building sites available, are worth way more than their book value.

Primaris owns and manages only enclosed malls across the country (21 East, 14 West), some in major cities but most in secondary markets in mid-sized cities. In places you never heard of, such as St. Albert, Alberta, or Atholville, New Brunswick, but dominant in their trading areas.

With Primaris having gained 10 of the roughly 135 new Target locations being opened in Canada this year, it was now probably more valuable than its $470/sqft average Q3 same store sales number would indicate.

Let's talk about RioCan REIT and their folksy CEO Edward Sonshine. What is he going to do, with his position as the Canadian REIT king sitting in the balance?

RioCan has an enterprise of over $14 billion with 50 million square feet of leasable space and a "who's who" of tenants on its roster. RioCan is purely retail commercial.

RioCan had agreed to buy eight properties as part of KingSett's move on Primaris, six of which were enclosed and probably the ones with a Target location.

I would say it is very likely, if not certain, that Sonshine and RioCan are, as we speak, developing a plan to buy out Primaris, and retain the mantle as largest retail commercial REIT in Canada. They could bid for the whole company, and then sell off parts to the KingSett consortium, a reverse of the original offer plan.

They probably would also try to have struck down the H&R/Primaris break-up fee of $106.6 million which unbelievably, contained an option for H&R to get Dufferin Mall and some choice Yonge Street development properties, at $36.6 million below an "appraised value" as part of their walk away bonus if the deal went south.

Imagine walking away with a couple of choice assets and $70 million in cash in your jeans, for an idea concocted by a couple of investment bankers over the holidays?

I think the break fee to be egregiously large (you get $100 million for how much work on this deal?), unfair, and abusive to unitholders. Hofstedter gave some kind of lame explanation that it was fair compensation for the dilutive effect of the unused capital that would sit on the balance sheet if the deal were dropped.

As of September 30, H&R had $37.6 million in cash with a higher debt leverage ratio than Primaris. Mortgages payable of $4.156 billion versus $6.164 billion in real estate assets, plus another $1.2 billion in debentures payable, versus Primaris' $1.7 billion in debt on $4.0 billion in assets. H&R would be using Primaris' lower 42.5% debt/asset ratio to improve its own leverage ratios which were north of 50%.

H&R raised $150 million additional equity in late November, but that was before KingSett's move was made and well before any thought of H&R buying Primaris.

So the pain of cash dilution defense of the break fee doesn't add up.

Clearly, the H&R bid has one main thing going for it above the cash offer: a paper offer (over 75% of the bid would be in H&R units with a pro-rata 25% in cash) would allow some unitholders to roll-over all their Primaris units without triggering a cash tax payable capital gain.

KingSett couldn't offer this feature with an all-cash $26 bid from the private real estate LPs that it manages for big pension funds. Included in the ultimate beneficiaries for the Primaris assets via the LPs were Ivanhoe Cambridge and Alberta Investment Management Corp.

These funds were experienced real estate owners and have deep pockets, deeper than H&R REITs. They could afford to pay a couple of extra bucks for the assets they coveted.

RioCan can offer a deal with a paper component. RioCan has almost 300 million units outstanding, versus 194 million for H&R, so the dilution from a RioCan bid for Primaris would be less. Primaris has 102.6 million Primaris units which would be outstanding fully-diluted once in the money convertible debentures and options were exercised.

RioCan would add some of the 10 Target locations to its roster of 24 it already has, and XX out any future competitor of the size of H&R, for additional openings.

In addition, RioCan is a seasoned retail mall operator. As Hofstedter indicated on the conference call, without specific enclosed mall management expertise, they'd have to retain John Morrison and Company to manage the Primaris malls.

No synergies would be obvious, and Hofstedter was mute on where the accretive earnings would come from the buyout.

And a sweet deal for Primaris' executive and senior management: they get a nice payout for the change of control, plus they get to keep their jobs and have their units converted in to new units yielding more income.

Both Primaris REIT and H&R REIT have both increased their monthly distributions recently: Primaris to 10.59 cents per month from 10.16 cents (+4.2%) on December 19 probably in response to the KingSett attack, and H&R had already published in October it would raise from 10.417 to 11.25 cents per month (8%).

Both REITs are on track to pay out all their reported Funds From Operations in distributions based on Q3 numbers. H&R reported 33 cents AFFO per unit and Primaris reported 38.3 cents FFO per unit. It would appear Primaris has a much lower payout ratio (79.6%) but we know enclosed malls often come with heavy tenant inducement costs.

H&R is making it one of the deal features that the 1.13 exchange rate would increase Primaris unitholder distributions for those who take all H&R units, from $1.27 per annum to $1.5255 or 20.1%.

But office-weighted REITs are more risky than retail REITs, and are priced to offer a higher yield to compensate, so part of this is you get what you pay for. At Friday's closing prices, office-oriented REITs such as H&R yielded 5.81% ($23.35), and Dundee 5.84% ($37.60) whereas retail-oriented REITs were priced higher with lower acceptable yields. RioCan yielded 5.16% ($27.30), Calloway 5.21% ($29.71) and Primaris yielded 5.29% on December 4, although the yield has fallen to 4.76% ($26.70) now that the REIT is in play.

Since the KingSett bid was announced, Credit Suisse Securities Canada (CSSC) added 3.4 million Primaris to a pre-KingSett 4.6 million unit position they already had, "to offset risk as part of a broader client transaction." They also state the transaction was not made with the purpose of influencing the control or direction of Primaris." CSSC added another 183,100 yesterday to bring it to 10.039 million (10%).

Since it would be contrary to securities laws for any of KingSett, H&R or RioCan to be the beneficiary of these undlsclosed client transactions, I have to wonder what CSSC is doing, buying for an anonymous client as a risk reducing strategy. The convertible debentures Primaris has outstanding and in the money would convert to only 1.37 million units.

We know KingSett owns 7% of Primaris. And a handful of investment managers owned about 30% before the offer was launched. Apparently, some have a low cost base, and would prefer the all-paper rollover option offered by H&R's transaction.

We have local income investment fund manager Sentry Select and its CIO Dennis Mitchell with 2.2% prior to the battle being launched, saying they were happy with the H&R offer and had bought more. Either of the two offers on the table would require a two thirds majority vote from Primaris unitholders to go through (ex the bidder), and H&R would also require a simple majority from its own unitholders.

Yesterday, we have KingSett extending their offer to February 4. That was predictable, because KingSett had already obtained a January 30 court date to protest the Primaris poison pill.

So why did Morrison and Company have to sign a deal with a punitive break fee for a deal that hasn't even raised the unit price (last trade $26.49, 2 cents less than when H&R announced it) knowing that KingSett was going to extend their deal? I smell a court case coming against the trustees.

And Tom Hofstedter? His family reportedly stands to make up to $30 million in acquisition bonuses and property management fees if he gets Primaris (H&R as an external manager structure whereas Primaris doesn't), according to an article in the Globe and Mail yesterday. Was that Primaris offer really as strategically sound as they tried to make it out to be on the conference call? So far the H&R units have fallen in price, although both it and Primaris firmed up nicely at the Friday close.

I think either RioCan will come in with a unit and cash offer similar to the H&R proposal but with a dollar more value or, the KingSett people could raise their cash offer to $28.00 to nullify the tax advantage of the roll-over offered by H&R. Either option would take time to plan out.

Hold your Primaris units and let the Sonshine in.

Disclosure: I am long OTC:PMZFF, OTC:CWYUF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.