Artis REIT: Strong Operating Results Overshadowed Strategic Initiatives

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About: Artis Real Est In Tr (ARESF)
by: John Sheehy
Summary

Artis' 8/2 unit price is a a 22% discount to IFRS Net Asset Value of $15.37/unit.

The company trades at 8.8 X 2019 FFO, well below the 14X average for all Canadian REITs and 16X average for all US REITs.

The strategic initiatives announced in November 2018 have been aggressively implemented, and an independent Special Committee is considering further action.

Art is a way of survival

Artis REIT (OTCPK:ARESF, TSX:AX/UN) has provided a 37% total return since my December article. Strong 2Q19 operating results featured 13% yoy increases in FFO and AFFO led by growth from US industrial properties. The company has aggressively executed its unit buyback plan and is on pace to sell about $600 million of non-core property this year out of a 3-year goal of $800-$1000 million.

Artis’ projection of Year 3 Net Asset Value of $17.50 can be easily achieved and likely exceeded through development projects (long-term company target of $3.80/unit in value creation), retained cash flow (about $1.50/unit) and share buybacks (accretion of about $1/unit).

AX Target

A significant risk has been that the company could continue to trade at a large discount to Net Asset Value that might not be eliminated without more aggressive reorganization, but the formation of a new Special Committee, management support, and activist investor involvement should increase confidence that steps will be taken to deliver fair value to unitholders. Hiring of financial advisors by the Special Committee implies that a significant transaction is being reviewed.

Topics:

  • 2Q19 Operating Results
  • Relative Multiples
  • Strategic Initiative 1: Divestitures
  • Strategic Initiative 2: Buyback
  • Strategic Initiative 3: Development
  • Special Committee & Activist Involvement
  • Investment Considerations

Background

Artis is a diversified Canadian REIT with Office (52%), Industrial (28%) and Retail (20%) assets in Canada (52%) and the United States (48%). Additional information is available at the company website, investor presentation, financial reports, conference call transcripts and my prior articles (12/21/18, 03/19/19 and 5/13/19).

2Q19 Operating Results

Artis' 2Q19 results (press release, MD&A, conference call transcript) were ahead of expectations and overshadowed the strategic initiatives for a change. Key data:

AX 2Q19 Highlights

Artis has substantially reduced its exposure to the weak Calgary office market (only 6% of 2Q19 NOI). Results benefited from increased rents from existing US industrial properties (same property NOI +12% yoy) and expansion projects (GLA +22% yoy).

AX 2Q19 SP NOI

AX 2Q19 Portfolio composition

Net Asset Value was adversely impacted by appreciation of the CAD from US$0.749 at 03/31/19 to US$0.762 at 06/30/19, but benefited from significant accretion from unit repurchase. Earnings included a $59.5 million writedown of investment properties held for sale partially offset by $34.9 million positive revaluation of retained properties. During the conference call, management attributed the writedown to an office building in Denver, likely 1700 Broadway, where the primary tenant (Whiting Petroleum (WLL)) is leaving in October.

AX 2Q19 NAV

Relative Multiples

Artis trades at a large discount to the valuation of REITs in every sector where it owns assets:

AX 2Q19 Multiples

The large valuation gap shows that Artis' valuation is held back by the excessively diversified scope of its business.

Strategic Initiative 1: Divestitures

Artis is aggressively executing its plan to sell $800-1000 million of property within three years. As of 6/30/19:

  • $236 million sold
  • $398 million held for sale (includes US$92 million Phoenix Office property already sold in 3Q19)

During the 2Q19 conference call, Artis mentioned:

“We’re very confident we’ll be able to successfully dispose of at least $600 million of our properties, if not more, by year-end, on time and on price, on balance, and that’s not always - it’s not always a straight line, but on balance on prices that correspond to our NAV of over $15 per unit.”

It explained that the loss on the Denver office sale would be offset by gains on other properties expected to sell for more than carrying value.

While Artis has some out-of-favor assets such as the Calgary office space, their transaction prices are so low that further writedowns or surprises are unlikely. For example, in May, the REIT sold the 134,897 sf Britannia Building in Calgary for C$10.7 million (about C$80/sf). It was built in 1958 and largely vacant, but at that price, a buyer has multiple long-term options for adding value.

Strategic Initiative 2: Buyback

Artis intends to repurchase $270 million of units within three years at an estimated average cost of $11.50 and bought 3.8 million units in 2Q19 at an average price of $11.03. Purchases are currently being made through a Normal Course Issuer Bid permitting the company to buy 13.2 million units between 12/17/18 and 12/16/19. The REIT bought 83928 units, the maximum permitted under TSX regulations, every day until May, but purchases slowed sharply in June and there were none in July. During the conference call, the company explained that purchases were suspended in order to manage its debt level:

“So that was just getting up about the level where we wanted to cap off the debt. So deliberately, we did slow down the unit buybacks. We’ll resume as we close some more sales and get our debt down a little bit, but we didn’t want it to get too much higher and get anybody fussing over the debt levels.”

It’s also possible that price played a role in Artis’ thinking, since no weekly buybacks were filed with an average unit price over C$11.75. If asset sales are completed as planned and purchases resume, then the company has a remaining authorization of 3.1 million units that can be acquired by 12/16/19.

Artis has also briefly commented on the possibility of a “Substantial Issuer Bid” that would permit it to acquire a larger number of shares through a self-tender. In the 2Q conference call, management said: “it’s not at the top of our priority list” and “you wouldn’t see it happening in Q3.”

Strategic Initiative 3: Development

Artis plans to invest about $200 million over the next three years in multi-phase new industrial developments in the US. The company completed two Houston projects in 2Q19 (Park 8Ninety III and Cedar Port I). Both are 100% leased and contributed to the 28% yoy increase in US industrial NOI. Additional projects under construction are as follows:

Phased construction allows Artis to defer capital investment to match tenant commitments for the completed space and limits exposure to the risk of a market downturn. The company expects to achieve rental yields about 150-200bps above market cap rates, which could improve IFRS Net Asset Value by at least $0.38/unit.

AX Development Capex 2q19

Artis will earn additional profits by preparing certain existing properties for residential conversion and then selling to third parties after zoning approvals have been received (2Q19 MD&A excerpt):

Rezoning and Densification InitiativesArtis is exploring opportunities for a densification project at 415 Yonge Street in Toronto, Ontario. 415 Yonge Street is in a prime location in downtown Toronto, across from the College Station subway stop and in close proximity to the University of Toronto and Ryerson University. Preliminary plans to build 375 apartment units above this 19-storey office building are underway.Artis is exploring opportunities for a densification project at Concorde Corporate Centre in the Greater Toronto Area, Ontario. The site provides direct access to Don Valley Parkway and convenient access to other major thoroughfares in the Greater Toronto Area. Preliminary plans are underway to build approximately 600 apartment units on the site.Artis is exploring opportunities for a densification project at Poco Place in Port Coquitlam, British Columbia. The site provides access to major transportation routes and frontage on four streets, including Lougheed Highway, an east-west arterial corridor. Preliminary plans to build 600 to 900 apartment units are underway.Stampede Station II development land on Macleod Trail in Calgary, Alberta, has been rezoned from office to multi-residential. The original plan for a 300,000 square foot office project has been changed to a 30-storey multi-family project with 300 suites. This land is classified as held for sale at June 30, 2019.

During the 2Q19 conference call, management was optimistic about sale of the 415 Yonge property: “we’re very confident that we’ll be transacting on that. And something will be firmed up to you in Q3, for sure.”

The IFRS carrying values of these redevelopment properties are based on current usage and rents, so sales after successful rezoning with increased density should result in significant gains.

Special Committee and Activist Involvement

Artis has a clear path to increasing asset value over time through development, however its diversified business model is unpopular with investors. There has been a risk that the strategic initiatives announced last fall would be insufficient to improve the company’s appeal and that units would continue to trade at a discount to fair value. Prior Koneko articles suggested that Artis could be pushed towards further strategic actions by an activist investor (Sandpiper Group) who has successfully pushed for changes at other companies, including Agellan Commercial REIT and Granite REIT (see this article for a background on Sandpiper’s record).

In May, Artis announced the formation of a “Special Committee of Independent Trustees to review and evaluate additional strategic alternatives that may arise.” 2Q19 reporting had no update on the work of the Special Committee. CEO Armin Martens explained:

“None of us in this room are on the Special Committee. We talked about it earlier, and I was reminded that I’m not a spokesperson for the Special Committee and can’t give any - make - give any comments there. And all I can do is assure you that in the event we have anything most important to announce, they will disclose it to the public immediately.”

On 8/6, Artis announced that the Special Committee has retained financial advisors. The company's diversified business model is obscuring the high value of its industrial properties. It’s possible that the Special Committee could urge the company to sell all of its remaining non-industrial assets. Alternatively, the industrial sites could be sold in the current strong market and proceeds delivered to shareholders through dividends and unit buyback. I believe it’s unlikely that an acquirer would be interested in the entire company in its current diversified form.

Investment Considerations

Investors punished Artis for reducing its dividend rate, but 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 distribution (currently C$0.54/year) gradually returns a portion of the full NAV, which we can now acquire in the market at a discount.

Artis unitholders will be rewarded if corporate actions succeed in narrowing the NAV discount, so investors should be attuned to board membership, the unitholder roster and developments at peer companies that may hint at the path that Artis will follow.

The pause in unit repurchases pending completion of asset sales and possibly due to higher prices may mean that Artis units have less support if the price drops over the next 1-2 months. Unitholders with a short-term investing horizon may wish to lock in some gains now.

More positives could appear by year end, including continued strong growth of industrial property revenues, resumption of share purchases and announcements from the Special Committee.

Disclosure: I am/we are long ARESF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author is a unitholder of Artis 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.