H&R REIT: Giftwrapped With A Bow
Summary
- We were bullish the last time we covered this REIT and that bullishness stemmed from a belief that a big disposition should be coming soon.
- Well, that happened.
- We go over the big news and what this means for our thesis.
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All values are in CAD unless noted otherwise.
Then
We have been bullish on H&R Real Estate Investment Trust (OTC: OTCPK:HRUFF) (TSX: HR.UN) for some time now. In our last piece, we opined that if this diversified REIT had to trade anywhere close to its NAV rather than at a discount, it would have to reduce its office exposure to Calgary and specifically one large tenant, Ovintiv Inc. (OVV), that occupied The Bow building. The conference call at that time alluded to this and we included our thoughts on a possible sale in our verdict:
That language in the conference call was quite promising. We think a sale is achievable and investors bidding for The Bow might see it as a longer term play on a recovering Alberta economy.
Source: H&R REIT: Take A Bow
Now
Source: H&R August 3, 2021
While the sale includes the Bell Campus in Ontario, today we will talk about The Bow sale. The "Calgary Exposure" has been like noose around this REIT's neck for a few years now and it's only fair that we spotlight its efforts to alleviate investor concerns and improve long term viability.
Capitalization Rate
The Bow was sold for well over its IFRS fair value and at a capitalization rate of about 8.1%.
Source: H&R August 3, 2021
- Oak Street gets the land and most of the building, along with 40% of the OVV rent until the lease expiration in 2038.
- Deutsche Bank gets 45% of the OVV rent until the lease expiration in 2038.
H&R however, unlike Elvis, has not left the building yet. We talk about that next.
Bow Be Gone?
H&R has retained the right to 15% of the OVV rent until the lease expiration in 2038. It will also continue to manage the building and earn the fees in return. They got this for a cool price of $185 million.
Source: H&R August 3, 2021
But wait, there is more. Owing to what appears to be separation anxiety, The REIT did not sell The Bow in its entirety. They retained the south block, along with the adjacent lands. While they were on a roll, they also included an option to buy back the building in 2038 for 60% of the transaction value.
The sale includes an option in favour of H&R to repurchase 100% ownership of the land and building of the Bow at expiry of the Ovintiv lease in May 2038 for approximately $735 million ($368 per sq.ft.), substantially below the combined sale proceeds of $1.031 billion ($515 per sq.ft.) and 60% of the total Transaction of $1.216 billion ($608 per sq.ft.). This option provides H&R the ability to capture potential upside in the Calgary office market over an extended ~17 year time frame.
Source: H&R August 3, 2021
For accounting purposes, The Bow will remain as an H&R asset due to the option to repurchase. This will be offset by the sale proceeds being recorded as deferred revenue which will be recognized over the time until 2038.
The closing of this transaction is anticipated either this quarter or next.
The Aftermath
With this transaction, H&R reduced its Calgary office exposure from 9% to 3% and its dependence on OVV from 12% to 2%. The sale generated net cash proceeds of $800 million that H&R will use to pay down debt among other things. The REIT also anticipates paying a special dividend this year to spread the capital gain joy from this transaction amongst its unitholders.
Valuation & Verdict
Let's keep in mind just what H&R accomplished here. They reduced their dependence on Calgary's horrendous office market and validated their NAV values. Too often, REITs tend to mark their NAVs to inflated values but getting over $200 million above IFRS values should soothe those concerns.
The investment case here is if H&R can reach its stated NAV value, even via liquidation or buybacks over 4 years, while paying the current distribution.
Source: H&R
That gets us to an easy 15% compounded annual return. While they do carry a lot of retail properties, they also have $4.0 billion in residential and industrial properties which continue to appreciate by leaps and bounds. So reaching the NAV over 4 years with inflationary tailwinds is not exactly difficult. H&R has also reduced its exposure to OVV and that should count a lot for the longer term sentiment. Investors should note though that funds from operations (FFO) will fall here after this sale as the cap rate for the property is far higher than the weighted average interest rate on H&R's debt. We remain modestly bullish here after this outcome and think $17.50-$17.75 can be reached by end of the year.
Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.
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This article was written by
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