HRUFF - H&R REIT: 6.6% Yielder Offers Compelling Value For Risk-Adjusted Returns

2023-11-16 15:55:54 ET

Summary

• We had downgraded H&R to neutral in February and the REIT has since fallen by over 30%.
• Q3-2023 results were solid and management continued to execute perfectly.
• We explain why we are stepping off the sidelines and giving this a Buy rating.

In our last coverage of H&R Real Estate Investment Trust ( HR.UN:CA ) we reiterated our admiration for the asset base and the transition plan in place. We still decided to stay away from a Buy rating as the stock lacked the key requirements.

We have enough quality REITs today that offer investors a chance of good upside without these additional risks. We continue to rate H&R a hold and will consider an upgrade on further debt reduction and/or increase to weighted average debt maturity.

Source: An Attractive Discount To NAV, But It Needs To Fix Two Things

The fence-sitting was not at all expensive and in fact dodged another 12.62% decline in the stock.

Since our move to neutral in February 2023, the stock is down over 30% and has underperformed even the horrid iShares S&P/TSX Capped REIT ETF ( XRE:CA ) by almost 14%.

Prices fixes a lot of flaws and we think this is one case here where it has changed the average into beautiful. We are going to talk about the Q3-2023 today and tell you why we have decided to upgrade this to a buy.

Q3-2023

Q3-2023 saw a slight expansion of the NAV per unit versus Q2-2023 ($21.04). Aiding the expansion was the purchase of units way below NAV and the strong US dollar translating into higher Canadian dollar figures.

During the three months ended September 30, 2023, the REIT purchased and cancelled 1,304,900 Units at a weighted average price of $10.38 per Unit, for a total cost of $13.6 million, representing an approximate 51.7% discount to NAV per Unit. During the nine months ended September 30, 2023, the REIT purchased and cancelled 4,147,200 Units at a weighted average price of $10.30 per Unit, for a total cost of $42.7 million, representing an approximate 52.1% discount to NAV per Unit.

Source: H&R REIT Q3-2023 Financials

Going against the REIT was the change in fair value of properties with cap rates expanding once again.

What stood out though was the same property net operating income (NOI) and the huge gains in funds from operations (FFO) and adjusted FFO (AFFO). The payout ratio came in at a paltry 35.7%. You are not going to find many 6.5% yielders with a sub 40% payout ratio, pretty much anywhere you look.

But the number is a bit deceptive. A lot of the FFO gains were powered by an unusual transaction this quarter.

Included in net income, FFO and AFFO for the three and nine months ended September 30, 2023 is $30.6 million (U.S. $22.6 million) related to the proceeds on disposal of a purchase option. H&R had a mortgage receivable of approximately $37.2 million (U.S $27.6 million) which was repaid in August 2023. In addition, H&R sold its option to purchase the land. The combined proceeds from the mortgage receivable and the sale of the option amounted to $67.8 million (U.S. $50.2 million). As a result, H&R recorded $30.6 million (U.S. $22.6 million) as proceeds on disposal of purchase option.

Source: H&R REIT Q3-2023 Financials

Excluding that amount (and another minor item), FFO per share was at about 30 cents a share. Still the extra amount is a real gain for shareholders and helps in the whole deleveraging story. Getting back to the core numbers, they were spectacular once again. Same property NOI was at 12.6% and Residential was the top performer. One other number that we want to highlight below is the occupancy level. At 98.1%, H&R has the strongest office occupancy amongst REITs we follow.

H&R continued its disposition activities with six different properties (five retail and one office).

In July 2023, H&R sold four single tenanted retail properties in Québec totaling 476,802 square feet for $68.0 million. These properties were classified as held for sale at June 30, 2023. The proceeds were used to repay debt and repurchase Units under the REIT’s normal course issuer bid (“NCIB”). In August 2023, H&R sold a 85,725 square foot single tenanted office property in Temple Terrace, FL for U.S. $13.3 million. The property was classified as held for sale as at June 30, 2023. The tenant’s lease expired on June 30, 2023 and the property was vacant at closing. In August 2023, H&R sold a 13,510 square foot automotive tenanted retail property in Roswell, GA for approximately U.S. $3.6 million. The property was 37.5% occupied as at June 30, 2023 and at closing. 2023 non-core property sales to date total $431.7 million.

Source: H&R REIT Q3-2023 Financials

H&R maintained its guidance for $600 million of asset sales.

Given the line of sight we have into our current disposition pipeline, we plan to sell or have under contract to sell an additional $170 million of non-core assets by the end of the year.

Source: H&R REIT Q3-2023 Conference Call Transcript

Outlook

As we move into 2024, comparisons are going to get tougher. Residential same property NOI won't be able to maintain those growth rates as supply hits the sunbelt area. The US Dollar has also been quite strong in 2023 relative to 2022.

It likely won't power higher outside of a severe recession. But what helps out here is the raw valuation for H&R. With a round $1.20 expected for FFO, the REIT is trading at just 7.5X 2024 numbers. FFO payout ratio will come in at around 50%. Note that we will see a special distribution as a result of the property sales in Q4-2023, so year over year comparisons in 2024 might show a decrease in the distributions paid. Interest expense, which is the big bogeyman for Canadian REITs, will actually decline at the current pricing. The REIT's substantial debt reductions during 2023 will create an offset to the rising rates across the board. So far, the move to a higher quality asset base has been quite impressive. There has not been a mass liquidation at bad prices and at the same time, dispositions have continued regardless of macro stresses.

Liquidity was enhanced this quarter as well and current liquidity exceeds a billion dollars. That plus retained FFO and the asset sales already committed to, exceed the entire debt maturities lined up for 2023-2025. Valuation is getting extremely compelling at 0.45X price to NAV.

Of course NAV here refers to the management assessment, but even our conservative valuations point to at least a 50% upside for a distressed liquidation value. The implied cap rate here is close to 8.5% and we will note here that Artis REIT ( AX.UN:CA ), possibly the best comparative due to its diversified nature and US property holdings, is trading more expensive than H&R by this measure. In addition H&R has a huge percentage of NOI coming from residential, which should trade at a far lower cap rate (higher value). We are going to go ahead and give this a Buy rating with a $11.00 price target in two years. The total return profile looks attractive and we bought a starter position a day ago. On a related note, we also purchased a small position in Artis preferred shares ( AX.PR.I:CA )

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.

For further details see: