H&R Real Estate Investment Trust (HRUN) Earnings Call Transcript & Summary

Good morning, and welcome to H&R Real Estate Investment Trust Conference Call. Before beginning the call, H&R would like to remind listeners that certain statements which may include predictions, conclusions, forecasts or projections and the remarks that follow may contain forward-looking information, which reflect the current expectations of management regarding future events and performance and speak only as of today's date. Forward-looking information requires management to make assumptions or rely on material factors and is subject to inherent risks and uncertainties, and actual results could differ materially from the statements in the forward-looking information. In discussing H&R's financial and operating performance and in responding to your questions, we may reference certain financial measures which do not have a meaning recognized or standardized under IFRS or Canadian generally accepted accounting principles and are, therefore, unlikely to be comparable to similar measures presented by other reporting issuers. Non-GAAP measures should not be considered as alternatives to net income or comparable metrics determined in accordance with IFRS as indicators of H&R's performance, liquidity, cash flows and profitability. H&R's management uses these measures to aid in assessing the REIT's underlying performance and provides these additional measures so that investors can do the same. Additional information about the material factors, assumptions, risks and uncertainties that could cause actual results to differ materially from the statements in the forward-looking information and the material factors or assumptions that may have been applied in making such statements, together with details on H&R's use of non-GAAP financial measures, are described in more detail in H&R's public filings, which can be found on our website and at www.sedar.com. I would now like to introduce Mr. Tom Hofstedter, Chief Executive Officer of H&R REIT. Please go ahead, Mr. Hofstedter.

Good morning, everyone, and welcome to today's conference call where we will discuss the first steps made in our strategic repositioning announced earlier this morning. On the call with me here today is Larry Froom, Executive Vice President and Chief Financial Officer; Alex Avery, Executive Vice President, Asset Management and Strategic Initiatives; and Robyn Kestenberg, Executive Vice President of Corporate Development. Over the past few years, H&R's Board and management team have been working hard to better align the REIT's business model with investor preferences. The ownership of the Bow has been a characteristic element of the REIT's profile for more than a decade and something investors have focused on as a key risk elevating the REIT's cost of equity and limiting strategic flexibility. Today's $1.5 billion office portfolio sale is a critical step forward on our path to achieving a more simplified structure and is evidence of our commitment to our strategic repositioning. By substantially reducing the REIT's Calgary office exposure and improving our tenant concentration profile, we are addressing significant issues of concern as voiced by our unitholders. With today's announcement, we are now in position to enhance financial flexibility, enabling us to execute on the next steps of our strategic repositioning. The Bow and Bell Campus office transaction is comprised of 3 key elements: one, the first is the 100% ownership of the land and building of the Bow, together with a 40% interest in net rent payable under the Ovintiv lease for gross proceeds of $613 million; two, the effective sale of a 45% interest in the Ovintiv lease to Deutsche Bank through a securitization structure for gross proceeds of $418 million; and finally, the sale of 100% of the Bell campus for gross proceeds of the $439 million. On closing, these sales will generate approximately $800 million of cash proceeds net of associated mortgage repayments and transaction costs. Of significant importance, the transaction also includes an option in favor of H&R that allows us to repurchase the Bow on expiry of the event of lease in May 2038 for $735 million or 60% of today's total transaction value. And per square foot terms, the transaction services approximately $608 per square foot of value for the Bow as compared to the repurchase option at a price of $368 per square foot, which is 40% below today's transaction value. This option gives the REIT the ability to capture upside in the value of the Bow as the Calgary office market recovers over the next 17 years while providing substantial cash proceeds today to allow the REIT to pursue other opportunities. I'll now turn the call over to Larry to discuss a few financial implications.

Thank you, Tom. Good morning, everyone. The transaction announced today effectively reduced the REIT covering office exposure from 9% to 3% on a fair value basis and reduced the Ovintiv share of REIT revenues from 12% to 2% and Bell Canada's revenues from 9% to 5%. These 2 tenants make up 21% of H&R's total revenue in Q1 2021. On a pro forma basis, our top 10 tenants will comprise 34% of total revenue, an improvement from 44% of revenue as at the end of Q1. The dispositions will reduce annualized cash FFO by approximately $0.20 per unit, assuming 100% of the proceeds will be used to repay debt. This dilution in FFO will largely be offset by the lease-up of River Landing and Jackson Park. From a balance sheet perspective, the transaction reduces debt to total assets from 50% to approximately 44% on a proportionately consolidated basis and from approximately 10x debt to EBITDA on a trailing basis at Q1 2021 to 8.6x on a pro forma 2022 EBITDA, which includes the lease-up assumptions for River Landing and Jackson Park. The REIT will have legally disposed of its interest in the both property. But due to the repurchase option in favor of H&R and in accordance of IFRS 15, the Bow transaction will not be treated as a disposition for accounting processes. The Bow will continue to be recorded as an asset on the balance sheet with the proceeds from the sale being recorded as deferred revenue with both items being amortized over the remaining time of the lease. The sale of the 45% interest in the Ovintiv lease to Deutsche Bank will be treated as prepaid rent for income tax purposes and recorded as deferred revenue on our balance sheet. It is expected that this transaction will generate taxable income of approximately $225 million or $0.75 per unit of taxable income, including both recapture income and capital gains. We anticipate that a special distribution will be required, and we will provide you with full details in the upcoming months once they are finalized. I will now turn the call back to Thomas.

Thank you, Larry. While we're sharing good news, let me provide an update on the continued strong momentum we have been experiencing at Jackson Park and River Landing. Committed occupancy at Jackson Park recovered sharply, reaching 97% to date, effectively making the project fully leased. River Landing in Miami has seen a similarly remarkable pace of leasing momentum with over 86% of the residential units now leased. The retail component of River Landing is over 95% leased, and the office is now 36% leased with advanced lease negotiations of substantially all of the remaining office space. Management now expects the overall development to reach stabilization of 95% leased up by the end of the year, a full year ahead of our previous expectations. Upon stabilization, Jackson Park and River Landing are expected to contribute approximately $25 million and $30 million of incremental annualized NOI, respectively. The combined CAD 55 million is expected to add approximately $0.18 per unit of annualized FFO, offsetting most of the impact on FFO per unit of the office transaction we're announcing today. The REIT has also recently completed the sale of its interest in 16 industrial properties aggregating approximately 900,000 square feet, all through its joint venture with Crestpoint, PSP for $162 million of the REIT share, reflecting a 4.1% cap rate and a 28% premium to the REIT's last IFRS fair value of the properties. Management and the Board plan to continue to pursue opportunities to further streamline and simplify the REIT's portfolio and structure to better align with investor preferences. Earlier this year, we outlined plans to create at least one new REIT entity in 2021. And with today's announcement, we remain on track to achieve our goal, which we believe will materially enhance the value of our units. We appreciate the patience and support of our unitholders as we work through the execution of our strategic initiatives. We'd now be pleased to answer any questions from call participants. Operator, please open the lines for questions.

[Operator Instructions] Our first question is from Matt Logan with RBC Capital Markets.

Would you guys be able to provide any early thoughts on the nature or quantum of the planned special distribution?

No. We're still finalizing that, Matt. We still got to figure out, perhaps any other sales, interim guidance that we've given right now. Really, I don't have anything further to comment on that, Matt.

Fair enough. And in terms of the planned creation of new public entities, has there been any further thought on which entity might be spun out later this year?

Absolutely. Plenty of further thoughts. Just can't share them with you, Matt. Sorry. Stay tuned.

And maybe a couple of other ones, changing gears here. In terms of the South Block portion of the Bow, what was the logic in retaining that piece of the building?

It's land for future development. It has no revenue potential for our buyers. And therefore, they didn't really have an interest in it.

And lastly, any thoughts on why the pursuit of a secured lease financing arrangement versus just an outright sale?

Sure. To maximize value, the owners came together creating a higher value than an outright sale. This is a structured financing, and it's a large, large transaction, especially if anything in the Canadian marketplace is deemed to be one of the largest transactions, very hard to find a buyer who will take on that liability. By piecing it into 2 different components, you're effectively dividing the asset into smaller buckets which are now more easily saleable. And quite frankly, I don't think it's reflective necessarily of the strength of the Calgary market. I think this is a structured finance deal. And sorry, Matt, I was just joking beforehand on the answer to your question of any more guidance as to what the -- what will happen if we spin out our IPO. We hope to have something by the end of the year finalized. So stay tuned. It's not a never-never land.

Next question is from Matt Kornack with National Bank Financial.

Just a quick question as to the residual exposure to Ovintiv. Can you just walk us through what would happen in the case there was a default by them and what your exposure is ultimately at this point? Is it just the 15% residual lease component?

Yes.

Okay. So the Deutsche transaction is entirely their exposure to Ovintiv?

Yes. That's right. Deutsche transaction really is just a cash flow. Look at it like they sold an unsecured piece of Ovintiv's paper. And the logic being it's priced at a premium -- sorry, it's priced at a discount to the -- where the bonds trade, and it's an arbitrage on the Ovintiv bonds. It's not an uncommon phenomenon in the United States. We don't have in Canada, as you well know, bond of leases. This is one of the few animals that exists like this that don't have the right setoffs and the other things, so it can be sold as a debt piece instrument. It's priced off of the Ovintiv bonds.

And then I think it's fairly consistent with regards to a DCF approach. But like I guess if rents are above 25% net or so in Calgary in 17 years, it may be an interesting purchase on your part to get back into that market.

Yes. If I can just add a little color to it. I mean, it's not the only asset in the world that's being sublet. Even our Bell facility in the sub has substantial sublet component. And therefore, the logic being at the end of the 17-year term, it will probably be retenanted by other tenants who want the space, need the space or could be Ovintiv at that point in time. So you will be buying cash flow stream with tenants actually, live bodies, logically speaking, who are actually occupying the building and they have a value. The value we're paying -- we can rebuy that at a price per square foot basis, could be an interesting play. Don't forget we don't have an option to buy. You can sell the option. You can actually sell the asset before you actually buy the asset. It's a one-way street whereby we can make money, can't lose money on it.

Yes. No. It's a nice optionality to have if Calgary comes back, which it may well. And then last one for me. With regards to the pro forma balance sheet, Larry, I missed your commentary there on debt to EBITDA. And also, does that include the industrial sale that you provided subsequently? And where would sort of the EBITDA be as well as the debt to total assets on a proportional basis post these transactions?

On a pro forma basis, we'll go down to 44% debt to total assets. It does include the pro forma of the sale of the industrial asset. And on debt to EBITDA as well include the sale of the vertical assets. It goes down to 3.6x. So that includes the lease-up for the land in Jackson Parks, which, in Thomas commentary he indicated, leasing done that's pretty much gone much better than our expectations. And by Q4, we'll see a large improvement in our results on those 2 properties.