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 in the remarks that follow may contain forward-looking information, which reflects 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 certain 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 the proposed transactions and 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 or future Primaris REIT's performance, liquidity, cash flows and profitability. 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 www.sedar.com. I would now like to introduce Mr. Tom Hofstedter, Chief Executive Officer of H&R REIT. Please go ahead, Mr. Hofstedter.

Thank you, operator, and good morning, everyone. I'm Tom Hofstedter, H&R's CEO, and I'd like to thank everyone for joining us today on such short notice to discuss H&R's strategic repositioning plan. With me on the call today are Larry Froom, our CFO; Alex Avery, Executive Vice President, Asset Management and Strategic Initiatives and future CEO of Primaris REIT; Pat Sullivan, COO of H&R's Primaris Division and future President and Chief Operating Officer of Primaris REIT; Philippe Lapointe, President of Lantower Residential; and Matthew Kingston, Executive Vice President, Development and Construction; and finally, Robyn Kestenberg, Executive Vice President, Office and Industrial. We are incredibly excited to announce our transformational strategic repositioning plan to create a simplified, growth-oriented company focusing on multi-residential and industrial properties to service significant value for our unitholders. Our target is to be a leading owner, operator and developer of multi-residential and industrial properties creating value through redevelopment and greenfield development in prime locations within Toronto, Montreal, Vancouver and high-growth U.S. sunbelt and gateway cities. We will fund this growth through a disposition program that synchronizes sales with capital requirements. As we detailed in our announcement this morning, our strategic repositioning plan comprises 4 key steps: the tax-free spinoff of Primaris, including all of H&R's enclosed malls to our unitholders; exiting over time our remaining retail assets by selling our remaining grocery anchored and essential service retail properties and our interest in ECHO Realty; exiting office while retaining properties with redevelopment opportunities; and finally, growing our multi-residential and industrial portfolio through the development and redevelopment of properties in prime locations, primarily within the GTA and high-growth U.S. sunbelt and gateway cities. Our strategic repositioning will create a more compelling investment profile for unitholders. By exiting retail and office, we are streamlining our operating platform and expanding our exposure to high-growth multi-residential and industrial properties. Our exposure to major markets will increase over time as our development pipeline completions begin to come online. This streamlined operating platform will allow us to focus on development and redevelopment opportunities in our existing portfolio to drive future growth. The spinoff of the Primaris portfolio, as we announced today, along with the completion of the Bow and Bell office transactions, significantly strengthens our balance sheet, providing us the flexibility to execute on our growth and transformational plans. The first part of our plan announced today is the highly anticipated tax-free spinoff of Primaris REIT. We are very excited to be partnering with one of the largest and most respected pension plans in Canada, Healthcare of Ontario Pension Plan or HOOPP, to create Primaris REIT, Canada's premier and closed shopping center REIT with a $3.2 billion portfolio of properties. H&R will contribute 74% of properties, primarily comprised of regional and closed shopping centers and retail and mixed-use properties, while HOOPP will contribute 26% of the portfolio, primarily comprised of enclosed shopping centers. Independent third-party appraisals were completed on all of the properties. Each existing H&R unitholder will receive 1 unit of Primaris for every 1 H&R unit held, subject to any consolidation or split of Primaris units pursuant to the arrangement. We anticipate the spinoff to be completed on January 1, 2022, as a nontaxable distribution subject to CRA approval. As a result of the recently closed Bell and Bow office transactions, we have significantly reduced our Calgary office exposure from $1.1 billion as at June 30, 2021, to $370 million on a pro forma basis immediately post spin and enhanced our balance sheet with reduced leverage from 50% to 47%. In addition, immediately post primary spin, our retail exposure falls from $4 billion as of June 30 to $1.8 billion. Our strategic repositioning initiatives will have a favorable impact on operating credit and credit metrics. Our plan is to exit our remaining retail portfolio through a disposition program that synchronizes capital funding requirements with property sales, redeploying proceeds from dispositions to fund our multi-residential and industrial development pipeline. The sale of our remaining grocery-anchored and essential service properties, including our interest in ECHO Realty, is expected to generate approximately $1.1 billion in proceeds. The grocery-anchored and essential service disposition portfolio includes $600 million of high-quality properties anchored by strong covenant tenants such as Lowe's, Metro, Sobeys and Walmart. This 56-property 2.8 million square foot portfolio primarily located in Ontario is 98% leased and will be a ready source of capital at favorable pricing. Our investment in ECHO Realty, which we also plan to exit, comprises 237 grocery-anchored shopping centers, which is 95% occupied, primarily by Giant Eagle, the largest supermarket chain in the Ohio and Pennsylvania markets. We also intend to exit office. We began this process with a $1.67 billion Bow and Bell campus sale and intend to continue to sell up to an additional $2.3 billion of high-quality office properties located in key business districts in major cities across the United States and Canada. The office disposition portfolio comprises 15 properties, 99% occupied with a weighted average lease term of 9.5 years, and again, being a very source -- a ready source of capital at very favorable pricing. This strategy will provide us the liquidity to achieve our goal of increasing exposure to multi-residential and industrial. Our disposition program will carefully synchronize property sales to match our capital funding requirements. The remaining $1.4 billion of office properties located in Toronto, Vancouver and Montreal will be held to surface value through future redevelopment. These properties are projected to add approximately 5,900 residential units over time. The second component of our development pipeline is our Class A greenfield multi-residential developments located in high-growth U.S. sunbelt and gateway cities. In 2022, we plan to start construction of 2,150 residential units with a budgeted cost of $900 million, with a further 1,450 residential units at a cost of $650 million in 2023. This $1.6 billion of development, spread over 12 locations, comprises a total of 3,600 residential units with an attractive yield on cost ranging from 5% to 6%. In total, our development pipeline encompasses 12,700 residential units and 3.2 million square feet of institutional quality industrial space. As I mentioned, 2022 and '23 construction starts totaled 3,600 residential units and 1 million square feet of industrial space, while in 2024 and beyond, we intend to build a further 9,100 residential units and 2.2 million square feet of industrial. We expect to evaluate each potential development in the context of our capital allocation strategy and may elect to pursue development on our own with capital partners or sell the developments with approvals in place, capturing much of the value creation. I'll now hand it over to Alex to provide an overview of Primaris' strategic advantage and capital structure before I close with a few closing remarks. Alex?

Thank you, Tom, and good morning, everyone. Before I begin, I would like to say how excited I am to be joining Primaris REIT and to meet its talented team at such a unique and exciting time in the Canadian retail property environment. Primaris REIT will be exceptionally well positioned to take advantage of market opportunities at an extraordinary moment in the evolution of Canadian retail properties. The strength and scale of the Primaris platform, combined with its unique financial model, provides significant flexibility and capacity to both self-fund the REIT's business strategy and positions it well to pursue investment opportunities. The REIT will have significant scale with a $3.2 billion national portfolio and enclosed shopping centers that are dominant in their trade areas. Economies of scale are achieved through its full-service internal national management platform, which will comprise over 300 dedicated team members. Primaris will be very well capitalized. This will limit the REIT's reliance on external capital sources and allow the REIT to grow with an optimal cost of capital. We anticipate leverage to be one of the lowest amongst its Canadian peers with a debt-to-gross book value of 29%, forecasted debt-to-EBITDA of 5.3x and our targeting an FFO payout ratio in the range of 45% to 50%. These metrics are clearly differentiated -- reflect a clearly differentiated financial profile. Our size, scale, portfolio composition and capital structure were designed to allow Primaris REIT to grow and thrive in the new retail landscape. Primaris' strategy will focus on 3 key strategic pillars: number one, providing affordable retail space to profitable retailers; number two, consolidation of retail assets in a market with limited institutional competition; and number three, disciplined internal capital allocation across investment opportunities. The first piece of our strategy is our focus on retailer affordability, offering attractive and economic store locations. Primaris has a long-standing and disciplined approach to cost management, supported by economies of scale and a collaborative approach to relationships with its tenant partners. More recently, Primaris has established a proprietary e-commerce integration technology platform, which will be fully launched by year-end. This platform connects the shopper, both in-store and online, to the mall and retailers offering a one-stop destination to shop multiple participating malls and direct-to-consumer brands anywhere in Canada. Primaris will capture retail sales at the mall and receive a percentage of marketplace sales. Today, approximately 85% of all retail transactions in Canada continue to take place in store and integrating this technology platform strengthens the ties between the shopper, the tenants and our properties. The second piece of our strategy is the opportunity for Primaris to be a consolidator in the enclosed shopping center space in a market with limited institutional competition for assets. Primaris will be uniquely positioned as Canada's only REIT focused on owning and managing enclosed shopping centers with an established large, fully internal and scalable management platform and a balance sheet with capacity for growth. And our third leg of the strategy is our disciplined capital allocation. Beginning with a properly capitalized balance sheet and a low payout ratio, Primaris will judiciously allocate capital across internal investment alternatives, including intensification and redevelopments such as our flagship development at Dufferin Grove paying down debt, repurchasing units and increasing distributions. The spinoff and formation of Primaris as a stand-alone REIT comes at an opportune time, having demonstrated resiliency with stable operating performance through the COVID-19 pandemic and having attractive exposure to the ensuing economic recovery and beyond. Primaris' fully internal management platform with nearly 20 years of operating history will be led by myself and my partner, Patrick Sullivan, currently Chief Operating Officer in H&R's -- at H&R's Primaris division. Together with our team of over 300 members, we bring significant real estate investments, capital markets and retail property operating expertise. Our independent Board of trustees will be comprised of 7 experienced members that have been purposefully assembled for their expertise and complementary skill sets well suited to today's retail property market. Our intensification development pipeline is anchored by our flagship property Dufferin Grove, where we expect to replace surface parking with 1,300 residential units across 3 towers and 130,000 square feet of new retail space. This 4-acre development site is among the most attractive locations in Toronto and sits adjacent to the other 17 acres of land under the remainder of Primaris' Dufferin Mall. In total, Primaris' pipeline of potential intensification opportunities spans approximately 300 acres of urban land that is owned by the REIT, with the potential to build 2,300 residential suites at share. All this is to say that Primaris REIT is well positioned to grow and succeed in today's retail environment. With that, I will turn it back to Tom for some closing remarks.

Thank you, Alex. Just adding my own personal thoughts to what Alex just said. We are very pleased with how well we have positioned Primaris, and we are confident in Alex's and Pat's leadership and vision for the company. We are excited to watch them with their capable management team to lead the company to thrive and to grow. And at the same time, we are very excited about the future of H&R. We plan to complete the balance of the transformation over the next 5 years, investing in high-quality distribution facilities and upscale multi-residential through our Lantower platform, targeting the GTA in Canada and the sunbelt and gateway regions in the United States. I know we have delivered a lot of information today and our presentation will be available on our website just so you will have the opportunity to review the details at your leisure. But in summary, we will be focusing on 5 key pillars. The first we will be focusing on Class A multi-residential through our Lantower platform, growing exposure through acquisitions and developments in high-growth U.S. gateway and sunbelt cities. The second, we'll be focusing on property redevelopment through the rezoning of our $1.4 billion of existing office properties to construct 5,900 upscale multi-residential properties in Toronto, Vancouver and Montreal. Thirdly, we'll be focusing on the development and acquisition of high-quality distribution facilities in both Canada and the United States. Fourthly, we'll be focusing on redeploying proceeds from retail and office sales to fund our significant development pipeline and growth. And finally, we'll be focusing on maintaining a strong and flexible balance sheet to support this growth. We remain committed to maintaining our investment-grade rating and further plan on reducing leverage over time. The newly repositioned H&R offers value and growth. Our units are trading at a significant discount to where we believe the true intrinsic value lies and this differential and gap that we are committed to close. We'd now like to be pleased to answer any questions from the call participants. Operator, please open the line for questions.

[Operator Instructions] Your first question comes from Matt Logan from RBC Capital Markets.

Tom, when I look at the presentation, trying to get a sense for what H&R 2.0 will look like at the end of the next 5 years. Would it be fair to say that this is a business that is approximately 75% to 80% multi-res, 20% to 25% industrial and maybe thematically, evenly diversified across the U.S. sunbelt, gateway cities and the GTA?

That is what we presented. So there's a slide in there that says exactly that, 20/80 and 1/3, 1/3, 1/3. Correct.

Okay. I just didn't do the numbers there on the chart. So that's great. And when you think about the development potential across this business, it's fairly material. Can you talk about what that would be as a percentage of gross book value?

Sorry, what was the question? I didn't understand.

Development as a percentage of gross book value over the next 2 or 3 years?

I can calculate it. I don't have the number handy because it's -- you're asking a question that goes out. We talked about construction commencing, and we discussed 2022-'23 commitments on construction, which was around $1.5 billion. Going forward in 2024, we haven't put numbers to the -- the budgeted numbers yet. It's too far out into the future.

Sorry, Matt, I'll just add. In the deck, there's a slide which shows 2022 and 2023 construction starts, which is what Tom is referring to. That total budget is $1.8 billion, but that's not what we'll be spending because those projects will take time to complete.

Right. Those are construction starts.

Of course. And so...

And the intent is also to pair the development spend with dispositions over time to maintain a relatively stable leverage profile.

No. I appreciate that and all that makes sense to me. I was just wondering if there was a cap on development or some way that we could frame what would be projects under construction at any given time? But if those numbers aren't handy, that's okay. I will -- I guess, I'll turn the call back then.

Your next question comes from Sam Damiani from TD Securities.

Congratulations on coming to the stage. We've been waiting for this for a while, and it's good to see. First question, and I'll limit it to 2. First question is just on the future pie chart that Matt was referring to. What's the rationale for keeping industrial and multifamily together? Is there a rationale for that? And if there's any synergies, what would you say those are?

Well, you have to manage the -- what we've done over here with cash, with tax, with distributions, with maintaining our credit rating. So you can't dispose of everything effectively and -- you'll lose your credit rating, you'll be tax inefficient and your FFO will go down as well. Therefore, the rationale is, from an accounting perspective, from a tax perspective, maintaining Canadian precedence and maintaining a presence in the 2 largest and growing sector, which means there's a possibility down the road, of course, of hiving off one of the sectors. But for now, it's impossible to exit everything because you lose your status as a REIT effectively. It's not practical. You can't exit everything to the rationale. We keep them together because we need to keep things together in order to enable us to go ahead and sail enough to fund our development approach.

Okay. No, that's helpful. And just over to Primaris. Just adding up the numbers, is there a fair value or an appraisal shortfall relative to the Q2 fair values that we're looking at here? Sort of squaring it up, it looks like there was a bit of a shortfall. And if you could offer what the sort of implied cap rate is on the Primaris REIT assets, including the HOOPP portion as well?

Yes, Sam, I didn't really understand the first question. Could you...

Sure. The first question was...

I'm sorry, go ahead. There will be no shortfall from the Q2 IFRS numbers. I don't know why you think that. We're not exiting the whole retail. So you're maybe looking at all of our retail IFRS at Q2. This is only a part of it. There will still be a part remaining. And the appraised values were in line with our IFRS values. And in fact, we've got a little bit more for Dufferin Grove, which is a development that's going over to Primaris. And that was not part of our NAV. So there's a little bit of an increase for that development that's going over to NAV. But otherwise, everything else is pretty much in line with our IFRS.

And to your second question about what the implied valuation is on the Primaris portfolio. It's a little bit difficult to sort of nail down a cap rate on a one statistic basis. I can tell you that the approach that the appraisers took was a discounted cash flow and that reflects the fact that coming out of the pandemic, there were bad debts and other impairments to cash flow. On a trailing basis, the appraisals imply about a 5.8% cap rate. On a forward basis, they're in the mid-6s. And we think that there's still significant reversionary potential on the NOI above that. And that -- those numbers, I guess, also would not be adjusted for excess land and non-income-producing assets. So on an income-producing-only cash flow perspective, you would see a higher implied cap rate on the valuations.

Okay. That's helpful. And just to my other question, I was adding up the Primaris assets and the 2 buckets of assets that are -- and retail assets that are targeted for sale. It just came up short of the $4 billion number total retail fair value from the Q2 investor deck, but I'll have another look there. And just maybe finally before I -- sorry, go ahead.

I think what might be happening there is we do have retail included in a number of different properties like River Landing, where there's a significant component of retail. And so depending on whether you include or don't include some of those assets, it's really a question of basis.

That makes sense. That makes sense. And I guess further details on the assets HOOPP is contributing and any lockup on their interest in the REIT, et cetera, that will come in the circular. Is there anything you can share at this point?

That will come in the circular, but if you check our website, it was a little bit lagging, the main presentation, but there is a full presentation outlining Primaris, its business plan and its investment merits on the website now.

[Operator Instructions] Your next question comes from Matt Kornack from National Bank Financial.

With regards to the retail and office sales, are you currently -- or sorry, any of the list assets that would be in those buckets currently listed for sale? And do you have any sense as to -- I mean, I assume these are your IFRS fair values you've been fairly conservative in the past on that front as to whether those may be beatable numbers?

We are very -- there's nothing for sale. Quite frankly, as you know, we don't need any cash right now. We have more than enough. So there's nothing planned right now. From a tax perspective, we don't plan on selling anything right now. We are very, very comfortable with our IFRS values. And as you know, from the Bow and Bell sales, we did exceed expectations there on those sales. So our assets or our properties are also very saleable. There's long-term leases. They're high-quality properties, and we're very confident that we'll be able to exceed our IFRS values or at a minimum retain -- sell them at that IFRS values.

Okay. No, that makes sense. With regards to the residential, some of these projects, I think you're doing on downtown Toronto office assets. Would that be purpose-built rental? Or is there a contemplation of potentially doing some condo sales as well within those projects?

So the way it goes in America is the highest and best use is condo. And if you're a pension for a REIT, you need recurring income. Therefore, we did mention in the speech and in the presentations that we're leaving ourselves open to potentially partnering, potentially selling as it may be. If the condo value, and if you look at 55 Yonge or 145 Wellington, as an example, the value as a condo far exceeds the value as a residential, then we would consider selling it. We do not, at this point in time, have made any decisions whether we would be going into the condo market or whether we'll be partnering with someone in the condo market, we're leaving ourselves open for that. Again, you can appreciate the fact that the condos at Yonge and King are going to be worth an awful lot of money and maybe the value is a condo may be significantly higher. No decision, therefore, has been made as whether we're going to go condo or rental or sell. We leave ourselves open to it, whatever is invested at that time.

Okay. No, makes sense. And then, Larry, I don't know if you have a target debt-to-EBITDA or debt-to-asset figure. It sounded like you're going to tie these dispositions with some of the development side of things. But can you give us a sense as to where you'd like to see leverage be when all is said and done as we move more into development?

Sure, Matt. That's a good question. We actually have a slide in the deck that gives our target metrics. And for debt-to-EBITDA, which was one of your questions, we're trying to go below 9.2x. And for debt to gross book assets, we're currently at 47% and we will maintain around 45% to 48%. That's the metrics. And there are some other metrics in the slide deck that we have given.

Okay. No, and I mean, in spinning off Primaris, you've clearly set it up with the stellar balance sheet, I would say, are very good quality for the asset type. Could you give us a sense as to whether you've talked to DBRS about potentially having that be a investment-grade rated entity?

Yes, Matt, that is part of the plan. We have had preliminary discussions, and we are engaging in the process of pursuing an investment-grade credit rating. We think highly of the capital structure that we've been able to put together here and look forward to being able to confirm that at some point in the future.

And the rationale as to keeping the grocery-anchored retail at H&R versus Primaris, is that -- was that a cost of capital issue or the ability to sell? What was the thought process there?

We needed to retain these assets to fund our growth, and these are highly liquid assets that sell piecemeal as cash is required.

It was a topic that we spent a lot of time discussing internally. And I think just to add a bit of color, positioning Primaris with the differentiated financial profile that it has, came at a significant cost to the remainder of H&R and from a value maximizing perspective for all H&R unitholders across the 2 pro forma entities. Aside from the single tenant assets being described as retail, they have actually very little in common with the enclosed shopping center business. The average remaining lease term, I believe, is 10 years on that portfolio or might even be longer. Very liquid. It's a hands-off limited management business. And to the extent that, as Tom mentioned, the ability to sell those to fund all of the very attractive value-creating opportunities within the pro forma H&R. It was -- we decided that, that was best for the value maximizing across the 2 platforms. But it was a topic of a lot of discussion.

Okay. And congrats again, guys. A lot of work here, and we like that there is a distinct vision for these 2 separate entities at this point. So congrats.

Thanks, Matt.

Our next question comes from Sam Damiani from TD Securities.

Yes, I did find the asset listing on the Primaris deck there. Any other information you can provide on the HOOPP assets in terms of their overall occupancy or if there's any sort of significant variance in NOI expected on those assets going forward?

The occupancy -- sorry, in terms of the NOI, I think we're seeing stabilization in the retail assets from the sales and the tenants generally that give leasing activity. We see positive growth in the NOI over the near term as the market is stable and sales have returned. In terms of the occupancy levels, I think generally I don't have the overall average, but most of them sit around the 88% to 90% mark for the most part.

Okay. And just -- sorry, and just finally, going back to, I guess, Matt's first question, I just want to sort of leave that unanswered. Is there a percentage of total book value at which you don't want to exceed in terms of development investment?

I don't know how to answer that because I don't think -- I don't understand honestly the relevance to the question. It's a process that's going to take years. A development takes 3 years, for example, in the case of 55 Yonge, 145. The case of the developments that are being undertaken by Lantower, those take 2 years. And in the case of [ Grove ], for example, that they're -- each 1 takes 3 or 4 years. So I think it's almost impossible for us to give you the answer to that question that's going to be synchronized with the -- with on an annual basis of what our spend will look like.

I think it's important also to add that I don't think the expectation is that we will develop out 100% of all of the projects that are identified in the deck. There are certain situations where other developers are so keen to gain or acquire these properties that you can effectively capture the development upside without having to go through that process. And...

As was mentioned, it's a good example. The condos could be condo residential downtown. It could be sales. It could be -- we could just sell the land. So we can't really give you a scientific answer because, quite frankly, the market will dictate in the future is what we decide to do what the highest and best use is.

Not too much. No, no.

Yes, Sam. I think if you look at our net debt, again, coming back to the $1.8 billion of [ stock ] for the 2022 and '23, so we don't expect to spend more than $1 billion in any 1 year to about 10% of our total assets. I don't expect that would be actually something more than -- much more than that in any 1 year.

We have no further questions in queue. I would like to turn the call back over to the presenters for any concluding remarks.

Thanks, everybody, and we look forward to closing this transaction in the beginning of January. Have a great day.

This concludes today's conference call. Thank you for your participation. You may now disconnect.