Description

Summary

Choice Properties (CHP.UN – TSX) is Canada's largest REIT. Choice has a national real estate footprint consisting of more than 750 properties and more than 69 million square feet of GLA. 60% of Choice’s net operating income is derived from Loblaw, Canada’s largest grocer and pharmacy.

Choice’s real estate portfolio is comprised of some of the best urban real estate in Canada, built up over the last century. This real estate offers significant redevelopment opportunities, which management is actively pursuing but is currently not reflected in Choice’s share price. This is not another publicly listed REIT with latent real estate value:

• In February 2018, Choice acquired CREIT, Canada’s oldest and best performing REIT. Despite being less than a third of the size of Choice, CREIT’s management team succeeded as the management team for the newly merged entity. This effectively shifted the culture from Choice’s origins as “Loblaw’s real estate department” to a best-in-class active real estate manager

• Concurrent with the acquisition announcement, Choice called out 60+ sites located in urban areas with substantial mixed-use development potential

• In addition, Choice turned off its dividend reinvestment program (DRIP) given the REIT's low overall valuation

• In September 2018, George Weston Limited, a holding company controlled by Canada’s Weston family announced a transaction whereby they would increase their effective interest in Choice from 35% to 65%. This transaction is a significant testament to the value the Weston family sees in Choice. To finance the purchase, the Weston's effectively diluted their ownership interest in the underlying Loblaw grocery business, for an interest in Choice Properties at $12.53 / unit 

Today, Choice is trading at ~$12.00 / unit, which translates into an implied 6.2% cap-rate, in-line with Choice’s underlying real estate comparables. In an unchanged cap-rate environment and before accounting for any large mixed-used developments, Choice should provide for a HSD annual return (8-9% IRR):

• Choice is currently yielding ~6% (~90% payout)

• NOI should grow by ~1.5% / year based on a contractual escalator embedded in its Loblaw leases and from re-leasing spreads

• Remaining cash flow plus debt capacity will be reinvested in small intensification projects at its historical redevelopment average ROIC of ~7.5%

In the context of the current market and relative to all other major REITs, this is a fair valuation. However, this does not account for the 60+ mixed used redevelopments Choice has called out. The exact properties have yet to be spelled out publicly and each project is unique. While the Choice team is still assessing the value of these properties, simply assuming a $20 million lift for each of the 60+ properties gets you to an incremental ~$1.2 billion or $1.75 / unit. Trying to be a little more calculated, I estimate just using recent Toronto land sale precedents for just Choice's Toronto properties, you can easily get to an incremental ~$2.0 billion or ~$3.00 / unit. Regardless the number, at this point the redevelopment opportunity is completely free and this option conservatively represents ~20% upside from here.

All-in-all, I believe Choice is an attractive opportunity. Choice’s valuation can be rationalized just based on current cash flow metrics. There’s significant upside potential should these 60+ called out mixed-use development opportunities come to fruition.  Moreover, ~65% of Choice is owned by George Weston Limited and is controlled by the Weston’s whose incentives are aligned to navigate the business in the right direction. The Weston’s have the most information regarding Choice’s redevelopment plans and have substantially increased their ownership in Choice at prices above current levels. 

Background

Historically wholly-owned by Loblaw, Choice Properties’ origins date back to the early 1920s when the first Loblaw stores were established in Toronto. Over the coming decades, Loblaws grew into the largest grocer across Canada and in turn, one of the largest real estate owners in the country.

The idea of Loblaw’s surfacing its real estate value through a separately listed entity was pitched by Canadian investment banks for decades, however, it wasn’t until December 2012 that Loblaw announced plans to go ahead with this spin-out. In June 2013, Choice Properties successfully IPO’d, with Loblaw’s retaining an 82% ownership interest, George Weston Limited (Loblaw’s majority shareholder) investing 6% into the transaction and the minority public investors representing the residual 12%.

Loblaw’s share price reacted favorably to the Choice spin-out. From the time of the announcement in December 2012 to the close of the transaction in June 2013, Loblaw’s share price increased by ~50% (from $33.50 per share to $50.00 per share), equivalent to ~$4.5 billion in equity value creation. There were several motives driving this decision to spin Choice from Loblaw, but with the benefit of hindsight, the primary motivation was to get Loblaw’s share price higher ahead of it’s soon-to-be-announced acquisition of Canada’s largest pharmacy chain, Shopper’s Drug Mart. In July 2013, Loblaws announced that it would be acquiring Shoppers Drug Mart for $12.4 billion, of which nearly ~45% was in Loblaw stock.

From the IPO in July 2013 through the end of 2017, Choice Properties performed exceptionally well, generating a total return of ~70% versus ~5% for the S&P TSX Canadian REIT index. Choice’s total return over this time period can be attributed to a ~30% return from dividends, ~20% growth in FFO and multiple expansion of ~10%.

The spin-out of Choice was a large success and Loblaw, the Weston’s and minority shareholders all benefitted.  However, not satisfied with the status quo, Loblaw’s and the Weston’s believed Choice was ready for its next leg of growth.  

The management team in place at Choice at the time the IPO was good at building out a separate business and operating the legacy Loblaw real estate assets, but over time it became apparent that a new team would be required to accelerate the growth of Choice. Despite Choice being a completely separate entity from Loblaw, Choice did not operate that differently from when it was just “Loblaw’s real estate department”. In addition, as a separate entity, Choice stakeholders believed Choice could further benefit from greater diversification and enhanced liquidity.

Managing all of these considerations, in February 2018, Choice announced the acquisition of CREIT for $3.9 billion. CREIT was Canada’s oldest public REIT, listing on the TSX in 1993. At the time of acquisition, CREIT had 206 properties and 25 million square feet of GLA. By acquiring CREIT, Choice achieved the following:

• A new management team –The current CEO, Stephen Johnson, COO, Rael Diamond and CFO, Mario Barrafato are all from CREIT. Not only is this team regarded as best in class, but by bringing in a new management team, there is a shift in culture from Choice’s origins as "Loblaw’s real estate department"

• Greater diversification – Loblaw’s now represents ~60% of Choice’s total NOI (from ~90%) and total retail represents less than ~80% of NOI (from ~95%)

• Enhanced liquidity for unitholders – Prior to the CREIT acquisition, only 12% of Choice was publicly floated. Following the deal, the total float of Choice is now ~35% as ~$2.3 billion in units were issued to acquire CREIT.  

Following the CREIT deal in February 2018, the pro forma ownership of Choice moved to 62% Loblaw, 4% George Weston Limited, 27% CREIT unitholders and 7% Choice unitholders.

In general, the deal caught the market by surprise – no one was expecting a REIT controlled by one of Canada’s oldest institutions to acquire a smaller, more nimble REIT. Moreover, the deal was FFO dilutive in the mid-single-digit area. Certain Choice shareholders did not like the Weston’s strategy of diluting Choice’s earnings power in the near-term. Similarly, many CREIT shareholders did not see much upside in owning the largest REIT in the market. In turn, there was a rotation in the investor basis, resulting in a ~10% decline in Choice’s share price.

Since this initial decline, Choice’s share price has only slightly recovered, albeit Choice is still trading in line with all the other Canadian retail REITs. While it can be debated if Loblaw / the Weston’s needed Choice to acquire CREIT in order to pursue a growth strategy, there are two important data points:

1. In the February 2018 Choice - CREIT acquisition presentation, Choice called out 60+ mixed-use development opportunities. This is a divergent shift from Choice’s legacy development strategy of small intensification projects.

2. In September 2018, George Weston Limited announced it would purchase Loblaw’s Choice stake for $12.53 / unit in an all-stock deal. George Weston Limited is the effective holding company of Loblaw and is controlled by the Weston family. This transaction increases George Weston’s effective interest in Choice from 35% to 65%. George Weston Limited and in turn, the Weston family are the ones with the most information and would not pursue this transaction if they did not see significant upside potential in Choice. 

The idea

Choice’s valuation is currently in-line with the broader Canadian retail REIT market. Choice is currently yielding 6.2% with a ~90% AFFO payout ratio. Choice has highlighted a small intensification pipeline (e.g. adding a few pads to a Loblaw parking lot) with a capex spend run-rate of $175 million per year. If we assume excess free cash plus debt is used to redevelop this pipeline at a development yield of ~7.5% (in line with their historical returns), then 5-years out assuming cap-rates unchanged, we would expect an IRR in the ~9% area. However, what this simple DCF approach fails to capture is the significant redevelopment value embedded in Choice’s portfolio.

What’s the redevelopment opportunity of Choice’s portfolio?

As highlighted, Choice has called out 60+ mixed-used redevelopment opportunities. The vast majority of these developments are expected to be in the Greater Toronto Area (GTA). To put some simple numbers around this opportunity, we can look at year-to-date land sales in the GTA:

• There have been 68 land transactions slated for redevelopment in the GTA

• The median transacted lot size has been 10,500 sq.ft

• The median density approved / approval being sought is 16 stories

• The median transaction price was $10.4 million, implying $49 / sq. ft

As it relates to Choice:

• Choice has 56 properties within the GTA

• The median GLA of a Choice GTA property is 81,370 sq. ft

• Assuming an average coverage area of 50% equates to a median Choice lot size of 162,740 sq. ft. This is 16x the size of the average land size transacted YTD

• Applying a density multiple of 16 and $50 / sq. ft gets you to an estimated rezoned land value of $7.3 billion for Choice’s GTA portfolio. This compares to an implied enterprise value of Choice’s primary market leases in Ontario at ~$4.8 billion

Clearly this is very theoretical but illustrates the scale of Choice’s GTA portfolio and its redevelopment potential.

To better illustrate Choice’s redevelopment potential, I’ve gone through Choice’s property list and have highlighted it’s prime GTA properties that are located on major rail transit hubs within Toronto. In total, Choice has about 15 properties that meet these criteria. I’ve then applied an appropriate density multiple and valuation per square foot based on recent precedents. From this analysis, I estimate the land value of just these 15 properties could be in the ~$2.0 billion area or equivalent to ~$3.00 per unit. This analysis only assumes prime GTA properties and does not include Choice’s other prime urban properties in markets such as Vancouver, Edmonton, Calgary, Ottawa or Montreal.  

If Loblaw is the major tenant, is there an incentive for Loblaw to allow Choice to execute these redevelopment projects?

Yes. At the time of the Choice IPO, Loblaw and Choice structured the sale of the real estate portfolios such that Choice did not pay any value for the excess land. Instead, an arrangement, referred to as the Strategic Alliance Agreement, was put in place. Under this agreement, Choice is required to pay Loblaw for any construction, development, or redevelopment of commercial leasable area or residential dwellings, on any original Loblaw properties within 20-years of the IPO. This agreement allows for a payment to Loblaw in the future if, and only if, a property is developed into income producing or other area. The terms set out in the agreement are fixed based on the grid below.

Since the time of this agreement, density values have gone up significantly albeit under the terms of the Strategic Alliance Agreement, there is no inflation escalator present. This is incredibly beneficially to Choice unitholders. For context, based on the development grid above, Choice would have to pay Loblaw only $28.35 per sq. ft in intensification payments for a condo development in Toronto or Vancouver. This is less than a quarter of recent transaction values in either jurisdiction.

Most notably, this agreement falls away in 15-years from now and Loblaw will not receive intensification payments thereafter. Therefore, Loblaw is incented to see these major projects commence within the next 15 years.

What’s this redevelopment opportunity worth?

Assuming there is an incremental ~$2.0 billion in unlocked real estate value (~$3.00 / unit) in Choice’s portfolio, if the market begins to unlock this value in ~5-years from now, in 2022, then you would expect to earn an IRR closer to ~14%. If the market surfaces this value in 10-years from now, then you could expect a ~10% IRR. I suspect Choice’s share price will begin reflecting this redevelopment value faster as land becomes zoned, redevelopment project renderings are surfaced and as management brings more attention to the opportunity in future earnings calls.

Why does this investment opportunity exist?

• Change in investor base following CREIT deal – Legacy CREIT unitholders are the largest unitholders of Choice’s float. CREIT was a smaller, more nimble, diversified REIT. Choice is now Canada’s largest REIT primarily concentrated in retail real estate. This combined entity is very different than CREIT.

• Interest rate sensitivity – The current implied cap rate of Choice is ~6.2% versus ~2.5% for the 10-year Canada bond. The average lease term of Choice’s real estate portfolio is 8.4 years with on average only 1.5% rent escalators present. Should there be a major interest rate shock, Choice’s valuation will decline with very few offsets.

• The potential for deteriorating retail grocery fundamentals and e-commerce headwind - Canadian grocers have historically over-earned versus global peers as there has been less hard discount players in the marketplace. This may change over time and would negatively impact the operating profitability of Loblaw. In addition, Canadian grocery e-commerce penetration is only 70 bps of total grocery sales compared to 5% in the US and 9% in the UK. A comparable penetration to other developed markets would potentially be negative for grocery-anchored real estate values.

• Fear of an overvalued real estate market - Canada has not seen a real estate correction in more than 20 years. If there is a real estate correction, the redevelopment potential of the portfolio will decline significantly, limiting the upside of Choice.

• Lack of control - the Weston’s control this entity and may operate on an intergenerational time horizon.

Catalyst

Execution on the redevelopment pipeline