Description

Primaris REIT (PMZ.UN-T)

I believe Primaris REIT (PMZ) is a classic good co/bad co situation with the usual spinoff dynamics and a few additional attributes giving the investment an asymmetric risk/return profile. 

My investment thesis summary: 

1. PMZ is the classic “bad co” in a good co/bad co split. Specifically, in this case, H&R REIT wanted to retain its higher quality real estate assets while spinning off its enclosed mall retail portfolio

2. In addition to the usual (negative) spin-off dynamics, you could not find a worse REIT category given current market sentiment: a dedicated enclosed mall REIT in secondary markets 

3. Shortly after the spinoff, PMZ press released the change in black out period to enable insiders to purchase shares given the significant discount PMZ was trading at relative to its NAV – I haven’t seen this with many spin-offs which really highlights how attractive the business is to insiders to convince legal counsel to change the blackout dates so insiders could buy units

4. While many investors are aware of the US experience in terms of the performance of secondary/tertiary mall assets, there are some nuances in Canada that should make PMZ not the CBL of the North. 

5. Unlike some spinoffs where the parentco puts significant debt or liabilities onto the spinco, PMZ has minimal debt. In fact, the circular notes PMZ unencumbered assets total almost $1.2 bln or just under $12 per unit – this serves as a realistic downside value for PMZ

6. There is meaningful development potential not reflected in PMZ’s NAV. In particular, our work suggests some of the residential redevelopment opportunities are understated. Likelihood PMZ monetizes this value – a catalyst for units to rerate

Background

H&R REIT was formed in 1996 by Thomas Hofstedter holding primarily office buildings. Perhaps not the best demonstration of unitholder alignment, H&R REIT was externally managed until 2013 before the property management function was internalized in exchange for issuing the property management arm units in H&R. As well, H&R REIT had a mixed record in capital allocation, including building the large Bow office complex in Calgary (energy capital of Canada) at the peak of the market in 2007 and subsequently sold in 2021 just before oil went back to $100. 

Not too surprisingly then, H&R’s “strategic repositioning” involves exiting both office (Bow property sale) and retail (PMZ spin off) properties to focus on the currently hotter areas of real estate: multi-residential and industrial properties.

Spin-off Dynamics

Without focusing too much on H&R, I think the PMZ spinoff dynamics are very interesting. First off, the implied “goodco” / “badco” set up of this spinoff already makes it likely for PMZ units to be undervalued – especially when the headline is a retail, enclosed mall portfolio in secondary or tertiary markets in Canada. (I bet each of those words I underlined contributed to a 25bps increase in capitalization rates)

To make matters worse, going through the Management Information Circular, detail oriented readers would see that H&R management and trustees (i.e. the board) was anticipated to exercise the “gross up” option for their outstanding options – meaning to adjust their exercise price of their H&R holdings, as they do not expect to want PMZ units. Perhaps H&R wanting to quickly get rid of PMZ (via spinoff) is the reason why H&R did not bother loading PMZ up with debt and other liabilities typical of some spinoffs.

As many of us are familiar with spinoff dynamics, what served as a clincher for me is this press release: 

https://s29.q4cdn.com/368328936/files/doc_news/2022/01/Primaris-REIT-Announces-Anticipated-Insider-Purchases-Inaugural-Distribution-Jan-0622.pdf

Imagine PMZ units are trading at such an attractive level that the new management and trustees went back to the lawyers to change the blackout period to start January 15, 2022 instead of January 1, 2022 so insiders could buy PMZ units during this time. I’ve seen a few spinoffs before and do not recall a blackout period change so insiders can buy the dip.

Fundamentals – Unencumbered Assets Provide Downside Protection

Naturally, I wondered what gave insiders such confidence there is not much more downside to where it was trading in early January. While we would never know with certainty, there are some important clues in the H&R Management Information Circular (re PMZ spinoff).

In addition to the usual size of this filing (320 pages), the PMZ financials are further obfuscated by the disclosure of 2 different sets of carve-out financial statements, one for the original assets under Primaris Retail Properties (PRP) and one for the assets the Healthcare of Ontario Pension Plan (HOOPP). The separate disclosures are because HOOPP is selling its retail assets into PMZ just prior to the spinoff, in return for 26% of units outstanding.

At any rate, going through both sets of financials will reveal they discuss the fair value of the unencumbered (no debt on them) asset pools of both entities. As of Dec 2020, the PRP unencumbered assets included 14 properties with a fair value of $674 mln and the HOOPP assets included 6 properties with a fair value of $604 mln – for a total of 20 properties with a fair value of $1.3 bln or roughly $12.40 per unit. 

Just to hammer the point home, the $12.40 per unit implies that even if the valuation/appraisals are so far off that the remaining 15 properties with a FV of ~$1.6 bln can only cover $750 mln of mortgage debt associated with them, you’re still left with 20 properties free and clear.

Why this is not CBL & Associates

To be positive on PMZ, I think some analysis should be done as to why PMZ is not the next CBL. Based on my analysis, I think there are a few reasons why:

1. Canada is not as retail real estate oversupplied as the US, especially on a retail sf per capita basis (something like 16 vs 24, I won’t go through the entire analysis and overview but those interested can review my previous writeup on GGP for background: https://www.valueinvestorsclub.com/idea/GGP_INC/0195329859). As well, the Canadian population is probably more dispersed than the US, making purely online e-commerce slightly less disruptive due to logistics.

2. PMZ is probably underlevered until the US REITs that got in trouble. We already discussed the unencumbered assets but PMZ’s debt to value is just under 30% and debt/EBITDA at just over 5x

3. Redevelopment potential. While PMZ assets are largely in secondary markets, they seem to be in areas with residential development opportunities given their proximity to transportation nodes and/or regional rezoning initiatives (upside to be discussed later)

4. Specific to PMZ, the properties already went through repurposing with the departure of Target from Canada, and the Sears restructuring.

Valuation and Reasonableness Check

Portfolio Overview

PMZ is primarily an enclosed shopping center (with some open air retail) REIT in Canada with 35 properties mainly in the provinces of British Columbia, Alberta and Ontario. ¾ of the Net Operating Income (NOI) of the portfolio comes from secondary markets. PMZ has 11.4 mln sf of gross leasable area (GLA) that is expected to generate $186 mln in NOI in 2022. 

In terms of a quick valuation check, PMZ is trading at about 7.7% cap rate on 2022 NOI, at a discount to virtually every comparable Canadian REIT. Morguard REIT trades at that level likely due to: 1) it being significantly more levered and 2) market’s concern about succession and capital allocation going forward (see comp table below).

Its not an exact science but it would be reasonable to see PMZ trade at an implied 6.5% cap, a discount to other Canadian REITs (given their size (Riocan), urban locations (First Capital) or anchor support (CT REIT etc.). 6.5% cap implies just over $19 per unit. 

Source: TD Securities

Sources of Upside – Improvement Near-Term Fundamentals Not Reflected in Guidance/Forecast

In the near-term, we think PMZ is purposely overly conservative with its 2022 guidance that is essentially unchanged from the 2022 forecast contained in the circular. The reasons are:

1. Retail tenants are now operating at pre-pandemic levels, as explicitly noted on their inaugural conference call:

2. Committed occupancy (committed but not moved in yet) continues to trend higher and into the 92% range which should also drive rents, especially when compared to Primaris historically when it was still working through Target and Sears restructurings (i.e. higher rents vs these previous “anchors”) 

3. Despite the above, and acknowledging the 2022 forecast in the circular was created 6-9 months ago, PMZ still refused to update and increase its guidance – likely setting up an easy hurdle to beat.

Longer-term Operational and Development Upside

On the operations side, I believe PMZ can meaningfully improve earnings power in the medium term, especially relative a previously flat NOI profile for almost ten years:

Specifically:

1. Near-term leasing activity and rents are heading in the right direction, especially with previous anchor spaces redeveloped and now attracting higher rents

2. The historical heavy capital spending will not need to be repeated. In fact, management provided explicit guidance of maintenance capital being $1.7 psf (or about $20 mln). Adding up the historical PRP and HOOPP financial statements, we can see PMZ (if it were 1 entity) was spending > $100 mln a year to deal with Target and Sears anchor tenant restructurings. So even with a similar NOI profile, capital spending is expected to decline materially, leaving room for capital allocation between dividends, buybacks and development. 

On the development side, PMZ has various intensification opportunities at its retail sites for multi residential units developments (meaning extra land to construct residential buildings). While PMZ’s fair value NAV includes a project called Dufferin Grove, we thought it is easier to build on our valuation estimate above to see the incremental value from development. 

Given development projects have a long lead time (from partnering to rezoning/permitting to construction to sale/income generation), we took the approach industry players practically use in evaluating development projects, which is essentially looking at how much buildable square footage is available for the site (given the density allowable) and how much a developer would pay to acquire the site, expressed in a $ per buildable square foot price.

While there are many variables involved, we assume the average residential unit buildable in PMZ’s presentation is 700 sq. ft. and then in return apply what we think a developer would pay on a $/building sq ft basis. 

We generally took PMZ’s residential units as a guide but note that they seem fairly conversative. In particular, Orchard Park’s estimate is particularly low given the site area and the density the city allows/plans for (can be found here: https://www.kelowna.ca/our-community/planning-projects/2040-official-community-plan/ch-3-future-land-use). In this case, we think PMZ’s site could easily accommodate 1,000+ residential units.

Based on our estimates, the development sites should reasonably add $2-$3 per unit to our valuation estimate. 

While the pushback here generally is investors rarely given credit to REITs for development potential, we would highlight that PMZ appears to be actively monetizing this value. For instance, with the 4Q21 results, PMZ disclosed in early 2022 they sold to a developer 2 acres of land at Northland Village Calgary for $5.8 mln that covers 240 residential unit development. While it is hard to triangulate how much more land can be sold (PMZ slides show 34.6 acres) and how much retail income may be lost in the process, it is reassuring that this $/acre transaction is happening and PMZ will likely continue monetizing this asset base going forward. 

To sum it all up, I would peg the downside/upside to be $12/$20 with a 5.5% yield and PMZ with an active buyback program to help narrow the discount.

Disclaimers: Not investment advice, write-up subject to errors, do your own due diligence

Catalyst

Beat guidance

Execute buyback

Development site sales