The average distribution yield in the sector remains more than five percentage points above the government of Canada five-year bond yield, a level that suggests strong returns for REIT investors for the next two years.
H&R Real Estate Investment Trust is the Rodney Dangerfield of the Canadian REIT space.
It "don't get no respect," says Desjardins Capital Markets analyst Michael Markidis.
Despite its solid balance sheet, well-diversified property portfolio and improving performance, H&R's units are trading at roughly the same level as they did four years ago. For investors who believe in buying solid companies when they are out of favour, H&R – which now yields 6.5 per cent – may present an attractive opportunity, analysts including Mr. Markidis say.
Here are four reasons that Canada's largest diversified REIT may deserve a spot in your portfolio. Remember to do your own due diligence before investing in any security.
A large discount to NAV
H&R's units trade at an "unwarranted and deep discount" of about 22 per cent to the net asset value of its property portfolio, CIBC World Markets Inc. analyst Dean Wilkinson said in a recent note. What's more, the current market price represents a multiple of about 11.4 times estimated funds from operations (FFO) for the current year, compared with an average of about 13.4 times for a peer group of comparable REITs, "offering what we believe to be one one of the best risk/reward propositions in our coverage universe," Mr. Wilkinson said.
It's anyone's guess what H&R's units will do in the short run, but the fact that they are already trading at a hefty discount suggests that the downside from current levels may be limited. Most analysts are bullish: there are seven "buy" recommendations, two "holds" and no "sells," according to Thomson Reuters. The average 12-month price target is $24.78 – a 17-per-cent premium to Tuesday's closing price of $21.09 on the Toronto Stock Exchange.
A well-diversified – and growing – portfolio
H&R's roughly $14-billion portfolio includes office (about 47 per cent of assets), retail (38 per cent), industrial (9 per cent) and multifamily residential properties (6 per cent). The portfolio is also diversified geographically, with about two-thirds of the assets in Canada and the other one-third in the United States.
Although residential is H&R's smallest segment, it represents a significant growth opportunity. For instance, H&R owns a 50-per-cent interest in Jackson Park, an 1,871-unit luxury apartment complex under construction in Long Island City, N.Y., with occupancy expected to begin in early 2018 for the first of three towers. Jackson Park "will be materially accretive to NAV over the course of the next 12-18 months with the potential to add in excess of $1 in value that is not currently captured in the trading value," Mr. Wilkinson said. H&R is also acquiring and developing apartment properties in its Lantower Residential subsidiary, which focuses on areas in the U.S. Sun Belt with high population and employment growth.
A rising distribution
After holding its distribution steady for a few years, H&R raised its payout in November, 2016, to 11.5 cents a month from 11.25 cents – an increase of 2.2 per cent. A distribution hike is a positive sign because it reflects management's confidence about the future. With FFO poised to continue growing, further distribution hikes are possible, analysts say.
H&R is also exploring ways to boost its languishing unit price, including a review of the REIT's capital structure or a possible share buyback. Despite the elevated yield, the distribution appears safe: The payout ratio is a conservative 74 per cent of estimated FFO for the 2017 fiscal year, according to Raymond James analyst Ken Avalos. Based on adjusted funds from operations or AFFO, a more stringent cash flow measure, the payout ratio is a still-comfortable 88 per cent, falling to an estimated 85 per cent in 2018, Mr. Avalos said in a recent note.
An improving retail picture
H&R's Primaris subsidiary, which operates enclosed malls and plazas, has been hurt by exposure to troubled tenants such as Target Corp. and Sears Holdings Corp.. However, H&R has made good progress releasing the vacant Target real estate, with seven new tenants – including London Drugs, H&M and Sobeys Inc. – taking over about 193,000 square feet of former Target space in the second quarter and another 150,000 square feet expected to open in the third quarter.
The Primaris portfolio also includes nine Sears stores, two of which are being disclaimed under Sears Canada's court-supervised restructuring. However, this may actually be a blessing for H&R, as Sears pays substantially lower rent per-square-foot than other retailers.
"Given our success in backfilling Target premises, we view the closure of Sears in our properties as an opportunity to increase net operating income," said Patrick Sullivan, chief operating officer of Primaris, during H&R's second-quarter conference call on Aug. 11. In the Primaris portfolio, occupancy was 90 per cent as of June 30 – up 4.7 percentage points from the previous quarter. Including tenants who have binding agreements, but have not yet taken possession of their premises, occupancy was 94.6 per cent. "It is our view that the performance from this segment is turning a corner," Desjardins's Mr. Markidis said. Across H&R's entire portfolio, occupancy improved to 96.3 per cent at June 30, up from 95.6 per cent a year earlier.
Closing thoughts
There are risks with every investment. Retail store closings, an economic downturn or sharply higher interest rates could put pressure on H&R and other REITs. But for investors with a long-term horizon, the current soft patch in H&R's unit price could offer a favourable entry point given that its property portfolio, cash flow and distributions will likely continue to grow. And, if the market finally starts giving H&R some respect, the unit price could also move higher.
Disclosure: The author personally owns units of the REIT
John Heinzl