In your recent column on H&R Real Estate Investment Trust, you discussed several reasons that the REIT should be trading at a higher price but said little about why its units (HR.UN) have been languishing. Can you elaborate?
In a recent report, RBC Dominion Securities Inc. analyst Neil Downey argued that H&R's "business may simply be too complex."
H&R began in 1996 with a focus on office and industrial properties in Canada but has since expanded into retail and residential real estate and also built a large presence south of the border. Moreover, in addition to its assets in major metropolitan centres, it now owns dozens of properties in secondary and tertiary markets. While many of these assets have long-term leases, they often suffer from "completely flat rental profiles," Mr. Downey said.
To increase H&R's appeal with investors, Mr. Downey advocates streamlining the portfolio and "moving the overall quality and character … further upmarket." H&R has already taken steps in that direction with acquisitions such as Corus Quay, an office building on Toronto's waterfront, and a 50-per-cent stake in Jackson Park, a luxury residential development in Long Island City, N.Y.
Regarding potential asset dispositions, Mr. Downey said H&R should consider selling "a wide swath or all" of its single-tenant U.S. retail properties; its 33.6-per-cent stake in U.S.-based Echo Realty (which operates grocery-anchored retail centres); "some or all" of its part-owned U.S. industrial real estate; and "many of the scattered, smaller/tertiary market Canadian retail, office and industrial properties."
H&R could use the proceeds to reduce debt, repurchase units and redeploy capital into more promising areas such as its pipeline of wholly or partially owned residential and mixed-use developments in U.S. cities such as San Francisco, Miami, Austin, Dallas and Seattle, for example.
H&R has many strengths, Mr. Downey said, including prudent financial leverage, strong liquidity, a portfolio that is generating "stable to modest long-term growth" and a payout ratio that is "in check" at about 88 per cent of adjusted funds from operations. As such, H&R's situation is not "acute" and the REIT does not require "major surgery," he said.
However, if H&R were to trim its portfolio selectively, "the potential payoff is in what could come out the other end: We believe a more focused and cohesive, albeit still diversified business, with higher overall asset quality" and a unit price that trades at a higher multiple to cash flow and is more in line with the underlying net asset value of the portfolio, Mr. Downey said.
Is there a Canadian REIT exchange-traded fund that you can recommend?
The advantage of owning an exchange-traded fund, as opposed to investing in individual REITs, is that you'll get diversified exposure to a large segment of the REIT industry. The downside is that you'll pay a management fee and other expenses and the weighting of the ETF's constituents might be less than optimal.
Consider the iShares S&P/TSX Capped REIT Index ETF (XRE). It charges a management-expense ratio of 0.61 per cent and holds 15 of Canada's largest REITs. However, because XRE's weightings are determined by market capitalization, the top-three holdings – RioCan REIT, H&R REIT and Canadian Apartment Properties REIT – account for more than 40 per cent of the fund, whereas the bottom three – Boardwalk REIT, Crombie REIT and Northview Apartment REIT – make up just 8 per cent.
The Vanguard FTSE Canadian Capped REIT Index ETF (VRE) has a similar problem. The MER is an attractive 0.38 per cent, but the top three of VRE's 18 holdings account for about 35 per cent of the fund, while the bottom three make up less than 5 per cent in total.
As an alternative, you might consider the BMO Equal Weight REITs Index ETF (ZRE). The MER is identical to XRE's at 0.61 per cent, but – as ZRE's name implies – weightings for each of the 17 constituents are roughly equal at around 6 per cent (give or take a percentage point). The benefit of equal weighting is that it improves diversification, which helps to control your risk.
Disclosure: The author owns HR.UN units personally and holds XRE in his Strategy Lab model dividend portfolio. View it at tgam.ca/divportfolio.
John Heinzl