PRIMARIS REAL ESTATE INVESTMENT TRUST Marketing Takeaways Our Conclusion We recently hosted the management team of Primaris REIT for a series of virtual meetings. The key message was that management remains dedicated to a disciplined capital allocation strategy even as several growth and consolidation opportunities present themselves. With units trading ~27% below NAV, buybacks are a compelling investment, and can drive per-unit accretion while utilizing retained cash flow alone.
Operationally, sales have largely recovered to pre-pandemic levels, and leasing activity is recovering in step with shopping centres reopening.
Near term, we expect a lingering drag from the pandemic, but see significant organic growth runway from occupancy gains. We believe growing investor awareness is key at this stage and reporting of upcoming quarters should offer investors more insight into (and more comfort with) healthy underlying fundamentals.
Key Points Capital Allocation Will Be Disciplined:
The consolidation opportunity is evident as the REIT has received considerable interest from owners looking to divest malls. At current unit prices, however, management’s preference is to reinvest retained cashflow into unit buybacks. The self-funding structure (~$60MM/year of retained cash) enables the REIT to accomplish this on a leverage-neutral basis. Similarly, the REIT has no plans to undertake sizeable developments on its own. Rather, management views the intensification potential as a strategic asset and an additional source of capital. Management also reiterated the goal of keeping leverage in the 25% to 35% range.
Credit Rating Imminent: The REIT expects an investment-grade rating shortly after reporting Q4 results, following which the REIT plans to issue unsecured debt to address certain upcoming mortgage maturities. As secured debt declines to less than 40% of total debt, the rating could also get a notch upgrade.
Catalysts And Valuation: Units are trading ~27% below our NAV vs. retail REITs at a 9% discount. Increasing investor awareness, in particular dispelling read-throughs from negative U.S. mall headlines, could help narrow the ‘new entity’ discount. Other near-term potential catalysts include: buybacks (which the REIT can activate following Q4 reporting), achieving an investment-grade rating, and getting up-weighted in indices (could result in additional demand of ~3MM units)
Starting With A Blank Slate Looking back at the evolution of enclosed malls in Canada underscores the favorable environment around the timing of the Primaris REIT spin-off. From 2005 onwards, the sector underwent an expansion phase and saw institutional consolidation in Canada and the U.S. A large number of private equity-backed retailers were in growth mode but with a greater focus on top line growth vs. profitability. This expansion phase was in harmony with mallowners’ agenda to lease space, and mall square footage also expanded in that timeframe. The relative resilience of malls during the financial crisis served to cement their status as fortress assets, fueling cap rate compression and valuation increases. 2015 marked the beginning of headwinds from department store failures and e-commerce, and large blocks of space were returned to the market. Retailers who had taken on excess space now faced the challenge of figuring out an omnichannel strategy while lacking basic building blocks (e.g., inventory management systems). As a result, rents, occupancy and values declined until the start of the pandemic. Mandated closures during the pandemic and sales declines effectively washed out the weaker retailers, and at the same time, almost a decade of e-commerce growth was pulled forward. Following this upheaval, the current mall landscape encompasses lower values, lower occupancy, lower rents, and stronger retailers. Retailers have embraced e-commerce and are increasingly using stores as distribution hubs. Hence, institutionally-owned malls are now performing well; however, the concentration relative to other asset classes in pension fund portfolios remains high. Entering at the bottom of the cycle, we believe Primaris is well-positioned to take advantage of the consolidation opportunity, as the REIT is the only buyer with scale, management capability, and is an owner-operator with a mandate for growth.
Retailer Affordability Is Front And Center The REIT has a longstanding focus on controlling costs to support tenants, particularly as costs relating to e-commerce have increased. Several institutionally owned malls have attempted to outdo the competition by ramping up capex spending over the last decade, with escalating operating costs forcing retailers to re-think their market presence. As a result, the market is seeing store rationalization as retailers look to scale back unprofitable stores. Primaris malls were originally acquired from pension funds in good condition and have not needed significant capex. Costs have averaged under 2.5%/year over the last five years and there could be incremental benefit from property taxes declining, and savings from efficiency projects. These cost savings flow to retailers who see much lower additional rent per sq. ft. than at pension fund-owned malls.
State Of The Market Like most landlords, the REIT restructured certain leases during the pandemic at lower base rents or lower threshold for percentage rents, but going forward is adopting the steady 2% annual escalation approach, to which retailers are receptive. Large-format retailers have maintained their preference for longer-term leases, while small shop tenants have been more variable. Access to tenant sales data allows the REIT to monitor underlying tenant health and address tenants of concern proactively. Prior to the pandemic, Primaris had reduced its small shop tenancies by ~25%, replacing them with large format tenants, grocery stores and pharmacies. Following a muted H1/21 (largely from mall closures), the leasing environment is starting to recover. Typically sales have recovered to 90% to 110% of pre-pandemic sales levels. Management is seeing the evolution from a tenants’ market during the pandemic to an improvement in demand, and expect to see a return to regular rents, though some tenants are seeking flexibility over the next 6 to 12 months. The REIT retained ~65% of tenants that filed for CCAA and per the bankruptcy lawyers’ report, no further filings are in the pipeline. While the REIT is seeing demand pick up from large, international retailers that want to establish a presence in secondary markets, local and regional retailers remain a key part of the tenant mix.
Sears Update: The REIT has addressed all the former Sears space with the exception of a couple of locations. The 100,000 sq. ft. space in Quinte Mall will be torn down to make room for a 30,000 sq. ft. Winners store, and the REIT will retain space for outparcels. In Devonshire Mall, the ~200,000 sq. ft. tri-level Sears store will be remerchandised with larger tenants. At 10 acres, the site could encompass a broader master plan that can potentially include residential, hotel or storage space.
Dufferin Grove: A Bargaining Chip The prime residential intensification site has high scarcity value and offers the REIT several alternatives. Management does not plan to undertake sole development of the site given the sheer scale of the project vs. balance sheet capacity. Management acknowledged the long time horizon, uncertain return profile and the potential for risk in undertaking a project of this magnitude. Further, while the return profile might be attractive to a residential developer, it is not as attractive as other opportunities available to Primaris. A more plausible scenario could be a full or partial sale to a pension fund looking to grow its multi-residential footprint and who could in turn, reduce its mall exposure through a sale to the REIT. In the event that units continue to trade at a wide NAV discount, a sale of the site would enable management to buy back ~12% to 14% of units without giving up any NOI. Strong expected population growth has the potential to drive even more value appreciation at Dufferin Grove in the next 18 to 24 months, and we expect the REIT could wait to transact on the site. Overall, the Primaris portfolio is 900 acres of well-located malls with the average site between 40 and 70 acres. Several malls intersect with existing or upcoming transit, have excess land, are poised for value appreciation, and provide an additional source of capital.
Growth Outlook The in-place occupancy of ~86% has considerable runway to grow to the low-90% stabilized level, which would drive significant SP-NOI growth in the near-term. Management acknowledged that disclosures around SP-NOI growth on an occupancy-neutral basis would provide a clearer view of stabilized organic growth. 2022 could see some lingering caution holding back a full recovery in leasing and occupancy, and a return to pre-pandemic NOI could take until 2023-24 to unfold. There is also potential upside from stabilization of the assets acquired from HOOPP where NOI margins are ~40% vs. low-50% for the Primaris assets. Occupancy gains would help close the gap, plus there is an opportunity to renegotiate and improve the leasing profile (assets were previously third-party managed).
Capital Allocation Priorities Disciplined capital allocation is core to the Primaris strategy. Management is deeply committed to its financial model and intends to keep leverage within the 25% to 35% range. The REIT has continued to receive interest from pension funds seeking to downsize their retail footprint, underlining the significant consolidation opportunity available. While the REIT could replicate the HOOPP transaction, we expect units would have to trade much closer to the $22 IFRS NAV before management contemplates an equity deal. The unique financial model and ~$60MM of annual retained cashflow provides the flexibility to buy back units (significantly accretive on a per unit basis) or build out retail pads, or reinvest into existing assets. At an implied ~8% cap rate, however, buybacks present the most attractive opportunity and the REIT has the ability to repurchase ~$5MM/month of units on a leverageneutral basis.
Target Acquisition Profile: While the consolidation opportunity encompasses a whole spectrum of malls, Primaris’ focus would be on quality assets while avoiding large, capital intensive tier-one malls (e.g., Yorkdale). Mid-market second-tier assets that need active management and that are going up in value are more aligned with the current portfolio character. For instance, Marlborough Mall, Orchard Park, Sunridge Mall and Place D’Orleans are all centres that have strong appreciation potential over the next three to four years from rezoning to residential, and we expect the REIT to target similar malls with value-creation potential.
Price Target Calculation Primaris REIT trades at 10.1x our 2022E FFO, a ~27% discount to our $19.50/unit NAV estimate at a 6.5% cap rate, and a yield of ~5.6%. Our price target of $17.50 reflects a ~10% discount to our NAV estimate, to account for some of the uncertainty associated with the higher-discretionary retail footprint, smaller scale, and yet-to-be-established track record, offset by a superior balance sheet, and equates to 12.5x 2022E FFO.