In the seven-and-a-half months since Hudson's Bay Co. chief executive officer Richard Baker said his company would look at spinning off a real estate investment trust, Canadian REITs have gone from market darlings to dogs. But it's a virtual certainty that he will now go ahead with a spinoff anyway.
The S&P/TSX Capped REIT Index, which posted a blockbuster total return of 17 per cent last year, is down 7.8 per cent so far this year and nearly 12 per cent in just the last three months.
Mr. Baker, who devoted much of his career to real estate investing and who is still the chairman of a U.S. shopping centre REIT, has spent the past couple of months pursuing Saks Inc. When he unveiled his successful $2.4-billion (U.S.) bid for Saks Monday morning, he seemed just as excited to point out again – just as he did back in December – that HBC is mulling the creation of a real estate investment trust. The Canadian retailer's initial pursuit of the idea was undoubtedly sidelined when the Saks opportunity came up.
While REITs are taking a beating in the face of higher long-term interest rates, that isn't scaring off retailers. Loblaw recently spun off Choice Properties REIT and Canadian Tire is still working on the creation of its own $3.5-billion REIT, first announced in May. Both retailers saw their stocks pick up as a result.
"REITs have sold off since last summer, but for a retailer, the comparison is what is the cost of capital for a REIT versus what is the cost of capital for a retailer that owns real estate, and the spread is pretty dramatic," says CIBC analyst Alex Avery.
In other words: even after the selloff, REITs enjoy richer valuations than most retailers do. "You look at the average REIT in Canada trading somewhere in the neighbourhood of 15 or 16 times EBITDA before and the average retailer in the single-digits, it's an arbitrage that makes a lot of sense. It's an optimization of their capital structure and cost of capital, and I think the argument to pursue that strategy remains as strong today as it was last summer."
(EBITDA represents earnings before interest, taxes, depreciation and amortization.)
It's hard to say just how receptive the market will be to an HBC REIT until more details are known about which properties would be in the trust, and what items like the lease terms, rental rates, and payout ratio would be. But after the Saks deal is complete, HBC will have 32-million square feet of retail space – 17 million square feet of which is currently owned or ground leased – throughout Canada and the U.S., including, as the company is currently boasting, premier locations such as New York City and Beverly Hills.
Whatever the REIT ultimately looks like, it's likely to be fairly unique. RioCan, Canada's largest retail REIT, is also cross-border with about 18 per cent of its portfolio (by square footage) in the U.S., Mr. Avery points out, "and there are some smaller-cap REITs that do have cross-border structures, including some retail property, but nothing of this type of scale."
Adding credence to the notion that the REIT is pretty much a sure thing is that Mr. Baker could use the money it would generate to pay off some of the debt that it will be acquiring in the Saks deal, and that's important. The strategy for de-leveraging in the wake of this deal is something that HBC investors will be watching closely.
While the prospects for retail REITs are still good, HBC would nevertheless be wise to hit the market soon. Any significant upward shift in long-term rates could again spook the market, and eat into the proceeds from the IPO.
( Tara Perkins is a Globe and Mail real estate reporter.)
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