Allied Properties Vs. H&R REIT: 3 Reasons For A Preference (TSX:AP.UN:CA)

Everyone loves a bargain, and the office sector has certainly produced a few bargains over the last three years. Of course those bargains have become cheaper and cheaper. On the Canadian side, the key player investors run to is Allied Office Properties (TSX:AP.UN:CA), (OTC:APYRF). This is primarily a survivorship bias. The other three office plays, Slate Office Trust (SOT.UN:CA), True North Commercial REIT (TNT.UN:CA) and Inovalis REIT (INO.UN:CA), look like this.

So investors are buying the one that looks most likely to survive.

While not exactly in the same sphere, H&R REIT (TSX:HR.UN:CA), (OTCPK:HRUFF) has also been weighed down by its office exposure.

You will note both the price charts are over 3 years. Investors tend to run towards the one that has declined more, thinking it offers them a higher upside. All else being equal, this can be true. But all else is almost never equal. We give you three reasons why we still favor H&R over Allied.

1) Recent Results

Allied announced Q4-2023 results a few days back and the numbers were steady.

FFO(1) was $86 million (61.4 cents per unit), up from $84 million (59.8 cents per unit) in the prior quarter. AFFO(1) was $79 million (56.2 cents per unit), up from $76 million (54.5 cents per unit) in the prior quarter. This resulted in FFO and AFFO pay-out ratios in the fourth quarter of 73.3% and 80%, respectively. While Allied’s FFO per unit in the fourth quarter was down 0.6% from the comparable quarter last year, its AFFO per unit was up 2.6%. Same Asset NOI from Allied’s rental portfolio was down 0.2% while Same Asset NOI from its total portfolio was up 4.6%.

Source: Allied Q4-2023 Results

Nothing worrisome there. But Allied did admit that most of its metrics were likely to contract in 2024 and occupancy gains were unlikely. It also took a rather much need $0.5 billion charge on the fair value of its properties.

The guidance in general was below expectations for 2024. This led to downgrades in estimates across the board.

For H&R, we don’t have Q4-2023 results, but the Q3-2023 numbers were quite strong. Of note here was the fact that H&R’s same property Net operating income (NOI) growth was rock star level.

Even ignoring everything else and just focusing on the NOI growth, gives H&R a big lead over Allied.

2) Diversification

With Allied you are getting to make the office bet and you have absolutely nothing else to bail you out if things go south. Sure, there are some mixed use properties and Allied has some steady parking revenues as well. But realistically, it is a 90-95% bet on office. With H&R, you are making that same bet but with a rather healthy buffer of residential and industrial properties. About 27% of the asset base is tied to office for H&R. Even within that, a good chunk is marked for rezoning (conversion to apartments for example).

The weighted average lease term on office side is 6.9 years.

Allied, by comparison, is lower and near 5.8 years. Neither have material lease maturities on this side for 2024. But just on pure numbers again, it is hard to argue that Allied is safer here, considering the problems within the office sector.

3) Implied Cap Rate

This is the main reason why we are still gravitating towards H&R. Regardless of the above two points we have made, if Allied was trading far cheaper today, one could argue that it would make sense for the risk-seeking investor. After all, if things become fantastic for office in 3 years, Allied would likely deliver better results. One way to assess cheapness is to look at price to tangible book value. Both stocks trade at large discounts, and Allied definitely looks cheaper.

But these NAVs are based on management assessment of cap rates. Allied’s cap rates came in at a weighted 4.83% with Calgary getting 7.13%.

We still believe these cap rates (even after the write-downs) are optimistic. This is where Cushman & Wakefield sees Q4-2023 cap rates, which are also optimistic in our opinion.

Allied’s properties can be considered unique but we believe the cap rates will move higher on their next annual report. H&R’s NAV is based on those numbers below.

If you adjust for these factors, we see both Allied and H&R, trading at a rather similar discount to tangible book value. They are both trading at similar implied cap rates as well (8.4%). But with Allied you are getting office properties at an 8.4% implied cap rate. With H&R, you are getting Residential (40%), Industrial (16%), Retail (17%) and Office (27%) trading at a 8.4% implied cap rate. 3 of those 4 assets trade at far lower cap rates. Which seems cheaper to you taking into account this data?

Verdict

We still rate H&R a buy and rate Allied Properties as a hold. It is hard to envision a scenario where Allied does well but H&R does not. We can certainly envision a few different scenarios where the reverse happens. Both REITs have relatively shorter debt maturities. H&R will have to refinance over $2.0 billion in the next 3 years.

Allied does relatively better on this metric but it will likely see its weighted average interest rates move up substantially as well.

So neither is a slam dunk, even in the most optimistic of outlooks. But we see H&R navigating this, and the risk of a total return loss (inclusive of dividends) five years out is remote. With Allied, we are still unsure whether we could make money here. One factor that put Allied more on the backfoot relative to H&R is that it had started a number of development projects (office of course) right near COVID-19. Those have been a huge liquidity sink. In the absence of those, we think the data-center sale would have been suffice to have derisked in the whole balance sheet. But as it stands, Allied has to still navigate a minefield.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.