Description

Morguard REIT (MRT.UN-T)

Like many REITs with commercial real estate exposure (esp. office), we believe Morguard REIT (MRT) is undervalued. In addition to being cheap, we believe there should be a catalyst on the horizon to unlock this value. Our confidence is derived largely from a very similar fact pattern we observed with Temple Hotels (TPH).

(my TPH writeup: https://www.valueinvestorsclub.com/idea/TEMPLE_HOTELS_INC/4790849791)

Investment thesis summary:

1)  MRT is essentially part of the Morguard group of companies, with Morguard Corp (MRC) as the parent. The two subsidiaries include: MRT focused on commercial real estate and Morguard North American Residential REIT (MRG). Similar to US MLPs, the intention was for each focused subsidiary to attract a premium valuation while MRC provided capital allocation expertise and property management services.

2)  This has not worked overtime as MRC’s opportunistic strategy resulted in a seemingly eclectic mix of assets, particularly on the MRT side. Over time, MRT began trading at a substantial discount to its own IFRS NAV.

3)  Fundamentally, we estimate MRT’s value $7.5+ per unit, with development asset upside. Downside is likely in the $4.5 per unit range. While MRT optically has a meaningful amount of debt, we believe financing risk is manageable especially given MRC’s tendency to provide intercompany loans as required.

4)  Real estate titans tussle round #2. We saw back in 2019 that Morguard was aggressively accumulating Temple Hotels, a busted (non distribution paying) hospitality REIT, seeing underlying value in the business. George Armoyan (activist investor and CEO of Clarke Inc.) also acquired ~15% of TPH before MRC ultimately took TPH private at a premium.

5)  We are seeing a very similar fact pattern here. MRC has been slowly buying more MRT shares, now along with its CEO holding almost 69% of MRT. Armoyan as well accumulated 11% of MRT shares (plus convertibles) and continues to do so aggressively.

6)  We think a catalyst to unlock value could be imminent, including the potential for a take-private transaction similar to TPH. The recent MRC $410 mln hotel portfolio sale further increases this possibility. 

Background

Kuldip Rai Sahi is self-made Canadian immigrant entrepreneur who created the Morguard group of companies to invest in real estate, and to have dedicated subsidiaries MRT and MRG with the intention of these entities attracting a premium valuation while providing MRC with property management fees and upside. This 40-minute interview with Sahi should provide sufficient background: https://www.youtube.com/watch?v=YqwHf4V0rBk

My observation is that Rai is a shrewd, patient and disciplined value (real estate) investor. However, being fully opportunistic, accumulating a hodge podge of commercial real estate assets in MRT and spending little time communicating MRT’s strategy to the Street led to MRT trading at a persistently wider discount to NAV than perhaps other Canadian REITs. Of course, the COVID pandemic, the subsequent distribution cut and its office portfolio exposure (with WFH trends) did not help the unit price either.

Currently MRT has a portfolio of 46 commercial properties with ~ 8.2 mln sq ft in 6 Canadian provinces, with a breakdown of ~ 4.5 mln sq ft in Retail, ~3.2 mln sq ft in office and ~270k sq ft in industrial.

MRC Keeps Buying More MRT

Mirroring Rai’s patience and LT horizon, MRC slowly and methodically raised its MRT ownership from ~47% 10 years ago to over 65% today (69% if Rai’s 3% is included). With almost 70% ownership, we believe the rationale of having MRT public and generating fees for MRC (i.e. MRC only receives 30% of the property management fees, effectively on a net basis) is now much weaker.

Armoyan Ready for Round 2?

Although we don’t know when Armoyan began accumulating MRT shares, we know he crossed the 10% threshold (including units and convertible debt) in August 2023. Since then, Armoyan has been almost in the market daily buying units:

Interestingly, the MRT convertible matures in 2026 and has a conversion price of $7.8 per unit, almost 50% higher than the current price. Although we can never be sure what is going on in the minds of Sahi and Armoyan, the setup seems to be very similar to Temple Hotels.

As a refresher, TPH was a busted REIT that was no longer paying a distribution as the management team overextended themselves to acquire hotels that were hurt by the energy downturn around 2015. Morguard decided to accumulate shares and go activist, ultimately removing incumbent management and installing their own team. Along the way, Armoyan showed up and aggressively bought shares (17%) but ultimately supported a take-private transaction by Morguard.

I would suggest the current set up is even better than TPH as it is less likely MRT plays games by doing rights offerings as a shrewd way to dilute uninterested unitholders while giving Morguard a chance to increase its ownership. This is because MRC is already close to 70% and the size of MRT makes playing these games more expensive. More interestingly, Armoyan is also a >10% holder of MRC (the parent) so there is definitely some 3-D chess going on between these two.

Why Now? MRC $410 mln Hotel Portfolio Sale

MRC recently (and likely opportunistically) completed a hotel portfolio sale consisting of 14 hotels in Eastern Canada. After repaying 1st mortgages, MRC noted net proceeds of $361 mln. Just speculating here but buying out the remaining 30% of MRT at $8 per unit from minority holders would cost ~$160 mln and taking out the convertible would be also ~$160 mln for a total of $320 mln.

Fundamental Valuation

Notwithstanding the attractive setup, we are fundamental investors and have come up with our independent valuation of MRT. We took a more generalist approach and an asset-by-asset approach.

Generalist approach:

We applied broad brush assumptions to the major commercial property groups. Specifically:

1)  Retail occupancy dipping slightly to 94% before recovering to 96-97% longer-term. Broadly reflecting some of the repositioning work MRT has completed. Minor inflation like step up in rents over time (~3%)

2)  Office occupancy continuing to deteriorate to <80% before recovering to 87-88% longer-term but never hitting the pre-COVID levels of 95-96% (reflecting hybrid/WFH impact). Similar trajectory in terms of rents.

3)  Industry occupancy remaining low for the time being until space is leased up longer-term.

4)  Capex in the $25-$35 mln range slightly higher than the PCME MRT estimates.

5)  10% discount rate on cashflows

We get a fair value of $6.25 per unit + $1.50 per unit in the Burquitlam asset = $7.75.

Using the same math but office without the LT partial office recovery, fair value drops = $4.50.

Asset by asset approach:

With the help of costar and industry participants, we looked at MRT’s portfolio asset by asset. Most assets were based on an NOI / cap rate approach with the exception of certain higher value assets we understand industry participants would potentially bid on (i.e. Burquitlam, 111 Dunsmuir, we took the conservative approach to 77 Bloor St West using NOI even though there is higher and better use value here).

We got $7.30 per unit using this approach.

Round numbers we think the risk/reward here is something like $4.50/$7.50 per unit.

Investors Starting to Pay Attention

We suggest that MRT is likely broadly underfollowed but not so neglected that fundamental value is unlikely to surface. For instance, we noticed in the latest quarterly call, an investor aggressively questioned management on MRT’s valuation and capital allocation priorities:

Why Does This Opportunity Exist?

I think this opportunity exists because:

1)  Externally managed REIT with office exposure

2)  Lack of interest due to optically high debt levels and distribution cut

3)  No clear strategy or succession plan – although it appears things are changing with the Angela Sahi COO appointment at MRC

Disclaimers: Not investment advice, write-up subject to errors, do your own due diligence. No obligation to update changes in our holdings.

Catalyst

Strategic Review, Transaction or Take Private