Breaking down HBC’s big deal – and why it matters

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Scrap the retail roots – so much of Hudson's Bay Co.'s future is now tied to real estate.

The repositioning can be hard to follow. In the United States, HBC is teaming up with Simon Property Group Inc. to create a brand new company. HBC will sell 42 of its properties to the new firm and then lease them back, paying $131-million in annual rent. In return, Simon will initially contribute $63-million in equity, and ultimately put in cash and properties worth $348-million.

The new joint venture is taking out $750-million in new mortgages on its properties and that will provide HBC with some cash up front. The venture's total value will clock in around $2.2-billion: HBC's equity stake is worth $1.4-billion, Simon's $63-million and the $750-million of new debt. HBC will own 80 per cent, and Simon will hold the remaining 20 per cent.

HBC is also partnering with RioCan REIT to create a similar company on this side of the border. HBC will sell 10 properties to this new venture and then lease them back, paying $85.5-million in annual rent payments. RioCan is initially contributing $144-million in equity, but will ultimately put in cash and properties worth $325-million.

Because $352-million of new debt is being added to the Canadian joint venture – largely through new mortgages – HBC will again get some cash. The Canadian joint venture is being valued at $2-billion: HBC's properties worth $1.3-billion, RioCan's $144-million of equity and $552-million of new debt.

Each joint venture will have its own four-person board – two directors nominated by HBC, two nominated by the respective real estate partner. They will also have their own management teams.

In total, the deals will deliver $1.1-billion in cash to HBC, which the company will use to pay down its massive debt load and to finance upgrades at some existing stores.

So think of it this way: HBC just created two new companies that are purely focused on real estate, and will own 80-per-cent stakes in each.

You could argue that doesn't shift HBC all that far away from its retail roots because Canadian Tire Corp. Ltd. and Loblaw Cos. Ltd. did something similar. Both companies created real estate investment trusts and then sold their own properties into them, and they are still retail-focused.

But Mr. Baker is taking it a step further. The two new ventures are actively seeking acquisitions, and on a conference call Thursday the CEO stressed that new purchases do not have to tie directly into HBC's existing retail strategy. He would much rather diversify the real estate portfolios. The domestic joint venture will focus on "high-quality Canadian retail properties," while the equivalent company south of the border will target "retail buildings and quality retail projects" both in the United States and globally.

HBC made it clear that it could have launched a simple REIT if it wanted to. "We could have gone and done an IPO today instead of the joint venture," Mr. Baker said, "... but we wouldn't have created as much value as we will when we have a more mature, diversified portfolio." HBC hopes to beef these new companies up and then take them public within three to five years.

HBC also chose the current structure, which involved partners, because it needed to prove the value of its real estate. The purchase prices paid for the 20-per-cent stakes are now matters of public record. "We own assets that were invisible to our shareholders and what we've done is expose them … so they could understand what value in our company was related to the real estate," Mr. Baker said on the call. Investors got the message: the stock was up 22 per cent mid-afternoon.

Looking back, it's pretty clear HBC had been plotting such a major deal. The company hired Paul Beesley last April, bringing him over from Empire Co. Ltd., where he led the team that created Empire REIT. HBC also quietly hired Ian Putnam last December and named him chief corporate development officer. Mr. Putnam previously worked at Stikeman Elliot LLP, where he advised HBC on the sale of Zeller's leases to Target Corp.

It's a pretty transformative deal, both for corporate strategy and structure. And it looks good on paper, if you gloss over the part about HBC taking out new debt to pay off old debt. However, giddy investors better hope the timing works out. Real estate values benefit from lower rates, and it's hard for current yields to fall much further.