Good day, and welcome to the Allied Properties REIT third quarter 2018 earnings conference call. Today's conference is being recorded. At this time, I would like to turn the conference over to Mr. Michael Emory, President and Chief Executive Officer. Please go ahead, Mr. Emory.
Thank you, Ron. Good morning, everyone, welcome to our conference call. Tom, Cecilia, and Hugh are here with me to discuss Allied's results for the third quarter ended September 30, 2018. We may, in the course of this conference call, make forward-looking statements about future events or future performance. These statements, by their nature, are subject to risks and uncertainties that may cause actual events or results to differ materially, including those risks described under the heading "Risks and Uncertainties" in our most recently filed annual information form. Material assumptions that underpin any forward-looking statements we make include those assumptions described under "Forward-Looking Disclaimer" in our most recent quarterly report. Our third quarter was active and successful. We propelled strong organic growth in our rental portfolio and made excellent pre-leasing progress with our development portfolio.
We continued to focus on large-scale capital allocation necessary for a growing and successful development pipeline, strengthening our debt metrics meaningfully for the second time in 2018. Cecilia will elaborate on our financial results for the quarter. Tom will follow with an overview of our operating results. Hugh will discuss our development pipeline, and I'll finish with a discussion of our outlook. Now, over to Cecilia.
Good morning. I'll touch on the quarter's financial highlights, our approach to capital allocation, and the re-articulation of our business. First, the quarter's financial highlights. Driven by occupancy gain and rent growth in Toronto and Montreal, our same-asset NOI in the third quarter was up 9.7% from the comparable quarter last year, driving 22.6% growth in our AFFO per unit. Same-asset NOI for our urban workspace portfolio was up 10.7%. This included higher-than-expected increases in Montreal and Toronto as leasing results exceeded forecasts. We expect 2018 to finish with mid-to-high, single-digit growth in same-asset NOI. Driven largely by the recent completion of upgrade properties in Montreal and continued de-leveraging, our NAV per unit at the end of the quarter was up 8.7% from the end of the comparable quarter last year. The IFRS value adjustment in the quarter was CAD 155 million, excluding incremental capital investment of CAD 49 million.
At CAD 272 million, our annualized EBITDA was up 4.8% from the same quarter last year. This growth is also consistent with our internal forecast. Second, our approach to capital allocation. We use our unsecured operating line throughout the year to fund acquisitions, developments, and mortgage repayments. As the line is drawn, we look to fix our cost of capital regularly. This is primarily because we don't want to expose ourselves to inevitable short-term variability in the equity and debt capital markets. As a matter of interest, we received a term sheet enabling us to increase our unsecured operating line from CAD 250 million- CAD 400 million. While this has an ongoing cost to us, we consider the added flexibility and liquidity well worth it. As any given year progresses, we evaluate the impact of different financing options on our debt metrics and AFFO per unit.
In terms of the specific debt metrics, we're most attentive to debt to EBITDA, as it is less variable due to changes in the fair value of our assets. In deciding how low we go, our focus will ultimately be on debt to EBITDA. We took the opportunity at the end of September this year to fix the cost of CAD 155 million of capital by issuing equity and paying down our unsecured operating line. We were able to do this in a minimally dilutive manner while making significant additional improvement in our debt metrics, which are now stronger than ever. At quarter end, net debt to EBITDA was 6.3 times, and debt to gross book value just below 28%, both solidly within our targeted ranges. Interest coverage in the quarter was 3.5 times, representing good progress towards our target of four times.
Our pool of unencumbered properties has grown significantly in 2018 and now totals CAD 4.1 billion, representing just under 70% of the IFRS value of our properties. This is up 49% from the same time last year. From a liquidity perspective, we finished the quarter with nothing drawn on our operating line, leaving us with full access to CAD 250 million, which will expand shortly to CAD 400 million. Third, the re-articulation of our business, which you'll have noticed in the letter to unit holders, as well as set out on page 14 and page 15 of the MD&A. Some have suggested in the past that there is a fundamental operating distinction between our urban workspace and our network-dense urban data centers. We've never seen it that way. We look at our business as an integrated whole.
Our urban workspace and network-dense urban data centers do essentially the same thing for knowledge-based organizations that use our space. They provide urban environments for human creativity and connectivity. From a financing perspective, there are future implications of continuing to look upon our business as an integrated whole. The first and most obvious is that we do not and will not look upon our urban data centers as an opportunity to redeploy capital. The second is that our urban data centers afford the potential for outsized revenue growth without having to allocate significant amounts of capital, as we did previously in retrofitting 905 King West and 250 Front West. The third is that our urban data centers going forward will fall primarily within our rental portfolio rather than within our development portfolio.
We may one day expand existing facilities, but we're highly unlikely to develop new ones on a speculative basis. I will now pass the call to Tom for a discussion of our leasing and operating activities.
Thank you, Cecilia. Our leasing environment remains strong, with demand in all markets. In fact, each of our markets showed growth in leased area in Q3. We completed 1.1 million sq ft of transactions in the quarter and 2 million sq ft so far this year. Pre-leasing activity on development projects continues to be strong, but more on that later. Our occupied area increased by 0.21% over Q2 and 1.6% year-to-date. Leased area increased by 0.8% over Q2 and 1% year-to-date. We continue to show healthy lifts in net rent on space renewed or replaced. For the nine months ending September 30, rents grew by 16% on the affected area. We fully expect this trend of very positive revenue growth on maturing leases will be sustained in the foreseeable future.
Moving from east to west, I'll provide a brief leasing update on our major markets, Montreal, Toronto, Calgary, and Vancouver, and conclude with an update on our network-dense urban data centers. Starting in Montreal, fueled mostly by tech sector growth, this market has been a great performer in 2018. Le Nordelec is 97.4% leased. 6300 Parc, 96%. Cité Multimédia, 97.5%, and our properties on de Gaspé, 98%.
We have some work to do to improve our occupancy in our buildings on Saint Laurent, but that area is also coming along well. Our target is to have the Montreal portfolio 97% leased by year-end. Construction at 425 Viger is proceeding well, where we are adding 100,000 sq ft to a 200,000 sq ft building. Leasing is going equally well. We have completed a lease for 95,000 sq ft with a global brand, and a 60,000 sq ft deal is nearing the finish line.
We expect to be 50% leased by year-end. Rents are at or above pro forma. Moving to Toronto, the prime focus of our leasing team in 2018 has been to secure pre-leasing commitments for The Well. With Shopify, Index Exchange, and Spaces, we are now 71% leased, with space expected to be turned over for tenant work early 2021. Activity at our presentation center remains brisk, and we are currently working with three potential tenants for space totaling 180,000 sq ft. Demand for our existing portfolio remains high, with our biggest challenge being an ability to accommodate expanding tenants. As some would say, a champagne problem. Our portfolio in Toronto is 98.6% leased. Moving to Calgary, our existing portfolio, largely located in the Beltline, has held up well over the course of the downturn, and we now sit at almost 90% leased, with activity levels continuing to improve.
With respect to TELUS Sky, our development project with Westbank and TELUS, we are completing 3 transactions totaling 45,000 sq ft. We expect to lease the balance of the space in this project in one or two floor increments. Consequently, we are planning to build out show suites in this project to assist with leasing, as we have done with great success in our existing portfolio. It has been our experience that smaller tenants make decisions more quickly when the space is basically in move-in condition. In Vancouver, the market remains very strong, and we are sitting at 96.8% leased. At 400 West Georgia, a Westbank project we are financing with an obligation to acquire a 50% interest upon completion, pre-leasing has gone extremely well. 3 separate transactions have been finalized, with 82% of the space now committed. Delivery for tenant work is not until mid-2020.
Our network-dense urban data centers, 151 Front and 905 King, are both highly leased. At 250 Front, we are in the final stage of negotiation with a new tenant for sequential requirements of 10,000 sq ft each, which will bring our leased area to 75%. Ancillary revenue continues to build at each of the facilities. The Crosslake Fibre cable linking Toronto and New York, mentioned last quarter, is being installed as we speak. This will boost our ancillary rental revenue in 2019 and beyond.
I will now turn the call to Hugh for discussion on our development activities.
Thanks, Tom. I will now touch on the quarter's development highlights. This quarter has seen progress made in both our active development projects as well as our future development pipeline. I will begin by giving an overview of the progress made on the projects we have under construction and then give an update on the projects for which we are pursuing approvals. Projects under development. Working from east to west, there has been significant progress made at our 425 Viger project. We have completed the interior demolition and have now started work on the addition. This project remains on track for completion at the end of 2019. In Central Canada, we are nearing the completion of the commercial component of King Portland Centre. All of the tenants have taken possession of their spaces in order to commence their fit-out work.
We anticipate achieving occupancy for the commercial component by the end of the year. On the residential side, we anticipate construction to wrap up in Q2 2019, with the condo purchasers occupying the building beginning in the late spring. Construction on The Well continues to progress according to our schedule. For the office tower at the corner of Front and Spadina, we anticipate to be at grade by the end of the year, with the remaining buildings coming to grade through Q2 2019. We have tendered out approximately 70% of the work for the project, anticipate to procure the remainder over the next couple of quarters. For the JV project with Westbank at Adelaide and Duncan, we have begun the selective demolition of the heritage structure.
We have seen cost escalations due to market conditions, are actively looking at ways of mitigating our risks by locking into fixed-price contracts. We currently stand at approximately 50% of hard costs in fixed-price contracts. For our JV projects with RioCan on College Street, we have completed the intensification of College and Palmerston and have turned our attention to College and Manning. Both projects are being managed by RioCan. In Western Canada, TELUS Sky is nearing completion. We anticipate the first office floors to be turned over to TELUS in late Q1 2019. Occupancy is scheduled for Q3 2019 for the commercial component of the building and late in 2019 for the residential component of the building. We have adjusted our project costs and timeline to take into account the delays in delivering the space and complications experienced during construction.
In Vancouver, Westbank is well underway in the excavation of 400 West Georgia. This project is progressing according to our anticipated schedule. Intensification approvals. Our current focus for approvals is on our intensification projects in Central Canada. Our King and Spadina project with Westbank was approved by the Ontario Municipal Board in August, with the final binding zoning likely to come into effect by the end of the year. This has allowed us to commence presales activity for the residential component of the project. We have seen strong demand at an unprecedented price point consistent with our pro forma. We intend to commence construction in the summer of 2019. We continue to push for municipal approvals for our Adelaide and Spadina project, as well as our King and Brant joint venture project. We anticipate receiving their approvals in Q1 2019.
Both projects have received great interest from potential tenants, we are working diligently to achieve the approvals. In Western Canada, we have established a plan to redevelop the Leahy Building. We anticipate the design progressing through the end of the year, with construction starting in earnest in Q1 2019. The construction should be completed in late 2019 or early 2020. I will now turn the call back to Michael.
Thank you, Hugh. The outlook for our urban workspace portfolio remains positive, as is evident from what Cecilia, Tom, and Hugh have just said. The outlook for our network-dense urban data centers is equally positive. In our last conference call, I mentioned that we were evaluating the possibility of increasing our exposure to assets where urban real estate and communications technology intersect. I also promised to follow up in this conference call, which is what I'd like to do now. We had three overriding objectives in evaluating our urban data center assets. First, we wanted to explain more fully how critical a component of Canada's communications infrastructure these assets have become. I believe we've done a good job on that in our MD&A for the third quarter. Second, we wanted to ensure that these assets continue to be fairly and responsibly valued in our financial statements.
I believe we've done a good job on that as well by ensuring that 151 Front West, in particular, is valued consistently with recently completed transactions in the United States. I also believe there's room for further growth in value of our urban data center assets as the income-producing potential of 151 and 250 Front West and 905 King West continues to grow. Third, we wanted to develop a preliminary plan for increasing our exposure to network-dense urban data centers in Canada. We've done that as well. Before I elaborate, I want to articulate our background thinking. It relates to our business as a whole. When we went public in 2003, it was sufficient to say that Allied is in the business of consolidating Class I workspace that is centrally located, distinctive, and cost-effective.
Five years later, it was necessary to add that Allied is in the business of intensifying underutilized land within its portfolio. A year later, it was necessary to add that Allied's business includes owning and operating the largest internet exchange point in Canada and the fifth largest in North America. The need for more refined and precise articulation continued unabated from 2010 onward. In the early articulations of what we do, we made no mention of who we serve or why. In terms of the business we're now in, we serve, one, users of urban workspace in Canada's major cities, and two, users of network-dense urban data centers in Toronto. There's significant overlap between the two groups of users, as well as almost complete overlap in what we provide to them.
Through our urban workspace and our urban data center space, we provide knowledge-based organizations with distinctive environments for creativity and connectivity. Our workspace facilitates human creativity and connectivity in a deep and meaningful way. Interestingly, our data center space does exactly the same thing on a global basis through a vast and dense superhighway of networks. As I'm sure you've noticed, we now describe our business consistently with what I've just said. This is a meaningful, accurate, and fulsome description of Allied's business, in my view, and one that will continue to guide us going forward. With that as background, let me articulate our preliminary plan. First, after considerable reflection and evaluation, I consider it unlikely that we'll acquire network-dense urban data centers in other Canadian cities.
Downtown Toronto is so critical to Canada's communications infrastructure that there's no meaningful incentive to pursue the limited opportunities in Montreal or Vancouver. Second, I consider it probable that we'll drive consistent and material rental revenue growth over time at 150 and 250 Front West and 905 King West, both in terms of regular rental revenue and ancillary rental revenue. Needless to say, this will be reflected in our internal forecasts from 2019 onward and will be segmented in our MD&A going forward. Third, I consider it likely that we'll materially expand the capacity of 151 Front West when we construct the adjacent property at Union Centre. The opportunity represented by Union Centre deepens with the passage of time. We are now redesigning the workspace to exploit fully the remarkable opportunity inherent in the site. I believe the site may have considerably more development potential than we initially envisaged.
A prospect that we are now exploring actively. If there's a material long-term opportunity to increase our exposure to network-dense urban data centers, it's almost certainly at Union Centre. A smaller opportunity may also exist at 250 Front, as we have rights of expansion there. These opportunities aren't likely to be exploited within the next two to three years, but rather within the next five to 10 years, which I believe will prove to be the optimal timeframe. I think it follows that the expansion of our exposure to network-dense urban data centers will be evolutionary rather than revolutionary, will occur organically over time, and will not be executed on a speculative basis. Evolutionary though it may be, we're determined to make it happen and confident of our ability to do so.
Overall, we continue to have deep confidence in and commitment to our strategy of consolidating and intensifying distinctive urban workspace in Canada's major cities and network-dense urban data centers in Toronto. All as we've outlined in this conference call presentation. We firmly believe that our strategy continues to be underpinned by the most important secular trends in Canadian and global real estate. We also firmly believe that we have the properties, the people, and the platform necessary to execute our strategy for the ongoing benefit of our unit holders. I do hope this has been a useful and comprehensive update for you. We'd now be pleased to answer any questions you may have.
Thank you. Ladies and gentlemen, if you would like to ask a question, please signal by pressing star one on your telephone keypad. If you're using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. Again, please press star one to ask a question. We'll pause for just a moment to allow everyone an opportunity to signal for questions. We'll take the first question from the line of Chris Cooper from CIBC. Please go ahead.
Morning.
Good morning.
I appreciate the new disclosure on the incremental density in the MD&A. You've identified a few new markets. I'm just curious, in terms of the potential incremental density, if you have an idea of what % of it will be office commercial versus residential. When you're looking at the potential development timeline, what's the thinking involved in which projects were short, medium versus long-term?
With respect to the first question, Chris, the vast bulk of the intensification we envisage in the future will be office space. That is what we do. The demand for it is deep. The vast bulk of that number will be urban workspace, having the attributes that people need and want in order to attract, motivate, and retain the employees they need to drive their businesses forward. In terms of the second aspect of your question, we tried to anticipate where we would direct our attention over time. Of course, the only thing we know about the estimate is that it will somehow be wrong. One thing I can say that helped guide us here is we don't anticipate undertaking any additional new large projects in the next two to three years. We do anticipate undertaking smaller projects in the next two or three years.
By smaller, I mean a range that would start at the low end with QRC West phase two of 80,000 sq ft-90,000 sq ft. At the high end, which would be Spadina and Adelaide, at 200,000 sq ft-300,000 sq ft. Within that range, we see initiating projects, not rapidly and not continuously, but we see initiating projects over the next two to three years. We expect the demand wave that is now very evident in Montréal, Toronto, and Vancouver to ebb two or three years out. Our timing would certainly have taken that into account. I think the reason you see very large intensification farther out along the spectrum of time is because it's only then that we would anticipate the very large opportunities we have being put into production.
It is educated guesswork, but it's based on the assessment primarily, that we don't want to overcommit in the near term because we expect this wave of demand, which is very strong and very deep, has to subside or moderate two or three years out as the supply is created to meet the excess demand.
I'm guessing that Union Centre is going to be either in the medium or long-term bucket. Of the 1.1 million sq ft that's currently estimated on completion, is there a component of that that includes 151 Front expansion?
Yes.
Approximately how much of that?
We haven't yet quantified that, whereas we once thought it would be a small, if not negligible component of Union Centre, we now envisage the possibility of it being a larger segment of Union Centre. It would be premature, I think, to try and quantify that other than to say we envisage it being a larger component than we did, say, 24 months ago. The structure of the building lends itself well to the establishment of urban data center space at the base. At the base of the building, you don't really get good viewpoints north until you rise above 151 Front. That becomes ideal location for urban data center space. I do expect it to be material, but it would be irresponsible really to project how much we would be comfortable creating five years down the road.
The other thing I will say, though, is we will not create that space on spec.
Got it.
That's not to suggest that we'll have every square foot leased up when we commit, but we will not create that space on spec any more than we will create the workspace at Union Centre on spec.
Great. Thanks. I'll turn it back.
Thank you.
Ladies and gentlemen, if you find that your question has been answered, you may remove yourself from the queue by pressing star two. We'll now move on to the next question from the line of Michael Markidis with Desjardins. Please go ahead.
Hi. Good morning, everybody. First of all, congrats on getting the move go ahead on King Toronto. A couple of questions on that project. Just with respect to the development pro formas that you've put forth in the, or introduced in this MD&A. Can you just walk us through how that's going to work? There is a material condominium component here, so I'm just looking at the 9%-11% return and just want to get an understanding of does that refer to the entire expected sale proceeds on the condos plus the smaller commercial component, or is it just on the commercial component?
Yeah.
Yeah.
Sorry, Mike.
Go ahead. No, go ahead.
I'll let Hugh articulate that more fully. I think the concept is important. What we've done there, as we have with the very limited number of other projects involving condominium space, is we have envisaged the profit on the sale of the condominiums, effectively reducing our cost on the residual commercial component, and then taken the yield on that commercial component as a percentage of the reduced cost. That's how we look at it, although there are other ways to evaluate it, but in terms of the disclosure we've made, that's exactly how we have presented it or how we have calculated it.
Okay. Of the CAD 313 million of total cost roughly how much of that would be attributable to the condominium component?
About two-thirds of that would be attributable. For space, the building is broken up into about two-thirds the residential and one-third commercial.
Would it be too early at this juncture to talk about what the anticipated development profit on the condo component would be?
That's something that we will look to disclose, potentially in Q4, Mike.
Yeah. The sales process is underway now. It is going very well, and as Hugh mentioned, we're achieving price points that I think are unprecedented in the market. The phase 2 of marketing, I believe, will begin this week. There will be a phase 3. We're not yet sure whether it will be initiated this year or early next year, and that decision will depend entirely on how we think we can optimize the outcome. It'd be a bit premature to articulate the profitability of the condominium component of the transaction. I think that's something we can responsibly do in conjunction with our Q4 results because we'll have very hard and almost complete data on which to base that.
Okay. With the 50% now that is going to be transferred to Westbank to establish that partnership, will there be any funding provided by Allied, for Westbank's purchase, or is that just going to be a straight cash exchange?
That will be partially cash, partially funded by us with a good yield-
Okay
on the portion we fund.
Okay. Just switching topics. Michael, appreciate your comments on the urban data center space and what your plans are there. That's very helpful. It seems like you seem, and I know this is five to 10 years out, but it seems like the bigger opportunity in terms of expanding would be at 151 Front in conjunction with Union Centre. I'm just trying to get a better understanding of why that might be the case relative to what you have at 250 Front. If I remember correctly, you've got a material opportunity to expand your footprint there-
Yeah
in maybe a more cost-effective way.
Agreed, in every respect. I think simply in terms of magnitude, the opportunity at 250 Front is smaller. The amount of space we can and likely will create at Union Center, that will be a literal extension of 151 Front, I think will be much larger than any additional area we can create at 250 Front. I think you do make a good point. It is conceivable that we could pursue the smaller opportunity at 250 Front sooner in time, than we are likely to pursue the opportunity at 151 Front. Of the two, 250 might be something we can pursue more imminently. It will necessarily be smaller in scale than anything we can create at 151 Front and will require, in our view now, that we expand purely on a build-to-suit basis rather than on a spec basis.
I just see the opportunity as smaller in scale than the opportunity that is associated with the construction of Union Center. It is one that we could conceivably pursue sooner in time.
Thank you. I'll turn it back.
Thank you.
We'll now take the next question from the line of Jonathan Kelcher with TD Securities. Please go ahead.
Thanks. Good morning.
Good morning.
Just going back to Union Center. You said you wouldn't start that without significant pre-leasing on both the data center and the office. Do you have to have sort of on both?
Yes.
Okay. Secondly, just in sticking with the urban data center, you talked about potential significant rent growth. Can you quantify your thinking on that? How should we think about that going forward the next couple of years?
What I'd like to suggest, again, is that we provide you with more granular guidance in that regard when we report on Q4. Because it will, at that point in time, be built into the 2019 internal forecast. We've obviously done a great deal of work on that, Jonathan. I'd love to talk about it, but my colleagues might be upset with me if I did. I do think it would be appropriate and responsible for us to provide more guidance in that regard in conjunction with our year-end results. Because then literally, our estimates will be baked into our 2019, and indeed, into our forecast for the following two years. We'll do that then.
I will only say at this juncture that we are confident in the ability of these assets to generate above-average earnings growth on an annual basis in the next three to five years. I think it's incumbent upon us to quantify what above average means. The outlook is encouraging, and we'll certainly share it in a quantitative way, when we've finalized our own thinking in that regard.
Okay. Would part of that be the remaining lease up at 250 Front?
That's part of it that's been baked in forever, if you know what I mean. This would be in addition to that.
Okay. Just on the Crosslake. I guess you're going to be able to charge on cross-connects, and you said in the MD&A that you have a significant amount of them already in place at 151 Front. Is there potential longer term to be able to charge for the existing cross-connects?
It's a very good question. I think my answer would be a tentative yes, we're really talking about the long run. The existing arrangements are arrangements that have been established with the existing users of space at 151 Front. In some respects, the rental rate we derive from them on a per square foot basis takes cognizance of those cross-connections. We do think it will be possible in the fullness of time to change the basis upon which we charge for cross-connections and to have the charges more direct. It isn't something we can do today, and indeed, the existing understanding between ourselves and our users, which Allied of course will honor, will preclude us from doing that until, at the earliest point in time, the user's lease is up for renewal.
The answer is yes, but it is not something that forms a significant component of our expected revenue growth in the next 5 years. It might potentially become a component of revenue growth for Allied in the 5 to 10-year timeframe, it will not become meaningful in the 1 to 5-year timeframe. There are other revenue growth areas at 151 Front, at 250 Front, and at 905 King, which will grow materially, we believe, in the 1 to 5-year timeframe.
Okay. Thanks. I'll turn it back.
We'll now take the next question from the line of Mario Saric with Scotiabank. Please go ahead.
Hi, good morning.
Good morning.
Just dovetailing on the last question in terms of the cross-connects that exist at 151 Front today, how those may be taken into consideration from a rental perspective in the existing in-place rents. Do you have any sense in terms of what the kind of longer term net potential upside may be? For example, if your net rent is CAD 130 a square foot, is that reflecting the full potential of the cross-connects at the building, or is there additional upside above and beyond what's in the net rent today?
My view, Mario, is the current levels of net rent do not, if you will, reflect the value of the cross-connects. That's simply a function of history. I think the opportunity, at least in theory, is material. Until we start demonstrating it in practice, I'm loath to get overly excited about it. I do believe that the current rental rates for space at 151 Front are below market, independently of the fact that the tenants are entitled to, if you will, non-revenue generating cross-connects in the Meet-Me Room. They do pay for rack space in the Meet-Me Room, but that amount is modest in relation to what I'll call the market for cross-connections.
I do think there is, at least in theory, significant potential revenue growth at 151 Front, not only from the rental of space, but also from the conversion in time, or the more active exploitation of the cross-connections that are in place there. As I say, the optimism we feel about growth in the next five years is not predicated on monetizing that enormous number of cross-connections at 151 Front, but rather is predicated on establishing new cross-connections there on a different financial basis, and other areas of earnings growth there. I think it's almost unwise at this juncture to begin to look forward six years and beyond and postulate dramatic growth, simply because there's a lot that will have to be thought through and evaluated in terms of our relationship with our users.
Certainly, we don't want to do anything that would be taken amiss by the, if you will, the ecosystem of users at 151 Front. It's a possibility, but not one that we would even venture to quantify yet.
Okay. Maybe a related question. Given 151, I guess you articulated that 151 Front is expected to be a much bigger part of Union Center relative to what you envisioned two years ago. Going forward, how does that change, if at all, your optimal ownership of Union Center in terms of JV relationships and whatnot?
It's a really good question, and we've discussed that internally. I think almost certainly, to the extent we have a JV partner at Union Center, which is highly likely, we will stratify the urban data center component and own it in its entirety, and then share the ownership of the urban workspace component with our partners. I don't believe there's any reason for us to share ownership of the urban data center space with our joint venture partner. There is good reason for us to do so with respect to the urban workspace.
Understood. Okay. My last question pertains to the incremental intensification disclosure that you provided, which I thought was really useful, and maybe delving or pushing the envelope on some of the educated guesswork that you talked about earlier on. Of the 7.8 million sq ft that you've identified, you've noted 2.1 million sq ft are already in your appraised fair value. What would have differentiated what is in your appraised value today relative to the other 5.7 million sq ft?
It's really a conceptual and actual reality, that Cecilia can perhaps confirm. The way we look at it is this: if we have approval in place for intensification, that doesn't necessarily mean we can recognize, for the purposes of IFRS, the incremental value associated with that approval. There's one exception to that, and that is where we have an asset that we intend to intensify and there is no material impediment to our intensifying, then we can recognize the incremental value resulting from approval. A good example of this, there are numerous projects in our portfolio where we have approval in place, but we have no present intention of initiating the intensification, and therefore, we won't recognize that value until we have that intention. Is that a reasonable description, Cecilia?
I think the bulk of it would be what's currently earmarked as future development projects in the intensification table, Mario, on page 37.
Got it. Okay.
They're not part of the current PUD, but because we have either current zoning approval or current very detailed plan to kick that off at some point in the future, and we have the ability to do so legally, financially, et cetera, then part of that value would be in our current IFRS values.
Understood. Okay. Just maybe an interesting question. In terms of that 7.7 million square feet, how would the value per buildable square foot for that look today, in your opinion?
That is a good question, and something that we'll take under advisement. It is difficult. It would vary, of course, from market to market. Right now, it would also be important to recognize that most of what we intend to create is office space, and the value per buildable square foot for office space is lower than it would be for residential space. We'd have to look at it on a market-by-market basis, and we'd have to take, what I think would be the conservative assumption, that it will all be built out as office space. When I say conservative, I mean conservative in the sense of value per buildable square foot. Given the demand for office space, and given the probably long-term sustainability of that demand, the value for office space per buildable foot is definitely on the rise.
It wouldn't rival, for example, the value per buildable square foot for condominium residential, which just continues to skyrocket, as we all know. I wouldn't want anyone to use sort of CAD 200 a foot and think that would be an accurate valuation of the buildable area. If I was to just stick my thumb up in the air and guess, which I've been known to do sometimes at my peril, we're looking at CAD 70-CAD 100 a foot. Again, we'd have to be more refined than that because clearly in Montréal it would be lower, clearly in Calgary it would be lower, clearly in Vancouver it could even be higher. I wouldn't want anyone to apply CAD 200 a foot to that number and conclude that kind of unrecognized value is reposed in our portfolio. That would be too optimistic.
Understood. Okay. In the CAD 70-CAD 100 a square foot, just again, very blue sky number, that would reflect the existing status of the land as opposed to fully zoned or would that be kind of the envisioned value upon appropriate zoning?
Yes. I would say, in my opinion, there's little difference in our case between zoned and unzoned. In the sense that our estimates, as set forth in the MD&A, are based on what we're supremely confident we could achieve on rezoning today. Even if it doesn't happen to have approval, my estimate of value would be that it's more or less identical with the value that would be applicable if approval was in place. Clearly, there's more certainty attached to an existing approval. One thing we've learned from long experience now, when we're creating workspace in the urban environment, and we're operating within the parameters established by the current zoning, we're almost invariably successful in getting what we anticipate in terms of density and coverage.
What Hugh and his team and the finance and asset management teams have done in the MD&A is endeavor to determine reasonably what we can achieve on these different opportunities, given our experience today in getting municipal approvals in the relevant marketplaces.
Okay. Thank you for that.
No problem.
We'll now take the next question from the line of Howard Leung with Veritas Investment Research. Please go ahead.
Thanks. I just want to ask about the equity issue to pay down the line of credit. Do you have a view on interest rates? Seems like you're shying away from variable rate debt. If you think they're rising over time, how do you think that will affect office cap rates in the next few years?
Good question. We hate variable rate debt and have very little, if any, of it. In fact, the only variable rate debt that I believe we have is the operating line, and we make a practice of fixing that on a regular basis, either in terms of equity issuance or unsecured debt issuance. We do believe interest rates are on an upward trend. Not dramatically, but noticeably. I don't expect the trend that we anticipate to have a material impact on office cap rates. Urban office space is so greatly in demand that I think it is certainly buffered in relation to interest rate increases, and It would be reasonable to assume that cap rates are going to somehow rise just because, and in tandem with, the rise of interest rates.
Clearly, if we see material increases in interest rates over time, that's going to have some impact on office cap rates. I don't think that's built into the way the market is operating now. People are paying very aggressive capitalization rates for high-quality urban office space in Montreal, in Toronto, and in Vancouver. Trades are beginning to occur in Calgary. Clearly there, it's more on a contrarian basis. I believe that the likely rise in interest rates won't materially change the capitalization rate for urban office space. Beyond urban is a different question, and outside of our sphere of knowledge and understanding.
Right. No, that makes sense. For the urban data centers, I did want to ask a question there. The extra disclosure this quarter was pretty helpful. On the ancillary revenues, have you started to look at the churn rates? I would imagine the churn rates are very low, but they are monthly contracts.
There are different forms of ancillary rental revenue in the portfolio today and looking forward. They are all very stable, even though the charge for them is monthly. To illustrate this, at 151 Front, when people run fiber from their space to the Meet-Me Room, they pay for space in the conduits. They do so on a monthly basis, no one ever doesn't renew, if you will, its monthly entitlement, because nobody can afford to disconnect themselves from the Meet-Me Room. That basically grows rather than contracts. Likewise, in the Meet-Me Room, people pay for rack space on a monthly basis, no one ever contracts, rather expands there, again, because it's that interconnectivity that allows them to achieve their overall objectives. Finally, the cross connection, the monetized cross connections, similarly, are charged for on a monthly basis.
While our experience in that area is, if you will, the least long-term at the moment, it again appears, it's like the other two components in that nobody doesn't renew or doesn't extend their cross connection. If anything, the number of cross connections seems to just grow and grow and grow as the need to interconnect becomes more and more profound. The whole movement that is underway in the world to the cloud, basically is the assurance we have that the monthly cross connections, while again, in theory, monthly, are really almost permanent realities, at least as this cloud evolution unfolds. Perhaps down the road, if it one day peaks, it's conceivable people will cut back on their connection to the cloud. Again, I think that's more a theoretical possibility than a probable one.
Right. No, that makes sense. Seems like you think it's sticky enough that you would have also that pricing power in the future as well.
Absolutely.
Great. Just maybe one for Cecilia. On the CAD 650 million of PUD, how much of that, or how many of those 8 projects, I guess, are valued based on cost, and which ones are valued based on fair value less cost to sell?
I'm just flipping to the page, Howard.
Yeah. No worries.
The ones where there's leasing done, which would be a lot of the larger ones, it would be a DCF model. Where there isn't a certain level of leasing achieved, like over 50%, it would be largely assumption-driven. I'm not sure if that's what your question is? How are they currently being valued?
Yeah.
Yeah.
Yeah.
For TELUS, yeah, TELUS is at cost plus. That will flip into more of a DCF as we get closer to completion and we achieve a bit more on the leasing side of things. King Portland Centre is fully leased, 425 Viger is a third leased, Adelaide and Duncan is fully leased. All of those would be just straight up DCF less the cost to complete.
Right. For The Well, because it is at 71% pre-lease now, would you start using DCF or is it still pretty far out from that, so you use cost?
I think, because of the retail component, which we are purposely keeping at, you know, 0% leased until we get closer to completion, that will still be a bit more of a hybrid. Cushman would take the leases that we have and not have assumptions for that commercial component, but it is still largely assumption-driven. We would need to get closer to completion to get more of a strict DCF approach. It is still a bit of a hybrid, less the cost to complete.
Right. No, that is helpful. I guess, there is an internal limit of kind of 15% of PUD as a percentage of GBV. It right now is at 8.9%, and I think part of that is the fair value lift. Do you anticipate getting closer to that as you do more DCFs fair value?
Yeah. When we look at our development spending, which as you know, will total CAD 1.2 billion from the beginning of 2018 through the following five years. We do expect that PUD percentage to peak at about 12% in 2020, we expect it to come down. As Michael said, we won't be initiating any large projects in the next two to three years, we wouldn't want to get much north of 12% either. That's where we see it peaking out.
Great. No, that's great. Thanks. I'll turn it back.
Thank you.
We'll now take the question from the line of Matt Kornack with National Bank Financial. Please go ahead.
Hi, guys. I just wanted to quickly touch operationally, your Eastern Canada, and I presume that was Montréal number in terms of same property NOI growth was pretty spectacular this quarter. What's driving that? Is there anything one-time? What is a normal number on that portfolio?
The Montréal same asset NOI was certainly driven by higher weighted average occupancy in the period. Three-month comparison to three-month comparison, we were up about 70 basis points in terms of weighted average occupancy. It's not as much rental growth, although we are starting to see that in Montréal. It was more occupancy take up Q3 to Q3. Going forward, it'll be less occupancy take up and more the smaller rent growth that we will see on renewals and replacements. What would we expect going forward?
My expectation is that Montréal same asset NOI will moderate as we get closer to the 97% that Tom referred to this year. If we're successful at getting to 97%, there will be some growth next year as the leased area converts to occupied and rent-paying area. I fully expect the same asset NOI growth in Montréal to moderate once we've got sort of full economic occupancy at the 97% level running through our income statement. It's really hard to improve, or to generate occupancy gain off a 97% base. We might be able to do that in Toronto, and in fact, we clearly have, but I wouldn't expect to be able to do that as easily in Montréal.
I do expect built-in rent escalation and rent growth in Montréal would allow us to continue to generate same asset NOI growth, just not quite as material as Q3 2018.
Fair. I was recently at a leasing conference in the city. It sounds like for Nordelec, you're doing better than expected in terms of some of your rental rates on new leases there. Is that a fair assessment?
I think it is fair. Nordelec has leased up somewhat more rapidly than we expected at net rental rates, somewhat higher than we initially expected. We have an opportunity at Nordelec, which is interesting. It's currently carried, I think, in our PUD, if I'm not mistaken, its density of around 251,000 sq ft. It was originally envisaged by the vendor as residential density. We now believe, given how well Nordelec has performed as a workspace venue for TAMI users in the city of Montreal, we actually are looking at developing that 250,000 sq ft plus as additional rental workspace at Nordelec.
The results there have exceeded expectation, and we believe, especially once we get the work done that's underway at Nordelec to make it function, the way it needs to for a vast number of users, that we'll be able to expand the office space in that complex.
Matt, the Nordelec, the density that Michael's referring to is in the intensification table on page 37.
Oh, good.
Right. Presumably, with Airbnb locating in a building next to you, a new build, that area's becoming its own little tech office node to some extent.
It is, and it's developing a great vitality and a great vibe. Notre Dame, it's a bit like Queen West. It just keeps going and going and going in that direction. Yes, it's becoming a wonderful node for TAMI users in the city of Montréal.
Sorry. Last question from me with regards to the King and Spadina project and the retail component there. Is it fair to say that you'll lease The Well in advance of actually focusing on that? Obviously, it's a couple of years after The Well's completion. Would you take a similar approach as you're taking at The Well where you wait towards the end of the project before you lease the retail component?
Yes and yes.
Okay. Thanks, guys.
Okay.
There are no further questions at this time. Mr. Emory, I'd like to turn the call back over to you for any additional comments or closing remarks.
Thanks, Ron, and thanks to each of you for participating in our conference call. We'll keep you apprised of our progress going forward. Have a good day. Thank you.
Ladies and gentlemen, this does conclude today's call. Thank you for your participation. You may now disconnect your lines.