Good morning. My name is Stephanie, I will be your conference operator today. At this time, I would like to welcome everyone to the Choice Properties REIT Second Quarter Results Conference Call. All lines have been placed on mute to avoid any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star, then the number one on your telephone keypad. If you would like to withdraw your question, press the pound key. Thank you. Kim Lee, you may begin your conference.
Thank you, Stephanie. Good morning, everyone, welcome to the Choice Properties REIT Second Quarter 2018 conference call. This call is also being webcast simultaneously on our website at choicereit.ca. I'm joined here this morning by Stephen Johnson, President and Chief Executive Officer, Rael Diamond, Chief Operating Officer, and Mario Barrafato, Chief Financial Officer. Before we begin today's call, I want to remind you that by discussing our financial and operating performance, and in responding to your questions, we may make forward-looking statements, including statements concerning Choice Properties' objectives, its strategies to achieve those objectives, as well as statements with respect to management's beliefs, plans, estimates, intentions, outlook, and similar statements concerning anticipated future events, results, circumstances, performance, or expectations that are not historical facts.
These statements are based on our current estimates and assumptions and are subject to risk and uncertainties that could cause our actual results to differ materially from the conclusions in these forward-looking statements. Additional information on the material risks that could impact our actual results and the estimates and assumptions we applied in making these statements can be found in our 2017 annual report and management's discussion and analysis related thereto, together with Choice Properties annual information form that are all available on our website and on SEDAR. With that, I'll turn it over to Stephen.
Thank you very much, Kim. Good morning, everyone, welcome to all. Thank you for taking the time to attend our second quarter conference call. I would like to extend a special welcome for the former CREIT unit holders who are now investors in Choice. Welcome to Choice. Obviously, the most significant event of the quarter was the combination of the CREIT business and Choice Properties. This was a transformational transaction for both entities that resulted in the creation of Canada's largest and preeminent real estate investment trust. From a high level, Choice now has an enterprise value of just under CAD 16 billion. Net operating income on an annualized basis is just over CAD 900 million. This is generated from a portfolio of high-quality real estate assets, which in aggregate totals approximately 67 million sq ft.
Most importantly, we expect that this combined portfolio will provide reliability and income stability for our investors over a very long-term investment horizon. The combined entity also has a very significant development program. There are numerous development opportunity on sites already owned, ranging from simple intensification projects to industrial, to residential, to large-scale mixed-use projects. We will provide more detail to you in future quarters as we determine how these opportunities should be prioritized beyond what is already underway. Rael will update you in a few minutes on projects that we already have underway. In addition to both the high-quality portfolio of income-producing properties in the development pipeline, Choice will continue to benefit from the support and commitment of both Loblaw and George Weston as tenants, investors, and strategic partners. As well, we expect these relationships will create significant ongoing opportunities for our REIT.
Since the announcement on closing the merger transaction on May the 4th, our management team has spent a considerable amount of time working on the integration. This involves many important steps, each of which must be completed in the context of a business model and strategy for the combined entity. In addition to combining our real estate portfolios, the merger also included the joining together of two of Canada's leading real estate teams. Our focus has been on aligning the organizational structure to further enhance our operating platform and our capabilities. We have organized our groups to foster collaboration and teamwork and to strive for excellence. As part of this process, we identified areas of redundancy and overcapacity, and as a result, we have reduced the combined workforce by just over 8%. This is certainly a difficult part of the merger.
I would like to sincerely thank those employees who were impacted, and I wish them every success in their future endeavors. Most significantly at this stage, we are positioning ourselves for future success, and we now have a wonderful platform to build upon. In terms of the financial results, apart from the merger transaction, it was an in-line quarter, and Mario will now provide you with some high-level details. Mario?
Thank you, Stephen, and good morning, everyone. I'd like to start with an overview of the acquisition transactions and the impact on our balance sheet. I will follow with a review of our key performance metrics. The most significant item in the quarter was the acquisition of CREIT. From a balance sheet perspective, the value attributed to the net assets acquired was CAD 3.7 billion. The total consideration paid was a combination of CAD 1.65 billion in cash and CAD 2.05 billion of equity, which reflects the issuance of 183 million Choice Properties units at the May 4th trading price of CAD 11.25 per unit. As part of the purchase price allocation, most of the value was assigned to the acquired investment properties, except for CAD 30 million, which was assigned to certain management contracts and reported as an intangible asset. There was no goodwill recorded on the transaction.
To finance the cash portion of the acquisition, Series K and Series L senior unsecured debentures were issued at closing for proceeds of CAD 1.3 billion at a weighted average interest rate of 3.9% and a term to maturity of 8.4 years. Plus two unsecured variable rate term loans totaling CAD 800 million were obtained at a weighted average term of maturities of 4.8 years. As well, a new five-year CAD 1.5 billion revolving credit facility was arranged, replacing all existing credit facilities for both CREIT and Choice. This provides us with liquidity and financial flexibility moving forward. Concurrent with the acquisition closing, Choice converted all outstanding Class C LP units held by Loblaw with a face value of CAD 925 million into 71 million exchangeable units based on a 20-day VWAP of CAD 11.66 per unit, with the balance of CAD 98.7 million being paid in cash.
In conjunction with this conversion, a CAD 37 million accounting loss was recorded, which reflected the accelerated amortization of a debt premium that had been netted against the face value of the Class C LP units. Lastly, the transaction cost expense in the quarter relating to the acquisition was CAD 108 million. Collectively, these three items, the issuance of equity to CREIT unit holders, the net impact from the exchange of the Class C units, and the transaction costs incurred account for much of the change in the net asset value for the quarter. Before I go over our key performance measures, I wanted to note that the consolidated results for the quarter consist of a full quarter of the existing Choice operations, plus the contribution of the former CREIT business from May 4th onwards.
Fundamentally, in merging the two businesses, there were no material accounting policy differences between Choice and CREIT. With respect to the combination, the most noticeable impact on our results is the positive contribution from a reset of the straight-line rent calculation for the CREIT-acquired assets, as well as a mark-to-market premium on the debt assumed. Presentation-wise, in our MD&A, you will notice that we now have three operating segments. We've reintroduced AFFO as a key performance indicator, and we've applied select uses of proportionate share accounting to discuss our results. Our reported funds from operations for the second quarter was CAD 157 million, or CAD 0.272 per unit diluted, which excludes the accelerated amortization I referred to earlier. Our FFO includes a lease surrender revenue of CAD 10.2 million, which is partially offset by net financing charges of CAD 3.1 million relating to funds raised prior to the closing of the CREIT acquisition.
Excluding these one-time items, FFO per unit diluted for the quarter would have been CAD 0.26 per unit, relatively flat compared to the same period last year. Looking now at adjusted funds from operations for the second quarter, we reported CAD 140 million or CAD 0.243 per unit diluted. Due to timing of capital spending, reported AFFO is higher in the first half of the year. On average, we estimate operating and leasing capital to be approximately CAD 20 million-CAD 25 million per quarter. As such, capital spending will ramp up over the latter part of the year, and AFFO will trend lower. Overall, our financial metrics remain solid. Using amounts from our proportionate balance sheet, our debt to gross book value is 47%, and normalized leverage and interest coverage ratios are 8 and 3.2 times respectively. These measures are further backed by a pool of unencumbered assets of CAD 11 billion.
Overall, we're very pleased with our second quarter results, and we look forward to Q3, which is the first full quarter for the combined entity. I will now turn the call over to Rael.
Thank you, Mario, and good morning, everyone. As Stephen mentioned, I'll provide a brief overview of our combined portfolio and an update on transaction activities. Our consolidated portfolio includes 757 income-producing properties comprising 67 million square feet of GLA. The portfolio is located across Canada with a concentration in Canada's largest markets. Our retail portfolio is primarily focused on necessity-based retail tenants. This portion of our portfolio is the foundation of our reliable cash flow with potential for incremental growth through intensifications. One of our key competitive advantages is our strategic relationship with Loblaw, Canada's largest retailer. This relationship provides Choice with an exceptionally strong anchor tenant at many of its retail sites, and the long-term nature of the leases provide us with stable, secure, and growing cash flows. Our industrial portfolio includes 119 properties and approximately 16.6 million square feet of GLA.
The portfolio includes Loblaw distribution facilities on long-term leases and high-quality distribution and warehouse facilities in key industrial markets across Canada that readily accommodate a broad range of tenants. Industrial markets across the country continue to operate with relatively healthy fundamentals. In terms of industrial development, Choice owns 85% of a recently constructed 665,000-square-foot modern distribution facility on Peddie Road in Milton, Ontario. Milton is in the GTA West sub-market, one of the strongest industrial markets in the country. We have a conditional deal done for approximately 500,000 square feet of the building and strong interest on the balance of the space. Assuming we firm our conditions, we hope to have more to disclose next quarter on key terms of the deal. The performance of our office portfolio continues to vary in our two largest markets. The office leasing market in the GTA remains strong.
Currently, there's significant tenant demand and limited availability. Our portfolio is almost fully occupied when considering all committed leasing. Conditions in the Calgary office market remain difficult. The imbalance between supply and demand persists, and market vacancy levels remain high. We continue to focus on working with our existing tenants to complete early renewals. Finally, I'd like to speak about residential. Our residential platform provides an opportunity to further diversify our portfolio. Choice has been working on expanding our residential platform. Currently, we have three residential rental assets that are income producing and another seven residential rental assets that are currently in various stages of development. We also signed a contract to acquire another residential rental development site, and I'd like to provide some further details on that transaction.
In the quarter, we announced that we had entered into an agreement to acquire a 50% interest in a development parcel in Toronto to develop a purpose-built rental project. The transaction is expected to close in the first half of 2019. The development parcel is approximately 0.9 acres located between Grosvenor Street and Grenville Street in Toronto. The property is exceptionally well located and is within walking distance to College subway station, universities, hospitals, and the downtown financial core. The property is being acquired in partnership with Greenwin from the province of Ontario as part of the Provincial Affordable Housing Lands Program. Choice and Greenwin plan to deliver a two-tower, purpose-built rental community with approximately 700 units or 350 units at our ownership share. 30% of the units will be maintained as affordable rental housing for a period of 40 years. We're excited about our residential initiative.
When complete, these projects will represent approximately 1,500 units at Choice's share. Looking forward, we see this initiative as a key part of our strategy. That concludes my comments. I would now like to pass it back to the operator for questions.
At this time, I would like to remind everyone, in order to ask a question, please press star then the number 1 on your telephone keypad, and we'll pause for a moment to compile the Q&A roster. Your first question comes from Sam Damiani with TD Securities. Please go ahead.
Thank you. Good morning. First, congratulations on the transaction being completed. I know you've been a bit busy with the integration and whatnot. I just wanted to touch on the balance sheet with the leverage coming in perhaps a little bit higher than originally expected. Stephen, what are your thoughts on the level of leverage and, with the active development pipeline already underway, what are your thoughts on dispositions or other means to reduce leverage and over what timeframe?
Hi, Sam. It's Mario. I'll come in first just on the reported leverage. Right now, like I said, we're at 47%, and I think part that wasn't known maybe at the time of announcement was that there'd be the additional CAD 98 million on closing for the Class C. I think that explains partially maybe why the leverage today might be a little higher than your expectation a few weeks ago.
Sam, it's Stephen. Good morning. Long term, we're in the process of putting together a long-term business model, long-term strategy. We'll have more on that basically as future quarters evolve. We don't have a specific target at this stage.
Okay. Maybe, Rael, just on the residential. VIA123, could you update us on, I guess, the lease-up status there and the rents that you're getting?
Yeah, sure. We approximately 62% leased at the moment. We currently doing about three or four leases a week. We're achieving rents between CAD 2.80 and CAD 2.90 a foot. We would expect that the asset will be stabilized by Q1 of 2019.
Rents achieved, Stephen, Sam, rents achieved are much higher than our original pro forma.
That's fantastic. Okay, great. I will turn it back. Thank you.
Your next question comes from Jenny Ma with BMO Capital Markets. Please go ahead.
Thanks. Good morning, everyone.
Good morning, Jenny.
I was wondering, Stephen, you made some comments about the reduction in the workforce. Is there any impact on acquisition-related costs or G&A in Q3, or was that all taken in Q2?
There'd be amounts in the transaction costs, Jenny.
Okay. I guess the G&A number for Q2 then is a G&A-only number. All those personnel-related costs would've been taken in the CAD 108 million?
Yes, that's correct.
Okay. Then for Q3, I guess there would be a little bit more of a creep up given that there's a month that the transaction was not in place in Q2. Is that fair as far as the run rate goes?
There'd be an adjustment to every line item for a month, yeah.
Okay. Gotcha. Now that the portfolio has been integrated for a couple of months, have you taken the time to look over the whole portfolio to see if there's any sort of assets that you think are non-core to the portfolio that you could prune over time, or is it still early days for that part of the integration?
Jenny, it's Stephen. Certainly, we have 750 odd properties, and we haven't looked at everything yet. Certainly getting familiar with the portfolio, we have identified some assets that are non-strategic, we don't have a specific divestiture plan in place at the present time. That'll again follow basically as we put our business model and strategy in place. There are certainly some non-core assets, non-strategic assets that over time we will divest.
Would that be from generally the retail side, or would there be any from the CREIT portfolio that would fit into that category?
In CREIT, we had an ongoing divestiture program where we culled things that were just over time. As we evolve as a business, some of the assets we acquired many years ago no longer fit for us in terms of the core objectives of the portfolio. It would be on both sides. It would be both on the CREIT side and on the Choice side.
My last question is with regards to the DRIP, which was recently turned off. I can't recall exactly the rationale for that, when you're thinking about Sam's earlier question about leverage and looking for funding sources, is that something that you guys are considering or reconsidering at this point?
Hi, Jenny. Not right now. The DRIP, when you have to issue units at a discount. Right now, I think we have other sources of capital, and as we finalize our strategy, we'll figure that out. Right now, I think leaving the DRIP where it is is fine, and we don't need the capital to run what we have in progress right now.
Great. That's all for me, I'll turn it back. Thanks.
Thanks, Jenny.
Your next question comes from Joanne Rodriguez with Raymond James. Please go ahead.
Hey, guys. Stephen, you talked about it a little bit, at the beginning in terms of integration. I guess I was just wondering, in terms of the list of high-level things that you guys have to do as part of this integration. You talked a little bit about turning assets, integrating the IT systems. What have you guys done up to this point, and what are the big issues still to tackle?
Look, there's many issues. Obviously, the personnel organization is front and center. The consolidation of offices will be considered in terms of cities where we have two offices, combining those offices, if that is determined to be functional. The integration of our information systems is a big item on our list, and we're spending a considerable amount of time on that. Those are the major items, and beyond that, basically it's really just focusing on the people and focusing on the assets.
Okay. Then maybe for Rael. On the residential side, where are you guys sourcing the new residential deals that are coming to you? Are they being brought by Greenwin? Then, I guess, how many kind of external residential land parcels or projects can we expect you guys to either acquire or start working on kind of annually in concert with the residential projects you guys will be working on the properties you already own?
As far as where the original projects came from, it came from a variety of places. Primarily through the relationships or on-market transactions. The one with Greenwin we mentioned was acquired with Greenwin from the Province of Ontario through a competitive process. Stephen mentioned it in his script that we're going to be looking at all development projects, including the mixed use, and we'll give you greater clarity in future quarters.
Okay. I'll turn it back. Thanks.
Thank you.
Your next question comes from Pammi Bir with Scotia Capital. Please go ahead.
Thanks. I think that was me. Just a quick question on the residential intensification opportunities. Can you maybe just comment on where you are in terms of prioritizing those projects?
It's Stephen. That's certainly a big part of the integration. As we mentioned, we have a number of projects that we're committed to start and underway. In terms of future densification on sites, we're in the process of prioritizing that. Over the next couple of quarters, we'll give you more clarity on that. Right now, we have certainly plenty on the way, basically, that is moving along and in progress as we speak sort of thing.
Stephen, would the intent be to provide sort of that full list? Thinking back to the outset of when the transaction started, there were 60 sites, I guess, identified. Is the intent to provide disclosure on those specific sites? Do you have a rough sense of what the potential density and economics could be at this stage?
The two questions. In terms of future disclosure, we'll disclose what we think is kind of relevant and where we have certainty or a reasonable degree of certainty. Trying to prioritize 60 projects and so on, and disclosing where we are on those would be not rational. We wouldn't be able to get to a situation where that would be meaningful information for our investors. We will disclose whatever we can basically as it becomes available with our quarterly results.
Okay. Maybe just looking at the internal growth outlook, I guess, the CREIT portfolio will be in the 2019 numbers for, I guess, only a part of the year. How do you see the same property NOI profile shaping up for 2019?
Hey, Pammi. Well, I think, the way the P&L is classified, I think, the same asset will be primarily, the former, the Choice assets. I think there, if you go on a cash basis, you have 1.5% step rents. As we're now starting our capital spending, we'll have an increase in recovery revenue, and then there's also some ancillary leasing. I could see that being in the 2 to 2.5% range. The CREIT portfolio will be primarily in the transaction side, and I think, as we've talked about before, where we'll have growth in retail and growth in industrial. As we get into 2019, we'll see Calgary office put pressure on that. We see ourselves kind of where we were before being kind of flat to maybe plus or minus a bit, positive or negative.
I think the organic growth from occupancy or rental rates from the CREIT portfolio is pretty muted, and the growth is going to come from the development side.
Okay. Thanks very much.
Your next question comes from Tal Woolley with National Bank Financial. Please go ahead.
Hello. Good morning.
Morning.
Stephen, I never covered CREIT on the sell side, but the one thing I always knew about it was that it had a very unique sort of balance sheet and payout proposition for the public markets. You've run that company for a long time in a certain way, and you're taking control of an organization that's maybe not following kind of the same strategy. Do you have a real preference one way or the other for how you want to see this business be run going forward? What sort of conversations, or have you had conversations with Gal en Richard and Darren about recreating that proposition in the public markets with Choice?
I think philosophically, what we developed at CREIT was attractive to the people you mentioned. Long term, in terms of the business model and strategy, we're in the stages of formulating that. Generally, you have a conservative view of how the business should be run. That means, where the leverage is, where the payout ratio is, and so on. As we kind of get more clarity on what's doable with the combined entity and what's practical and what kind of timeframe, we'll speak to you that over subsequent quarters. Generally, my personal views are not changed. We're just in a larger, different entity. Basically our views will be sort of consistent with what we have in that entity. Meaning the stability of the cash flow, the strength of the assets, and the strength of the sponsorship.
We'll develop a new business model and new strategy that will take into account those factors. Generally, I think you'll see a bias towards a conservative balance sheet and conservative payout ratio.
Okay. One other thing that CREIT did successfully too was completing new square footage in development via mezzanine financing. Is that something you would be looking to do more of, going forward, with all of the new projects you potentially have at your fingertips now?
Yes. The short answer is we will continue to use that as a way to facilitate new opportunities, whether it's IPP or land or development opportunities. The extent of which basically is to a large extent driven by our appetite at the time and driven by the strength of the opportunity. Certainly it's worked well for us, exceptionally well for us, that program. We will continue to use that as appropriate.
Okay. My last question is just on the development team. Obviously, the pipeline looks probably poised to expand somewhat going forward. Do you need more development staff? What I also can't remember, too, is are there any remaining real estate execs within Loblaw that are not within Choice as well? Is that some expertise that you can tap to as well?
Loblaw's does have its own real estate people, we work in a very collaborative way with them. In terms of our own group, future staffing, kind of in process basically, in terms of how we add. It's likely we will have to add to that group, it's early days yet. As I mentioned earlier, just getting your arms around and trying to corral the numerous opportunities we have. Which is the good news. We have kind of so many opportunities, just getting our head around those and kind of determining how we should prioritize them is one of the significant events that we will be focused on over the upcoming months. The bottom line is we will likely add to that group over time.
Okay. Thanks very much for your time. Appreciate it.
Okay. Thank you.
Your next question comes from Sam Damiani with TD Securities. Please go ahead.
Thank you. Just a couple follow-ups. Maybe picking up where we just left off there on the development pipeline. Listed as number 1 of the major mixed-use redevelopments is Golden Mile, and it did get some attention on conference calls over the past couple of years. I wonder if you could just give us an update on the status of the application, zoning, and site plan process at this point. I have a follow-up question as well.
Yeah. Sam, there's no significant update from what the Choice management team disclosed at the last quarter and last conference call. The process of entitlement is continuing and ongoing, there's no significant update to report at this stage.
Just lastly, there were some Loblaw lease cancellations in the quarter. Can you perhaps give a bit of color in terms of the circumstances and the reasons Loblaw decided to cancel those leases?
Sure. Hey, Sam. I guess in 2015, Loblaw had noted that they were going to close certain stores. They continued to pay rent, in the meantime, we were figuring out whether to sell the properties or we could redevelop them. One property was sold, and so the lease was terminated. On two other ones, there's redevelopment opportunities, hence the leases were terminated there, now we're moving on to a new use for the property.
Would you be willing to identify those two that you're retaining?
I don't have them handy, Sam, but I'll follow up with you later, I guess. They're smaller properties.
Thank you.
There are no further questions at this time. Mr. Johnson, I turn the call back over to you.
Well, thank you everyone again for attending. We're very, very excited about the platform we now have in place and the opportunity that gives us really to create a bigger and better business. We look forward to future calls. Enjoy your weekend, everyone. Thank you for attending.
Thank you. This concludes today's conference call. You may now disconnect.