Good afternoon, ladies and gentlemen. Welcome to the Dream Office REIT Third Quarter 2018 conference call for Thursday, November 8th, 2018. During this call, management of Dream Office REIT may make statements containing forward-looking information within the meaning of applicable securities legislation. Forward-looking information is based on a number of assumptions and is subject to a number of risks and uncertainties, many of which are beyond Dream Office REIT's control, that could cause actual results to differ materially from those that are disclosed in or implied by such forward-looking information. Additional information about these assumptions and risks and uncertainties is contained in Dream Office REIT's filings with securities regulators, including its latest annual information form and MD&A. These filings are also available on Dream Office REIT's website at www.dreamofficereit.ca. Later in the presentation, we will have a question and answer session.
To queue up for a question, press *1 on your telephone keypad. Your host for today will be Mr. Michael Cooper, Chair and CEO of Dream Office REIT. Mr. Cooper, please go ahead.
Thank you very much. Good afternoon, and welcome to Dream Office REIT's third quarter conference call. Today, I'm with Jay Jiang, our CFO. I'd like to make a few comments about the business. Jay will address our results, and once he's complete, we'd be happy to answer your questions. We're pleased to discuss our progress in our business over the last quarter. We're currently preparing our business plan for next year and subsequent years, and we'll have a lot more information for you at our year-end call. Having said that, there's a number of things that have come up that we've disclosed, we'd like to give you a little bit more information to help understand what's new. Our current portfolio consists of 34 buildings, plus three that will have development. Of these 37 buildings, 19 are in downtown Toronto, which represents the vast majority of our value.
We own three in the GTA, one in Montreal, three in Calgary, although two of those buildings make up the Barclay complex, one in Ottawa, a parking lot in Saskatoon, and an office building in a very desirable suburb of Kansas City. One of our GTA assets is the Sussex Centre, which is in the heart of downtown Mississauga. There's a building boom all around the building, and there will be a new train station in front of the building. We are increasing occupancy currently, and rates are also increasing, but ultimately the building will benefit from a substantial improvement as the density surrounding the building increases. In addition, we've made an official plan amendment application for our Eglinton and Birchmount site, which will benefit from the opening of the Eglinton Crosstown Subway and LRT in 2020.
The site is in the planning area called the Golden Mile area, and it's adjacent to sites owned by RioCan, Madison, KingSett Capital and Choice Properties REIT, and SmartCentres. This entire area with over 100 acres of land will be redeveloped in the next 10 years or so, and Dream Office will benefit from the higher use of these lands on its 15 acres. We've considered selling 700 de la Gauchetière because we only have one asset in Montreal. It's a large stable asset, but we debate whether we prefer to repatriate the equity to pay down debt, invest in other properties, or continue to own the high-class property. We believe that sometime in 2019, we'll make a decision on that. In Calgary, we own Kensington House, which is a building, it's just by the river. It's a really cool area. It's our head office out West for our land and housing business in Dream Unlimited.
It'll be a valuable residential site one day. It's got a lot of presence on the street. It's got a lot of land. In the meantime, we're generating very good returns on our cost base. We also own Barclay Square, which is extremely well located, well leased, and we believe it's a good asset to weather the current market disruption. When things settle down, we think there'll be lots of upside on it, but that's really the Calgary exposure we want to have. We have 19 buildings in downtown Toronto, which are very much in demand, which we think we can continue to improve upon. We have nine buildings in the area of Bay and Temperance that we are in the process of improving into what we think of as luxury boutique office buildings.
The first example is 357 Bay Street, that we're going to completely gut and renovate and turn into a building that can attract among the highest rents in the city. We've entered into a lease with WeWork to make this their Canadian head office, and they will also be spending significantly to make the building a showcase for their organization. We are in the process of creating plans for each of the other eight buildings in this district so that we can command similar premium rents over time. Again, we'll have more details for you on our plans for this area in February. Even prior to transforming our portfolio in downtown Toronto, we have 98% of our space committed, and we're achieving 20% increase in rents or more.
However, we believe that there's a demand for the type of buildings we own and that capital invested will be well rewarded over the short and long term. We intend to invest in all of our downtown assets, as we want excellent air quality, elevators, and all other systems, and want to create more exciting aesthetics in the public areas. However, our start will be concentrating on the Bay Temperance assets first. We're making progress on our 250 Dundas Street West application. While it's still a year or two away from an approval, our interactions so far have been very encouraging. We're also working on a development plan for 212 King Street West. We hope to have a design created in the next six months and then start to work with the city and community to seek approval.
This building is at the edge of the financial and cultural centers of the city. We believe it has a very exciting development future. As you know, a few years ago, we decided to concentrate our portfolio on very high-quality assets that have a better future than their past. We've sold 140 properties since 2015 for almost CAD 3.7 billion and used the proceeds to pay down debt and reduce our units outstanding. We have four assets that are under contract, which will close shortly, and that leaves about eight assets to sell, including Sherwood Place. We have six in Saskatchewan, a CAD 3 million asset in Alberta, one asset in Southwestern Ontario.
The total value of all these assets is about CAD 150 million at IFRS. We think that although there are a few tough assets to sell that may take time, ultimately, we don't think the sales price is significant for the company. We're pretty pleased with the progress we've made. We're weathering the increases in interest rates relatively well, as the rental rates in our buildings are driving revenues faster than the cost of debt is increasing. We believe that we'll continue to grow our value as we seek individual asset optimizations. While we have concerns about the broader economy, we are trying to manage risk by improving the quality of our assets and focusing on our best locations in the best market in the country, we're also looking to reduce our overall debt level.
While we will buy some units back over time, we have accomplished our major goal of rightsizing the equity base of the company. Asset value increases are meaningful. Jay, do you want to go over the financials?
Sure. Thanks, Michael. Good afternoon. Our FFO this quarter was CAD 0.40 per unit, relatively in line with Q2. Our net asset value per unit was CAD 24.40, an increase of 2% since last quarter and up 9% since the same quarter prior year. This increase was mainly driven by a value uplift in our downtown Toronto portfolio due to higher NOI and rental rate assumptions from leasing, while cap rates for the buildings we hold have remained flat. We've reduced our shares outstanding from 81 million units this time last year to 65 million as of quarter end. Increases in the value in Toronto have had a more meaningful impact to the value of our company. During the quarter, we sold IBM Corporate Park in Calgary for CAD 97 million, or approximately CAD 272 per sq ft, with most of the proceeds applied to debt repayment.
That contributed to a decrease in our leverage of about 190 basis points since quarter end to be at 46.2% on September 30th. Interest coverage remained flat at 2.8 times since Q2 and net total debt to adjusted EBITDA fair value declined from 9.3 to 9.1. Over the next few months, we are targeting to close about another CAD 100 million of assets in Western Canada, which has about 50% LTV. The equity repatriated will be mostly used to repay debt. Downtown Toronto represented about two-thirds of our gross portfolio value at quarter end. The leasing market continues to perform very well. Comparative properties NOI was down 5.6% year-over-year. That was mainly attributed to the vacancy at 438 University. If we exclude that building and 357 Bay, which is currently under development, the comparative properties NOI would've been positive 4.2% year-over-year for the quarter.
Net rents that took occupancy during the quarter were approximately 10% above expiring. Now note that these were leases signed in prior periods. We currently estimate that market rents are about 17% above in place. We have over 200,000 square feet of positive absorption in 2018 and are currently over 98% in place and committed. In 2019, on 400,000 square feet of GLA expiring at CAD 22.73, we currently have over 70% of that addressed already. Our rents are consistent with the spreads that we reported. We remain confident in leasing out the remainder in the first half of 2019. In Mississauga and North York, the 240,000 square feet expiries in 2019 represent mainly one tenant at 5001 Yonge, which we have already renewed at par relative to expiring. That was about CAD 24. For Q4, we expect our FFO per unit to be around CAD 0.38 per unit.
At 438 University, we'll have Infrastructure Ontario taking occupancy just under 200,000 square feet in December. Now, one month of contribution from that lease is offset by the IBM Corporate Park disposition in August and also the properties we expect to sell in Q4. There will be some variability in the results dependent on if and when the closings happen. As we continue to sell non-core assets to repay debt or reinvest in our core business, our leverage will decline. Our goal is to high-grade average portfolio quality and improve the stability and safety of our business. We'll give formal guidance next quarter for 2019. We have also highlighted two of our projects currently in development and provided additional disclosures on the capital requirements and the estimated returns. At 357 Bay, we have vacated the building and commenced the full reconstruction.
We will invest approximately CAD 29 million into the building. WeWork will also invest a substantial amount of capital into the space. WeWork is expected to take occupancy in the second half of 2020 for a minimum term of 15 years, with net rental rates starting at CAD 45 per square feet. Now, originally, in 357 Bay, it was partially occupied. We were already looking at investing significant amounts of capital on spec into the building to elevate it to best-in-class. With the WeWork deal, the year one cap rate against the current value and incremental capital is about five and a half. That's higher than the carrying cap rate of the building without the improvements or the lease. With the deal in hand before we commenced the work, we have effectively reduced the risk and the downtime.
We also introduced the 1900 Sherwood deal briefly in the second quarter. We did an 18-year lease with Co-operators to consolidate their operations and over 650 employees in Regina. The capital we put in will change the asset, including a 13,000 sq ft expansion, increase of 180 parking stall, a new HVAC system, curtain wall, and other upgrades throughout the building. Our estimated year one cap rate is approximately 8%. The return on equity is attractive because it creates above-average cash yield for a very long period of time if we choose to hold the asset, or if we choose to sell it in the future, we think it will be much more desirable for a prospective buyer because of the quality of the building, the wallet, and the covenant.
We believe each deal improves the value and the long-term cash flow profile of the building and collectively contribute towards making our company better and safer over the long term. We will continue to have a financially prudent and holistic approach to our capital program and provide additional guidance on capital allocation on our next call. I'll now turn it back to Michael for the Q&A.
Thank you, Jay, for your premier performance. If there are any questions, we'd be happy to answer them now.
Thank you. We will now begin the question and answer session. If you have a question, please press star then one on your touch-tone phone. If you wish to be removed from the queue, please press the pound sign or the hash key. There will be a delay before the first question is announced. If you are using a speakerphone, you may need to pick up the handset first before pressing the numbers. Once again, if you have a question, please press star then one on your touch-tone phone. I'm standing by for questions. We have a question from Michael Markidis. Mike, go ahead with your question.
Hi. Thanks, everybody. Jay, can you remind me what the gross rent on 438, the Infrastructure Ontario lease is going to be when that kicks in, please?
Sure. It'll be in the low twenties for about seven years. The incremental contribution and income on an annualized basis is about CAD 7.5 million, starting in 2019. The building had some tenants in there, but because the occupancy was low, we couldn't get much back in terms of recoveries and insurance taxes, that will be the delta for next year.
CAD 7.5 million is the NOI upside that you see in 2019?
Yeah, that would be the run rate.
Okay. From that lease. Great. Okay. Clearly, there's a very strong rental market in downtown Toronto, and I see that your market run estimates are rising. Just curious what you guys have seen as well from a landlord and TI package perspective and sort of what range that would look like for a five-year lease today.
They've come down a lot. On renewals, there's almost nothing except for the commission. For new tenants, it really varies based on how much they want us to contribute, but I wouldn't be surprised if they're down a third or more from two years ago.
Okay. 250 Dundas West, it sounds like you think you're still another year or two away from getting appropriate zoning there. I don't know if it's going to LPAT or what's happening there. What would be the next major milestone? Is there a community meeting that you have to have? Just curious.
My kid goes to a school, and they weren't able to get the school open in time for September because they couldn't get a permit. My neighbors do an extension, can't get a permit. The city is pretty much completely useless. When we talk about times, you should know that it's Look, everybody's dealing with this. It is impossible to get things done. When you get them done, they're very, very valuable. I'm not even going to pretend to say that we're in charge of the timing. We've been meeting with the city, and we've gotten good feedback on our plan. That's very encouraging. We are having a community meeting in the next couple of months, and we've gotten a response from the city on our plan, so it's coming together.
Yeah, it'll probably be a year or two before we have significant progress.
Okay. Last one from me before I turn it back. Jay, just with respect to the, I think it's CAD 434,000 of NOI from the properties that are now under development. Is that going to trend lower or evaporate as we go through 2019? Will it stay relatively stable? I'm just thinking, I think in the one that you have in Saskatchewan, that the existing tenants are going to stay in place while you do that work, but I would assume there's some loss there from 357.
Yeah. I'll break it out in detail. 357, it was already partially occupied. In Q3, I think the income, including PM recoveries, was only about CAD 120,000. The building is fully vacant now, so that'll just be down over the course of 2019 until the second half of 2020. At 1900 Sherwood, I think there was still income in there. It's half occupied, and those tenants will stay in place while we redevelop the building. That'll still be there.
Okay. Thank you. I'll turn it back.
Our next question comes from Mark Rothschild. Go ahead, Mark.
Thanks. Good afternoon, guys.
Hey.
In regard to the asset sales, so you had spoken in the past about additional asset sales in Calgary and I see you sold to IBM. Was that the last one you anticipate selling? You had indicated you planned on keeping a core portfolio in Calgary. If you could also comment on the likelihood, if anything's changed, about selling your property in Montreal, which I think it had been reported it was listed for sale.
In Calgary, I think what I said was, we're looking to Barclay Centre and Kensington being our only assets there. I think they're all done except for a partial interest in an asset for CAD 3 million. We're just going to have Barclay Centre and Kensington. Is that a complete answer on that?
Yep. Thank you.
Sorry. Then on 700 de la G, we have been marketing it selectively. We took it out during the peak of the NAFTA uncertainty, and there's been some stuff going on with tenants that are coming up. Andrew's working away on that. We're going to see how things settle and then decide whether we sell it or keep it.
Okay, great. Then, with the move into higher price NAV, which is up once again, do you believe that the appraisers are gradually catching up to the rising value of office properties in downtown Toronto? Do you think the increase in rental rates fully captured in that, or how do you look at that?
Yes and no. I think in general, in a hot market, there's probably going to be a bit of a lag. I think the cap rates are there. The cap rates haven't really changed since we appraised the entire portfolio in 2017. I think what will happen is typically at year-end, when they look at stabilized NOI or let's call it 10-year DCF model, you'll drop the first year, you'll add the 10th year on top of that. That's where you'll see a lot of the pickup in NOI. With the way things are and the spreads that we're seeing, you'll probably still have a bit of tailwind on the NAV.
I would look at it a bit different. Not disagreeing, but differently. I think that the question becomes what's going to happen going forward with the interest rates rising and stuff like that. I think we're in a good position right now. The rental rates are increasing much faster than interest rates, but we could see some increase in cap rates, and the valuation will have to do with how much the rent goes up. We could end up crossing. I think the appraisers are catching up, and we'll see what happens to values going forward.
Okay. Thank you so much.
Our next question comes from Matt Kornack. Go ahead, Matt.
Good afternoon, guys. Just with regards to next year, this may be premature because it sounds like you're going to provide guidance. Other than the CAD 7.5 million that's coming online, are there any other major leases that are coming online or any major ones coming offline outside of the development portfolio?
No. I think on my prepared remarks, I gave some commentary on all the expiries that were going to happen in downtown Toronto and in the GTA. If you apply those assumptions, that will help you on the NOI side. We also commented that we're looking to sell some assets, so that will be offset, but with the proceeds used to pay debt, so you might lose a bit of spread there. We'll give more fulsome guidance in February.
Yeah. We had it broken down in our mind to the downtown Toronto portfolio. What it's going to do, it's going to add a lot more than just 438 University. I think that what Jay is saying is if you take a look, with the not being certain which assets we'll have in for both periods, it's a little hard to tell what the overall one is. As far as the core goes, it's going to be a lot more increases than just 438 University.
Okay, fair. With regards to 700 DLG, if you do end up selling that, it sounds like the near-term net proceeds would be used to repay debt. Would you entertain buying incremental assets in this market with some of those proceeds?
The only assets we would look at are ones that are additional to our development or existing assets. I'm not saying flat out, generally when we see transactions now, we wouldn't use our cash. We wouldn't buy another asset downtown at where they're trading. I don't think it works for us. We would look at paying down debt, putting them back into our properties or buying back stock. I think those are the three uses we would see.
Okay, fair enough. With regards to the WeWork space, if I understand you, that's their corporate head office. That's not a WeWork co-working property.
It'll be both.
Okay.
It'll be their corporate head office, and there'll be space there. From what we believe, there'll be space there as well for co-working.
I know in the initial, when you guys were looking at taking the space you were adding to the top, is there any addition as part of the renovation, or is it just within the existing frame?
There's going to be most likely some work on the roof to make it a nice space. I'm not sure if it's going to be enclosed or not. We're finalizing some of the plans inside. There won't be really more office space added. There's not another three floors or anything. It's existing space.
Okay. Jay, I apologize if you mentioned this in your beginning remarks. Do you have a sense as to what the capital outlay is for the anticipated near-term projects over maybe the next year?
Outside of 357 and 19, we're doing that as part of our December strategic meeting. We're not quite done the work yet, that will also be in February.
Okay, great. Thanks, guys. Jay, congrats on the appointment. Well deserved.
Thank you.
Our next question comes from Sam Damiani. Sam, you can go ahead with your question.
Thank you. Good afternoon. Just on the dispositions, just trying to understand high level. You've got CAD 100 million on the books held for sale. Those will ultimately gone. There's another CAD 150 million beyond that, I think, is what I heard earlier. Then there's 700 DLG. Does that basically complete the picture on sort of disposition potential over the next couple of years?
Well, it's by far the vast majority, for sure. That'd take us to CAD 4 billion.
Yeah.
We'll look at every asset. The 19 downtown we're keeping for sure. We might sell a different one, keep one, but that will be substantially complete.
Okay. What sort of leverage do you envision sort of operating the REIT at given it sounds like a steady and maybe growing component of development activity. Are there percentage LTV or debt EBITDA? Where would you like to see the balance sheet over the next couple years?
Sure. I won't commit to a timeline, but I think long-term, if we had it around 40% on the leverage and preferably get it down there through debt repayment and increase in the income on the properties as opposed to cap rates. On the cash flow side and the income side, probably be closer to eight times and three times.
Okay. Appreciate that. Will you be capitalizing interest as part of these development initiatives?
I'm sure on the developments we will, yeah.
Okay.
When I say I'm sure, it's like we haven't done it before. No, I just don't know why you would expense it when it's a proper interest incurred to When you do a development pro forma, you got the interest in it. It's part of the overall cost of the development. We'll let you know next quarter.
Yeah. It's not entirely unprecedented. I've seen both. Okay, thank you.
Thanks a lot.
Once again, if anyone has a question, you can press star then one on your touchtone phone. We have no questions at this time. I'll hand the call back to Mr. Cooper.
Thank you very much. I'd like to thank everybody for spending some time with us when you've got so many other things to do this quarter. Thanks a lot. If you've got further questions, please don't hesitate to call Jay or myself. Thank you.
Thank you. Ladies and gentlemen, this concludes today's conference. Thank you for participating. You may now disconnect.