Earnings Call: Q3 2018

Nov 8, 2018

Quarterly report

Good afternoon, ladies and gentlemen. Welcome to the Dream Office REIT Third Quarter 2018 Conference Call for Thursday, November 8, 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 and 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. 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 3rd quarter conference call. Today, I'm with Jay Jing, our CFO. I'd like to make a few comments about the business, then 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 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 3 that will have development. Of these 37 buildings, 19 are in Downtown Toronto, which represent the vast majority of our value. We own 3 in the GTA, 1 in Montreal, 3 in Calgary, although 2 of those buildings make up the Barclays complex, 1 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 Center, 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 made an official plan amendment application for our Edmonton and Birchmount site, which will benefit from the opening of the Edmonton Crosstown Subway 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, King, Set, Choice and SmartCenters. 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 a higher use of these lands on its 15 acres. We've considered selling 700 to the G 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 and 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 and it's just by the river. It's a really cool area. It's our head office in out west for our land and housing business in Dream Unlimited. It will be a valuable residential site. One day, it's got a lot of presence on the street. It's got a lot of land. And in the meantime, we're generating very good returns on our cost base. We also own Barclays Square, which is extremely well located, well leased. And we believe it's a good asset to weather the current market disruption. And 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 9 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 showplace for their organization. We are in the process of creating plans for each of the other 8 buildings in this district so 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 big temperance assets first. We're making progress on our 250 Dundas Street West application. While it's still a year or 2 away from an approval, our interactions so far have been very encouraging. We are also working on a development plan for 212 King Street West. We hope to have a design created in the next 6 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, and we believe it has very exciting development future. As you know, a few years ago, we started to concentrate our portfolio on very high quality assets that have a better future than their past. We sold 140 properties since 2015 for almost $3,700,000,000 and use the proceeds to pay down debt and reduce our units outstanding. We have 4 assets that are under contract, which will close shortly and that leaves about 8 assets to sell including Sherwood Place. We have 6 in Saskatchewan, a $3,000,000 asset in Alberta, 1 asset in Southwestern Ontario. The total value of all these assets is about $150,000,000 at IFRS. And 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. So 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 and we are trying to manage risk by improving the quality of our assets and focusing on our best locations and 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, so asset value increases are meaningful. Jay, do you want to go over the financials? Sure. Thanks, Michael, and good afternoon. Our FFO this quarter was $0.40 per unit, relatively in line with Q2. Our net asset value per unit was $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, cap rates for the buildings we hold have remained flat. We reduced our shares outstanding from 81,000,000 units this time last year to 65,000,000 as of quarter end. So increases in the value of 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 $97,000,000 or approximately $2.72 per square foot, 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 30. Interest coverage remained flat at 2.8x since Q2 and net total debt to adjusted EBITDA fair value declined from 9.3x to 9.1x. Percent. Over the next few months, we are targeting to close about another $100,000,000 of assets in Western Canada, which has about 50% LTV. Equity repatriated will be mostly used to repay debt. Downtown Toronto represented about 2 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, but that was mainly attributed to the vacancy at 4 38 University. If we exclude that building and 357 Bay, which is currently under development, the comparative properties NOI would have 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 and we currently estimate that market rents are about 70% 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 $22.73 we currently have over 70 of that addressed already. Our rents are consistent with the spreads that we reported and we remain confident in leasing out the remainder in the first half of twenty nineteen. In Mississauga and North York, the 240,000 square feet expiries in 2019 represent mainly one tenant at 5,001 Young, which we have already renewed at par relative to expiring, and that was about $24 For Q4, we expect our FFO per unit to be around $0.38 per unit. At 438 University, we'll have Infrastructure Ontario taking occupancy just under 200,000 square feet in December. Now 1 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. So there will be some variability in the results depending 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 2 of our projects currently in development and provide additional disclosures on capital requirements and estimated returns. At 357 Bay, we have vacated the building and commenced a full reconstruction. We will invest approximately $29,000,000 into the building and WeWork will also invest a substantial amount of capital into the space. WeWork is expected to take occupancy in the second half of twenty twenty for a minimum term of 15 years with net rental rates starting at $45 per square feet. Now originally for in 3 57 Bay, it was partially occupied and we were already looking at investing significant amounts of capital on spec into the building to elevate it to the best in class. With the WeWork deal, the year 1 cap rate against the current value and incremental capital is about 5.5 percent or that's higher than the carrying cap rate of the building without the improvements or the lease. With the deal in hand before we commence the work, we have effectively reduced the risk and the downtime. We also introduced a 1900 share with deal briefly in the Q2. We did an 18 year lease with cooperators to consolidate their operations and over 6 50 employees in Regina. The capital we put in will change the asset, including a 13,000 square feet expansion, increase about 180 parking stall, a new HVAC system, curtain wall other upgrades throughout the building. Our estimated year 1 cap rate is approximately 8%. Now 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 asset or if we choose to sell it in the future, we think it will be much more desirable for prospective buyer because of the quality of the building, the wall 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 and 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 And we have a question from Mike 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 will be in the low 20s for about 7 years. The incremental contribution in income on an annualized basis is about $7,500,000 starting in 2019. The building has some tenants in there, but because the occupancy was low, couldn't get much back in terms of recoveries and insurance taxes. So that will be the delta for next year. So $7,500,000 is the NOI upside that you see in 2019? Yes, that would be the run rate. Okay. From that lease, great. Okay. Clearly, there's a very strong rental market in Downtown Toronto. I see that your market rent 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 5 year lease today? They've come down a lot. So on renewals, there's almost nothing except for the commission. And then 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 2 years ago. Okay. 250 Dundas West, it sounds like you think you're still another year or 2 away from getting appropriate zoning there. I think there was a I don't know if it's going to LPAD or what's happening there, but what would be the next major milestone? Is there a community meeting that you have to have or just curious? Yes. I think that my kid goes to 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. So when we talk about times, you should know that it's I mean, look, everybody is dealing with this. It is impossible to get things done. But when you get them done, they're very, very valuable. So like I'm not even going to pretend to say that we're in charge of the timing. But we've been meeting with the city and we've gotten good feedback on our plan. So that's very encouraging. And we are having 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. But yes, it'll probably be a year or 2 before we have significant progress. Okay. And last one for me before I turn it back. Jay, just with respect to the I think it's $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 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? Yes. So I'll break it out in detail. I mean 357, it was already partially occupied. So in Q3, I think the income including PM recoveries was only about 120 thousand and the building is fully vacant now. So that will just be down over the course of 2019 until the second half of twenty twenty. 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. So that will still be there. Okay. Thank you. I'll turn it back. And our next question comes from Mark Rothschild. Go ahead, Mark. Thanks. Good afternoon, guys. Hey. In regards to the asset sales, so you had spoken in the past about additional asset sales in Calgary AC sold to IBM. Was that the last one you anticipate selling? And you had indicated you planned on keeping a core portfolio in Calgary. And if you could also comment on the likely if anything has changed about selling your property in Montreal, which I think had been reported it was listed for sale? So in Calgary, I think what I said was, we're looking at Barclays Square and Kensington being our only assets there. So I think they're all done except for a partial interest in an asset for $3,000,000 So we're just going to Barclays Square in Kensington. Is that a complete answer on that? Yes. Thank you. Sorry. And then on 7.5 dilajit, we have been marketing it selectively. We took it out during the sort of peak of the NAFTA uncertainty, and there's been some stuff going on with tenants that are coming up. Andrew is working away on that. So we're going to see how things settle and then decide whether we sell it or keep it. Okay, great. And then with the move into IFRS 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? Or do you think that is the are 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. So 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 like I said, let's call it year DCF model, you'll drop the 1st year, you'll add 10th year on top of that. So that's where you'll see a lot of the pickup in NOI. So 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. So 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. So we could end up crossing. Like I think the appraisers are catching up and we'll see what happens to values going forward. Okay. Thank you so much. And our next question comes from Matt Kornack. Go ahead, Matt. Good afternoon, guys. Just with regards to next year and this may be premature because it sounds like you're going to provide guidance. But other than the $7,500,000 that's coming online, are there any other major leases that are coming online or any major 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. So if you apply those assumptions, that will help you on the NOI side. But 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. Yes, we think it broke down in our mind to like the downtown Toronto portfolio, what it's going to do, it's going to add a lot more than just 438 University. And I think that what Jay is saying is if you take a look quickly, not being certain which assets we'll have in for both periods, it's a little hard to tell what the overall one is. But as far as the core goes, it's going to be a lot more increases than just 438 University. Okay, fair. And with regards to 700 De La Gee, 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 mean, I'm not saying flat out, but 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. But we would look at paying down debt, putting them back into our properties or buying back stock. I think those are the 3 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 will be both. It will be their corporate head office and there will be space there. From what we believe, there'll be space there as well for co working. And I know when the initial sort of 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. And we're not we're finalizing some of the existing space. Okay. And Jay, I apologize if you mentioned this in your beginning remarks, but 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 2019, we're doing that as part of our December strategic meeting. We're not quite done to work yet, but so that will also be in February. Okay, great. Thanks guys. Jay, congrats on the appointment. Well deserved. Thank you. And our next question comes from Sam Damiani. Sam, you can go ahead with your question. Thank you and good afternoon. Just on the dispositions, just trying to understand high level. So you've got $100,000,000 on the books held for sale. Those will ultimately gone. There's another $150,000,000 beyond that, I think, is what I heard earlier. And then there's $700,000,000 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, because that would take us to $4,000,000,000 We'll look at every asset, the 19 downtown we're keeping for sure. But we might sell a different one, keep one, but that will be substantially complete. Okay. And then 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. So are there percentage LTV or debt to EBITDA? Where would you like to see the balance sheet over the next couple of years? I won't commit to a time line, 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 income on the properties as opposed to cap rates. On the cash flow side and income side, probably be closer to 8x and 3x. Okay. Appreciate that. And then would you be capitalizing interest as part of these development initiatives? I'm sure on the developments we will. Yes. Okay. But when it's damn 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 as part of when you do a development pro form a, you got the interest in it. It's part of the overall cost of the development. But we'll let you know next quarter. Yes. It's not entirely unprecedented. So I've seen both. And 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. And 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.