Good morning, welcome to H&R Real Estate Investment Trust 2018 third quarter earnings conference call. Before beginning the call, H&R would like to remind listeners that certain statements, which may include predictions, conclusions, forecasts, or projections in the remarks that follow, may contain forward-looking information, which reflect the current expectations of management regarding future events and performance and speak only as of today's date. Forward-looking information requires management to make assumptions or rely on certain material factors and is subject to inherent risks and uncertainties, actual results could differ materially from the statements in the forward-looking information.
Additional information about the material factors, assumptions, risks, and uncertainties that could cause actual results to differ materially from the statements in the forward-looking information and the material factors or assumptions that may have been applied in making such statements is described in more detail in H&R's public filings, which can be found on our website and www.sedar.com. I would now like to introduce Mr. Larry Froom, Chief Financial Officer of H&R REIT. Please go ahead, Mr. Froom.
Thank you, Lindsay. Good morning, everyone. Welcome to our call. Thank you for joining us. Tom Hofstedter, our President and CEO, is with me. Pat Sullivan, Chief Operating Officer of Primaris, is on the call from Calgary, and Philippe Lapointe, Chief Operating Officer of Lantower Residential, is on the call from Dallas. I will begin with some brief remarks on this quarter. Pat and Philippe will follow up with updates on their divisions, Tom will make some concluding remarks. Finally, we will open up for some questions. On August 31st, H&R and H&R Finance Trust effected a reorganization where H&R Finance Trust was dissolved. Accordingly, the staple structure has been unwound, and unit holders now only hold H&R REIT units. H&R's annualized distribution of CAD 1.38 per unit will now be paid in its entirety by H&R REIT.
This was also the first full quarter post the sale of the U.S. retail assets for $633 million U.S. and the sale of First Tower in Calgary for CAD 53.5 million Canadian. These dispositions were the main reason for the decrease in property operating income and FFO. Q3 FFO was CAD 0.42 per unit, down from CAD 0.46 in Q3 2017. However, Q3 2017 included lease termination fees of CAD 5.5 million compared to the lease termination fees of CAD 444,000 received this quarter. Excluding these lease termination payments, FFO decreased from CAD 0.44 last year to CAD 0.42 this year. On a same asset basis, Q3 2018 property operating income from Canada was up 2% over Q3 2017. Excluding the lease terminations just mentioned, the U.S. portfolio in local currency was up 2.8%. Same asset property operating income cash basis from the office division increased by 3.4%.
Primaris same asset property operating income cash basis increased by 0.8% despite this year's vacancy. Same asset property operating income from the H&R retail division increased by 3%. Excluding the lease termination fees from 2017, same asset property operating income from Echo Realty in U.S. dollars increased by 4.7%. Same asset property operating income from Lantower Residential in U.S. dollars increased by 7.3%. These increases in same asset property operating income are a testament to our capital recycling program to sell assets with low growth potential and replace them with assets that have higher growth potential. Part of our proceeds from the asset dispositions have been used for our development pipeline, which will be a source of significant growth in property operating income and FFO in the next few years.
Unitholders' equity per unit, which is unitholders' equity for our financial statements, divided by the number of REIT units outstanding, was CAD 24.85 per unit as at September 30th, 2018. This quarter, H&R disclosed net asset value, NAV per unit for the first time. This is a non-GAAP measure calculated by dividing the sum of unitholders' equity, exchangeable units, and deferred tax liability by the total number of H&R units and exchangeable units outstanding. Under IFRS, exchangeable units are classified as debt. However, these units are not required to be repaid. The exchangeable unitholders receive the same distributions as the REIT unitholders, and each unitholder has the option to convert their exchangeable units into H&R units on a one-to-one basis at any time. Management considers them as equity.
The deferred tax liability shown on the balance sheet is an undiscounted liability that would only be crystallized in the event that U.S. properties are sold. Management expects to continue to take advantage of U.S. tax legislation, specifically the 1031 exchanges, to further defer taxes owing on sold properties. The NAV per unit, as per the above calculation as of September 30th, 2018, was CAD 25.73 per unit. Management believes this is a useful indicator of the fair value of the net tangible assets of H&R. I will now hand over to Pat Sullivan. Pat?
Thank you, Larry, good morning, everyone. We're nearing the completion of our Target replacement program. Construction is progressing on the former Target at Sunridge, and we anticipate CAD 1.5 million in annual base rent contribution
From new tenants at Sunridge Mall starting in Q4 2019. New tenants opening at Sunridge include Mark's and Winners. With respect to Sears paid annual base rent at H&R ownership interest of CAD 2.3 million. We anticipate CAD 7 million in annual base rent will be generated from Sears' replacement tenants with rental payments starting in Q4 2019, and most tenants open and paying rent by Q3 2020. In addition to paying rent below market rents, Sears and Target leases typically contain provisions restricting development on our sites. During our last quarterly call, we discussed development opportunities, including intensification opportunities at several of our strongest properties, including Dufferin Mall and Orchard Park Shopping Center. With the closure of these department stores, we have added flexibility to pursue intensification opportunities at a number of our shopping centers, creating a long-term development pipeline.
With management's focus on opportunities at our larger properties, we are pursuing the sale of assets that offer limited potential for growth. Earlier this year, we sold a 46,000 sq ft neighborhood retail plaza in Sherwood Park, Alberta, situated nearby, but not adjoining Sherwood Park Mall. In 2019, five additional assets will be marketed for sale. We anticipate these properties will generate approximately CAD 37 million in net proceeds upon disposition, in line with our IFRS valuations. We continue to add new tenants to the portfolio that will drive traffic to our malls, which are dominant in their respective markets and are often the only major regional enclosed mall in their region. Earlier this year, Marshalls/HomeSense opened a new 40,000 sq ft store at McAllister Place in Saint John, and later this year, Old Navy will open a 15,000 sq ft store at Place du Royaume in Chicoutimi.
At Sherwood Park, Urban Planet opened a new 15,000 sq ft store earlier this year, and Shoppers Drug Mart will open from an expanded store later this year, with a significant beauty boutique section. In 2019, Old Navy will open a 15,000 sq ft store at Regent Mall in Fredericton, and Marshalls/HomeSense will open a 40,000 sq ft store at Garden City Shopping Centre in Winnipeg. Twelve-month rolling same-store sales within our enclosed mall portfolio are relatively flat at CAD 569 per sq ft, but considerably higher than the CAD 539 per sq ft recorded in 2016. Since 2013, our merchandise mix has evolved due to changing market conditions. Our allocation of space to fashion has declined in favor of food and electronics as well as health and beauty tenants. The closure of Target and Sears has resulted in the transformation of our properties.
Both Target and Sears occupied large areas, paid low rents, and did not generate significant traffic to our malls. Department stores, including The Bay, Walmart, and Canadian Tire, now account for 4.2% of gross revenue, compared to 9% in 2013. While large format retailers such as Sport Chek, Indigo, Sobeys, Cineplex, and Winners account for 24% of gross revenue, approximately 5% higher than in 2013. These specialty large format retailers have recognized the significant traffic generated by our properties and seized the opportunity to locate within the dominant retail property in the market. In turn, our properties have and will continue to benefit from the additional traffic generated by these retailers. Thank you, and I'll now turn the discussion over to Philippe.
Thanks, Pat. Good morning, everyone. I am pleased to be on this call today to share the latest news from Lantower Residential. We mentioned last quarter the pending closing of Lantower Weston Corners, a 308-unit development in the Cary submarket of Raleigh. We are happy to announce that we closed on Weston Corners in October, which marks our third acquisition in the Raleigh MSA. The five-story property benefits from its proximity to some of the most prized white-collar employers in the entire Raleigh MSA, such as MetLife Global Technology Headquarters Campus and the SAS Institute Headquarters, which is the world's largest private software company. We have more exciting news coming from North Carolina with the pending acquisition of a new Class A asset in one of the most affluent submarkets in Charlotte. We are in due diligence and look forward to potentially closing on the property in early December.
We will disclose more details on this potential acquisition on our fourth quarter call. On the portfolio front, upon closing on the acquisition of our Charlotte asset, Lantower will consist of nearly 7,300 apartments across 22 properties. As a reminder, Lantower's weighted vintage of 2011 represents one of the newest multifamily portfolios in our sector. This vintage could continue to trend newer as we may dispose of our older assets and bring in more recently constructed properties as we complete our ground-up multifamily developments. As mentioned last quarter, our occupancy is artificially lower due to the inclusion of the lease-ups of Lantower Ambrosio and Edgewater in Austin and Bullhouse in Durham. Excluding the impact of these lease-ups, our portfolio occupancy was over 93% at the end of the third quarter.
On the financial front, our same-asset quarter-end operating income increased in U.S. dollars from $6,298,000 in the third quarter of 2017 to $6,760,000 in the third quarter of 2018. This equates the same-asset quarter-over-quarter operating income growth of 7.3%, representing yet another strong quarter of NOI growth. Our same-asset trailing nine-month-ending operating income increased nearly 5.6% compared to the first nine months of 2017. On the development front, we recently closed on the land for Shoreline Tower, a 35-story multifamily project in Long Beach, California. Lantower's interest in the approximately CAD 217 million project is 30.7%. We expect to start shoring work by the end of the year and look forward to keeping you up to date on this high-profile development. Construction at Jackson Park has been progressing as scheduled, and the project is currently 92% complete.
Leasing velocity has continued, with well over 450 new leases signed in the third quarter alone. Jackson Park has 1,124 occupied units at the end of October, reflecting 60% of the total unit count. We expect leasing to continue to remain strong during the winter due to the fact that the entire amenity building is now open to residents, and Tower B2 will be opening its rooftop amenity space in November. Additionally, Jackson Park's two-acre park has grass laid and will be fully open by the end of the year. Construction is expected to be 100% complete in the first quarter of 2019, and we look forward to sharing more exciting progress on our developments on our next quarterly call. With that, I will pass along the conversation back to Tom.
Thanks, Philippe. As you just heard and can read about in our quarterly report, we have been very active in 2018, and we are very proud of our accomplishments. We have recycled CAD 1 billion from our lowest growth assets to our highest growth assets through Lantower acquisitions, developments, and buying back our units. All of this activity ties back to the objectives we outlined at the beginning of the year, namely enhancing the internal growth profile of our portfolio and streamlining and simplifying our business. In addition to all of the acquisitions and dispositions, we have advanced our development portfolio, including both investments in Gateway City mixed-use and multi-residential developments in the U.S., as well as intensification opportunities in our Canadian portfolio, most notably Devonshire Mall. It is gratifying to see all the hard work our team has done translate into real progress in our business.
It is also nice to have luck on your side from time to time in this regard, and we have two bits of luck that have come our way. Tax policy changes in the U.S. allowed us to simplify our structure this quarter, collapsing our stapled unit structure into a simple REIT structure comparable to most Canadian REITs. Secondly, if The Wall Street Journal, CNN, and The New York Times are to be believed, Amazon will announce today that it has chosen Long Island City and Crystal City as the sites for its second headquarters. Our Jackson Park development, which sits in the heart of Long Island City, has already been very rewarding for us, delivering over $150 million of fair value gains, and has a carrying value of approximately $675 million at our share today.
This announcement from Amazon should cement Jackson Park as one of the most attractive residential developments in North America. Last night, New York City's Mayor Bill de Blasio described the Amazon announcement as the single biggest economic development deal in the history of New York City. Jackson Park is already leasing up at higher rents than forecast, and Amazon's announcement should only improve the prospects for this development, contributing to our overall growth profile. In conclusion, while the actions we have taken to enhance the growth profile of our portfolio have cost us in FFO for periods of this year, we believe we are largely past the dilutive impact of these changes and are turning the corner on FFO growth. We will continue to work to improve and streamline our portfolio and are pleased with the significant progress to date.
On that, I'll ask the operator to open up the calls for questions.
At this time, ladies and gentlemen, if you would like to ask a question, please press star, then the number one on your telephone keypad. We'll pause for a moment to compile the Q&A roster. Again, that is star one on your telephone keypad to ask a question. Our first question comes from Mike McCartney with Desjardins. Your line is now open.
Good morning. Jackson Park, sounds like lease-up is tracking ahead of expectations, obviously, HQ2 is a big event. Just curious, your projected NOI from those properties didn't really change in 2019 and 2020. Why perhaps that may be the case?
Hey, Mike. We did not change our projections. We did not factor in HQ2 in our projections, we've just kept with the same projections we've always had at the same release rate that we've currently been leasing at.
Why wouldn't we change our projections?
Yes. I guess, but you're tracking ahead of expectations, suffice to say that all else equal, your current projections for 2019 and 2020 just on that basis alone are somewhat conservative. Can you just remind me, apologies, I'm not as well steeped in the New York rent control scene as I should be. If HQ2 does come to reality, it sounds like it's coming to reality, does that change your lease-up strategy at all in terms of, is there any rent control and would that change how you might view the lease of that asset, just delaying it somewhat given the developments around HQ2?
Isn't it fair to say, there is no rent control. Isn't it fair to say that the reality of Amazon is still a couple of years away, at least? They have to rezone the site. They have to build the site. You're probably looking at three, four years away.
Okay.
Nothing's going to change in the short term, I think, that what's going to change the math.
Yeah. There's no rent control or rent affordability on our project.
Okay. That's exactly what I was going with. Okay. Larry, what was the change in the Even though the NOI didn't really change, you've got an increase in FFO due to lower finance costs. Can you just help us understand what's driving that?
It was. Sorry. Lower finance costs.
Yeah, it seemed that that came down considerably in terms of the projections.
Compared to last quarter? Mike, I'll have to check with you. We've stopped capitalizing as much interest, but that shouldn't be a driver. Sorry, I have to check with you what we had last quarter.
Okay. Yeah, no problem. We'll follow off offline. Just thanks for your disclosure on the net asset value, 25.73 units trading at a big disconnect. Curious, your NCIB did terminate in August, and I haven't seen a renewal. Is there any reason why you wouldn't be buying at these levels?
No, we will be reinstating the NCIB in the next couple of weeks. NCIB actually fell out of place when Finance Trust was dissolved, we have to apply for a new one, and we will. Whether we start to buy will remain to be seen. We would like to buy. We need cash to buy. As probably as we sell more assets, we will have some more cash to deploy into the NCIB. Right now, we have not been active on it.
Okay. I think the original intention when you guys sold the U.S. retail assets was to redeploy substantially all those proceeds into Lantower. Assuming that hasn't changed, where would we be in terms of net incremental capital that you see yourself putting into Lantower over the next, let's call it six months?
Besides the development pipeline, we only have one asset that we're looking to acquire, and that's for about another CAD 70 million to CAD 80 million. That is it into Lantower.
That's really a product of a reverse 1031 that we're involved in because we have projected to sell some assets in the U.S. We took the opportunity to buy an asset to give inflation to that 1031. Other than that, I think we're on a slowdown mode on acquisitions, waiting to see what happens with NAVs and CAPs relative to the increase in interest rates, which hasn't manifested itself to date into a change in values. We expect it to show a change in values as the interest rates have an impact on valuations.
Okay. Just last one from me before I turn it back. The income growth on the assets on lease-up from Lantower looks pretty substantial once they stabilize by the end of 2019. Larry, is there any interest being capitalized with those assets or no at this juncture?
No, there's not.
Okay. That's very helpful. Thank you.
Thanks.
Our next question comes from Matt Kornack with National Bank Financial. Your line is now open.
Hi, guys. Just with regards to Lantower and the organic growth figures, occupancy on the same property portfolio was fairly stable. What was the main driver? Was it rent increases, or was there lack of incentives in that number as well? Just wondering what drove the 7% organic growth figure.
I would say it's probably a healthy combination of both. We are seeing an uptick in our rental increases. I don't think there's been much change in the concessions, but also our asset management team has been tremendous in compressing expenses. I would think less so on concessions, more so on rental growth and on expense compression.
Are you seeing, from a supply standpoint, less of an impact or at least a slowing in the addition of new supply in the markets you're in?
Yes, quite noticeably as well.
Okay. Fair. With regards to the Primaris portfolio, thanks for the disclosure for Target and Sears space. Do you expect some common area recoveries as well on top of the base rent, or how should we look at the NOI impact of that lease-up over the next few years?
Yeah. In terms of recovering costs, some of the common area cost gains that we get from the new tenants coming in will be applied towards recovering some of the costs that we're spending. I can't quantify it right now, but there will be a recovery.
Okay. It'll be maybe incrementally more than that from an NOI standpoint as these tenants take possession.
Yep.
Okay. Finally, with regards to the debt on Jackson Park, have you thought of what a long-term financing solution is there? You have a partner, so I'm not sure how you'll go about it, or will it be dealt with through the unsecured debt markets in Canada?
Yes. We've just started talking about it with Tishman's. We're expecting to get an appraisal by the end of the year or in January, they may be looking to put permanent financing on, they are hopeful that we may be able to, with permanent financing, get all our equity out of the project.
Okay. Wow. If you did in fact do that, would the use of proceeds be to fund, I guess, your other development projects that you've highlighted?
No, to pay down debt. Our construction financing.
Okay. Sorry.
It's 100% LTV to pay down our debt. The point of the matter is, well, then we won't be in the project.
Well, matter of fact, initially, it's to pay back our banking debt on this, and then it'll be put towards the rest of the development pipeline.
If you get anything incremental above the development debt.
Yes.
Yes.
Okay. Fair enough. Thanks, guys.
Again, if you would like to ask a question, that is star then one on your telephone keypad. Our next question comes from Sam Damiani with TD Securities. Your line is now open.
Thank you. Good morning. Just on the last question regarding permanent financing of Jackson Park, what would the market cost for fixed-rate debt on that asset be today?
What is the interest rate?
Correct.
The yield curve is relatively flat. Doesn't matter if you're five, seven, or 10. Probably around four and a half.
Four and a half?
Yeah. It doesn't really matter, sure. 65% LTV.
What is your equity in the project at this time?
About $260 million.
Yeah, your real question is what it will be at the time of financing, right?
No, our equity won't change.
Yeah, that's what I said. The equity won't change, but the equity now will be equity then. It'll take out the back debt.
Your equity is CAD 260 million?
US.
U.S. $260.
At your share. Just on leverage again, what is the current plan at the REIT level to operate going forward, now that you've largely completed your disposition program? How do you see the REIT's leverage two to three years out?
We're at 44% now, assuming we have no dispositions, but we are still planning on having some dispositions. Assuming no dispositions, then obviously our leverage would tick up, and with our development pipeline, feeding the development pipeline, it would tick up to call it 46%. Again, we will expect to have more dispositions as we go into 2019.
Is that a level you're comfortable operating at for the foreseeable future, in the mid-40s?
45%, yes.
Yeah.
Okay. Just lastly, back to Toronto. What's the latest on what you're hearing from CIBC with respect to their relocation strategy from many of your buildings? And with respect to Atrium on Bay, are you still contemplating an expansion to that asset? And if so, can you give us an update?
The answer to the question is, there has never been a decision coming out of CIBC, so we don't really have clarity, and we are still working on an expansion. We haven't pulled the trigger on it yet. We're still doing the costing.
Okay, thank you.
Thanks.
There are no further questions in queue at this time. I will turn the call back over to Mr. Larry Froom for closing comments.
Thanks, everyone. Thank you for joining us. We look forward to reporting more good news at the end of the year. Have a good day.
This concludes today's conference call. You may now disconnect.