Good afternoon, ladies and gentlemen. Welcome to the Morguard North American Residential Real Estate Investment Trust second quarter results conference call. At this time, all lines are in listen-only mode. Following the presentation, we will conduct a question and answer session. If at any time during this call you require immediate assistance, please press star zero for the operator. This call is being recorded on Thursday, August 2nd, 2018. I would now like to turn the conference over to Paul Miatello. Please go ahead.
Thank you. Good afternoon, everybody. It's great to have you guys joining the conference call today. I'm Paul Miatello. I'll be moderating the call today. I'm the Vice President of the REIT and the Chief Financial Officer at Morguard Corporation. Mr. Sahi is not available to join the call today. Joining us on the call is Bob Wright, Chief Financial Officer, Sanjay Ritesh, Vice President of Canadian Operations, and John Talano, Vice President of U.S. Operations. With those brief introductions, I'll turn it over to Bob Wright, who will give us an overview of the Q2 results.
Thank you, Paul. As is customary, I will provide comments on the REIT's financial position and performance. We will open the floor to questions. In terms of our financial position, the REIT completed the second quarter of 2018 with assets totaling CAD 2.9 billion, compared to CAD 2.7 billion in December. This increase in assets during 2018 was due to the acquisition of property under development of CAD 15 million, a fair value gain of CAD 106 million, and the change in foreign exchange rates during the year having an uplift in assets value of approximately CAD 77 million. On April 5th, 2018, the REIT acquired the property comprising 116 suites located in New Orleans, Louisiana, for the purchase price of $11.4 million U.S. The property is vacant and designated as a property under development.
The REIT plans to complete significant capital upgrades during the remainder of 2018, at which time initial lease-ups will commence. The REIT finished the second quarter of 2018 with CAD 22 million in cash on hand and CAD 4 million owing to Morguard Corp under its revolving facility. The REIT has a CAD 100 million credit facility, which can be drawn on in either Canadian or U.S. dollars, which the REIT can use for acquisitions and general corporate purposes. The REIT completed the second quarter of 2018 with CAD 1.3 billion of long-term debt obligations. During the quarter, the REIT continued to make progress in strengthening its balance sheet through financing activities with the refinancing of two residential properties in the amount of CAD 62 million at the weighted average interest rate of 4.07%, about 60 basis points lower than in-place interest rate.
The weighted average term of 10 years that resulted in USD 9 million of up financing proceeds. At June 2018, the REIT's overall weighted average term to maturity was 6.3 years, an increase from 6.2 at December 2017. The REIT's weighted average interest rate declined slightly to 3.48 from 3.5 at December 2017. The REIT continues to make progress in reducing its overall leverage. The REIT's debt to book value improved to 51% in December, compared to 49% in June. MRG has IFRS asset value of CAD 23.33 per unit at June, compared to market value of CAD 15.4, still reflecting a significant discount to trading value. Turning to the statement of income, net income decreased by CAD 41.8 million to CAD 19.7 million for the three months ended June 30th compared to 2017.
The decrease was primarily due to lower non-cash charges to fair value real estate properties and fair value BLP units compared to 2017, plus an increase in deferred tax compared to the prior year. Net operating income of CAD 38.3 million for the three months ended June 30th, 2018, an increase of CAD 3.2 million or 9% compared to 2017. Proportionate share NOI increased by CAD 1.6 million or 5.3% to CAD 32 million compared to CAD 30.4 million in 2017. Interest expense increased CAD 2.2 million for the three months ended June 30th, 2018 compared to 2017. Excluding non-cash fair value adjustments, interest expense decreased by CAD 1.8 million. The REIT's 2018 performance has translated into basic FFO of CAD 15.7 million generated for the three months ended June 2018, a decrease of CAD 0.6 million or 3.8% compared to 2017.
On a per-unit basis, FFO of CAD 0.31 per unit for the three months ended June 30th, 2018, a decrease of CAD 0.01 or 3.1% compared to the CAD 0.32 per unit in 2017. The REIT's FFO payout ratio for the three months ended June 30th, 2018, was 53.6%. Operations. The REIT has been successful quarter with an average monthly rents in Canada increased to CAD 1,345. This reflects the quality of the Canadian portfolio and translates into an overall 3% increase over 2017. While in the U.S., average monthly rents increased 17.2%, with an average monthly rent of USD 1,221 at the end of the second quarter, compared to USD 1,042 at the end of the same period, 2017. The same property average monthly rents increased 3.2%. The REIT's strong rent growth in the U.S. markets in all places but Louisiana.
The REIT continues to report strong occupancy, with Canada finishing the second quarter of 2018 at 99.2% par for prior year. Same property occupancy in the U.S. has started to see an improvement over last year's occupancy. Same property increased 93.8% from 93.2% in 2017. Same property occupancy in the U.S. has improved from 92.7% occupancy reported at March 2018, resulting from increased marketing efforts at the beginning of the spring season. Occupancy levels at U.S. properties acquired by the REIT during 2017 have been impacted by a new supply and leasing seasonality. Occupancy of all three properties acquired in 2017 improved since the first quarter of 2018 and have seen significant improvements in traffic and leasing activities. This trend is expected to continue throughout the leasing season in these properties.
Management has seen recent improvements and expects the impact of the short-term in nature as the competitive properties complete their lease-up. I will now turn it back to the moderator who will open the lines for questions.
Thank you. Ladies and gentlemen, we will now begin the question-and-answer session. Should you have a question, please press the star followed by the one on your touch-tone phone. You'll hear a three-tone prompt acknowledging your request, and your questions will be polled in the order they are received. Should you wish to decline from the polling process, please press the star followed by the two. If you're using a speakerphone, please lift the handset before pressing any keys. Your first question comes from Jonathan Kelcher of TD. Please go ahead.
Thanks. Good afternoon.
Hi.
First question on the New Orleans development. How much do you expect to invest in that over the balance of this year?
The total program will probably end up being around CAD 5 million. It could be a little bit lower. The scope is set on the building envelope budget. Depending on how much we do on suite improvements, it could go lower than CAD 5 million, so the answer is CAD 4 million to CAD 5 million.
Okay. Then when you get it leased up, what sort of return do you expect on the whole thing?
We're expecting about in the range of eight to-
8% to 10%?
Eleven.
11. Yep. Okay. That's good. I noticed the incentives ticked up this quarter, actually quite a bit year-over-year. Is there any one market where that's happening, or is it sort of across the board? Maybe a little bit of color on that.
Yeah. Maybe I'll turn that question over to John Talano.
Sure. The incentives, specifically, were in Chicago, at Coast, and in the D.C. markets where we had weakness in occupancy late last year, earlier this year. Also at one property in Atlanta. That was where the bulk of it was, and that was specifically targeted at those three properties where we were experiencing those lower occupancies. Since that time, we have actually ended all of those. We've seen great results in Chicago. Coast is now 98% leased, so we have fixed that one. Briarhill in Atlanta was in the low 80s last quarter. It is also 98% leased. We've had some great progress there. Again, that was really going through a lease-up this spring at those properties, and we have finished with those.
Okay. We'll start to see that tick down next quarter?
Absolutely.
Okay. Last for me is just on the G&A was CAD 600 thousand higher this quarter versus last quarter, just wondering what a good run rate is going forward.
Yes, it's a little higher. It's largely on timing of expenditures and some consulting bills that came in. I think the number we're at is CAD 3.6 million.
3.6?
Yeah. As Chris just pointed out too, there's a little bit of FX fluctuation in there as well, John. Sort of around CAD 3.5 million-CAD 3.6 million is the normal-
That's a good run rate.
Yeah.
Okay, thanks. I'll turn it back.
Thank you.
Thank you.
Next question comes from Fred Blondeau of Echelon Wealth Partners. Please go ahead.
Thanks, good afternoon.
Hi, Fred.
I just have two quick questions there. First, I was wondering if you could give us a sense of your acquisition pipeline at this point. It looks like you're a bit less active this year.
Yeah, a little bit less active. We're still looking at a lot of product. Similar markets to where we're in terms of footprint right now. Things are still, to us, looking pricey. Especially in the face of what we think are going to be more interest rate increases in the year. We still think that there's that traditional sort of disconnection between buyer and seller. The seller doesn't think prices have moved, the buyers think prices have moved.
yeah. It's probably fair to characterize it as it's a little bit slow right now, but we are looking at a lot just on a pricing basis, cap rate per door basis. We're not seeing anything that we're jumping at right now.
Okay. Is it fair to say that you don't necessarily have a pipeline at this point?
Like I said, nothing that's under contract, nothing that's anywhere near that close.
Sure.
Like I said, we are still very active in terms of looking and investigating and lots of conversations going.
very hard to predict in this kind of market what's going to come to fruition.
Okay. Just on Jonathan's question on incentives, what do you see in terms of new supply in your markets at this point? Is it fair to say that, based on your comments, it seems like it's becoming less of a challenge here?
I'll just start off by saying Chicago is still a bit of a challenge. There's still a fair bit of supply. It's less than what it was at this time last year.
Okay.
It looks like it's continuing to slow down, it's still an issue. Sort of beyond that comment, John, is there anything else you can add to that?
We've had strong supply in South Florida. As you can see from our occupancy and rents there, those have been performing well. The demand and supply are matching. Everywhere else has been very stable. I would say Dallas is another area that continues to have a consistent supply. Beyond that, the only other area that has a significant supply would be in the D.C. and our Maryland markets. That too has definitely improved over the last quarter as well.
The other areas of the country, Colorado, Atlanta, that definitely has calmed down as well.
Perfect. Thank you. I'll leave it there.
Thanks, Fred.
Your next question comes from Yash Singhal of Laurentian Bank. Please go ahead.
Good afternoon.
Good afternoon.
Just on your U.S. occupancy, just looking out, where do you think your occupancy rate would be by the end of 2018? Just a rough estimate based on what you see.
John, do you want to take that?
Yeah. I'll handle that one. Well, we've seen very good trends recently. With our busy spring and summer leasing season, the portfolio as a whole it has already achieved very close to 95% occupancy, and that really is our sweet spot where we're trying to push rents where we can. We are there and we expect.
U.S., you mean to say?
What's that?
You are 95% in the U.S.? Are you talking about Canada and U.S.?
We're approaching 95%. It is very close today. The goal is to stay around that mark.
Okay, that's good. Also, in terms of acquisition cap rates, what do you see out there? Can you give us some commentary around where cap rates are, and if their expectations are changing or not? Anything.
Yeah. We're seeing for the garden-style wood frame, three-story walk-up style product, two and three-story walk-up. Depending on location, depending on construction and finishes, you're seeing cap rates in the low fives, 5.5 and then up from there. As I said in my earlier comment, that has tended not to move over the last few quarters. We've seen maybe a tiny bit of compression here and there in certain markets, the cap rates have sort of remained stable in the face of interest rate increases that happened over a year ago, that's what I'm sort of alluding to in my earlier comment. The boil has sort of come off. Certainly in U.S. markets, we're seeing a little bit of deceleration of rent growth. John talked about that in an earlier comment.
A year and a half ago, we were still seeing rent increases in the U.S. in the 4s, 5s, 6s, 6% range, 7% range year-over-year in some select markets. Those 5s, 6s, 7s are now 2%-5%. The rent growth has definitely decelerated. You sort of look at that combination of factors, again, coupled with interest rates and everything, and it sort of feels like pricing should be coming off the boil. Like I said, expectations between buyer and seller are still different, I think, which makes it difficult to get deals done.
Okay. That's good. Thank you.
Thanks.
Your next question comes from Dean Wilkinson with CIBC. Please go ahead.
Thanks. Afternoon, guys.
Hi, Dean.
On the Canadian portfolio, year to date, suite turnover 8.8%. Obviously a low number. I'm assuming that is trending lower. How does that number compare to the first half of the year, going back the last couple of years?
I don't have that in front of me. I'm not sure if we have that number in the room. I can tell you for sure, without quoting a number, it's down.
It's down.
again, understanding that a lot of our Canadian portfolio is located in the Greater Toronto Area-
Yeah
it's just such a tight rental market, right? We're seeing big rent increases on turnover, and we're seeing lower turnover just because there's less options. It's also a function, obviously, of the housing industry here in Toronto. It's just-
Housing shortage, rent control, all the rest of those things.
Yeah. That whole basket of circumstances just sort of leads one to understand easily that there's just less turnover, and people have less affordable options to look at, whether they want to rent a condo or buy a condo or buy a house or buy a town home. The affordability and the options just aren't great. We're just finding that people are sticking around longer, which isn't necessarily a bad thing. again, in the Canadian landscape on turnover, when we can get-
Yeah, it's a big gap
8%-10%, you're hoping for that turnover. Yeah, it's definitely down just for those reasons, Dean.
Would there be a little more of seasonality, say, in the back half of the year that turnover picks up a bit? Would you think that high single digits might be the world that we're in?
Yeah. Typically it'll pick up a little bit. Just with August being the back half of summer, families are getting settled for schools and stuff like that.
Yeah.
It tends to be a little more quiet, then it'll pick up a little more in September, October. Obviously you get into the winter months where it declines. I think based on.
It's an industry issue, right?
Yeah, it's an industry issue. My understanding is everybody's sort of seeing the same thing we're seeing. Whether high single digits is the new norm, I can't really comment on that. I would say it's definitely down.
The trend is definitely in that direction.
Yeah. That's going to be the reality, at least for the next little while, until some of those other circumstances change. I'll ask Sanjay maybe to add any other color or commentary to that he can.
Yeah, Paul, thank you very much. You very well explained. That's exactly what we're noticing and experiencing in portfolio-wide. As much we expect it to be higher, people are not moving out because of the reasons Paul mentioned. Every time any of the suites which are turnover, we're achieving over 9.5%-9.8% increase in the rent. We're just doing whatever we can to keep them bringing that up, but you're right, it's in single digits right now.
Yeah. Okay, good. Thanks, Sanjay. I don't even know if I understand what I'm asking here, but I'm going to ask it. The Tax Cuts and Jobs Act, you've got $3.5 million of unutilized interest expense deduction. What does that mean? Is it something that just we can ignore?
At the end of the day, it's the major implication, and I'm not going to get into the deferred tax side of it. I'm an accountant myself, so accountants love that stuff. The deferred tax, you're just setting up a liability for future tax on something you may never sell. If you leave all that aside, the major implication of the REIT is we have a bunch of taxable subsidiaries in the U.S. We don't pay any tax because we don't have any taxable income in the U.S.
Right.
We don't foresee that changing for several years. We forecast this stuff out obviously over the long term. The major implication of the change in the tax reform in the U.S. is that the corporate tax rate has gone down from something like 35% to 21%.
Yeah.
That's important if you're taxable, but again, we're not taxable.
You can shelter it, so it doesn't matter. You'll just have this unutilized expense offset that you won't need anyway. Okay.
Yeah, exactly.
All right. I think I got it. I'm assuming it's probably a little too early to talk about the 2019 debt maturity at this point?
Yeah, those ones don't roll till late in the year. I think it's December.
Okay.
Yeah, those are more than a year out. Yeah, too early to be talking. I'm not sure what's going to happen with base rates between now and then. Yeah, those really are the next rollovers for the REIT, and they don't happen for over 12 months.
It's a good ways away. Okay, thanks, guys. That's it for me.
Thanks.
Thanks.
Ladies and gentlemen, as a reminder, should you have a question, please press the star followed by the one. There are no further questions at this time. Please proceed.
Okay. Thanks everyone for joining the Q2 conference call. We look forward to Q3.
Thank you.
Thank you.
Ladies and gentlemen, this concludes your conference call for today. We thank you for participating and ask that you please disconnect your lines.