Good morning, ladies and gentlemen. My name is Sylvie and I will be your conference operator today. At this time, I would like to welcome everyone to Artis REIT's second quarter 2018 conference call. Note that all lines have been placed on mute to prevent 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 number 1 on your telephone keypad. If you would like to withdraw your questions, you will need to please press star then number 2. Thank you, everyone. I would like to turn the meeting over to Mr. Armin Martens. Please go ahead, sir.
Okay. Thank you, moderator, and good day, everyone. Welcome to our Q2 2018 conference call. Again, my name is Armin Martens. I'm the CEO of Artis REIT, and with me on this call is Jim Green, our CFO, as well as Kim Riley, Senior Vice President of Investments and Development, Heather Nikkel, VP of Investor Relations, and Philip Martens has joined us today as well, EVP of U.S. Operations. Again, to begin with, I'd like to advise all listeners that during this call, we may at times be making forward-looking statements, and we therefore seek safe harbor. Please refer to our website as well as see our filings such as our financial statements, MD&A, and our annual information form for full disclaimers as well as information on material risks pertaining to all of our disclosures. Again, thanks for joining us.
I'll now ask Jim Green to review our financial and operational highlights. I'll wrap up with some market commentary, of course, we'll open the lines up for questions. Go ahead, Jim.
Thanks, Armin, and good morning, everyone. A quick summary of the REIT. Artis is a diversified commercial REIT. We have assets in five Canadian provinces and six U.S. states. We do some calculations in our MD&A disclosure to show the impact of an adjustment for a proportionate consolidation of our joint venture interests. In our opinion, some of this is more appropriate language. While it does turn the numbers into what are considered non-GAAP, in many cases, we feel it's more relevant, and the bulk of my discussion will be about the proportionately consolidated numbers. Based on Q2 NOI, Artis is 45.3% weighted in Western Canada. We're 11.4% in Ontario, and we're 43.3% in the United States. On an asset class basis, we're 53.1% weighted in office, 20.7% in retail, 26.2% in industrial.
Given our Western Canadian weighting, a specific focus for us since the oil prices collapsed in late 2014 has been to reduce our exposure to the province of Alberta and the Calgary office market in particular. Looking back three and a half years ago to Q3 2014, before the oil prices crashed, our geographic mix resulted in 38.9% of our NOI coming from the province of Alberta, with just over half of that, or roughly 19.3%, coming from Calgary office properties. Based on Q2, the adjustments we've made, our Alberta exposure is now down to 21.7%. Calgary office is only 8.2%, and that's even with including some lease termination income. Without the lease termination income, we would've been down to around 7.5%. As mentioned on our year-end call, we feel we've fully executed our commitment to diversify while continuing to sell at good prices in the current market.
Having said that, we are continuing with the process on a patient basis. We sold two more Calgary office properties this quarter, along with a B.C. property at a very attractive cap rate. We have relatively manageable exposure to the Calgary office market in the near future, with just over 116,000 feet left to renew in 2018, only 141,000 feet in 2019, and only 47,000 feet in 2020. As mentioned before, our acquisition and disposition activities have been mainly focused on capital recycling to further diversify and improve our portfolio. In this quarter, as I mentioned, we completed the sale of three properties and acquired two new sites for future development opportunities, a future office site in Madison in close proximity to our other assets, and an industrial site in Denver that we have a preliminary start already with a joint venture partner to build that out.
Artis continues to be active in both new developments and redevelopment of our existing properties, has roughly CAD 89 million invested in properties under development at the end of the second quarter. During the quarter, the increase is roughly CAD 10 million in development properties under construction. As detailed in our MD&A, we have several new development projects that are just getting started, including a new residential tower at 300 Main, a new industrial space in Houston, Phoenix, and Denver. As detailed in our MD&A, we have several development projects in the planning stages where we haven't actively started yet, but they're progressing nicely through the development stages. We're not anticipating any difficulties being able to develop those properties.
We've been able to maintain our balance sheet with debt to GBV relatively flat, up just a fraction from 48.9 at the end of Q1 to 49.0 at June 30th, but still down from the 49.3 that we were at December 31st of last year. Our EBITDA interest coverage ratios remain over three times. We're pretty comfortable with that. The sales program we implemented through 2016 and 2017 to sell assets and reduce debt has had a dilutive effect on our FFO. FFO came in this quarter at CAD 0.32 versus CAD 0.36 in the comparative quarter last year. I'll talk a little more about the changes from Q1 a little later in my discussion. AFFO for the quarter was CAD 0.24, which does result in our payout ratio being above 100%, actually 112 to be exact. AFFO was also impacted by some of the same items as FFO.
As we've said at year-end and in Q1, our mission is to grow back into that distribution, and we're working as hard as we can to achieve that goal. Just highlighting for a few minutes the more financial position results. On a fair value basis, our investment properties are valued at fair value. This quarter, we saw an increase of CAD 23.9 million, largely driven by the hot markets in Toronto and Vancouver, which continue to increase in value. Mainly rent-driven this quarter, not cap rate compression, that's actually pleasing to us that we're seeing higher rents in those properties. We continue to monitor our retail valuations, although this is our smallest segment. At the current time, we're not anticipating major changes in fair values for the rest of the year.
However, we do think that we will see further increases in industrial valuations, as recent market transactions in that sector have been at pretty low cap rates. We remain pretty comfortable with our debt-to-GBV ratios. As I mentioned, almost constant this quarter at 49.0% versus 49.3% at year-end. Unencumbered assets, we've maintained a pool of between CAD 1.6 billion and CAD 1.7 billion of unencumbered assets, down slightly this quarter because the asset we sold in Vancouver, Production Court, was unencumbered. We'll be using the proceeds at least partially for new assets and maybe a little bit of debt repayment that'll bring the unencumbered pool back up again. On our credit lines, Artis has a CAD 500 million unsecured revolving credit facility with a syndicate of lenders. We also have two non-revolving unsecured credit facilities in the aggregate amount of a further CAD 300 million.
We've extended the maturity dates on the revolving facilities this quarter, such that one tranche now matures in 2021 and the second tranche in 2023. Both of the non-revolving facilities have been drawn in full, and we placed interest rate swaps to fix the interest rates on those facilities, as we expect they will be outstanding for the full five-year term. Looking briefly at a couple of highlights from the results of operations. One we monitor fairly closely is, of course, the same property operating results. This quarter, it was a positive 1.3% in functional currency, but unfortunately a small decline of 0.3% once foreign exchange was factored in. The FX ratios in Q2 of 2017 were quite a bit higher than they were in Q2 of 2018.
We also present a stabilized same property calculation, which eliminates properties planned for disposition and repurposing, as well as the entire Calgary office sector. On this basis, we had growth of 3.5% in functional currency and 1.4% once FX was factored in. By asset class, the office segment in Canada was the weakest and also in the U.S. Although interestingly enough, the Calgary office sector actually had positive same property growth of almost 6% this quarter. That's an interesting statistic. Retail in both Canada and the U.S. remains fairly strong, and we also had good results from the industrial portfolio with our strongest results coming in the U.S. industrial segment. During the quarter, we were able to achieve a weighted average rental growth on leases maturing this quarter of 5%, this growth will help contribute to further same property growth in future quarters.
Looking at our FFO and payout ratio. I guess that's the not-so-fun part, but we'll touch on it anyway. As I mentioned in my opening results, the FFO year-over-year has declined, with the largest driver being the dilutive effect of asset sales, with a good portion of the proceeds being used for debt reduction. FFO for the quarter on a diluted basis was CAD 0.32, down CAD 0.01 from last quarter and down CAD 0.04 from the same quarter last year. Comparing back to Q1, the Q1 FFO was CAD 0.33. However, that did include a fairly large non-recurring lease termination income. Overall, property-level NOI, almost identical to Q1, numerous adjustments going both directions to result in that. No one major specific driver that was a big factor.
We did have, of course, growth from the assets we acquired in Q1, but that was offset by the lower lease termination income this quarter. To put numbers on that, we received CAD 2.15 million in lease termination income in Q1, but only CAD 860,000 this quarter. If we run the math of calculating FFO exclusive of lease termination income, the drop from Q1 to Q2 is about CAD 0.08. We did incur higher interest costs this quarter, partly due to the acquisition of properties in Q1, but also driven by higher interest rates on the variable rate debt that continues to creep up. We also generally see higher corporate expenses in Q2 compared to Q1. Part costs of holding the AGM and a few other reasons, but corporate expenses are comparable to Q2 2017, but it is up just over CAD 400,000 from Q1 2018.
It's not unusual for this time of year, but that's also an impact in the FFO decline. Despite the drop in FFO, we remain convinced that our strategy has been correct to improve the balance sheet in the current operating environment, the same time as we are diversifying away from Alberta. The FFO payout ratio this quarter was 84.4%. Flipping over to AFFO, it's impacted mainly by the same items as FFO, declining from CAD 0.25 at Q1 to CAD 0.24 this quarter, but that is down CAD 0.03 from the same quarter last year. Does give us, as I mentioned, an AFFO payout ratio of 112%. We are working as hard as we can to get that payout ratio back to a more reasonable ratio.
On the EBITDA basis, there is EBITDA calculations in our MD&A, the main ratios we track are EBITDA interest coverage, currently at 3.02 times, and debt to EBITDA, currently at 8.8 times. I guess one of our highlights this quarter would be our net asset value going up from CAD 1,503 last quarter and CAD 1,486 at year-end, up to CAD 1,539 this quarter. We're pleased to see our values continue to rise. Subsequent events. Artis ended the quarter with CAD 165 million cash on hand. The reason the balances are so high is that B.C. sale closed right at the end of June, so we had a lot of cash on the balance sheet. Didn't get it moved within that day, basically. Then we had CAD 279 million undrawn on the line of credit.
We've detailed several events in our subsequent events note, which we believe continue to reflect our strategy of intelligent recycling of capital. We plan to continue our focus on a strong balance sheet and improving the overall quality of our portfolio, while growing back into our distribution. That completes the financial review. We're pleased with the NAV growth, the same-property income growth, our weighted average rental increases, and our new development activities. Not as happy with the FFO decline, but I hope I explained that. We look forward to demonstrating results from operations in future quarter. I'll pass it back to Armin now for a bit more discussion.
Thanks, Jim. Folks, on balance, we feel that Artis is progressing well this year. Our earnings, our balance sheet, our liquidity are in good shape. Our NAV is trending well, we're not out of the woods yet. Our industrial and retail properties are performing quite well and have a good history of doing that, our office portfolio is still inconsistent. Much of this, of course, due to the Calgary office market. It continues to be our view that both the U.S. and Canadian economies will perform fair to good this year and next, with the advantage going to the U.S. economy. However, the hawkish monetary policy on both sides of the border is giving us some concern, increased interest rates are now impacting our earnings.
Our capital recycling program for 2018 is on track, we continue to guide that we'll recycle between CAD 200 million and CAD 300 million of properties this year with a view of continuing to reduce our exposure to the Calgary office market. In terms of the Calgary office market, we're grateful for our positive same-property NOI this quarter as a result of that one significant lease, we're not out of the woods yet. Including some space, vacancy rates are about 28% in Calgary now, it will of course take some time before stabilizing and improving. Oil and gas prices, however, have stabilized. Enbridge Line 3 and Kinder Morgan's Trans Mountain will eventually get done, the OPEC deal continues to have good traction. We're bouncing along the bottom with respect to office leasing rates.
Capital spending and job creation is slowly but surely increasing in Alberta, we're seeing green shoots of economic intent activity. It may be slow and protracted, it is our view that the economic recovery is well underway in Alberta and will be sustained for many years thereafter. As mentioned before, our industrial and retail portfolios are performing quite well on both sides of the border and indeed have a long-standing track record of success. Our challenges remain isolated to our office portfolio. Looking ahead, we will continue to work hard to keep our buildings full whilst bringing the rents up to market and consistently improving our real estate portfolio as well as our NAV per unit, which as we mentioned, is on a good trend line. That's our report for this quarter, folks.
Notwithstanding our challenges, we are pleased with the results and confident in our outlook. I'll now ask the moderator to take over and field your questions.
Thank you, sir. Ladies and gentlemen, if you do have a question, as mentioned previously, please press star one on your touch-tone phone. If you would like to withdraw your request, you will need to press star two. Note that questions will be taken in the order received. Your first question will be from Jonathan Kelcher at TD. Please go ahead.
Thanks. Good morning.
Good morning, John.
just on Calgary office, good to see positive same-property NOI growth there again.
Right.
Do you expect that to continue through the next few quarters, given that your occupancy is, I guess, up 700 basis points or so quarter-to-quarter?
Who wants to answer that in this room? The trend is our friend there, our overall Calgary office NOI, not all of our buildings are stabilized. Maybe half our buildings are stabilized in the sense that we've finished resetting all the leases to the new market rents. Maybe half our leases is the right way of putting it, and then the other half isn't. We're not out of the woods yet, as I've been saying. It wouldn't surprise me to get a quarter or two more of positive data out just because of that one major lease. If you look at our lease profile, it's disclosed on our MD&A, we don't have a lot of lease rollover right now in Calgary.
That's good. Just turning to, I guess, your capital recycling program. I guess you sold about CAD 160 million so far this year. You've committed to buying roughly CAD 130 million In terms of acquisitions, would it be fair to look at the balance of the CAD 30 million going into development?
Actually, it'll go to another acquisition, a very good one that wasn't disposable on time for the release of these results. It'll go into another acquisition, and we'll move on from there.
Roughly a CAD 30 million acquisition?
Closer to CAD 50.
Closer.
It's a really, really good acquisition.
Okay. I guess you're not going to give much more color on that.
No, you'll like it.
Okay, well, looking forward to hearing about it. How much would you expect to spend on your development program over the back half of this year?
You got that number?
Ballpark another CAD 30 million-CAD 40 million over the course of this year.
Okay. Just lastly, can you maybe give us an update on where you stand on leasing Inverness?
I'm glad Phil's here. What's the latest update, Phil?
We continue to get interest on full building users. We also have potentials where we have owner users who just simply want to take us out. It remains active in Denver. We have a program also to multi-tenant the building, our brokers advise us to yet remain patient. We are in month six of our budget 18-month lease-up program. We're waiting to go through the summer and hopefully have a lot more traction in the fall.
Okay. Now, is that property in the rental pool or is it still in the PUD?
It was transferred as a completed operation at the end of Q1, I believe.
Okay, thanks. I'll turn it back.
Thank you. Next question will be from Frederic Blondeau at Echelon Wealth Partners. Please go ahead.
Thank you, good morning.
Morning, Fred.
Three quick questions for me. First, I was wondering, how do you feel about the distribution at this point? I understand the commitment there, what's your timeline before maybe taking more drastic decisions in this regard?
Well, we were just looking at our history the other day, Fred, we've been in this situation before where.
Yep
payout ratio was actually much higher. We've patiently worked our way through it. In the last 14 years, we've raised our distribution twice. We've never cut.
Yep
No discussion of cutting it.
Mm-hmm. Okay, fair enough. Then maybe a more high-level question. You have a rather ambitious business plan in terms of development, redevelopment, and even intensification initiatives. How do you feel about the construction costs at this point, and how do you think they could affect or further affect expected yields?
Yeah. Costs are not coming down. In terms of our development pipeline, we're building this one multifamily building in Winnipeg because it's on top of a parkade we own, connected to an office building we own. Otherwise, our ambitious densification program, the multifamily part of it, we expect to sell off the entitlements, the land, once we get the rezoning. We don't expect to build any of those because we don't expect to have multifamily in our portfolio. We don't want a fourth asset class in our portfolio. Even the multifamily in Winnipeg that we build, we'll look to exit that building as well as soon as possible. We'll stay with our three asset classes. In the U.S., it's pretty manageable. The industrial buildings, these are working out very well for us. We build one at a time, we lease them, and we keep going.
Our industrial portfolio is performing well on both sides of the border, including new greenfield developments as we build the buildings there. We get good leasing traction.
Mm-hmm. Okay. Maybe lastly, I was wondering if you could give us a bit more color on the 3.3% and 5% cap rates achieved on Eau Claire and Production Court.
Well, let Kim address that a little bit if you want.
Heck of a cap rate, isn't it?
Well, I mean, yeah. The Eau Claire building and that other smaller building on Fifth Avenue, I guess it was.
Yep
Birchcliff Building. Both of them were substantially empty, the cap rate automatically was low. The price was based on price per square foot. It was right in line, a little bit better than our IFRS valuation. Which translates or corresponds to CAD 15 a unit. Production Court was a clean 4.9% cap rate on NOI. It was 99% leased. It's the Burnaby market, not downtown Vancouver. We thought we did well, and we know we have a good use of proceeds in terms of recycling that.
Yep. Thank you. I'll leave it there.
Thank you. Next question is from Michael Markidis at Desjardins. Please go ahead.
Hi, everyone.
Hi, Mike.
Armin, just to start off, I was wondering if you could just shed a little bit more color on the decision to sell Centrepointe. Your strategy has been to try and acquire new generation real estate, a 6 cap for a new generation office building in Canada didn't seem necessarily that robust. Maybe you could just share your thoughts on that one.
You're right. A couple of things that come to mind there, Mike. First of all, we are heavily invested in the Winnipeg office market. We are, for sure, the largest office landlord in Winnipeg, right downtown, Portage and Main, connected to the SkyWalk system. This building was a partnership. We're 50-50 partners. We were not the managing partner, so that wasn't our preferred way to be a partner. Also, the building did not have a SkyWalk connection. We thought we considered it, after a while, to be a non-core asset. We had a long-term lease there, I guess 10-year lease, 11-year lease with Stantec, with seven years remaining. You know the way it works, we decided that now was the right time to sell, given the amount of tenure left in order to maximize the price.
Those kind of things came to mind, and we felt we had a good use of proceeds in terms of redeploying the money.
Okay. That's helpful. Thanks. Second, I'm just trying to get a little bit, just make sure I'm clear in reconciling some of the disclosure in the MD&A in terms of the development activity in the balance sheet. Jim, if I understood you correctly, the PUD balance of CAD 89 million, that doesn't include any of the 100% completed developments. It only would include the developments that are in process?
That's correct.
Okay. Sorry, go ahead.
Yeah. The completed one gets transferred out when their construction is finished, in essence.
Okay. What about Sierra Place? Is that in PUD or is that?
Oh, that's a good question. No, I believe it's still in the income-producing properties pool.
Okay. Just digging in a little further on that, the new developments that have been completed, do you have a sense of what the contribution of NOI for those three properties was during the quarter? On a stabilized basis, where you expect those to get to?
Do you have a number on that, Phil, do you know?
No.
Okay.
No, Mike, I'm sorry, I don't have a number off the top of my head on that. There was very little contribution from them this quarter. Of course, Inverness is still not leased. Well, actually, a little bit of a negative drop because there's some operating costs getting written off now.
Yep. Okay. We can follow up offline. That'd be helpful disclosure to get.
Yeah.
Just, I guess in your NOI reconciliation, you got your property NOI, your same property, and then the acquisition dispositions and the contribution from development and redevelopment. Again, just trying to reconcile what that I think it was CAD 704,000. What's included in that figure? If that's part of the offline discussion, we could certainly wait for that, but it would be nice to sort of just reconcile all those different line items.
We're going to have to take that one offline too, Mike. I don't have that.
Okay.
Level of detail with me.
Great. Last one for me before I turn it back. Just on Wisconsin, I noticed that when you guys first bought that portfolio, I think it was high 80s% occupied, and you drove it into the low 90s%, and last several quarters, we've kind of been trending back down to the high 80s%. I wonder if you could give us an update on what you're seeing there and how the NOI is performing.
Yes, this is Phil here. One tenant ended up building their own building, and that we knew going into due diligence. This is at 8401 Greenway. That's where you're seeing the biggest vacancy. What we've done there is we've remodeled the lobby, and we've created new building standards for the elevator lobbies and bathrooms, and we do a regular broker event, and we've had some very good traction there. We've got about four floors now available, and we've got RFPs on two out of four of those floors already. We've had some good success with remarketing that building.
Yeah. When we actually bought the portfolio, this goes back almost two years, right? We knew that tenant had signed an agreement to do a build to suit and to vacate. We were optimistic that we'd have the space leased to University of Wisconsin by the time they left. We didn't get that deal done, but now the space is vacant. We have a very good leasing program in place, and we're optimistic we'll get it leased up again.
Okay, great. That's it for me. Thank you.
Thank you. Next question will be from Jenny Ma at BMO Capital Markets. Please go ahead.
Hi. Good morning, everyone.
Good morning.
Just as a follow-up to Wisconsin. You bought a piece of land out there, and my understanding was that for a number of your properties in the Wisconsin portfolio, that there was some excess density already. When you think about the excess land you already have and the fact that Madison is typically, generally been sort of in a stable market in the low 90s range, can you just talk a little bit about what you're seeing as far as development opportunity and how this new piece fits into your plans for office development in that market?
This is Phil again. This particular land that we acquired was a part of an option that we inherited with the portfolio that we wished to exercise in order to protect, at least at a minimum, the defensive position with our office assets adjacent to that site. We also have a fairly large parking structure also adjacent to that site. That was simply completion of a plan when we first acquired the portfolio. We actually had been pursuing a build to suit. We were seeing quite a bit of growth in the health area, from everything from pharmaceuticals to insurance. We consider it to be a very good defensive strategy.
For some of the other land that we have there, particularly in Heartland Trail, we can announce more in the third quarter, we are negotiating with an existing tenant to expand on their site, and we are just wrapping up leases there. We're encouraged to see that we're getting quite a bit of growth from existing tenants, and we're glad that we have that land.
That expansion is 50,000 square feet, right?
It's actually going to be more than that. It's going to be a 50,000-square-foot extra structure, but also an additional 20,000 square feet.
We're grateful to have some surplus land in that market, Jenny, and that one property in particular. We do want to protect our flank, so to speak. We don't want a competitor doing a design-built suit for a tenant right beside us. That bit of inventory, we thought, was a good investment.
Okay, got you. Are you able to speak to whether or not the portfolio you have there appeals to sort of the burgeoning tech market in the local area, or is it a different kind of space that those users are typically looking for?
Well, we do sometimes get one of the big, well, the big tech company there is called Epic, and they provide operating software for hospitals throughout the world. They get often spinoffs, which we have at times inherited, which has been great. Yeah, it's becoming increasingly a med tech hub in the Midwest. It helps having University of Wisconsin as a sort of incubator, but also this major software company also in Madison. We have other oddities, like, I don't know if anybody knows about the Call of Duty video game, but the.
Is that Activision?
That's Activision. They occupy a bulk of one of our buildings as well. We get a variety of tech in Madison.
Okay. Got you. Moving to Calgary Office, could you shed some color on what kind of buyer it was for Birchcliff Building? I'm just trying to think about who's kicking the tires for properties that are basically empty in Calgary Office and what do you think they're seeing in those properties and what kind of opportunities over the longer term.
This is Kim. I can comment specifically on the sale of the Birchcliff Building. That was a buyer that was planning on turning it into a hotel. We're seeing a lot of buyers like that are looking at the properties as redevelopment opportunities, whether it's hotels or apartments, multi-family. That was that specific buyer.
Could you speak to the profile? Is it a local buyer?
I think he was local. I'm not completely familiar with his background, but as far as I know, he was a local buyer. He'd done this before, in terms of turning buildings into hotels. That was kind of the company's business logic into it.
Okay. Just as a general observation, what kind of buyers are you seeing out in the Calgary office market these days?
Opportunistic, private, some institutional. It's definitely a blend again.
Domestic institutional?
Yes.
Would you say?
Yes, for sure. There's the U.S. buyers out there as well. What we're seeing, what we've sold, and you remember, Jenny, I guess it was last year, we sold Alpine buildings to an offshore buyer from Asia. It's a mixture, but that I would call private buyer, not institutional.
Production Court, Eau Claire was, again, a private buyer from BC. We are expecting, on that point, the BC buyers, the BC private buyers see value in Calgary right now.
Okay. Great. That's all for me. Thank you.
Thank you. Ladies and gentlemen, as a reminder, if you do have a question, please press star followed by one on your touch-tone phone. At this time, Mr. Martens, it appears that we have no other questions. Sir, I would like to turn the call back to you.
Okay. Well, thank you, moderator, thank you, team, everybody, for joining us on this call. We wish you all a good, productive day and a great long weekend. Take care. Bye-bye.
Thank you, sir. Ladies and gentlemen, this does indeed conclude your conference call for today. Once again, thank you for attending, and at this time, we do ask that you please disconnect your lines. Enjoy your weekend.