Automotive Properties Real Estate Investment Trust

TSX:APR.UN

Earnings Call Transcript 2021-Q1

[Operator]

Good morning. Welcome to the Automotive Properties REIT 2021 First Quarter Financial Results Conference Call and Webcast. My name is Chris, and I'll be your conference operator today. At this time, all lines are in listen-only mode. Following management's remarks, we will conduct a question-and-answer session. Please be aware that certain information discussed today may be forward-looking in nature. Such forward-looking information reflects the REIT's current views with respect to future events. Any such information is subject to risks, uncertainties and assumptions that could cause actual results to differ materially from those projected in the forward-looking information. For more information on the risks, uncertainties and assumptions relating to forward-looking information, please refer to the REIT's latest MD&A and Annual Information Form, which are available on SEDAR. Management may also refer to certain non-IFRS financial measures. Although the REIT believes these measures provide useful supplemental information about financial performance, they are not recognized measures and do not have standardized meanings under IFRS. And again, please refer to the REIT's latest MD&A for additional information regarding non-IFRS financial measures. This call is being recorded on Thursday, May 13, 2021. I would now like to turn the conference over to Milton Lamb. Please go ahead.

[Milton Donald Lamb, President, CEO & Director]

Great. Thank you, Chris. Good morning, everyone, and thank you for joining us today. With me on the call is Andrew Kalra, our Chief Financial Officer. We generated growth across all of our key performance measures in the quarter in comparison to Q1 of last year. Our property rental revenue grew by 4.3%. Cash NOI increased by 7.8%. Same-property cash NOI was up 1.3%, and AFFO per unit diluted increased to $0.227 from $0.208. Our financial flexibility has also improved. At quarter end, our debt to GBV ratio was 41.7%, down from 43.2% at 2020 yearend and 44.9% at the end of Q1 of last year. The automotive dealership industry in Canada has faced unprecedented challenges since the onset of the pandemic. Dealership operators, including our tenant groups, provided rapidly -- sorry, responded rapidly and effectively to the pandemic with enhanced e-commerce solutions and streamlined operations, demonstrating strong resiliency. While our tenants continued to operate on a limited basis during the quarter due to pandemic-related business restrictions, we received 100% of our contractual rent due under their leases, plus continued repayments on previous deferrals. No further deferrals were requested. This is a testament to the success of their businesses and resiliency. As a result, the capitalization rate applicable to our entire portfolio was reduced to 6.6% at quarter end, a reduction of approximately 10 basis points from 6.7% at 2020 yearend. The capitalization rate is now equal to the rate used at the end of 2020 -- sorry, at the end of 2019 prior to the onset of the pandemic. During the quarter, on March 1, we completed the acquisition of the Lexus Laval dealership property in Laval, Quebec from the Dilawri group, further increasing our presence in Canada's second-largest metropolitan market. We satisfied the purchase price by issuing the equivalent of $14.8 million in REIT units, increasing Dilawri's effective interest in the REIT to approximately 28.1%. As COVID restrictions ease, macroeconomic conditions will improve, driving further recovery of our dealerships' businesses. This should result in increased opportunities to continue advancing our acquisitions program. With our low debt to GBV rate and strong liquidity position, we are well positioned to capitalize on this. I'd now like to turn it over to Andrew Kalra, who will review our financial results and position in more detail. Andrew?

[Andrew Atul Kalra, CFO & Corporate Secretary]

Thanks, Milton, and good morning, everyone. Our property rental revenue for the quarter totaled $19.4 million. The 4.3% increase from Q1 2020 reflects growth from properties acquired during and subsequent to Q1 last year, contractual annual rent increases, and a lease termination fee paid by a former tenant during the quarter. Total cash NOI and same-property cash NOI for the quarter increased to $16.1 million and $14.8 million, respectively, reflecting increases of 7.8% and 1.3% respectively, compared to Q1 a year ago. Growth in cash NOI was primarily attributable to acquisitions, contractual rent increases and the lease termination fee, while growth in same-property cash NOI primarily reflects contractual rent increases. G&A expenses for the quarter were approximately 7% of cash NOI compared to 6.5% in Q1 last year. Higher G&A expense in Q1 this year is primarily due to the vesting of previously issued deferred units. Net income for the quarter was $26.3 million compared to net income of $15.7 million in Q1 last year, an increase of 67.2%. The increase was primarily due to higher NOI fair value adjustments for interest rate swaps and investment properties, partially offset by fair value adjustments for Class B units and unit-based compensation. FFO and AFFO for the quarter increased by 8.3% and 11.0%, respectively, compared to Q1 last year. FFO per unit diluted was $0.239 in the quarter compared to $0.224 in Q1 last year. And as Milton noted, AFFO per unit diluted was $0.227, up from $0.208 in Q1 a year ago. The growth was primarily due to properties acquired during and subsequent to Q1 last year, contractual rent increases, a lease termination fee that was offset by the reduction of a straight-line rent adjustment to the termination -- due to the termination of the lease. Three paid total distributions of $9.6 million or $0.201 per quarter, in the quarter, representing an AFFO payout ratio of $0.885 -- 88.5%. This compares to total distributions paid of $9.6 million or $0.201 per unit in Q1 last year, representing an AFFO payout ratio of 96.6%. As at March 31, we had a strong financial liquidity position with $56.9 million of undrawn credit facilities, 10 unencumbered properties with a value of approximately $166.8 million, providing us with additional financial flexibility and a debt to GBV ratio of 41.7%. We had $394 million of outstanding debt at the quarter end with an effective weighted average interest rate of 3.73%. We have a well-balanced level of annual maturities and our weighted average interest rate swap in mortgage term is 5.7 years. I'd like to turn the call back to Milton for closing remarks. Thank you.

[Milton Donald Lamb, President, CEO & Director]

Great. Thanks, Andrew. The automotive dealership industry is an essential business that has demonstrated strong resiliency through a difficult period. We have collected 100% of our April and May 2021 contractual base rent plus rent that is due under the deferral agreements. We have not received any additional deferral requests. We believe that the overall fundamentals of the automotive dealership businesses are strong and that the industry has demonstrated its resiliency. As the pandemic is brought under control, we expect the pace of the industry consolidation to rebound. Given our strong balance sheet position, we can pursue acquisitions on a strategic basis through debt financing and available liquidity. This now concludes our remarks, and we'd like to open it up for questions. Chris, please go ahead.

[Operator]

[Operator Instructions] Your first question comes from Mark Rothschild, Canaccord.

[Mark Rothschild, MD & Real Estate Analyst]

Maybe just following up on the last comments you made, Milton, it seemed like you were saying that you expect there to be more properties available for sale. Clearly, dealers are -- the business has picked up of late, they're doing well. Is this something you're seeing already in the market, more availability? And maybe just a second part of that question, if you could talk about have the values changed in what you're seeing price expectations compared to where we were maybe this time last year?

[Milton Donald Lamb, President, CEO & Director]

Yes. I mean, there's been -- I would say talking to the bankers that provide the credit facilities to the dealership groups, talking to the brokers who sell dealers, dealerships, they're all saying they're hearing a lot of murmurs, and there's a lot of people preparing for the consolidation that is going to occur. But they're not seeing the type of product during a lockdown that they would anticipate. It seems like everyone is kind of getting into a bit of a queue as opposed to acting on it right now. So short answer is, expecting it, loud murmurs, but we're not seeing the same sort of activity we would if there wasn't a lockdown. I don't think that changes the underlying consolidation theme. It just delays it a little bit. And then on the price availability, good question. Certainly, interest rates are dramatically lower than they were a year ago, which means the cost of capital for vendors or dealerships is lower and cost of capital for us is lower. So it will be interesting to see how that plays out and what their expectations are, but that's too early to say at this point.

[Mark Rothschild, MD & Real Estate Analyst]

Okay, great. Maybe just one more maybe for Andrew. It seems like you're saying that the lease termination income is offset by the impact of straight-line rent. Can you just walk me through exactly how that worked and if there really was no -- if it balanced out?

[Andrew Atul Kalra, CFO & Corporate Secretary]

It's not completely offset. If you look at the straight-line rent adjustment difference from 2021 Q1 to 2020, it's about $200,000. And a significant amount of that was a result of the lease termination. So it's not a pure offset, but I can lead you to the math on that one.

[Operator]

Your next question comes from Jonathan Kelcher, TD Securities.

[Jonathan Kelcher, Analyst]

Just to follow up on that last little bit on lease termination income, can you maybe give us your expectations for the balance of this year, like what's a good run rate?

[Andrew Atul Kalra, CFO & Corporate Secretary]

I would take that $518 million that we had and add the $200 million. So $700 million would be a decent run rate.

[Jonathan Kelcher, Analyst]

Okay. And then…

[Andrew Atul Kalra, CFO & Corporate Secretary]

And Mark, sorry, Jonathan, it will fluctuate as we move, as those things move accordingly with acquisitions.

[Milton Donald Lamb, President, CEO & Director]

And then obviously, we're not expecting further lease termination payments. That was an anomaly, and even then, that was more accounting. Because as we mentioned before, there was an offset whereby we collected a lease termination fee that was equal to what we provided to Tesla for improvements.

[Andrew Atul Kalra, CFO & Corporate Secretary]

Yes, Jonathan, from a pure cash, it would be net 0, but the accounting is going to have to pick accordingly.

[Jonathan Kelcher, Analyst]

Okay. Fair enough. When we look at your leases, can you remind us like what percentage of the leases are CPI related? And generally, how do those work? Is it like an annual reset or what are the mechanics there?

[Milton Donald Lamb, President, CEO & Director]

I don't have the percentage in front of me on that number, so we can kind of circle back on that. But as far as how it works, most of them are going to be provincial by nature with a base year and then obviously an inflator above that based on the CPI Index. And that will get adjusted annually on the anniversary.

[Operator]

Your next question comes from Kyle Stanley, Desjardins.

[Kyle Stanley, Associate]

So as we emerge from the pandemic, are you expecting capital commitments to ramp up at all, maybe as dealers or OEMs catch up on any deferred spending from the pandemic?

[Milton Donald Lamb, President, CEO & Director]

I would probably say yes, but I don't think that means it's the next day. I think as much as they can, they're pushing it off into '22 and '23. But I do believe that the OEMs are a lot more flexible now. But as soon as -- everyone is talking about the strong profitability, so I think the OEMs, as soon as the microchip supply chain and COVID has dissipated, are going to push them back to their capital imaging improvements, etc. But I would see that having a slight delay, and then yes, absolutely, it's going to come back to the forefront.

[Kyle Stanley, Associate]

Okay. And then just following up on kind of the deal market right now, so are you seeing much out there yourselves? Or do you expect the bulk of kind of what you'll be able to complete in the next say 12 to 18 months being driven by Dilawri's growth?

[Milton Donald Lamb, President, CEO & Director]

No. I don't know if it's going to be Dilawri, I don't know if it's going to be other dealership groups. But certainly, we do expect call it the 18 months that there is going to be -- with all the murmurs and discussions we're having, the consolidation is going to recommence. And a lot of our tenants and certainly other ones out there are going to be the significant players. As mentioned before, it's -- I think the larger groups are going to continue to get larger.

[Kyle Stanley, Associate]

Okay. And then just the last one and kind of following up on Mark's prior question, so your cap rate has come back down to pre-pandemic levels. And given interest rates and what they've done, like you just mentioned, I'm just wondering, with regards to the market pricing that you're seeing, do you think there's more room for cap rate compression within your portfolio?

[Milton Donald Lamb, President, CEO & Director]

Yes. So I'll do 2 parts on that. The first one is going back to 6.6. At previous calls, I had mentioned that because of my experience prior to APR, that any time you're giving any sort of tenant assistance, I was of the belief and the Board was of the belief that if you're giving tenant assistance, a new purchaser is going to discount or increase the cap rate that they require. We're no longer giving tenant assistance. As mentioned, starting January 1, everyone is paying their lease rates as per their lease and then actually paying back any deferrals. So that's normalized. And with 100% rent collection, we felt good about going back to where we were before. The second part of the question is, now interest rates are lower, the market as it gets back to activity, it will be interesting to see what's demonstrated on what cap rates are going to be. In other sectors, you've seen them drift lower. But we haven't seen that evidence yet because we haven't seen the activity. So when the activity comes back, certainly it's always an equation which is part initial return, part after leverage return. So we're watching that closely.

[Operator]

Your next question comes from Joanne Chen, BMO Capital.

[J. Chen, Director of Equity Research]

Maybe just a broader question. Of course, there's a lot of pent-up demand, and obviously, auto sales have come back pretty strong for 2021. With reopening, it will likely only pick up. But we're hearing a lot on a broader scale in terms of chip shortages that may get now extend beyond 2021. And of course, some of that is this disproportionately skewed towards the auto industry. But are you hearing anything from your dealership with respect to some of that supply that's able to come to the dealers right now to service that demand?

[Milton Donald Lamb, President, CEO & Director]

Yes. It's certainly a discussion that everyone's talking about is the inventory supply chain. Everyone's talking about that's going to affect '21 models probably less so, very much less so in the '22 models. But it is important when we look at this, 2 things. One is, new car sales may be a higher percentage of revenue. It's certainly a far lower percentage we've talked about, plus or minus 20% to the profits. At this point, it's kind of inverse in the fact that it's tough to get discounts on cars. Gross margins are up for new car sales because inventory is down. So I think it affects the OEMs more than it affects the dealer groups or the dealerships because their gross profits on new car sales are pretty healthy. There is less volume, higher profits.

[J. Chen, Director of Equity Research]

That hasn't changed at all on that front even as more [indiscernible] discussed, but it doesn't seem like that's changed, so that's good.

[Milton Donald Lamb, President, CEO & Director]

No, supply/demand is supply/demand. So when supply gets constricted because of what we're talking about, then that's going to have an effect on -- less on demand. I'd say demand, as we get back, if you look to the states where they've opened up earlier than we have, that demand has bounced back, so I would expect same thing to happen in Canada.

[J. Chen, Director of Equity Research]

Great. And maybe just shifting gears back onto the acquisition side of things, is there any markets where you're particularly focused right now or just kind of across your portfolio?

[Milton Donald Lamb, President, CEO & Director]

We always focus on metropolitan markets. Demographic, underlying demographic growth, positioning, etc. We've talked about that before. We still certainly like that triangle of Toronto, Ottawa, Montreal. Vancouver, we along with everyone else, love it, but it's at a different cap rate level, so we'd only do so much of it. The Alberta, Edmonton and Calgary is showing signs of recovery, which we like. But we will look at that as kind of a stable growth as we grow the portfolio as opposed to going long on Alberta.

[J. Chen, Director of Equity Research]

Okay. Got it. And maybe just one last one for me, it looks like the weighted average rental rate for the overall portfolio did tick down a little bit because of the Tesla Laval. So was that primarily because the lease term was extended by the 2.5 years, that's why it was a little bit lower? Or was there some other mechanics in there?

[Milton Donald Lamb, President, CEO & Director]

No. I think it would have drifted lower. No, I mean the Tesla Edmonton was a very similar -- well, actually, same levels, so that wouldn't have adjusted. I think it's the Tesla Laval, which because it's a 120,000-odd foot location that is a bit more service and distribution as opposed to pure retail and a normal dealership footprint, that would have lowered our -- you'll see that in the Montreal stats, that would have lowered our average. Andrew? Is that…

[Andrew Atul Kalra, CFO & Corporate Secretary]

Yes, that's correct. It's the square footage on that Montreal property that's just covering the average.

[Operator]

[Operator Instructions] Your next question comes from Himanshu Gupta, Scotiabank.

[Himanshu Gupta, Analyst]

First on Dilawri exposure, 62% now. Do you have a target where you want this number to be? I mean, coming off the crisis, will you look for more diversification in the portfolio?

[Milton Donald Lamb, President, CEO & Director]

No, I think that remains pretty consistent. It's a balance between -- we certainly like and have a strategic alliance with Dilawri, so adding strength of covenant never hurts. But the bottom line is, we own most of Dilawri's real estate, whereby the rest of the dealership universe is far greater. So we expect, as we continue to grow, that there should be a higher proportion that is other dealership groups. So that's naturally going to dilute Dilawri at the same time. So we like the fact that we're looking to increase diversification. But no, we haven't set it at a specific target. And we don't really look at it that we want to sacrifice a deal with a good tenant just for diversification. But naturally, there's a far greater universe out there from other dealership groups than it would be just with Dilawri.

[Himanshu Gupta, Analyst]

Got it. And then a follow-up. You mentioned auto dealerships' cost of capital has improved quite a bit. How does that impact your acquisition pipeline? I mean, are the dealerships in a better position now to own the underlying real estate as well?

[Milton Donald Lamb, President, CEO & Director]

I guess the good news is we've mostly wanted to focus on groups that, well, we have focused on groups that have access to capital. So it's about leverage, liquidity, all those good things as they continue to expand. It always comes down to what's their cost of capital and where do they want to use it, what are their profit margins, return on investments on owning the real estate versus acquiring another dealership. So certainly, part of the equation is what interest rates are they paying to their banks? I would say when it's free money, that they're going to take advantage of it. And last time we saw significant activity, there was actually a small uptick in interest rates, and that was reminding dealers that there is a cost of leverage.

[Himanshu Gupta, Analyst]

Got it. That's fair enough. And then just turning to your IFRS cap rate, obviously back to pre-pandemic levels. How do you incorporate the land values in your IFRS valuation? I mean land values in Toronto have gone up in the last 2, 3 years. Will that flow through in your portfolio valuation as well?

[Milton Donald Lamb, President, CEO & Director]

We certainly look at individual markets. I mean, as an example, this time last year, we had moved up Alberta more than the rest of the portfolio, and we could probably -- prior to that, we talked about reducing our cap rates in Toronto and Vancouver versus the rest of the portfolio. So that certainly comes into it overall prior to the pandemic. We've been pretty consistent around that 6.5%, 6.6%. We don't love playing the games of moving cap rates up or down too dramatically on a regular basis. Certainly, the interest rate environment has a place to -- a place within the kind of mental calculation on where cap rates should go, but we certainly want to see more of the trades to occur to demonstrate that. Certainly, as you said, the Toronto, Ottawa, Montreal, I would say that the cap rates have gone down on most product categories.

[Himanshu Gupta, Analyst]

Got it. And my final question is on the CapEx reserve. I know I think you do 0.5% of the base rent. Have you spent any of that CapEx reserve you had in the last year? Or are you planning to spend anything this year?

[Andrew Atul Kalra, CFO & Corporate Secretary]

We have not spent anything at this point in time, but we will be spending it based on the acquisitions that we've done. There's some commitments that have been made, but nothing has been spent as of today.

[Operator]

Your next question comes from Tal Woolley, National Bank.

[Tal Woolley, Research Analyst]

I just wanted to go back to the dealership profitability discussion you were having with Joanne. Can you remind me how -- like how to think about the service side, the profitability of the service side of the business versus the use in the new auto sales?

[Milton Donald Lamb, President, CEO & Director]

Yes. I mean, if you look at whether it's Auto Canada or Penske Group I, some of the other U.S. public dealership groups, they kind of break it down nicely. But a lot of them tend to be sales, new car sales approximately 50%, and profits are approximately 20%. And then within the F&I and used car has certainly kind of popped up nicely right now. But we always look at it as plus or minus 20% is the new and then 80% is the other buckets. I think that's probably similar now, except you've seen actually the profits from new car sales go up a bit as profit margins, even though the revenues are down, the profit margins for those new car sales have gone up.

[Tal Woolley, Research Analyst]

Okay. And have you heard anything from just chatter about when the supply chain issues might be resolved? Like what are the dealers saying?

[Milton Donald Lamb, President, CEO & Director]

Yes. I mean, the dealers or the industry overall is just talking about that they expect it to continue for the '21 models, but then start resolving itself for the '22 models. So I don't know if that means January '22 or as you see the new models coming out in October, November, December. Because often, the '22 models or the next year's models kind of leak out a bit before the calendar date.

[Andrew Atul Kalra, CFO & Corporate Secretary]

The estimates range by various analysts as to how long this will go, but they're pretty much down for the next couple of months for sure, but they do range in timing.

[Tal Woolley, Research Analyst]

Okay. And then just to go back to on your discussion around geographies, have you guys ever given consideration to maybe looking at some of the more regional dealerships outside of the urban markets? I know like, obviously the land value and stuff like that is not as high, but I wonder if like there's ever been thought given that you might be able to find some decent risk-adjusted returns in those markets?

[Milton Donald Lamb, President, CEO & Director]

We certainly have thought about it, but we keep on coming back to, both on the plus side and on the defensive side, that if you're in metropolitan markets, you have intensification. You have lack of supply to relocate. You have the advantage of the dealership model that includes radius clauses, so it's very tough to move. Define that 2 to 3 acres in that 8-kilometer radius because if you move 2 or 3 kilometers with that 8-kilometer radius, you trip over another dealer group or another dealership, I should say. So that's one of the baselines that we really enjoy. Now having said that, that doesn't mean it's just VECTOM. I mean as an example, do I like Halifax? Yes, it has a lot of those characteristics. Do I like Colona? Do I like Victoria? Do I like Kitchener-Waterloo? Which Kitchener-Waterloo-Guelph, we've done some acquisitions there. The answer is yes. But those all have the same sort of underlying fundamentals that I just talked on. Going into an area that is very rural, that makes us a lot more nervous on retaining the tenant at the end of term. Certainly, we do underwriting as well on them, and most of the time when we get indemnification on the dealership groups. So we feel good about the lease in the meantime. But there is something nice about the underlying radius clauses and the supply/demand on land.

[Tal Woolley, Research Analyst]

Okay. And any thoughts at all ever about maybe looking at some U.S. markets, too?

[Milton Donald Lamb, President, CEO & Director]

Well, that kind of goes to the second half of the equation, is in the U.S., there are certainly markets that have those fundamentals that a tertiary market in Canada would not. So I wouldn't say we're blind or deaf to those ideas. If we do it, it's going to be on a strategic basis. We like what we're seeing in Canada. We expect that market on the M&A to open back up. But that doesn't mean we're blind to other opportunities or that we can only do Canada.

[Operator]

Your next question comes from Brad Sturges, Raymond James.

[Bradley Sturges, MD & Equity Research Analyst]

In terms of I guess your commentary there on discussions are starting to pick up a bit on the transactional side, given that we've been in a more muted environment with lockdowns, like is it possible being a little bit of pent-up demand from a transactional point of view once consolidation does really start to resume?

[Milton Donald Lamb, President, CEO & Director]

I don't know, are you itching to get on a patio? I think it's the same sort of thing. Everyone right now is kind of looking at what they want to do as soon as things open back up and getting prepared to do that. So I mean, I just think overall, whether you're talking about M&A within the dealership, yes. When you're talking about activity overall and getting back to normal, the answer is going to be yes. And that goes down to kind of consumer behavior as well. Everyone's getting a bit of an itch to get this lockdown over with and kind of getting back to business. So I think there will be a noticeably mental rebound.

[Bradley Sturges, MD & Equity Research Analyst]

To answer your question, yes, I am. In terms of -- and once that transaction activity starts to occur again, do you believe it's going to be kind of still following consumer historical patterns in terms of deal flow being more back-end weighted let's say this year?

[Milton Donald Lamb, President, CEO & Director]

You know what, we've always been back -- back-half of the year weighted. Especially the last quarter, the last Q4 of the year weighted as far as transaction activity. I keep on talking about the next 18 months. It's hard to pin it exactly. I was wrong for the last 6 weeks. I didn't expect this lockdown to continue. I don't think anyone did. So certainly, when we're talking about 18 months, it's really hard to pin exactly when it's going to occur.

[Operator]

Thank you. There are no further questions at this time. Please proceed.

[Milton Donald Lamb, President, CEO & Director]

That's great, everyone. Take care, and we will talk to you after Q2. All the best.

[Operator]

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.