Automotive Properties Real Estate Investment Trust

TSX:APR.UN

Earnings Call Analysis

Earnings Call Transcript 2023-Q3

[Operator]

Good morning. Welcome to the Automotive Properties REIT 2023 Third Quarter Financial Results Conference Call and Webcast. My name is Joanna, and I will be your conference operator today. [Operator Instructions] 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 related 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. Again, please refer to REIT's latest MD&A for additional information regarding non-IFRS financial measures. This call is being recorded on Tuesday, November 14, 2023. I would now like to turn the conference over to Milton Lamb. Please go ahead, Mr. Lamb.

[Milton Lamb, executive]

Great. Thank you, Joanna. Good morning, everyone, and thank you for joining us today. On the call with me is Andrew Kalra, our Chief Financial Officer.

We generated continued year-over-year growth in all of our key financial metrics in the quarter, reflecting the quality of our portfolio, the positive impact of acquisitions earlier this year and contractual rent increases. Compared to Q3 of last year, property rental revenue increased 13%. Cash NOI increased by 11.6%. Same property cash NOI increased 2.5% and AFFO per unit on a diluted basis increased to $0.23 from $0.227.

Our portfolio and debt strategy continue to demonstrate resilience in the current environment of elevated inflation and interest rates. We are well insulated from these external pressures due to our triple net lease structure as all property level, operating and energy costs are the responsibility of our tenants, allowing contractual rent escalations to flow directly to our NOI.

We also have a significant proportion of leases with CPI-linked adjustments. Leases with CPI-related adjustments represent 26% of base rent this year and for 2024, an additional 10% of our existing leases will be subject to capped CPI related adjustments.

We are well positioned to generate continued growth in same property NOI due to this increased proportion of CPI length leases.

We have currently managed our debt this year to limit exposure to elevated interest rates, enhance our financial flexibility. At quarter end, 91% of our debt was fixed through interest rate swaps and mortgages. We currently have approximately $65.8 million of undrawn capacity under our revolving credit facilities and 5 unencumbered properties with an aggregate value of approximately $70.6 million. Our debt to GBV as of September 30 is at 44.5%.

I'd now like to turn it over to Andrew Kalra to review our third quarter results and financial position in more detail. Andrew?

[Andrew Kalra, executive]

Thanks, Milton, and good morning, everyone. Our property rental revenue for the quarter totaled $23.4 million, a 13% increase from Q3 a year ago, reflecting growth from properties acquired subsequent to Q3 last year and contractual annual rent increases. Total cash NOI, same-property cash NOI for the quarter totaled $19.2 million and $17.1 million, respectively, representing increases of 11.6% and 2.5% respectively, compared to Q3 a year ago. Growth in cash NOI was primarily attributable to acquisitions, contractual rent increases, growth in same-property cash NOI, primarily reflects contractual rent increases across our portfolio.

Interest expense and other finance charges for the quarter were $6.3 million, representing an increase of approximately $1.6 million from Q3 last year. The increase was primarily due to additional debt incurred to acquire properties subsequent to September 30 last year, together with an increase in weighted average interest rates. Further, we still have approximately $25 million in debt at floating rates as we did not want to lock this amount in for term at today's elevated long-term rates. We tend to lock this amount at more favorable rates in the future.

Our G&A expenses in the quarter were approximately $1.4 million, up from $1.2 million in Q3 last year. Net income increased to $28.3 million in the quarter compared to $8.9 million in Q3 a year ago. The increase was primarily due to higher NOI and favorable changes in noncash fair value adjustments for interest rate swaps, investment properties and Class B units and unit-based compensations. The impact of the movement in the traded value of REIT units resulted in an increase in fair value adjustments for the Class B units and unit-based compensation of $10.6 million in the quarter compared to an increase of $2.3 million in Q3 a year ago.

FFO and AFFO for the quarter increased by 1.5% and 1.9%, respectively, compared to Q3 last year, reflecting the impact of properties acquired subsequent to September 30 last year and contractual rent increases. FFO per unit diluted was $0.239 in the quarter, up from $0.237 in Q3 a year ago and AFFO per unit diluted was $0.23, up $0.227 in Q3 last year. To repay total distributions of $9.86 million or $0.201 per unit in the quarter, representing an AFFO payout ratio of 87.4%. The AFFO payout ratio in Q3 last year was 88.5%.

The capitalization rate applicable to the REIT's entire portfolio increased to 6.56% at quarter end, a nominal increase from 6.52% at the end of Q2 and 6.42% at the end of year-to-date 2022. The fair value loss in investment properties in the quarter was $0.8 million, reflecting market conditions that compares -- or excuse me, that compares to a fair value loss of $5.8 million in Q3 last year.

Discount rates at 7.46%, up 30 basis points from 6.88% December 31, 2022. We had $537 million of debt -- outstanding debt at quarter end with an effective weighted average rate of 4.18%. We continue to have minimal exposure to floating or short-term interest rates with 91% of our debt through interest rate swaps and mortgages. We have a well-balanced level of annual maturities with a weighted average interest rate swap and mortgages remaining of 5.1 years and a weighted average turn of maturity of debt of 3.1 years. I'd like to turn the call back to Milton for closing remarks. Thank you very much.

[Milton Lamb, executive]

Thanks, Andrew. The fundamentals of the Canadian automotive sector remain positive. According to DesRosiers Automotive Consultants, Canadian new light vehicle sales increased by 10.1% in the first 9 months of 2023 compared to the same levels last year, reflecting continued consumer demand for new vehicles. With our strong portfolio of essential retail properties located in prime urban markets, high-quality tenants with triple net lease structures and embedded or CPI-adjusted rental growth, we are well positioned to generate continued growth and stable distributions to our unitholders. We continue to elevate acquisition opportunities in metropolitan markets across Canada to drive further growth.

That concludes our remarks today. And now I'd like to open up the lines for questions. Joanna, please go ahead.

[Operator]

[Operator Instructions] First question comes from Frank Liu from BMO Capital Markets.

[Frank Liu, analyst]

Just want to start with the current dynamic in the dealership transaction market. What are you seeing in terms of the transactions these days? And should we expect more deals to come towards the end of this year or it will be more early 2024 story?

[Milton Lamb, executive]

Sure. On the back of what we're seeing on the operating side, M&A, the actual dealership sales, we are seeing a bit of a lag on the buy/sell as we're coming off of '21 and '22 where dealers' profitability was incredibly strong. We're expecting it to still remain well above pre-COVID levels and very healthy. But those numbers are coming to -- coming down a bit. And really, there's a discussion on vendors versus buyers' expectations on what's the real EBITDA to kind of base a multiple on acquisitions on. We're starting to see that buy/sell kind of come together a bit, but we're expecting to see that happen a lot more once they get the full print of a more normalized, very healthy 2023 numbers. So that flows directly to APR on opportunities.

Our conversations continue to be good. And I would say that just the fact that it used to be, especially in '21, dealers used to compare our costs to their short-term 90-day money with floating rates, which was incredibly tight and high LTVs. Those LTVs are reducing and certainly short-term interest rates have spiked dramatically. That just allows us to be a better proposition now than it would have been in 2021.

And as far as what that means for us, I mean, in today's capital market interest rate environment, we're being extremely selective. We're having good conversations. I don't know if that means it's Q4 2023 or later in 2024 but I do like the opportunities that are coming forward. It's just we are wanting to be selective for good and obvious reasons. And at the same time, we also like the fact that we've got liquidity and some flexibility in our balance sheet.

[Frank Liu, analyst]

Got it. And I guess, with the current interest rate environment, do you see the bid-ask spread like narrow a little bit or more in favor for APR?

[Milton Lamb, executive]

I mean the bid-ask spread on operations, I mentioned it a bit. We're not as close to that as we are on what we have been requesting now as far as applicable cap rates. We're asking for a bit more because we need it to be very constructive and appealing if we're going to trade off some of the liquidity and flexibility that we have for good acquisitions. We want our unitholders to be paid for it. Those conversations are going deeper now than they would have 6 months ago when vendors were doing a very quick flashback to what cap rates they were hoping to achieve in '21 and '22, which were certainly dramatically lower than what you'd see today. And remember, we didn't do acquisitions in 2021 because we thought those cap rates were way too low.

[Frank Liu, analyst]

Got it. Lastly, I want to touch on the balance sheet side. I believe you have like a 10%-odd swap, let's call it, like $43 million swap expiring in the next couple of years. Could you just remind us quickly what's the rate on those swaps? Is it fair to call it like a 4%?

[Andrew Kalra, executive]

Yes. I mean those were done way past at the time of the IPO, and they had long-term ladder maturities of over 5 to 7 years. We've taken that approach historically to do long-term swaps. In particular, we did that at the beginning of this year. But as we've seen long-term rates rise, we've paused on a $25 million swap that we have. And we have a relatively small revolver balance of $23.6 million right now. So overall, 91% fixed.

[Milton Lamb, executive]

Yes. I mean to Andrew's point, we don't do specifics on each swap but certainly, when you look at our rollover schedule, we've spread it out so that there should not be a shock to the system. And those are a bit more historical. So it depends what we see later in 2024 on what we think that, that will roll over at. Even if it's a marginal increase, we don't think it will be dramatic.

[Andrew Kalra, executive]

And just talking on the weighted average, a year ago, we were at 3.8% and now we're at 4.18%. But we've added about $70 million of swaps at the beginning of this year. A new debt for the new acquisition, so which balances out.

[Operator]

The next question comes from Mark Rothschild from Canaccord.

[Mark Rothschild, analyst]

Milton, you've been historically pretty careful with the markets you've gone into and with the acquisitions. There's clearly quite a bit of population growth in Canada. Does this lead to opening up new markets or new submarkets or maybe historically you haven't gone into that might be more interesting going forward. And I'm just asking in the context of -- it's definitely difficult to find good acquisitions that are accretive, that fit the model. So I'm just wondering if there's going to be any opportunities over the next few years to maybe expand your targets?

[Milton Lamb, executive]

I mean it's interesting. The population growth you're talking about, a lot of that is actually being absorbed in the markets that we know and like. So I don't really think that changes it. We do think there will be some good opportunities in the markets that we like, whether it's a [ Kelowna ], Kitchener-Waterloo, Quebec City, some of the markets that are not just VECTOM. But we closely watch our VECTOM level because we do like to be -- we're just about 80% now, and we'd like to be extremely high on that level.

I don't think it's population growth that's going to drive our opportunities. It's a nice backstop. I think it's just the fact that short-term rates have come to a level that our proposition is a lot more attractive to dealers. So we're looking forward to 2024. Quite frankly, we're looking forward to the end of 2023 because of all the macro. 2024 is -- it's going to be nice to see.

[Mark Rothschild, analyst]

Okay. Great. And maybe just one question regarding the floating rate debt. Is there something you guys are waiting to see to fix all the debt? And are there some points where we will...

[Milton Lamb, executive]

We've traditionally gone longer when rates were low. In that, you can argue that cost us a little more in each quarter, but we think it was for good reasons, and we have been reaping some rewards for that. On the flip side, what we're seeing, especially over the last 6 months is rates that are incredibly elevated compared to historical. And we'd rather pay a bit more to keep some of that, as Andrew was saying, some of the secured financing of approximately $25 million that we could swap out. There's not a -- it's very flat right now. There's not a significant advantage to kind of embed that longer -- that lower rate -- sorry, higher rate for longer. So we're leaving that flexible to allow us, as we go into '24 that we can fix that at a lower rate.

So it's paying a bit more right now, but it's not locking in high rates for longer term, which I just don't think helps anyone. It doesn't help our unitholders.

[Operator]

The next question comes from Jonathan Kelcher from TD Cowen.

[Jonathan Kelcher, analyst]

First question, I guess, we'll stick with acquisitions. You said you're looking like you're a better proposition now for dealers. Does that mean you're seeing more opportunities given a certain level of M&A than you would have seen in the past?

[Milton Lamb, executive]

We are seeing less M&A because there is the buy/sell gap for dealers. But in the discussions that we have, they are going deeper because the proposition that we're having is more compelling compared to certainly 2021, where if we're competing against short-term 90-day money, it was incredibly hard/impossible to compete without kind of giving away the shop, which we refused to do.

[Jonathan Kelcher, analyst]

Okay. So, on a net basis, it sounds like you're seeing similar opportunities to past years?

[Milton Lamb, executive]

I would say similar and slightly better pricing. Similar number of opportunities and slightly better conversations and better pricing.

[Jonathan Kelcher, analyst]

Okay. And then on that, I think you said you're being extremely selective. Is that more so on pricing? Or is that -- I guess, related a little bit to Mark's question on choosing a geographic location or dealer quality, maybe expand on that a little bit.

[Milton Lamb, executive]

Today's elevated even short-term rates. But as I said, it's kind of flat with long-term rates as well. We've got to get paid on a return on investment. So certainly, the first one is the equation. What does that do for our unitholders, what does it do for AFFO. But we've always liked looking at the real estate. We like high-quality dirt in good locations. So that can be in a midsized market or it can be one of the VECTOM markets. We certainly look at the debt, but we do want to achieve certain returns.

[Operator]

The next question comes from Brad Sturges from Raymond James.

[Bradley Sturges, analyst]

Just on the IFRS valuation change, I guess, it sounds like you made more change in the cap rate just based on where interest rates have moved over the last few months and less to do with -- I guess, transactions you're seeing in the market at this point, it's more of a reflection of where you think values are trending at this point.

[Milton Lamb, executive]

It's been a combination of both. I mean we -- this is 3 quarters in a row that we've moved up cap rates slightly. So it's been a slow movement. And if we flash back to when you saw interest rates dropping dramatically, we didn't move cap rates a lot then either. We tend to be the vast majority of the acquisitions on an income basis for dealership properties. So in a weird way we kind of help set the market. So we're very comfortable with what we're seeing because we did not see a dramatic drop in cap rates and therefore, an increase in cap rates. But I think it's only fair that some of our discount rate gets flowed through because, obviously, cost of capital and expected returns are slightly higher today than they were 2 years ago or 4 years ago.

[Bradley Sturges, analyst]

Okay. That makes sense. Just in terms of the rent growth for 2024, with the CPI-linked leases, I guess, a portion of them are capped, what would be your expectation for the average rent growth for next year?

[Andrew Kalra, executive]

It's hard to give that number because since it's inflation-related. You've got 53% or so at [ 1.5 ] and then the remaining 36 -- sorry, [ 26 ] at CPI and then the [ 10 ] that are capped, and then you got some other amounts that are -- have got increases. So it's hard to give a number. It all depends on where CPI is going to be.

[Milton Lamb, executive]

We have traditionally been between [ 2 ] and [ 2.5 ]. We don't see that dramatically changing.

[Operator]

The next question comes from Lorne Kalmar from Desjardins.

[Lorne Kalmar, analyst]

Maybe flipping back to the acquisition side of things. Is -- if I understand correctly, typically, M&A is the big catalyst. But are there any dealers who are looking to recapitalize their own business just by monetizing the underlying real estate? Or are you not seeing much in the way of opportunities?

[Milton Lamb, executive]

We're hearing some murmurs on that right now that there could be. But even then, a lot of the time, it's related to acquisitions that may not be those properties, but they may take some equity off the table to go do an acquisition somewhere else. So not directly in M&A, but related to an M&A. So I think -- well, I'm going to also say, we've seen, including the last acquisition, a few more conversations where ex dealers who retain the real estate are now looking to monetize that real estate. So it's a bit of -- on the back of an M&A, and it's a bit of historical M&A where some of the vendors have kept the real estate.

[Operator]

The next question comes from Gaurav Mathur from Laurentian Bank.

[Gaurav Mathur, analyst]

Just one quick question from a macro perspective. Now, south of the border, we've been seeing the American consumer fall behind on their car payments. I'm just wondering if you could talk to your conversations with the dealers currently in the portfolio and if they're seeing any sort of activity here in Canada, which is pointing to duress not only to dealer profitability, but even just car sales over the next sort of 12 to 18 months?

[Milton Lamb, executive]

Yes. The short answer is nothing material or significant. What we're hearing is that some groups, because the elevated price per unit is gone up, that you may see some rotation into mass-produced vehicles as opposed to some of the luxury and some rotation into used cars. But those still remain profitable. If it goes into a full recession, you often see people retain their cars a bit longer, which you will see service go up and service is some of the most profitable areas for dealers. And I would certainly say Canada versus U.S., you saw a lot of U.S. dealers able to push through pricing to consumers above MSRP. So highly inflated numbers, so the very nature of it, it's negative equity the day they buy it. So that would have a greater impact on delinquencies than in Canada.

We're not hearing from dealers a lot of chatter or, quite frankly, from the banks, a lot of chatter on that negative equity kind of default really flowing through to hurt dealers. It's something they watch, but we are seeing longer duration acquisitions. And quite frankly, we're seeing more of a push towards the leases than acquisitions because you used to be able to just pull out money from your home equity loan at very low rates to buy your car. Now sometimes it's better used in the advertised lease rates from some of the OEMs.

[Operator]

The next question comes from Sumayya Syed from CIBC.

[Sumayya Hussain, analyst]

Just to follow up more on the M&A side of things. Just Milton, I guess the both cap rates and your cost of capital stays sticky at current level, like how would you trade capital deployment? And what's your appetite to use that to fund acquisitions at this point in time?

[Milton Lamb, executive]

As we mentioned, it's got to be compelling. There is a nice level of flexibility and a strong balance sheet that we have right now, which we certainly do appreciate in times like now. We think that's going to open up a bit more in 2024. So I mean, I would just say we're not going to, nor have we ever just done acquisitions for the sake of acquisitions and growth. We are sensing that there's going to be some good opportunities, and we want to be able to take advantage of those.

[Sumayya Hussain, analyst]

And so what level of spread versus your cost of capital would you require today given the current environment to make that work?

[Milton Lamb, executive]

It's so volatile right now on the spread. I mean, if you're talking about longer-term rates, they've certainly flattened out on the curve versus even our short-term floating rate. But we don't expect that to stay as elevated as it is today. And certainly, we're committing for 10-, 15-, 20-year leases that also have escalations. So it's more than just a spread on capital. It's who we're dealing with, what's our spread, what's our growth profile within that lease.

[Sumayya Hussain, analyst]

Okay. Fair enough. And your current leverage is fairly low. What would be your acquisition capacity based on where it sits at today versus your target?

[Milton Lamb, executive]

Yes. It's low, and we certainly appreciate that. It's even lower when you put it in context that as a triple net lease, that's a very clean number at the bottom. There's not a lot of leakage afterwards. We've always said getting to that [ 50, 52 ] level is still a comfort zone. So it really depends what we're looking at in front of us and the returns that we're able to achieve.

[Operator]

[Operator Instructions] Next question comes from Himanshu Gupta from Scotiabank.

[Himanshu Gupta, analyst]

What is the cost of debt financing available to you now? I mean if you were to put a 5-year swap today, what would be that rate?

[Andrew Kalra, executive]

About 6% for us all in, probably a [indiscernible] a quarter.

[Milton Lamb, executive]

It's amazing how flat it is between 3 years and 7 years, even 3 years and 10 years.

[Andrew Kalra, executive]

Pretty much all in that 6.25% range at this point in time.

[Himanshu Gupta, analyst]

Okay. And then how is the appetite for banks to lend to this asset class now?

[Andrew Kalra, executive]

Overall, we've had a strong relationship with our lenders. At the beginning of the year, we had $25 million we converted from revolver to non. We added $70 million to one of our facilities. So the appetite is still there overall. And it obviously will depend on which facility and what in timing.

[Milton Lamb, executive]

I don't know if it affects us as much in this comment. But I think it may positively impact us. We've traditionally borrowed on a per asset basis about kind of 50% to 55%, maybe 60% level and let some other assets unencumbered. Certainly, in the past, we've been competing against dealers that have been looking at 75%, 85%, 90% LTV, those ones are pulled back. So they have to come up with some more equity right now. And the more that they compete with us on a similar loan to value, the better off our equation is and advantages to work with them. So we think that's a positive impact. But certainly, when we're talking about the REIT itself at 50% to 60%, we're not seeing a significant impact.

[Himanshu Gupta, analyst]

And then you have typically done credit facilities in the past, would you consider like a traditional mortgage at this point? Will that be beneficial pricing?

[Andrew Kalra, executive]

We've done mortgages a lot in the past. We just did 1 in -- at the beginning of the year. The rates are slightly higher right now for mortgages as well or pretty close to. So we'll pick and choose which properties that we would take a long-term mortgage on. We're open to mortgages as well, and we have been.

Credit facilities allow for flexibility, and that's the approach that we've taken.

[Operator]

There are no further questions. I will turn the call back over for closing comments.

[Milton Lamb, executive]

Thank you, Joanna. We appreciate all of you joining us for our Q3 call today, and we look forward to speaking to you again in the future. All the best.

[Operator]

Ladies and gentlemen, this concludes your conference call for today. We thank you for participating, and we ask that you please disconnect your lines.