Choice Properties Real Estate Investment Trust

TSX:CHP.UN

Earnings Call Transcript 2018-Q2

[Operator]

Good morning, my name is Stephanie and I'll be your conference operator today. At this time, I would like to welcome everyone to the Choice Properties REIT Second Quarter Results Conference Call. [Operator Instructions] Thank you. Kim Lee, you may begin your conference.

[Kim Lee]

Thank you, Stephanie. Good morning, everyone, and welcome to the Choice Properties REIT Second Quarter 2018 Conference Call. This call is also being webcast simultaneously on our website at www.choicereit.ca. I'm joined here this morning by Steven Johnson, President and Chief Executive Officer; Rael Diamond, Chief Operating Officer; and Mario Barrafato, Chief Financial Officer. Before we begin today's call, I want to remind you that by discussing our financial and operating performance and in responding to your questions, we may make forward-looking statements, including statements concerning Choice Properties objectives, its strategies to achieve those objectives as well as statements with respect to management's beliefs, plans, estimates, intentions, outlook and similar statements concerning anticipated future events, results, circumstances, performance or expectations that are not historical facts. These statements are based on our current estimates and assumptions and are subject to risk and uncertainties that could cause our actual results to differ materially from the conclusions in these forward-looking statements. Additional information on the material risks that could impact our actual results and the estimates and assumptions that we applied in making these statements can be found in our 2017 annual report and management's discussion and analysis related thereto, together with Choice Properties annual information forms, that are all available on our website and on SEDAR. And with that, I'll turn it over to Stephen.

[Stephen E. Johnson, President, CEO & Trustee]

Thank you very much, Kim. Good morning, everyone, and welcome to all. Thank you for taking the time to attend our second quarter conference call. I would like to extend a special welcome for the former CREIT unit orders who are now investors in Choice, welcome to Choice. Obviously, the most significant event of the quarter was the combination of the CREIT business and Choice Properties. This was a transformational transaction for both entities that resulted in the creation of Canada's largest and preeminent real estate investment trust. From a high level, Choice now has an enterprise value of just over -- just under $16 billion. Net operating income on an annualized basis is just over $900 million. This is generated from a portfolio of high-quality real estate assets, which, in aggregate, totals approximately 67 million square feet. But most importantly, we expect this combined portfolio will provide reliability and income stability for our investors over a very long-term investment horizon. The combined entity also has a very significant development program. There are numerous development opportunity on sites, already owned, ranging from simple intensification projects to industrial, to residential, to large-scale mixed-use projects. We will provide more detail to you in future quarters as we determine how these opportunities should be prioritized beyond what is already underway. Rael will update you in a few minutes on projects that we already have underway. In addition to both the high-quality portfolio of income-producing properties in the development pipeline, Choice will continue to benefit from the support and commitment of both Loblaw and George Weston, as tenants, investors, and strategic partners. As well, we expect these relationships will create significant ongoing opportunities for our REIT. Since the announcement on closing the merger transaction on May 4, our management team has spent a considerable amount of time working on the integration. This involves many important steps, each of which must be completed in the context of a business model and strategy for the combined entity. In addition to combining in our real estate portfolios, the merger also included the joining together of 2 of Canada's leading real estate teams. Our focus has been on aligning the organizational structure to further enhance our operating platform and our capabilities. We have organized our groups to foster collaboration and teamwork and to strive for excellence. As part of this process, we identified areas of redundancy and overcapacity. And as a result, we have reduced the combined workforce by just over 8%. This is certainly a difficult part of the merger. I would like to sincerely thank those employees who were impacted, and I wish them every success in their future endeavors. Most significantly at this stage, we are positioning ourselves for future success, and we now have a wonderful platform to build upon. In terms of the financial results, apart from the merger transaction that was an in-line quarter, and Mario will now provide you with some high-level details. Mario?

[Mario Barrafato, Chief Financial Officer]

Thank you, Steven, and good morning, everyone. I'd like to start with an overview of the acquisition transactions and the impact on our balance sheet. I will then follow with a review of our key performance metrics. The most significant item in the quarter was the acquisition of CREIT. From a balance sheet perspective, the value attributed to the net assets acquired was $3.7 billion. The total consideration paid was a combination of $1.65 billion in cash and $2.05 billion of equity, which reflects the issuance of 183 million Choice Properties units at the May 4 trading price of $11.25 per unit. As part of the purchase price allocation, most of the value was assigned to the acquired investment properties, except for $30 million, which was assigned to certain management contracts and reported as an intangible asset. There was no goodwill recorded on the transaction. To finance the cash portion of the acquisition, Series K and Series L senior unsecured debentures were issued at closing for proceeds of $1.3 billion at a weighted average interest rate of 3.9% and a term to maturity of 8.4 years, plus 2 unsecured variable rate term loans, totaling $800 million were obtained at a weighted average term of maturities of 4.8 years. As well a new 5-year $1.5 billion revolving credit facility was arranged, replacing all existing credit facilities for both CREIT and Choice. This provides us with liquidity and financial flexibility moving forward. Concurrent with the acquisition closing, Choice converted all outstanding Class C LP units held by Loblaw, with a face value of $925 million into 71 million exchangeable units based on a 20-Day VWAP of $11.66 per unit, with the balance of $98.7 million being paid in cash. In conjunction with this conversion, a $37 million accounting loss was recorded, which reflected the accelerated amortization of a debt premium that had been netted against the face values of the Class C LP units. And lastly, the transaction cost expense in the quarter relating to the acquisition was $108 million. So collectively, these 3 items: the issuance of equity of CREIT unit holders, the net impact from the exchange of the Class C units and the transaction costs incurred account for much of the change in the net asset value for the quarter. Before I go over our key performance metrics, I wanted to note that the consolidated results for the quarter consists of a full quarter of the existing Choice operations, plus the contribution of the former CREIT business from May 4 onwards. Fundamentally, in merging the 2 businesses, there were no material accounting policy differences between Choice and CREIT. With respect to the combination, the most noticeable impact on our results is the positive contribution from a reset of the straight-line rent calculation for the CREIT acquired assets as well as a mark-to-market premium on the debt assumed. Presentation-wise, in our MD&A, you will notice that we now have 3 operating segments. We've reintroduced AFFO as a key performance indicator, and we've applied select uses of proportionate share accounting to discuss our results. Our reported funds from operations for the second quarter was $157 million or $27.2 per unit diluted, which excludes the accelerated amortization I referred to earlier. Our FFO includes a lease surrender revenue of $10.2 million which is partially offset by net financing charges of $3.1 million relating to funds raised prior to the closing of the CREIT acquisition. Excluding these onetime items, FFO per unit diluted for the quarter would've been $0.26 per unit, relatively flat compared to the same period last year. Looking now at adjusted funds from operations for the second quarter, we reported $140 million or $0.243 per unit diluted. Due to timing of capital spending, reported AFFO is higher in the first half of the year. On average, we estimate operating and leasing capital to be approximately $20 million to $25 million per quarter. And as such, capital spending will ramp up over the later part of the year and AFFO will trend lower. Overall, our financial metrics remain solid. Using amounts from our proportionate balance sheet, our debt-to-gross book value is 47%, and normalized leverage and interest coverage ratios are 8x and 3.2x respectively. These measures are further backed by a pool of unencumbered assets of $11 billion. So overall, we're very pleased with our second quarter results and we look forward to Q3, which is the first full quarter for the combined entity. I will now turn the call over to Rael.

[Rael Lee Diamond]

Thank you, Mario, and good morning, everyone. As Steven mentioned, I'll provide a brief overview of our combined portfolio and an update on transaction activities. Our consolidated portfolio includes 757 income-producing properties, comprising 67 million square feet of GLA. The portfolio is located across Canada with a concentration in Canada's largest markets. Our retail portfolio is primarily focused on necessity based retail tenants. This portion of our portfolio is the foundation of our reliable cash flow with potential for incremental growth through intensifications. One of our key competitive advantages is our strategic relationship with Loblaw, Canada's largest retailer. This relationship provides Choice with an exceptionally strong anchor tenant at many of its retail sites and the long-term nature of the leases provide us with stable, secure and growing cash flows. Our industrial portfolio includes 109 key properties and approximately 16.6 million square feet of GLA. The portfolio includes Loblaw distribution facilities on long-term leases and high-quality distribution and warehouse facilities in key industrial markets across Canada that readily accommodates a broad range of tenants. Industrial markets across the country continue to operate with relatively healthy fundamentals. In terms of industrial development, Choice owns 85% of a recently constructed 665,000 square foot modern distribution facility on Peddie Road in Milton, Ontario. Milton is in the GTA West submarket, one of the strongest industrial markets in the country. We have a conditional deal done for approximately 500,000 square feet of the building and strong interest on the balance of the space. Assuming with firmer conditions, we hope to have more to disclose next quarter on key terms of the deal. The performance of our office portfolio continues to vary in our 2 largest markets. The office leasing market in the GTA remains strong. Currently, there's significant tenant demand and limited availability. Our portfolio is almost fully occupied when considering all committed leasing. Conditions in the Calgary office market remain difficult. The imbalance between supply and demand persists and market vacancy levels remain high. We continue to focus on working with our existing tenants to complete early renewals. Finally, I'd like to speak about residential. Our residential platform provides an opportunity to further diversify our portfolio. Choice has been working on expanding our residential platform. Currently, we have 3 residential rental assets that are income-producing, and another 7 residential rental assets that are currently in various stages of development.We also signed the contract to acquire another residential rental development site and I'd like to provide some further details on that transaction. In the quarter, we announced that we had entered into an agreement to acquire a 50% interest in the development parcel in Toronto to develop a purpose-built rental project. The transaction is expected to close in the first half of 2019. The development parcel is approximately 0.9 acres, located between Grosvenor Street and Grenville Street in Toronto. The property is exceptionally well located and is within walking distance to College Subway Station, universities, hospitals and the downtown financial core. The property has been acquired in partnership with Greenwin, from the province of Ontario as part of the provincial affordable housing lands program. Choice and Greenwin plan to deliver a 2-tower purpose-built rental community with approximately 700 units or 350 units at our ownership share. 30% of the units will be maintained as affordable rental housing for a period of 40 years. We're excited about our residential initiative. When complete, these projects will represent approximately 1,500 units at Choices shares. Looking forward, we see this initiative as a key part of our strategy. That concludes my comments. I'd now like to pass it back to the operator for questions.

[Operator]

[Operator Instructions] Your first question comes from Sam Damiani with TD Securities.

[Sam Damiani, Analyst]

First, congratulations on the transaction being completed. And I know you've been busy with the integration and whatnot. I just wanted to touch on the balance sheet with the leverage coming in, perhaps a little bit higher than originally expected. Steven, what are your thoughts on the level of leverage? And with the active development pipeline already underway, what are your thoughts on dispositions or other means to reduce leverage and over what time frame?

[Mario Barrafato, Chief Financial Officer]

Hi Sam. This is Mario. I'll comment first just on the reported leverage. Right now, like I said, we're at 47%. And I think the part that wasn't known maybe at the time of announcement was that there'd be the additional $98 million on closing for the Class C. So I think that explains perfectly maybe why the leverage today might be a little higher than your expectations a few weeks ago.

[Stephen E. Johnson, President, CEO & Trustee]

Sam, it's Stephen. Good morning. Long term, we're in the process of putting together a long-term business model, long-term strategy. And so we'll have more on that, basically, as future quarters evolve, but we don't have a specific target at this stage.

[Sam Damiani, Analyst]

Okay. Maybe Rael, just on the residential. [ Via 1, 2, 3 ], could you update us on, I guess, the lease-up status there and the rents that you're getting?

[Rael Lee Diamond]

Yes, sure, so we -- approximately 62% leased at the moment. We're currently doing about 3 or 4 leases a week. We're achieving rents between $280 and $290 a foot, and we would expect that the asset will be stabilized by Q1 of '19.

[Stephen E. Johnson, President, CEO & Trustee]

And rents achieved -- Stephen's here, and rents achieved are higher than our -- much higher than our original portfolio.

[Operator]

Your next question comes from Jenny Ma with BMO Capital markets.

[Jenny Ma, Analyst]

I was wondering, Stephen you made some comments about the reduction in the workforce. Is there any impact on acquisition-related costs or G&A in Q3? Or was that all taken in Q2?

[Mario Barrafato, Chief Financial Officer]

There would be amounts in the transaction cost, Jenny.

[Jenny Ma, Analyst]

Okay. So I guess the G&A number for Q2 then is a G&A only number. So all those personnel-related costs would have been taken in the $108 million?

[Mario Barrafato, Chief Financial Officer]

Yes, that's correct.

[Jenny Ma, Analyst]

Okay. And then for Q3, I guess, there would be a little bit more of a creep up given that there are the months that the transaction was not in place in Q2, is that fair as far as the run rate goes?

[Mario Barrafato, Chief Financial Officer]

There'll be an adjustment to every line item for a month, yes.

[Jenny Ma, Analyst]

Okay, got you. From -- so now that the portfolio has been integrated for a couple of months, have you taken the time to look over the whole portfolio to see if there's any sort of assets that you think are noncore to the portfolio that you could prune over time? Or is this still early days for that part of the integration?

[Stephen E. Johnson, President, CEO & Trustee]

Jenny, it's Stephen. Certainly, we haven't -- in 750-odd properties, and we haven't looked at everything yet. But certainly, getting familiar with the portfolio, we have identified some assets that are nonstrategic and -- but we don't have a specific divestiture plan in place at the present time, that'll, again, follow, basically, as we put our business model and strategy in place. But there are certainly some noncore assets, nonstrategic assets that over time we will divest.

[Jenny Ma, Analyst]

Now would that be from, generally, the retail side? Or would there be any from the CREIT portfolio that would fit into that category?

[Stephen E. Johnson, President, CEO & Trustee]

Yes. In CREIT, we had an ongoing divestiture program where we culled things that were just over time. As we evolved as a business, some of the assets we acquired many years ago no longer fit for us in terms of the core objectives of the portfolio. So it would be on both sides, it would be both on the CREIT side and on the Choice side.

[Jenny Ma, Analyst]

Okay. And then my last question is with regards to the drip, which was recently turned off. I can't recall exactly the rationale for that. But when you're think about Sam's earlier question about leverage and looking for funding sources is that something that you guys are considering at -- or reconsidering at this point?

[Mario Barrafato, Chief Financial Officer]

Hi, Jenny, not right now. The drip, we have to issue units at a discount. Right now, I think we have other sources of capital. And as we finalize our strategy, we'll figure that out. So right now, I think leaving the drip where it is, is just fine and we don't need the capital to run what we have in progress right now.

[Operator]

Your next question comes from Johann Rodrigues with Raymond James.

[Johann Rodrigues, Research Analyst]

Given you talked about it a little bit at the beginning in terms of integration, and I guess I was just wondering, in terms of the lists of high-level things that you guys have to do as part of this integration, you talked a little bit about turning assets, integrating IT systems, what have you guys done up to this point and what are kind of the big issues still to tackle?

[Stephen E. Johnson, President, CEO & Trustee]

Look, there's are many issues. Obviously, the personnel organization is front and center. The consolidation of offices will be considered in terms of cities where we have 2 offices. Combining those offices, if that is determined to be functional. The integration of our information systems is a big item on our list, and we're spending a considerable amount of time on that. But it's -- those are the major items. And beyond that, basically, it's really just focusing on the people and focusing on the assets.

[Johann Rodrigues, Research Analyst]

Okay. And then maybe for Rael. On the residential side, where are these -- where are you guys kind of sourcing these -- the new residential deals that are coming to you? Are they being brought by Greenwin? And then I guess, how many kind of external residential, I guess, land parcels or projects can we expect you guys to either acquire or start working on kind of annually in concert with the residential projects you guys will be working on, on the properties you already own?

[Rael Lee Diamond]

So as far as the -- where the original projects came from? They came from a variety of places, primarily through the relationships or on-market transactions. The one with Greenwin we mentioned, was acquired with Greenwin from the province of Ontario through a competitive process. As Stephen mentioned it in his script that we're going to be looking at all development projects including the mixed use, and we'll give you greater clarity in future quarters.

[Operator]

Your next question comes from Pammi Bir with Scotia Capital.

[Pammi Bir, Analyst]

Just a quick question on the residential intensification opportunities. Can you maybe just comment on where you are in terms of prioritizing those projects?

[Stephen E. Johnson, President, CEO & Trustee]

It's Stephen. The -- that's certainly a big part of the integration. As we mentioned, we have a number of projects that are kind of we're committed to start and underway. But in terms of future densification on sites, we're in the process of prioritizing those. And so over the next couple of quarters, we'll give you more clarity on that. But right now, we have, certainly, plenty on the way, basically, that is moving along and in progress as we speak sort of thing.

[Pammi Bir, Analyst]

And Stephen, would the intent be to provide sort of that full list, think back -- thinking back to the outset of when the transaction started. There were 60 sites, I guess, identified. Is the intent to provide disclosure on those specific sites? And then is there -- do you have a rough sense of what the potential density and economics could be at this stage?

[Stephen E. Johnson, President, CEO & Trustee]

So the 2 questions. In terms of future disclosure, I mean, we'll disclose what we think is kind of relevant and where we have certainty or a reasonable degree of certainty. But trying to prioritize 60 projects and so on and disclosing where we are on those would be not rational. We wouldn't be able to get to a situation where that would be meaningful information for our investors. So -- but that is -- we will disclose whatever we can, basically, as it becomes available on -- with our quarterly results.

[Pammi Bir, Analyst]

Okay. Maybe just looking at the internal growth outlook. I guess the CREIT portfolio will be in the 2019 numbers for, I guess, only a part of the year. But how do you see the same-property NOI profile shaping up for 2019?

[Mario Barrafato, Chief Financial Officer]

Pammi, I think the way the balance -- the way the P&L is classified, I think, the same asset would be primarily, the former, the Choice assets. And I think there -- if you go on a cash basis, you have 1.5% step rents. As we're now starting our capital spending, we'll have an increase in recovery revenue, and then there's always some ancillary leasing. So I could see that being in the 2% to 2.5% range. The CREIT portfolio will be primarily on the transaction side. And I think, as we've talked about before, where we'll have growth in retail and growth and industrial, as we get into 2019, we'll see Calgary office put pressure on that. And so the way [ I see ] -- see ourselves kind of where we were before being kind of flat to maybe plus or minus a bit and positive or negative. But I think the organic growth from occupancy or rental rates from the free portfolio is pretty muted and the growth is going to come from the development side.

[Operator]

Your next question comes from Tal Woolley with National Bank Financial.

[Tal Woolley, Research Analyst]

Stephen, I -- I never covered CREIT on the sell side, but the one thing I always knew about it was that it had a very unique sort of balance sheet and payout proposition for the public markets. And you've run that company a long way -- or you've run that company for a long time in a certain way and you're taking control of an organization that's maybe not following the kind of the same strategy. Do you have a real preference one way or the other for how you want to see this business be run going forward? And what sort of conversations or have you had conversations with Galen, [ Richard and Darren ] about that sort of -- recreating that proposition in the public markets with Choice?

[Stephen E. Johnson, President, CEO & Trustee]

I think, philosophically, the -- what we developed at CREIT was attractive to the people you mentioned. But long-term, in terms of the business model and strategy, we're in the stages of formulating that. But generally, you have a conservative view of how the business should be run, that means where the leverage is, where the payout ratio is and so on. And -- but as we kind of get more clarity on what's doable with the combined entity and what's practical and what kind of timeframe, we'll speak to you that over subsequent quarters. But generally, my personal views are not changed. We're just in a larger different entity. And basically, our views will be sort of consistent with what we have in that entity, meaning the stability of the cash flow, the strength of the assets and the strength of the sponsorship. And so we'll develop a new business model, a new strategy that will be taking into account those factors. But generally, I think you'll see a bias towards conservative balance sheet, conservative payout ratio.

[Tal Woolley, Research Analyst]

Okay. And one other thing that CREIT did successfully, too, was providing -- delivering or completing the square footage in development by mezzanine financing. Is that something you would be looking to do more of going forward with all of the new projects you potentially have at your fingertips now?

[Stephen E. Johnson, President, CEO & Trustee]

Yes. The short answers is we will continue to use that as a way to facilitate new opportunities, whether it's IPP or land or development opportunities. The extent of which, basically, is to a large extent driven by our appetite at the time and driven by the strength of the opportunity. But certainly, it's worked well for us, exceptionally well for us, that program. So we will continue to use that as appropriate.

[Tal Woolley, Research Analyst]

Okay. And then my last question is just on the development team. Obviously, the pipeline looks probably poised to expand somewhat going forward. Do you need more development staff? And what I also can't remember, too, is there -- are there any remaining real estate execs within Loblaw that are not within Choice as well? Like, is that something that you eventually -- some expertise that you can tap to as well?

[Stephen E. Johnson, President, CEO & Trustee]

Loblaw does have its own real estate people. And so we work very collaborative -- in a very collaborative way with them. And in terms of our own group future staffing, kind of in process, basically, in terms of how we add. It's likely we will have to add to that group. But it's early days yet in terms of, as I mentioned earlier, just getting your arms around and trying to corral the numerous opportunities we have, which is the good news. We have kind of so many opportunities, but just getting our head around those and kind of determining how we should prioritize them is one of the significant events that we will be focused on over the upcoming months. So -- but the bottom line is, we will likely add to that group over time.

[Operator]

Your next question comes from Sam Damiani with TD Securities.

[Sam Damiani, Analyst]

Just couple follow-ups, maybe -- where we just left off there. On the development pipeline, listed as #1 of the major mixed-use redevelopments is Golden Mile. And it did get some attention on conference calls over the past couple of years. I wondered if you could just give us an update on the status of the application, zoning, site plan process at this point? And I have a follow-up question as well.

[Stephen E. Johnson, President, CEO & Trustee]

Sam, there's no significant update from what we -- or what the Choice management team disclosed at the last quarter, in last conference call. The process of entitlement is continuing and ongoing. But there's no significant update to report at this stage.

[Sam Damiani, Analyst]

And just on, lastly, there was some Loblaw lease cancellations in the quarter. Can you perhaps give a bit of color in terms of the circumstances and the reasons Loblaw decided to cancel those leases?

[Mario Barrafato, Chief Financial Officer]

Sure, Sam. I guess in 2015, Loblaw had noted that they were going to close certain stores. They continue to pay rent. And in the meantime, we will be figuring out whether to sell the properties or we could redevelop them. And so 1 property was sold and so the lease was terminated. On 2 other ones, there's development -- redevelopment opportunities. And so hence, the leases were terminated there and now we're moving onto a new use for the property.

[Sam Damiani, Analyst]

Would you be willing to identify those 2 that you're retaining?

[Mario Barrafato, Chief Financial Officer]

I don't have them handy, Sam. But I'll follow-up with you later, I guess. But they're smaller properties.

[Operator]

There are no further questions at this time. Mr. Johnson, I turn the call back over to you.

[Stephen E. Johnson, President, CEO & Trustee]

Thank you, everyone, again for attending. We're very, very excited about the platform we now have in place and the opportunity that gives us to really to create a bigger and better business. So we look forward to future calls. Enjoy your weekend, everyone. Thank you for attending.

[Operator]

Thank you. This concludes today's conference call. You may now disconnect.