Choice Properties Real Estate Investment Trust

TSX:CHP.UN

Earnings Call Transcript 2018-Q4

[Operator]

Good morning. My name is James, and I will be your conference operator today. At this time, I'd like to welcome everyone to the Choice Properties Real Estate Investment Trust Fourth Quarter Results Conference Call. [Operator Instructions] Thank you. Archna Sharma, you may begin your conference.

[Archna Sharma]

Thank you, James, and good morning, everyone. Welcome to the Choice Properties REIT Q4 and year-end 2018 conference call. This call is also being webcast simultaneously on our website at choicereit.ca.Before we begin, we would like to advise you that some of the statements made this morning may contain forward-looking information, including statements concerning Choice Properties' objectives, strategies to achieve those objectives as well as statements with respect to management's beliefs, plans, estimates, intentions, outlooks 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 a number of risks and uncertainties that could cause actual results to differ. We refer you to the cautionary statements contained in our financial report, including the MD&A for the year ended December 31, 2018, and other public documents for the full details. These forward-looking statements are made as of today's date. And Choice Properties REIT assumes no obligation to update or revise them to reflect new events or circumstances except as required by law.On today's call, we have our Chief Executive Officer, Stephen Johnson; our Chief Operating Officer, Rael Diamond; and our Chief Financial Officer, Mario Barrafato. I will now turn it over to Stephen.

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

Thank you, Archna. Good morning, everyone, and thank you for taking this time to attend our Q4 and year-end 2018 conference call. Yesterday, we put out 2 news releases, one for our quarterly earnings results, and the other, we announced my decision to retire as CEO of Choice Properties, which will be effective as of May 1 of this year. We also announced Rael Diamond as my successor. And I am absolutely delighted with this appointment. Rael has been a valuable partner of mine over the last 7 years, both as President and COO of CREIT, and most recently in his role as COO at Choice Properties. Rael has nearly 20 years of experience in asset management and real estate operations. He has the trust of our organization and the respect of the industry. Rael is very well suited to lead Choice Properties into the next chapter.I will be working with Rael to transition the CEO role between now and May 1. And after May 1, I will serve as an advisor through to May 2020 as our organization continues to execute its strategy. Now, onto the other news release, which summarized our Q4 results. We are very pleased with both the financial results and the operational results for the fourth quarter and for the full year of 2018. Our results met expectations. Operationally, same asset net operating income was up 1.4% for the quarter. And period-end portfolio occupancy remained strong at 97.7%. Our development program delivered 105,000 (sic) [ 106,000 ] square feet of new leasable area. And our capital recycling continued with the sale of $107 million of non-core assets and the reinvestment of $75 million into high-quality income-producing properties. Our fourth quarter results have dealt upon the positive momentum that we have had since the merger of CREIT and Choice Properties at this time last year. The combination of CREIT and Choice was a transformational transaction. Choice now has an enterprise value of approximately $16.4 billion. Since closing the Choice-CREIT transaction, our management team has spent a considerable amount of time working on the integration of the 2 businesses. And the integration continues to go very well. This involves many important steps, each of which must be completed in the context of a long-term business model and strategy for the combined entity. And while our business is growing substantially, our primary goal remains the same. The ownership of a high-quality income-producing real estate portfolio. Our business now for the most part has evolved into 2 functional areas: our income-producing property, or IPP portfolio, and our development business. Our IPP portfolio generates a high-quality rental revenue stream. Net operating income on an annualized basis is now well over $900 million, and there are contractual rent escalations in a significant part of our portfolio. We are positioning our IPP portfolio to provide long-term stability and net operating income growth over time. Our development business is now divided into 5 categories, including retail intensification, redevelopment, Greenfield, major mixed-use and residential projects. In our currently active development program, we anticipate investing approximately $1.1 billion of which $500 million is already invested. A significant portion of the balance of the $1.1 billion will be invested to complete our high-quality residential projects now at various stages of development within the greater Toronto area. It is also significant that beyond the current development program of approximately $1.1 billion, we have a pipeline of additional development opportunities on sites already owned. This includes a number of sites planned for major mixed-use development, 3 of which are in an active predevelopment stage where we are finalizing land assemblies and working through the zoning process. The 3 properties are located in key urban markets with close proximity to public transit. There are 2 sites in Toronto and 1 site in Coquitlam, British Columbia. Each of these mixed-use projects will include a significant residential component. It is also important to note that there are a number of other sites, which we now own that have significant potential as major mixed-use projects. It is just too early to credibly quantify the total extent of this opportunity. However, we expect it to be meaningful over time. The important point is that we already own these sites. Our development business is a very exciting part of our REIT that will add high-quality assets to our portfolio and we anticipate will contribute to growth in our net asset value. In summary, and from a macro perspective, we are building our business for stability and growth. Our focus is to position both our IPP portfolio and our development business, to grow net operating income, to grow cash flow and to grow net asset value over a long-term investment horizon. Mario will now provide an overview of our financial results for Q4, and then Rael will provide an overview of some of the operational and investment highlights. Mario?

[Mario Barrafato, Chief Financial Officer]

Thank you, Stephen, and good morning, everyone. I'll begin with a brief overview of our results and then comment on our balance sheet. Overall, our fourth quarter results were in line with our expectations and reflect the stability that is inherent in our portfolio.Our reported funds from operations for the fourth quarter was $171.9 million or $0.256 per unit diluted. With the exception of $400,000 of lease surrender fees, there were no unusual items in the quarter. FFO per unit for the quarter was consistent with amounts reported last quarter. On a year-over-year basis, FFO per unit declined $0.026 per unit compared to the fourth quarter of last year, primarily due to the change in capital structure resulting from the CREIT acquisition. As communicated last quarter, adjusted funds from operations for the fourth quarter reflects increased maintenance capital spending relative to prior quarters. This is merely a function of timing, bringing the year-to-date amount of maintenance capital spending into line with our annual expectations. On a full year basis, our AFFO exceeded our distributions by $52 million. And our AFFO payout ratio was 89.5%, both in line with our expectations. Included in our results was stable year-over-year growth in our same property cash NOI. For the quarter, same property cash NOI excluding development activities increased by 1.4%. And for the year, same property NOI growth was 2.4%.Furthermore, our overall period end occupancy remained unchanged at 97.7% compared to the third quarter of 2018. Slightly negative absorption was offset by a net increase in occupancy arising from property transaction activity and developments coming online. At December 31, retail occupancy was 98%, industrial occupancy was 97.8% and office occupancy was 92.3%. So overall, very solid operating results. Now turning to our balance sheet. On the transaction front, our capital recycling program continued with 2 dispositions during the quarter for proceeds of $107 million. And the acquisition of 4 properties at a cost of $78 million. These acquired properties consist of 1 industrial and 3 retail properties. And Rael will provide more color on these investments. We continued to be active on the development front with ongoing investments of $88 million in the quarter, bringing our full year spending to $242 million. As well, $45 million of development properties were transferred to income-producing status during the quarter, bringing our year-to-date transfers to $193 million. Our book net asset value increased marginally quarter-over-quarter. And our net earnings for the quarter were offset by cash distributions and an adjustment to the fair value of our investment properties. For the quarter, we had a fair value loss of $20 million, which was mainly due to changes in leasing and capital spending assumptions for specific assets in the portfolio. It was a quiet quarter from a financing perspective because we had a net decrease in our outstanding debt, having net repayments of $62 million on our credit facility and mortgage repayments of $9 million. This was offset by $10 million in new mortgages, which had an average term of 5 years and a weighted average interest rate of 4%. And we also had $11 million of new construction loans. Our financial metrics remained solid. Using amounts from our proportionate balance sheet, our debt-to-gross book value is approximately 47%. And normalized leverage and interest coverage ratios are 8x and 3x, respectively. These metrics are further backed by $1.2 billion of liquidity on our credit facility and $11.8 billion pool of unencumbered assets. So overall, this was another strong quarter for Choice. We end the year having made significant progress on our integration, and with 2 full quarters of financial results provided a baseline for the new combined entity. I'll now turn the call over to Rael.

[Rael Lee Diamond, Chief Operating officer]

Thank you, Mario, and good morning, everyone. As Stephen mentioned, I'll provide a brief overview of our income-producing portfolio and an update on transaction activities. Our consolidated portfolio of income-producing assets includes 731 properties, comprising 67 million square feet of GLA. This high-quality portfolio includes retail, industrial, office and residential properties, and is located across Canada with the 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. The stability is obtained through our strategic relationship with Loblaw. This relationship provides a strong anchor tenant on long-term leases resulting in stable, secure and growing cash flows.We continue to add to our retail portfolio through development, including a mix of greenfield development, redevelopment and intensifications. In Q4, we completed and transferred a total of 105,000 square feet of retail development and a total cost of $45 million. This includes 73,000 square feet of intensifications and redevelopment projects, which are primarily focused on adding at-grade retail density to our existing portfolio of retail assets at a cost of $35 million.And 32,000 square feet of retail development at a cost of $10 million. For the year ended 2018, we completed and transferred approximately 0.5 million square feet of retail development at a total cost of $182 million. Our development initiatives are key components of our business model, providing the opportunity to add high-quality real estate to our portfolio. Our industrial portfolio includes 113 properties, and approximately 16.5 million square feet of GLA. The properties include 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. In terms of industrial development, Choice is now 100% leased and has recently constructed 665,000 square-foot modern distribution facility on Peddie Road in Milton, Ontario. We finalized the long-term leases for approximately 550,000 square feet with Kimberly-Clark, a multinational consumer products company. The remaining 150,000 square feet was leased to a distributor of flooring products on a long-term lease. The rent achieved exceeded our original pro forma by more than 15%. This asset will be a great addition to our industrial portfolio as it is in the GTA West submarket of Milton, one of the strongest industrial markets in the country. And will be transferred to income-producing status in Q1 of '19. Next is our office portfolio. Fundamentals in most large office markets in Canada are healthy due to a strong economy and robust job growth. In the GTA, there is significant tenant demand and limited availability. Our portfolio is almost fully occupied when considering all committed leasing. Office property fundamentals in Calgary continue to be challenging. In Q4, we significantly reduced our exposure to the market with the sale of our 50% interest in Sun Life Plaza for $104 million. The decision was based on several factors, including the current market conditions and the lease expiry profile of the asset. Ultimately, we believe there are better uses of our capital, including new acquisitions like a Loblaw [ vendor ] and funding our ongoing development program. 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 rental residential assets in various stages of development. We also are currently under contract to acquire another rental residential development site located between Grosvenor Street and Grenville Street in Toronto. When complete, these residential projects will represent approximately 1,500 units and Choice's share. This includes over 1,000 units located in the GTA, all of which are in close proximity to make the transit. We're excited about the prospects of our residential initiatives.Next, I would like to provide an update on transaction activities. During the quarter, we closed on the acquisition of 3 [ growth reactive ] income-producing retail properties from Loblaw for a total cost of $55 million. This includes 104,000 square-foot grocery store in Calgary, with an ancillary liquor store at Gaspard at a purchase price of $32 million. This asset is in an expanding residential community of Seton in Southeast Calgary; 103,000 square-foot standalone grocery store in Ottawa at a purchase price of $15 million; and an 80,000 square-foot retail center anchored by Loblaw and a liquor store in Bedford, Nova Scotia for $9 million. These properties are all signed to long-term leases with Loblaw.Finally, we acquired 130,000 square-foot industrial building from Weston Foods for approximately $20 million. The asset is located in the Langley submarket of the greater Vancouver area, and is subject to a long-term lease with Weston Foods. Greater Vancouver is one of Canada's toughest industrial markets, and has extremely short supply of industrial assets, making this a very attractive acquisition. These transactions highlight the competitive advantage of our strategic relationships with both Loblaw and George Weston. We expect that these relationships will continue to be an excellent source of opportunities in the future. That concludes my comments. I would now like to pass it back to the operator for questions.

[Operator]

[Operator Instructions] And your first question comes from the line of Sumayya Hussain from CIBC.

[Sumayya Hussain, Associate]

I'll just open up, I guess, on a more high-level front first, just that the REIT is close to finishing the first full combined year. How do you look at capital allocation? Do we -- do you return to continuous dividend growth? Or is the priority more on deleveraging? Just your thoughts there.

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

So it's Stephen. Thank you for your comment. So there's 3 or 4 questions in there. We are in the process basically of resculpting our strategy in many ways. We -- certainly, directionally the most important thing is the quality of the IPP portfolio. So we anticipate some calling of that over time. And the -- in terms of level of debt, over time, again, directionally, we expect our debt levels to decrease but no immediate plans or no specific target at the present time.

[Sumayya Hussain, Associate]

Okay. And can you just remind us on the yields on your residential developments, and how they stack up across the different markets?

[Rael Lee Diamond, Chief Operating officer]

Yes. Sure. Rael speaking. The yields would all be what we have been achieving or slightly more for 5%. For example, the one in Toronto, VIA123, we completed that in a very, very robust market. And we exceeded well in excess of 5%.

[Sumayya Hussain, Associate]

Okay. And then they haven't really changed from, say, about a year ago?

[Rael Lee Diamond, Chief Operating officer]

No. Because much of the land that we had acquired was acquired pre the run-up in land process.

[Sumayya Hussain, Associate]

Great. And just lastly for me. There was a little reference to a change in assumptions around leasing and capital spend, specifically on some retail assets. What kind of assets are those? Are they grocery anchored or was it more of a primary versus secondary market dynamic?

[Mario Barrafato, Chief Financial Officer]

It's really varied. This is normal assumptions based on timing or some capital spend. No individual was significant and there was no real trend to take from that. It was just updating our financial valuations.

[Operator]

Your next question comes from the line of Michael Smith from RBC Capital Markets.

[Michael Smith, Analyst]

Congratulations, Stephen, and wish you the best in your retirement. And congratulations, Rael. Welcome news.

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

Thank you, Michael.

[Michael Smith, Analyst]

Just a couple of questions. For 1880 Eglinton and 2280 Dundas and your Coquitlam properties, you've got a lot of residential there. I know it's early stages. But from a big picture, what are you thinking in terms of condo versus rental? I mean, obviously, rental gives you a long-term income. But condo in some cases, the profits are -- or the economics are so skewed towards condo. So I'm just wondering what's your -- how you're thinking about that?

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

It's Stephen, Michael. Thank you for your comment and congratulations to you as well on your retirement, so the -- so it is too early to talk about the -- or from our perspective to determine the mix between rental, residential and condo. Clearly, there is some advantage basically to doing a portion of it as condo. But our objective is to build our IPP portfolio. So our bias is to maintain as much ownership as we can, which essentially means more rental residential. The competitive advantage we have is that these are on sites that we already own and we've owned for quite some period of time. So our ability to do less condo and more rental residential basically is -- would be greater than say if we went out, just buy the sites at market today. But clearly, our bias is to do as much rental residential as we can on these mixed-use projects.

[Michael Smith, Analyst]

Sure, that makes sense. And do you anticipate -- again, I realize it's early stages, but are you -- have you given any thought in terms of partners for those that are very large projects? Or the -- given your time horizon and your goals to build the IPP portfolio, are you thinking more on your own?

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

We have not -- we certainly discussed it internally whether bringing in a partner would be appropriate. But right now, our plan is to do them on our own.

[Michael Smith, Analyst]

Okay. Great. And just switching gears. I know it's only been a couple of full quarters. But when do you anticipate the integration to be more or less behind you?

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

It's -- most of it is done, Michael. I mean, basically, the -- I mean, there's always little things basically that will continue. But the bulk of it is behind us. And some of the larger items were systems, we were on 2 different enterprise systems. And so that was completed effective January 1. And that was both the conversion to one system to -- So we have all the same -- we're all on the same platform. Needless to say, that's completed. Office consolidations are more or less complete. The balance of the move will be completed during the course of 2019. Personnel reorganization was completed midyear last year. So most of the major things have been done, Michael.

[Michael Smith, Analyst]

Okay. Great. And lastly, for the 3 Loblaw acquisitions and the acquisition from Weston, would they typically be the usual lease term where there's usual like 1.5% bumps every year?

[Rael Lee Diamond, Chief Operating officer]

Michael, it's Rael. On the Loblaw side, yes, it is 1.5% bumps every year. On the Weston Foods side, it is slightly higher than that.

[Operator]

Your next question comes from the line of Pammi Bir from Scotia Capital.

[Pammi Bir, Analyst]

Stephen, congratulations on the retirement. And just an outstanding track record over the years. Rael, congrats to you as well. Just coming back to the comments around leverage. As you take on more development, do you expect that we may actually see leverage move up rather than down? Or at least make it a bit more challenging to reduce?

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

Yes. Certainly, the development program makes it a little more challenging. But it may move up a bit. But we anticipate directionally, as I said earlier, trying to reduce leverage over time. So -- I mean, we are generating cash and we do plan a divestiture program at some point in time. So as I said directionally, we would like to reduce it. But maybe it goes up a bit in the short term.

[Pammi Bir, Analyst]

And then as you take these projects on, is the intention to primarily fund them again through, perhaps, like contributing -- because there are sites you already own, contributing the land as your equity source rather than say -- and maybe retain cash as well rather than sort of a -- any equity issuance to fund these programs?

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

I mean, what we're focused on now, as I mentioned, we got our current program, our current active program is about $1.1 billion of which we've already invested about $500 million. So that -- to fund that balance there would be -- we expect basically to do that with a combination of 3 things. Cash flow that we're generating, maybe some increase in debt and possibly some divestitures.

[Pammi Bir, Analyst]

Okay. And then just with respect to acquisitions. Do you have a sense of what we could see from [ vend-ins ] from Loblaw over the next, call it, 12 months or so? And how any third-party opportunities may fit into the equation as well?

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

We do not have a target for that. We're just -- we don't have a number to give you. We simply do not have a target for that. We look at each one. Each individual, opportunity, whether it's a [ vend-in ] or whether it's a third-party, potential acquisition on the merits of the particular opportunity. And we will continue to do that on a go forward basis.

[Operator]

[Operator Instructions] Your next question comes from the line of Sam Damiani from TD Securities.

[Sam Damiani, Analyst]

Congratulations again. Happy to wish you all the best, Stephen. You've been a founder of the Canadian REIT industry so this is quite a moment for our sector. Admirable career and wish you all the best. And Rael, obviously, congratulations and well deserved. Just looking at the acquisition opportunities. Actually, I want to talk about development actually. The past CREIT development activity has been quite active with various private partners. How do we see that program going forward with those same private developers for Choice?

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

Sam, it's Stephen. Thank you for your comment. Look, we've been very successful in our partner relationships, and finding partners that have helped us achieve our goal in terms of finding development opportunities and executing with a lot of expertise. And so with each of our partners, I mean, in most of these, we've had long-term relationships with. And we will continue to work with them as we go forward to look at new opportunities and to -- not only to -- on acquisitions, but full development projects. So we don't see that changing as one of the competitive advantages we have had. And it's a competitive advantage just because we have these partners in place and a long, trusting relationship with them.

[Sam Damiani, Analyst]

So would you envision adding more projects to the active construction pipeline in the near term?

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

Right now, our active one -- I don't think so. I mean, they may -- nothing substantial. I mean, in terms of -- as I mentioned in my comments, we have the major mixed-use -- 3 major mixed-use projects that are in an active development stage. But those are -- those take many years to kind of complete the predevelopment stage, get your zoning done and so on. So nothing material, Sam, at this stage. I mean, that could change next quarter. We may find an opportunity we like or -- but as we sit today, nothing material, nothing substantial.

[Sam Damiani, Analyst]

Okay. And just the topic of [ net devs ], is there an opportunity or an expectation that Weston could provide additional opportunities in the near term for acquisition for Choice?

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

Absolutely. I mean, the -- part of the relationship, we have a strategic relationship with Loblaw. And again, as Rael mentioned in his comments, it's a competitive advantage for us and we expect basically there will be opportunities for the vend-in of high-quality, grocery-anchored retail over the coming years.

[Sam Damiani, Analyst]

Okay. Just on to the strategy, which I think you used the word, in the process of resculpting it in some ways, in some aspects. With respect to calling more of your properties, is this something that could be proceeding in a more meaningful way in the sort of near term, in the next year? Or do you see this evolving really more over sort of the medium term, 1 to 3, 5 years down the road? What is sort of the time frame on that strategy?

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

Yes. As you know basically, with any REIT, I mean there are restrictions on how you manage your divestiture program. So it's probably a medium-term, to use your phrase, strategy, as we execute that. We are not -- we have no intention basically of announcing a major, major divestiture program at the present time. So we really look at it as a -- our plan right now at the present time basically is that we would do it in an orderly manner over a number of years. And that's consistent with what we did in 2018. As we mentioned, we completed about $107 million of divestitures in Q4. And we expect basically that will escalate somewhat but it's a medium-term strategy, Sam.

[Operator]

Your next question comes from the line of Tal Woolley from National Bank Financial.

[Tal Woolley, Research Analyst]

I just wanted to start off by asking a bit about if you're able to sort of quantify the pipeline of assets that there might be at Weston for you to acquire? Like, can you sort of give some -- quantify like the amount of properties that might be there for Choice to acquire over time?

[Rael Lee Diamond, Chief Operating officer]

We aren't able to quantify it. But they would be of very similar characteristic to the one we purchased in Langley, BC. So essentially, from our perspective in the industrial facility that they may be using either as an industrial facility or as a bakery asset that could be converted in the future to an industrial asset. But we aren't able to quantify the exact number or quantum.

[Tal Woolley, Research Analyst]

Okay. And a good chunk of their business is in the U.S. too as well. Is that something that would interest Choice?

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

Tal, it's Stephen. At the present time, no.

[Tal Woolley, Research Analyst]

Okay. And then just a quick question on the CapEx. So just to be clear from your commentary between sort of the leasing and the property capital expenditures around $80 million a year for the combined organization looks about a correct number to be using.

[Mario Barrafato, Chief Financial Officer]

Yes. A little bit higher if you take into account that CREIT only had 2/3 of the year. And there's a bit more CapEx to CREIT, right? But the -- so really what you saw was just a function of timing. By the time you contract it -- a lot of it was roads and paving. And so by the time you contract it, it gets seasonal. And so really it's just a function of timing. But the quantum is in line with the direction you mentioned.

[Tal Woolley, Research Analyst]

Okay. And then just lastly, if I've done my math correctly, it does look like your equity accounted investments did sort of tick up, produced a little bit more FFO this quarter than last. Was there anything that changed significantly within that portfolio that we should be aware of?

[Mario Barrafato, Chief Financial Officer]

To be honest, Tal, we kind of run the business on a proportionate basis. So I really couldn't tell you exactly what's within that line. But our joint ventures have been performing well. But I can drill down and find exactly what drove that.

[Operator]

And there are no further questions in queue at this time. I turn the call back over to Stephen Johnson.

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

Thank you, everyone. Thanks again for taking the time this morning to attend our conference call. And enjoy the long weekend.

[Operator]

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