Dream Industrial Real Estate Investment Trust

TSX:DIR.UN

Earnings Call Transcript 2018-Q2

[Operator]

Good morning, ladies and gentlemen. Welcome to the Dream Industrial REIT Second Quarter 2018 Conference Call for Wednesday, August 8, 2018.During this call, management of Dream Industrial REIT may make statements containing forward-looking information within the meaning of applicable securities legislation. Forward-looking information is based on a number of assumptions and is subject to a number of risks and uncertainties, many of which are beyond Dream Industrial REIT's control, that could cause actual results to differ materially from those that are disclosed in or implied by such forward-looking information.Additional information about these assumptions and risks and uncertainties is contained in Dream Industrial REIT's filings with the securities regulators, including its latest annual information form and MD&A. These filings are also available on Dream Industrial REIT's website at www.dreamindustrialreit.ca.[Operator Instructions]Your host for today will be Mr. Brian Pauls, CEO of Dream Industrial REIT. Mr. Pauls, please go ahead.

[Brian D. Pauls, CEO & President]

Good morning, everyone. Thank you for joining us today for the Dream Industrial REIT conference call, which is for the 3 months ended June 30, 2018. Speaking with me today is Lenis Quan, the Chief Financial Officer of the REIT.On today's conference call, I will start off with a brief overview of our strategic growth initiatives, followed by an update on our markets and our results. Lenis will provide our financial highlights. We'll then be happy to field your questions.The second quarter of 2018 was quite eventful, highlighted by an equity raise of $144 million and the announced acquisition of one property in Etobicoke, Ontario and two in the U.S. The asset located at 161 The West Mall, Etobicoke spans 205,000 square feet and is occupied by two tenants. The building is very well located near the intersection of Highway 427 and the QEW. As part of the acquisition, we also have a right of first refusal for the neighboring property, which is approximately 2 acres, this was an off-market deal. We closed on the asset on August 2, and believe there is significant long-term value in the building and location.As disclosed in our press release dated June 20, 2018, we are also in advanced negotiations to acquire two high-quality industrial buildings in the Midwestern U.S. These properties total approximately 720,000 square feet of GLA and are expected to close before the end of the third quarter of 2018. The purchase price for these properties totals CAD 115 million and represents a going in cap rate of approximately 6.25% with average annual rent escalators of approximately 1.2% over the term of the leases.Over the past 9 months, we have actively grown our portfolio in the U.S. and Canada, including the recently announced transactions, the Trust has acquired approximately 4 million square feet of distribution and light manufacturing facilities in strong industrial markets. We are also in advanced negotiations to acquire a 120,000 square foot property in the Greater Montreal area at a going in cap rate of approximately 6%.We have grown the portfolio and the Trust while lowering leverage and strengthening the balance sheet. On a net debt to assets basis, our leverage was just 41.4% as of June 30, 2018, significantly below the 52.2% reported at the same quarter last year.Following the early repayment of $111 million of convertible debentures last week, we retain over $200 million of liquidity to pursue acquisitions and development opportunities. The Dream and PAULS Corp. acquisition teams continue their work to source new acquisitions in both Canada and the U.S. to identify opportunities that meet our investment criteria.Moving onto our markets. Industrial fundamentals continue to strengthen, the Canadian industrial market remains robust with overall industrial availability of 3.9%, a record low. New supply under construction remains limited at 19 million square feet or only 1% of the market inventory. It is unlikely that the new supply will meet the continuing demand resulting from e-commerce and other economic drivers.The Southeastern U.S. industrial markets in which we have invested all display robust industrial fundamentals supported by close proximity to major population and business centers in the U.S.. The impact of these strong fundamentals are being realized across our portfolio, especially in Ontario and Quebec.Year-to-date, we have transacted 738,000 square feet of deals in Ontario at rates 11% above expiry or prior in-place rents. Our focus on active asset management continues to yield positive results. Strong leasing activity and declining cap rates have led to continued increases in the value of our investment properties in these markets.Overall, the Western Canadian industrial market is improving with market availability dropping 120 basis points year-over-year in Calgary to 8.1% and 100 basis points in Edmonton to 7.5%. Occupancy in our Western Canadian portfolio declined quarter-over-quarter due primarily to 91,500 square feet of early terminations. While these terminations impact cash flow in the near-term, we are now actively marketing these spaces and anticipate Western occupancy recovering throughout 2018.Overall, with committed occupancy at 93% and a WALT to 3.5 years, our Western Canadian portfolio should provide stable cash flow and is positioned to benefit from the broader market recovery. We remain focused on maximizing occupancy and free cash flow, while prudently investing capital.in Eastern Canada, occupancy increased 90 basis points since this time last year, which should deliver steady income to the Trust. Our U.S. portfolio remains 100% occupied with a WALT of 6.1 years and no leases expiring before 2022.Overall, we continue to outperform the market in nearly every region that we operate in and the strong fundamentals in our core markets provide us with ample opportunities to increase our pace of organic growth.Lenis will now provide our financial update.

[Lenis W. Quan, Chief Financial Officer]

Thank you, Brian. Diluted funds from operations or FFO per unit for the quarter was $0.211 compared to $0.23 in the same quarter last year. Our FFO has increased due to higher comparative property NOI and contribution from acquisitions, offset by the impact of operating at lower leverage and higher G&A expense, largely deferred unit compensation. Comparative property NOI increased 1.7% from the same quarter last year, mainly reflecting higher average occupancy in Eastern Canada and rent growth in Ontario. We maintained a strong retention ratio of 75.4% for the second quarter and have secured leases representing 95% of our total 2018 priorities.The value of our investment properties increased to $1.9 billion compared to $1.7 billion at the beginning of the year. The increase was largely from $115 million in acquisitions and an $84 million increase in the value of the Trust's properties, reflecting higher underlying cash flows, market rents and lower capitalization and discount rates.Year-to-date, the Trust recorded net asset value per unit increased by $0.70 or 7.5% to $10.05, largely from higher investment property values in Ontario and Quebec. The Trust's payout ratio and diluted FFO increased temporarily to 82.9% due to the timing difference between the equity raise in June 2018 and deployment of these proceeds. We would expect the ratio to trend downwards as these funds are deployed.As Brian mentioned earlier, our net debt to assets ratio ended the quarter at 41.4%, a decrease of 10.8% from the same quarter prior year. At quarter end, we had cash of $197 million, unencumbered assets of $94 million and $123 million of liquidity on our credit facility. In the near-term, operating with lower leverage will have some short-term impact on our results.For Q3, we expect our diluted FFO per unit to be modestly lower than Q2 following the June equity offering and financing of our U.S. properties, until these proceeds are fully deployed. We utilized a portion of the proceeds towards the Etobicoke acquisition and debenture redemption last week and expect to deploy the remaining proceeds on announced acquisitions later in Q3.In addition, the recent vacancies in Western Canada will continue to impact comparative property NOI growth in Q3 and we expect occupancy to recover in Q4 .We are continuing to drive organic growth through contractual rental increases and increasing rental spreads across most of our portfolio. It will take a bit of time for them to reflect through in our results, but we expect to deliver stronger comparative property NOI growth beyond 2018 .Following the closing of the announced acquisitions, leverage should increase to approximately 45% by the end of Q3. As such, we expect our Q4 results to benefit from the completed acquisitions as well as higher comparative property NOI growth. Directionally, our diluted FFO for Q4 is expected to be higher than Q2.Our well-capitalized balance sheet is at its strongest since inception. Following the redemption of our convertible debentures last week, we have over $200 million of liquidity and investment of this capital would increase FFO further once deployed. We are well positioned to deliver stronger NOI, FFO and NAV growth in 2019.I will turn it back to Brian now to wrap up.

[Brian D. Pauls, CEO & President]

Thank you, Lenis. Over the last 6 months, our management team has met with a number of investors, industry participants as well as our tenant base. We've received a lot of good feedback from these meetings, which has influenced our strategy to surface value, while reducing the risk of our business. As we move to the latter half of 2018, Dream Industrial is well positioned to improve the value of the business by organic income growth, identifying asset recycling opportunities to improve overall portfolio quality and using the strength of its balance sheet for new investment opportunities that meet our investment criteria.We look forward to further improving our business in the second half of 2018 and are well positioned for continued growth in 2019 .We would now be happy to take any questions.

[Operator]

Thank you. [Operator Instructions] Our first question is from Michael Markidis of Desjardins.

[Michael Markidis, Real Estate Analyst]

Just circling back to what's going on in Western Canada, Brian. I noticed that, I mean obviously this quarter, you had some early terminations. So I guess, first off, I was hoping you can expand on that, but I also noticed that in Western Canada if you look at the last sort of several quarters that you guys have lost quite a significant amount of occupancy. So when you say occupancy getting back to or recovering in the back half of this year, are you expecting it to get back up to sort of 97% level you saw up until the third quarter of last year or are you kind of expecting to get halfway back there, just give us something, what's happening?

[Brian D. Pauls, CEO & President]

Our in-place occupancy with commitments right now is 92.9% in Western Canada. We think that we will continue to improve subsequent to the Q2 ending. We did 70,000ft of new leases in the Calgary area, 52,000 of that was new tenants, 18,000 of that was renewals of tenants. So we're starting to see the effects of the kind of the start of the recovery in the West, a lot of the leases that were reflected in our SPNOI in the West were done in late 2017. Some of the terminations, we have one in Edmonton, that was a significant part of the 91,000 feet, they were paying half rent there and we are pretty optimistic we'll be able to lease that relatively quickly at a higher rent of that expiring rent. So I don't think it will get to the point that you -- of the occupancy you mentioned, Mike but we see significant increase in occupancy throughout 2018 and that we're poised pretty well for 2019.

[Michael Markidis, Real Estate Analyst]

Okay, and the terminations this quarter, were those tenant failures or were they like a decision to terminate -- I didn't see any lease termination income in the statements?

[Lenis W. Quan, Chief Financial Officer]

Hi Mike, it's Lenis. Yes, I would say it was a combination of tenants that were just struggling financially and failures. So it's an opportunity for us to take back the space and re-lease them to better tenants.

[Michael Markidis, Real Estate Analyst]

Okay. And then the 8% renewal downtick that you saw in Western Canada, is that something that you expect to improve in the back half of this year and into '19 as well?

[Brian D. Pauls, CEO & President]

Yes, yes. I mean, part of it is [ NER ] -- the way we'd answer it, Mike is [ NER ] in the sense that we're getting less rent in some cases, but spending a lot less money to get that rent in terms of commissions and tenant improvement, so free cash flow [ NER ] is improving if the face rate is not necessarily improving.

[Michael Markidis, Real Estate Analyst]

Okay. Next topic of interest here would just be on the acquisitions. I don't know if you did disclose it or not but, Brian, are you able to disclose the cap rate on the typical asset?

[Brian D. Pauls, CEO & President]

Mid-5s.

[Michael Markidis, Real Estate Analyst]

And just with respect to I guess sort of $115 million of combined purchase price for the US, the stuff -- or the one property you have in Montreal, sounds like it might be around $15 million or so, so I guess just thinking about where the balance sheet is and where your capacity is, do you see the existing equity base supporting a higher figure than that, in terms of acquisitions, like or stated alternatively, if you're down into 45% leverage level once you deploy or acquire these assets, where do you see moving to beyond that?

[Brian D. Pauls, CEO & President]

Yes, maybe Michael I'll answer to start and Lenis will follow. We see the existing balance sheet supporting further acquisitions. Our target debt level would be somewhere under 50% and so we've got liquidity to do the -- execute on the deals that we mentioned in the preamble to this call as well as further acquisitions that are unidentified yet.

[Michael Markidis, Real Estate Analyst]

And last one from me before I turn it back, Lenis, could you just comment on what you're seeing in terms of financing cost on Canadian properties for 5 and 10-year terms currently?

[Lenis W. Quan, Chief Financial Officer]

Yes, sure. Sorry, just a follow-up on Brian's thing, I think in terms of our further acquisition capacity, we're looking at about another $200 million following the announced acquisitions. And in terms of rates that we're currently seeing, I think in for 5 to 10-year money, we're seeing around 4% in Canada and about 10 basis points or so higher than that 10 to 20 basis points higher that for 5 to 10-year terms in the US.

[Operator]

Our next question is from Chris Couprie of CIBC.

[Chris Couprie, Analyst]

A question on Quebec. Your vacancy or your occupancy is hitting its highs here, Montreal market is doing quite well. When do you think same property NOI might turn the corner for you guys?

[Lenis W. Quan, Chief Financial Officer]

We've actually done some leasing during the year in Montreal, so we -- that's reflected in our commitment and they are going to take occupancies in the latter half of the year. So we expect the same property NOI to pick up in the second half of the year for Quebec.

[Chris Couprie, Analyst]

And then just a question on -- just kind of a big picture question, NAFTA impact, is that anything being discussed by any of your tenants, either side of the border?

[Brian D. Pauls, CEO & President]

Yes, Chris, I think everyone is talking about it because it's in the news, nobody knows what impact it's going to have I think everyone's been kind of status quo with their business. We have not seen any direct impact from that and don't know that we will. It's not -- I guess our attitude on is it's not really worth worrying about it at this point is we can't control that. We've got great properties and we've got good tenants. We feel like their businesses will perform well regardless.

[Chris Couprie, Analyst]

And then, just a quick question on development, given your experience with PAULS Corp, two questions I guess. #1, anything in the portfolio that you have identified from your review since you've been there. And #2, I know PAULS Corp has developed in Canada in the past, would they do so again today?

[Brian D. Pauls, CEO & President]

So the first question is, there is a few small opportunities within our portfolio to expand, we're talking to a few of our tenants about growing either within the site or expanding the building, those kind of things that are not that material to our overall portfolio, though there are opportunities to increase value on a kind of property by property basis, but it's not much. The second question, we are looking at development opportunities in a number of locations, both in the US and in Canada. We'd like to add development to our portfolio. So we're actively looking for opportunities. And that would be -- Chris, that would DIR balance sheet, we're talking about doing that PAULS Corp. or Dream would be service providers for Dream Industrial be under industrial balance sheet.

[Operator]

Our next question is from Brad Sturges of Industrial Alliance.

[Bradley Sturges, Equity Research Analyst]

Circling back to to the same property NOI questions, and more relating to guidance, I think the last couple of quarters has been about 2% growth guidance for this year, given the expectations for Q3 to be impacted by Western Canada, Are you still comfortable with -- in around that 2% range for 2018?

[Lenis W. Quan, Chief Financial Officer]

Just with the recent terminations, it's going to be a bit later in Alberta. So we're probably seeing more or like 1% to 1.5%. But we do expect 2019 to be a lot stronger across the portfolio.

[Bradley Sturges, Equity Research Analyst]

And given you have a little bit more expiries in Ontario and you're pretty tight in terms of your vacancy rates, can we expect you to take on more vacancy there in Ontario, to be more aggressive to push rents and how do you balance that in order to get the growth?

[Brian D. Pauls, CEO & President]

Brad, I think we're going to keep pushing rents, we're going to push rents in every property in Ontario that may produce a little more vacancy. We are running very, very full in Ontario, there is not a lot of places for the tenants to go. So we think we'll be able to continue to push SPNOI without sacrificing too much occupancy, but it may produce a little more vacancy, but for a greater good in terms of more growth.

[Bradley Sturges, Equity Research Analyst]

Last question, you've highlighted the potential for further acquisitions and also have been reviewing potential for non-core asset dispositions and some capital recycling. I guess, where are you on that front from an asset sale perspective? Is it fair to say that first you like to use the excess capacity that you have first before looking at dispositions or is that more of a near-term opportunity as well?

[Brian D. Pauls, CEO & President]

No, that's fair to say. It's fair to say we'd like to spend the cash that's sitting around before we want to generate more cash to spend. So we are analyzing the whole portfolio, we're looking at what our best performers and what our assets or buildings that we should be calling to trade for higher quality or better performing assets. But the first priority is spending the cash we have.

[Bradley Sturges, Equity Research Analyst]

So really that's a -- potentially a 2019 initiative at this point?

[Brian D. Pauls, CEO & President]

Yes.

[Operator]

Our next question is from Brendon Abrams of Canaccord Genuity.

[Brendon Abrams, Analyst of Real Estate]

With respect to the acquisition pipeline, just to clarify, the $115 million figure referenced in the opening remarks, is that including the Etobicoke property or excluding that property and -- maybe I missed it, do you forecast those to be included and complete in Q3 or is that a Q4 event in terms of closing?

[Lenis W. Quan, Chief Financial Officer]

Hi, Brendon, it's Lenis. Yes, the $115 million includes the Etobicoke and the Midwest acquisition and we're anticipating -- so Etobicoke is obviously closed and for the Midwest, we are expecting that to close later in Q3.

[Operator]

Our next question is from Nana Yang of Scotiabank.

[Unknown Analyst]

So so many of my questions have already been asked. I noticed there was a spike in your G&A compared to last year, partially from a change in vesting of the board’s deferred units from 5 years to immediately vesting. How much of the increase in your G&A was attributed to this vesting change?

[Lenis W. Quan, Chief Financial Officer]

There was about $6,00,000 in the G&A, we'd expect that to kind of recur every second quarter when the annual grants are done. And really that change in the compensation plan was following an overall review of the compensation structure of the management and the Board, so the changes were made to the Board's compensation and that was to align with current best practices in Canada.

[Unknown Analyst]

And could you give a bit more color on the business taxes on the Tennessee property. Are these recurring or one-time?

[Lenis W. Quan, Chief Financial Officer]

These are recurring, and so we would bring them in on a quarterly basis throughout the year.

[Unknown Analyst]

And just a bit more color on your Western Canada portfolio, you discussed a bit early already, can you comment on the prospects and your sense of timing for re-leasing the vacant space?

[Brian D. Pauls, CEO & President]

Sure. I'd say we've got active prospect lists, we are actively marketing the recent terminations, the market continues to recover, every lease we're doing now is at a higher rate than we were doing even 3 or 6 months ago. So the market continues to recover, it's still a battle in Western Canada. But I think we're seeing significant signs of recovery, so. We got good prospect list, I mentioned earlier, the 70,000 feet of leasing that we did in Calgary alone since subsequent to Q2, we anticipate that trajectory to continue.

[Operator]

Thank you. And we have a question from Mike Markidis of Desjardins.

[Michael Markidis, Real Estate Analyst]

Hi, sorry, just a quick follow-up for me. On the change in the deferred unit plan, can you walk us through the philosophy on why the units are now immediately vested versus over 5-year period?

[Lenis W. Quan, Chief Financial Officer]

So sorry, that was -- the bit of background I was giving in terms of the overall comp review. So yes, the governance committee review that on an annual basis and they do kind of review the -- what best practices are in Canada. So this change was made to align with those best practices, and it's consistent with the -- a lot of the other REITs out there as well as the other Dream REITs.

[Operator]

Thank you. We have no further questions at this time. I will now turn the call back over to Brian Pauls for closing remarks.

[Brian D. Pauls, CEO & President]

Thank you for your time today, we look forward to speaking again soon.

[Operator]

Thank you, and thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.