Dream Industrial Real Estate Investment Trust

TSX:DIR.UN

Earnings Call Transcript 2018-Q3

[Operator]

Good afternoon, ladies and gentlemen. Welcome to the Dream Industrial REIT Third Quarter 2018 Conference Call for Wednesday, November 7, 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 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 afternoon, everyone. Thank you for joining us today for the Dream Industrial REIT conference call, which is for the 3 months ended September 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 operating results. Lenis will provide our financial highlights. We'll then be happy to field your questions.The third quarter of 2018 was eventful as we focused on driving company performance, building and executing on our acquisition pipeline as well as successfully deploying the proceeds from our June equity offering. We completed the acquisition of the innovation campus portfolio on Columbus as well as 161 The West Mall in Etobicoke. The purchase price for these properties totaled approximately CAD 115 million and represents a going in cap rate of approximately 6.3%, with average annual rental escalators of approximately 1.2% over the term of the leases. Subsequent to quarter end, we acquired 121,000 square-foot distribution facility in Montréal for a purchase price of $13.6 million, representing a going in cap rate of 6%. Over the past year, we have actively grown our portfolio in the U.S. and Canada. The trust has now acquired approximately 4 million square feet of distribution and light manufacturing facilities in strong industrial markets. While adding high-quality assets and improving our overall portfolio quality, we have lowered our leverage and improved our balance sheet flexibility.On a net debt-to-assets basis, our leverage was 44.3% as of September 30, 2018, significantly below 52.5% reported at the same quarter last year. We have ample liquidity and estimate our acquisition capacity to be over $200 million. Our potential acquisition pipeline stands close to $300 million across the U.S. and Canada, of which just over $200 million are in advanced negotiations. The Dream and PAULS Corp. acquisition teams continue to identify opportunities on both sides of the border that meet our investment criteria, which is to acquire high-functional assets in good locations that offer attractive yields with strong growth potential. Moving on to our markets. The Canadian industrial market remains robust with overall industrial availability of 3.3%, a record low. New supply under construction remains limited at approximately 20 million square feet or only 1% of the market inventory. Given the strength of the market, we believe it is unlikely that the new supply will meet tenant demand. Our markets in the Midwest and Southeastern U.S. continue to display strong fundamentals, supported by a close proximity to major population and employment centers. Absorption and rent growth in our markets have been robust, and the construction pipeline remains relatively low. In Canada, the impact of these strong fundamentals are being realized across our portfolio, especially in Ontario and Québec. Year-to-date, we have transacted 595,000 square feet of renewals and 385,000 square feet of new leases in Ontario. Renewals were completed at an average rental spread of 12.3%. In Québec, we completed 134,000 square feet of renewals and 218,000 square feet of new leases, with an average rental spread of 8.2% on renewals. We expect comparative properties NOI growth in these 2 regions to be higher in 2019. 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. Year-to-date, our investment property values have increased $77 million in Ontario and $29 million in Québec due to higher underlying cash flows, market rent growth and lower cap rates. In Western Canada, operating results in the first half of 2018 were impacted by early terminations, which led to a decline in occupancy. While the near-term impact on NOI is negative, we're focused on free cash flow by maximizing occupancy while prudently investing capital. We have been successful in leasing up a significant number of our vacancies, resulting in an occupancy increase of 130 basis points over the quarter to 94.2%. We expect comparative property NOI growth to be positive in 2019.Overall, with committed occupancy at 94% and a WALT of 3.5 years, our Western Canadian portfolio should provide stable cash flow and is well positioned to benefit from the broader market recovery.In Eastern Canada, occupancy was fairly stable through the quarter. We have significantly increased our occupancy in this region over the last 8 quarters, which has led to strong comparative property growth this year, and the East will continue to deliver stable income to the trust. Our portfolio remains 100% -- in the U.S., our portfolio remains 100% occupied with a WALT of 5.9 years and no leases expiring before 2022. Overall, our occupancy has remained stable, and we continue to capitalize on opportunities in strong markets to drive rental rates higher and 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 $0.206 compared to $0.23 in the third quarter of 2017. Higher FFO from comparative property NOI growth and acquisitions was offset by lower leverage and the timing difference between our June 2018 equity raise and subsequent capital deployments. Comparative property NOI increased 0.6% from the same quarter last year and 1.7% for the 9-month period, mainly reflecting higher rental rates in Ontario and Québec and higher occupancy in Eastern Canada, partially offset by lower occupancy and rental rates in Western Canada. We maintained a strong retention ratio of 78.2% for the third quarter and have secured leases, representing 95% of our total 2018 expiries and terminations. The value of our investment properties increased to $2.1 billion from $1.7 billion at the beginning of the year. The increase was largely due to $230 million in acquisitions and a $97 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's reported net asset value per unit increased by $0.77 or 8.2% to $10.12, largely from higher investment property values in Ontario and Québec. The trust's payout ratio and diluted FFO increased temporarily in Q3 due to lower leverage and a timing difference between the equity raised in June and the subsequent deployment of these proceeds. We expect this ratio to trend downwards next quarter. As Brian mentioned earlier, our net debt to assets ended the quarter at 44.3%, a decrease of 820 basis points year-over-year. At quarter end, our liquidity remained strong with over $8 million in cash, unencumbered assets of $210 million and $78 million of liquidity on our credit facility. We look forward to utilizing our strong balance sheet to acquire assets that further improve the financial and operating performance of our portfolio. We are on track to meet our guidance provided on our prior conference call. We expect our diluted FFO for Q4 to be directionally higher than Q2 and Q3, with leverage of approximately 44% by year-end. Our comparative properties NOI growth for 2018 is forecast to come in at the high end of the 1% to 1.5% range guidance provided on our Q2 conference call. For 2019, we expect our comparative properties NOI growth to be stronger from higher rental rates in Ontario and Québec as well as improved occupancy in Western Canada. As we work through our strategy plans in December, we look forward to providing more detailed guidance for our 2019 performance on our year-end conference call in February.In closing, over the past year, we have reduced the risk of our business through lowering debt and redeeming our convertible debentures. We have accomplished all of this while growing our portfolio and improving its overall quality. We retained significant acquisition capacity, and 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. We've transformed the business over the past year, and we believe there has been significant value created through the process. We are well positioned to continue to improve value through 2019 by organic income growth, identifying asset recycling opportunities to improve overall portfolio quality and using the strength of our balance sheet for new investment opportunities that meet our investment criteria.We would now be happy to take any questions.

[Operator]

[Operator Instructions] Our first question is from Chris Couprie of ACICB (sic) [ CIBC ].

[Chris Couprie, Analyst]

Close. I just want to chat a little bit about the acquisition pipeline. May be you could help us get a feel for geographies, timing, pricing types of things?

[Brian D. Pauls, CEO & President]

Sure, Chris. So I think I mentioned in the opening remarks that we're in advanced negotiations on our portfolio. The things I can tell you are that it's -- we've previously guided that we want to have 20% of our NOI in The States. The properties we're currently in advanced negotiations on are in the U.S., roughly a 6% cap. And we'd do this on balance sheet with current liquidity. And they are markers that we're -- some of the markets we're already in. It's a portfolio of properties that's in the U.S. We see timing being early '19 for closing.

[Chris Couprie, Analyst]

And I'm sorry, did you give a -- of that $300 million pipeline, is it pretty chunky?

[Brian D. Pauls, CEO & President]

Well, of the $300 million I mentioned, that we're in advanced negotiations on $200 million. And that would -- we would use existing liquidity in our existing balance sheet to do it. And our leverage would likely creep up at closing of this if we were to buy it.

[Chris Couprie, Analyst]

Okay. And just in terms of the opportunity set that you're seeing out there. Any comments?

[Brian D. Pauls, CEO & President]

On the types of properties? Or -- what's your question?

[Chris Couprie, Analyst]

Yes. In terms of the volume of deals that you're seeing.

[Brian D. Pauls, CEO & President]

Yes. We're seeing a lot of -- we've got a strong pipeline, both in Canada and the U.S. I mentioned the acquisitions that we just did in Montréal, Toronto and then this, the negotiations that we're in the U.S. I'd say we're seeing opportunities in all of those markets. Those are the markets we're really focused on growing through acquisitions. And we're looking at opportunities in all 3 of those places.

[Operator]

Our next question is from Nana Yang of Scotiabank.

[Nana Yang, Associate]

I know we've previously discussed when Blackstone bought Pure Industrial that Blackstone might be more aggressive in raising rents, especially in the GTA. Just wondering if you've seen that dynamic change in your negotiations? And what sort of rent increases out can we expect for 2019?

[Brian D. Pauls, CEO & President]

It's a good question. And yes, we are seeing that dynamic, particularly in Ontario as well as in Québec. But I think we're pushing rents hardest in the GTA. I mentioned in the opening remarks that our renewal spreads for Toronto or GTA were 12.3% year-to-date. So I think that's indicative of how we're pushing rents. We're going to continue to do that through 2019. The market remains very, very tight. And it's a good opportunity for us to grow rents. So we'll see that -- we expect to see that trend continue.

[Nana Yang, Associate]

Okay. And then on the flip side, can you help us understand what the weakness in Western Canada is attributed to? Is the pressure related to the flex industrial space in Calgary?

[Brian D. Pauls, CEO & President]

I think the West has generally been softer than Toronto and Montréal. The general economic conditions there have been slower. All industries have been affected by the oil and gas industry, whether that's homebuilders or service providers. And so those are affecting small and large tenants. Although I think we're seeing improvement in all of our Western markets, but it's slow. And so I think we're just seeing the early signs of that improvement.

[Nana Yang, Associate]

I know it's a tough question, but when do you see Western Canada stabilizing?

[Brian D. Pauls, CEO & President]

Well, I think we're seeing it now. We've increased occupancy by 130 basis points this quarter. That's a very positive sign. I think that's going to happen prior to really rent growth. We expect same-store sales or SPNOI to continue to improve as occupancy and kind of the effects of that increased occupancy take effect. So we think we're seeing that improvement now. That will -- the results on our financials will lag behind the improvements we're seeing on the ground in leasing right now.

[Nana Yang, Associate]

Okay. That makes sense. And just lastly, what is your outlook or re-leasing expectations for those 2 early lease terminations in Québec?

[Lenis W. Quan, Chief Financial Officer]

Well, the 2 terminations totaled about 20,000 square feet, the 2 smaller tenants within the portfolio. And I -- I mean, as Brian was saying, the market in the greater Montréal area has improved quite a bit. It's quite tight. So we don't see any significant challenges in re-leasing that. And in terms of timing, it's probably mid-2019.

[Operator]

Our next question is from Brad Sturges of Industrial Alliance.

[Bradley Sturges, Equity Research Analyst]

Just maybe -- just trying to get an understanding a little bit more of the in-place leases. And as a percentage of the portfolio, I guess, with some of the acquisitions being a little bit more long-term leased, what would be the percentage of the portfolio that would have contractual rent stops right now across the portfolio between single-tenant assets and some of the smaller bay, multi-tenant assets?

[Lenis W. Quan, Chief Financial Officer]

I don't think -- I don't actually have that breakdown off the top of my head. But I think, in general, for our total portfolio, we see about 1% to 1.5% average annual contractual rental bumps. That's sort of for the total portfolio, don't have the split between multi and single off the top of my head.

[Bradley Sturges, Equity Research Analyst]

And when you're going through these renewal process with your tenants, are your tenants approaching you early? And is that an area where you can see maybe a little bit more of a lift on those contractual stops seeing a little bit more of a bump that you're working into the leases, particularly like in Ontario or Québec?

[Lenis W. Quan, Chief Financial Officer]

I guess it's going to be a case-by-case basis.

[Brian D. Pauls, CEO & President]

Yes. I think it's a case-by-case basis, Brad. We're -- we have a lot of tenants coming to us for early renewals. Some of those we're entertaining, and some of them we're not. It depends on the market. It depends on the property. So in the West, for example, some of the tenants have tried to take advantage of the current market, wanting to renew early. Some of those we're resisting because we feel like, in a few years, we're likely to see higher rents than we are now. And healthy tenants are recognizing where the market is and trying to lock in for longer. We're saying no, we'd rather renew in a couple of years or 2, 3 years. In Ontario, that's probably the opposite. If we can renew early, like we did with Array, we'll do that. We locked that in with -- for 16 years with significant bumps. And so that was, I think, a really good early renewal for us given where the market is in the GTA.

[Bradley Sturges, Equity Research Analyst]

Okay. So if it's opportunistic, you may consider this if there's a -- if it's compelling to your end, I guess, and depending on markets.

[Brian D. Pauls, CEO & President]

Yes. We don't have a platform or a portfolio-wide strategy to go renew any market or any portfolio of ours early. It's more a case-by-case basis.

[Bradley Sturges, Equity Research Analyst]

And will that be your approach looking at an asset management program? Looking at assets that makes sense longer term to be in the portfolio will be a case-by-case basis still in the portfolio, whether you execute capital recycling? Or would you look at more at -- on a market-by-market basis, let's say, trimming in an area or a region?

[Brian D. Pauls, CEO & President]

Yes. I mentioned the asset recycling in my opening remarks. That'll be done on a case-by-case basis. We have had offers on individual assets from either tenants or investors. We're entertaining those. These are in noncore markets on individual assets. So we're kind of looking at those on a one-off basis as well and looking for what our opportunities to redeploy those proceeds if we were to recycle those assets.

[Bradley Sturges, Equity Research Analyst]

You have a sense of what the quantum of that capital recycling could look like at the moment?

[Brian D. Pauls, CEO & President]

No. I don't have guidance on that because it's really one-off individual assets. And I don't have any guidance on how much that would be.

[Operator]

Our next question is from Mike Markidis of Desjardins.

[Michael Markidis, Real Estate Analyst]

Brian, I just want to confirm that the 12.3% spread on the 595,000 of renewals in Ontario, was that dragged down by the -- as well by the early renewal that you did in the quarter for 2019 that was at 1.9% initially?

[Brian D. Pauls, CEO & President]

Yes. It's a good observation. That includes Array at 1.9%, but Array has a large bump in 2019, which is already in there now, which will contribute to SPNOI for 2019. But it includes that.

[Michael Markidis, Real Estate Analyst]

Okay. And then in your comments, I think you're saying in Ontario and Québec, you would expect same-property NOI growth to be higher than next year. When you say higher, do you mean based on what you're expecting? Like would it be versus what the quarter came in at or what are year-to-date on those 2 same-store sales?

[Brian D. Pauls, CEO & President]

Certainly higher than our guidance for 2018 we think our SPNOI. And this is -- I think, Mike, it's really going to be driven by the fact that we're going to have negative SPNOI in the West. We anticipate that to be positive in 2019. Ontario and Québec, we see those performing well. But the -- one of the biggest impacts is going to be positive same-store sales in the West.

[Michael Markidis, Real Estate Analyst]

Okay. And what about Eastern Canada? Because you've had pretty good, very strong growth in Eastern Canada this year. How do you see that playing out next year?

[Brian D. Pauls, CEO & President]

We've had very strong growth driven primarily by occupancy. We see that being more flat as we're getting close to -- very close to full there.

[Michael Markidis, Real Estate Analyst]

Okay. And actually, that's a good segue to my next question. Just, I mean, Ontario and Québec, you're basically full. Obviously, it takes some bobs every quarter. But Western Canada and Eastern Canada would be sort of where you guys have an opportunity or at least perceived opportunity to drive some additional occupancy. What do you think, I mean, just looking at those 2 markets? Eastern Canada actually kind of surprised me, how strong the absorption has been in the market there recently. Western Canada has been strong, where there's a lot of supply there over the next couple of years. So sort of do you think that there's room to push hard on occupancy there? Or existing levels sort of would you be happy with maintaining that going forward?

[Lenis W. Quan, Chief Financial Officer]

Mike, I think in the West, I think there's some room to improve on occupancy. I think for the East, we'll probably bump along kind of where we are now. So we'd expect the East to remain stable and for the West, that there's growth opportunity. And actually, for Ontario and Québec, we actually do have close to about 1.5 million square feet of leases rolling that we -- next year. So I think even though those properties are full, there is still some opportunity there for rental growth with that volume of leases rolling over next year.

[Michael Markidis, Real Estate Analyst]

Of course, of course. Yes, I was just looking more from the driving occupancy in the West and the East. So the situation in the East, is that really just a function of the market? Or is there any space in there that's functionally just not that marketable?

[Brian D. Pauls, CEO & President]

No. All the properties are good. I think it's just a function of the market and trying to grab as much market share as we can.

[Michael Markidis, Real Estate Analyst]

Okay. Last one from me. Lenis, the Columbus portfolio, did you guys put mortgage financing on that yet? Or was that just satisfied with the line?

[Lenis W. Quan, Chief Financial Officer]

It was satisfied with the line and in our working capital so from following the proceeds. We are in -- we are currently looking to put permanent mortgage financing on that one. So I'm assuming your next question will be the terms. So we're looking for longer term just kind of given where interest rates are. We're looking at 10-year terms on that one.

[Michael Markidis, Real Estate Analyst]

Okay. And indication of cost? Roughly?

[Lenis W. Quan, Chief Financial Officer]

Probably in the mid-4s.

[Michael Markidis, Real Estate Analyst]

Mid-4s. Okay. And I'll close it off with just what you're seeing 5- and 10-year for stuff in Canada these days, that would be great.

[Lenis W. Quan, Chief Financial Officer]

I think between 4% and 4.2%, 4% and 4.2%.

[Operator]

Our next question is from Matt Kornack of National Bank Financial.

[Matt Kornack, Analyst]

Strategically speaking, in this market environment, when you have leases come up for renewal, what type of term are you trying to get? Are you pushing them out as long term and putting rent steps into them aggressively? Or do you want to keep a shorter term so that you can mark-to-market as the market improves in Ontario or Québec, let's say?

[Brian D. Pauls, CEO & President]

I'd say, mostly, we were wanting enough term to -- the rollovers are usually -- have cost. Whether tenant improvements or commissions, we want enough term to spread those costs out over the term. Ideally, in today's rent environment in the GTA and Québec, the markets you mentioned, if we can get longer term with annual bumps, our target would probably be 2% for annual bumps on those leases. We welcome 5-, 6-, 7-year terms, even longer. So it's kind of on a case-by-case basis. The problem with shorter terms, it is costly when they come up. And so a little bit longer is generally better.

[Matt Kornack, Analyst]

A fair point. And are you seeing because of the tighter markets that you're having to put less CapEx into deals at this point? Or is that still pretty standard?

[Brian D. Pauls, CEO & President]

No. I think that's true. We think it's fair. In a landlord's market, we can reduce cost and improve our NERs a little bit.

[Matt Kornack, Analyst]

Fair. And then as you look at trying to maximize yield, can you speak to sort of where you guys have landed on some of the value-add opportunities within the existing portfolio? And what your thoughts are with regards to developments going forward?

[Brian D. Pauls, CEO & President]

So we're looking at development. We do look at value-add opportunities within our portfolio, whether we can expand a building or improve it in a way that will command higher rents going forward. We've done that in some cases. In the Array property, for example, we've expanded it. We're looking at a couple of other properties where we could add on to the existing building with the existing tenant and either extend their lease or add to the GLA, the gross leasable area. So we are looking at that. We've had discussions on development. Development is certainly on our radar. And we've had proposals from joint venture partners who would like to do development with us. We are entertaining some of those discussions. It's really early days to talk about that. But it's certainly on our radar as a way to continue to grow. We'd love to add that to kind of our batch of assets as new development and new properties within the DIR portfolio.

[Matt Kornack, Analyst]

And geographically speaking, are you entertaining both the U.S. and Canada? Or is it one of those 2?

[Brian D. Pauls, CEO & President]

Yes. Yes, we're entertaining both. Likely to see -- I mean, we do see more opportunities in the U.S. just because it's a bigger market and more things come up. However, we're certainly looking at it, opportunities in both places.

[Operator]

[Operator Instructions] And we do have a question from [ James Raymond of the Raymond Trust ].

[Unknown Analyst]

I was going to congratulate you on the work you're doing, but I would like to know what the average mortgage rates you are paying. And what are you doing to renew mortgages, which may be coming due?

[Brian D. Pauls, CEO & President]

[ James ], thank you for the congratulations. I'll let Lenis answer your question on mortgage rates.

[Lenis W. Quan, Chief Financial Officer]

So our average interest rate on all of our mortgages is about 3.62%, with the weighted average remaining term to maturity of 4.3 years. I mean, just given where interest rates are, we typically -- when we go to refinance our mortgages, we look at the assets, we look at the tenant profile or lease maturity profile. With a strategic view of the asset, we try to tie all that in, in terms of what term we're going to look for on the mortgages. We typically lock in 5, 7 to 10 years. Given where interest rates are right now, where it makes sense, we'll lock in for longer because it doesn't cost too much more to lock in a longer term than the 5-year term. So I had mentioned earlier on the call that we're probably seeing about 4% to 4.2% for 10 years -- for 10-year mortgage terms. So that's, in summary, sort of what we're planning to do. Our overall debt has come down year-over-year. We were at 52.5% leveraged. And we're now down to about 44%. And I think our target leverage is somewhere between 45% and less than 50% right now. Are there any other questions? Great. Thank you.

[Operator]

Thank you. And I'm showing no further questions at this time.

[Brian D. Pauls, CEO & President]

Well, thank you, everyone, 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.