Dream Industrial Real Estate Investment Trust

TSX:DIR.UN

Earnings Call Transcript 2018-Q4

[Operator]

Good morning, ladies and gentlemen. Welcome to the Dream Industrial REIT Fourth Quarter 2018 Conference Call for Wednesday, February 20, 2019. 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 & Director]

Thank you. Good afternoon, everyone. Thank you for joining us today for the Dream Industrial REIT conference call, which is for the 3 months and year ended December 31, 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 fourth quarter was productive as we focused on further improving our company performance as well as building and executing on our acquisition pipeline. During the quarter, we acquired a 121,000 square feet distribution facility in Montréal for a purchase price of $13.6 million, representing a going in cap rate of 6%. Subsequent to year-end, we waived all conditions on a 3.5 million square foot portfolio in 5 cities across the Midwest U.S. The purchase price for the portfolio was approximately USD 175 million or CAD 235 million and equates to a going in cap rate of 6% and a stabilized cap rate of 6.5%. The portfolio is leased to over 50 tenants and includes an attractive mix of single-tenant assets and multi-tenant facilities that service a broad range of tenant uses and sizes from small bay to large distribution facilities. The assets are well allocated, and in each city within the portfolio is supported by large commercial airports, intermodal transport hubs and is accessible to over 50% of the U.S. population within a 1-day truck drive. There are strong interests in our tour activity on the recently vacated property in Louisville. The property is very well located and provides an opportunity to increase our initial yield. In addition, we expect the portfolio will provide steady cash flow growth through approximately 3% annual rent escalators embedded in the current leases. We expect the transaction to close in March. Since December 2017, and including the recently announced Midwest U.S. portfolio acquisition, we have grown our asset base by over $500 million; and in less than 2 years, we have achieved our initial target of 20% of highly functional industrial assets in the U.S. At this time, we have strengthened our balance sheet and reduced leverage by 440 basis points. With our initial U.S. expansion strategy successfully executed, we intend to focus on growing primarily in Canada with a focus on Ontario and Québec. Our potential acquisition pipeline is approximately $200 million, and we continue to identify and execute on acquisition opportunities that deliver above-average income and net asset value growth over time. Moving on to our markets. The Canadian industrial market continues to strengthen and underlying fundamentals support continued momentum for the foreseeable future. The Canadian national industrial availability rate tightened further in 2018 to a new record low of 3.2%, with 10 consecutive quarters of declining availability. Our U.S. portfolio is 100% occupied, and demand for industrial real estate continues to drive asset values and occupancy rates. In Canada, the impact of these strong fundamentals is being realized across our portfolio, especially in Ontario and Québec. We have signed 550,000 square feet of renewals taking occupancy in 2019 in our Ontario portfolio at an average spread of 11% over expiring rents, in addition to 3% annual rent increases each year. On 200,000 square feet of leases that were transacted in 2019, the spreads have been even stronger at over 16%, and we expect this trend to continue. In Québec, we have achieved an average spread of 9% on 400,000 square feet of renewals taking occupancy in 2019. At the end of 2018, we renewed Nellson Nutraceutical, one of our largest tenants in Québec, occupying 211,000 square feet in Lachine for an additional 5 years with no costs at a 7% lift from the expiring rate.Strong leasing activity and declining cap rates have led to continued increases in the value of our investment properties in these markets. In 2018, our investment property values have increased $96 million in Ontario and $45 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. However, our focus on maximizing occupancy and cautiously investing capital in our lease deals has been successful. Our occupancy in the region has improved 230 basis points since mid-2018 to reach 95.2% at year-end, and we have achieved stronger NERs compared to the prior year. For 2019, we expect a rebound and positive comparative property NOI growth from the West, driven by increased occupancy and contractual rent growth. In Eastern Canada, occupancy increased 60 basis points during Q4 2018, capping off a strong year. We have significantly increased our occupancy in this region over the last 2 years, which led to 11% comparative property NOI growth in 2018 and should continue to generate steady cash flows. Our U.S. portfolio remains 100% occupied with a WALT of 5.7 years and no leases expiring before 2022. Overall, we have increased occupancy in Western Canada, which, along with strong rental growth in Ontario and Québec, should increase our pace of organic growth in 2019. 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 $0.22 compared to $0.23 in the fourth quarter of 2017. Higher FFO from comparative property NOI growth and acquisitions was offset by lower leverage throughout 2018. FFO per unit for the year was $0.86 compared to $0.91 in 2017. Higher FFO from comparative property NOI growth and acquisitions was offset by lower leverage throughout 2018 and the timing difference between the equity raise in June and subsequent capital deployment. In 2018, comparative property NOI increased by 1.5% year-over-year, driven by higher average occupancy in Eastern Canada, higher average occupancy and rental rates in Ontario, partially offset by lower average occupancy and rental rates in Western Canada. 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 $248 million in acquisitions and a $135 million increase in the value of the Trust's properties, reflecting higher underlying cash flows, market rents and lower capitalization and discount rates. In 2018, the Trust's reported net asset value per unit increased by $1.19 or 12.7% to $10.54, driven by higher investment property values in Ontario and Québec. Our net debt to assets ended the year at 43.5%, a decrease of 440 basis points year-over-year. At year-end, our liquidity was strong with unencumbered assets of $195 million and $98 million of liquidity on our credit facility. Subsequent to year-end, we completed a public offering of 13.8 million REIT units at a price of $10.45 per unit for gross proceeds of $144.2 million. The net proceeds will be used to partially fund the Midwest U.S. portfolio and for general Trust purposes. Looking forward to 2019, we expect our strong leasing momentum to result in improved comparative property NOI growth in the 2% to 3% range, driven by higher occupancy in Western Canada and Québec and rental rate growth in Ontario. We expect the stronger internal growth to be more apparent in the second half of the year. In terms of our growth strategy, we are looking to acquire assets that are well located, above the average quality of our portfolio and offer strong cash flow growth potential. As Brian mentioned, our primary focus for acquisitions will be in Canada, targeting properties in Ontario and Québec. Following the Midwest U.S. portfolio acquisition, we expect leverage to be around 43%. Over the long-term, we are targeting leverage of approximately 47%. Operating at a lower leverage will impact our FFO per unit, however, as our acquisition activity ramps up, we expect a corresponding pick up in FFO per unit. We will continue to prudently manage our capital expenditure and leasing costs and intend to focus on acquiring properties that are less capital and less management intensive. We expect our capital expenditure and leasing costs as a proportion of NOI to decline modestly from current levels. To summarize, over the past year, we had significantly reduced the risk of our business by lowering leverage and redeeming our convertible debentures. We have accomplished all of this, while growing our portfolio, enhancing our portfolio diversification and improving its overall quality. Looking forward, we are well positioned with sufficient liquidity and [indiscernible] strategies to further improve our overall portfolio quality as well as generate higher long-term free cash flow and net asset value growth. I will turn it back to Brian now to wrap up.

[Brian D. Pauls, CEO, President & Director]

Thank you, Lenis. Looking forward, we intend to increase our focus on asset recycling and adding further scale in our target markets. Following the strong operating results in 2018 from the Eastern Canada portfolio, we have received some initial investment interest in these properties. As a result of this interest, we have had very preliminary discussions to test the market appetite for this portfolio. At this stage, we have limited visibility on the outcome of our preliminary discussions. However, we continue to hold a dominant market position in the East, and with occupancy at 93.7% and a WALT of 3.2 years, we expect the Eastern Canada portfolio to continue to deliver stable income. We significantly transformed the business in 2018 and are off to an exciting start to 2019. We look forward to further improving our business and are well positioned for continued growth in 2019. We would now be happy to take any questions.

[Operator]

[Operator Instructions] Our first question is from Sam Damiani of TD Securities.

[Sam Damiani, Analyst]

Brian, just on your comment there at the end there about some dispositions. I just want to make sure I understood. There's a portfolio that you've got in the market that you're in discussions on, is that right? And did you specify where the portfolio is located?

[Brian D. Pauls, CEO, President & Director]

Yes, so the portfolio mentioned at the end is in the East, our Halifax portfolio. We've had interest from buyers for that. The interest is not very specific at this point in terms of dollars or even which properties. So when I mentioned we're testing the market, it's for the Halifax portfolio. We don't know the outcome of that, whether it'll be the right thing to sell or not, but we are going to entertain that interest and see how strong it is.

[Sam Damiani, Analyst]

Okay. So just to be clear, you're entertaining potentially selling the entire portfolio?

[Brian D. Pauls, CEO, President & Director]

Correct.

[Sam Damiani, Analyst]

Okay. And just flipping over to the acquisition side, the $200 million pipeline. How much of that is in Canada versus the U.S.?

[Brian D. Pauls, CEO, President & Director]

Nearly, all of that's in Canada right now. We've got 1 small property in the U.S. we're looking at, but it's almost entirely in Ontario and Québec.

[Sam Damiani, Analyst]

Okay. And I'll just wrap up with the balance sheet. Lenis, thank you for the comments on the leverage in terms of your goals. And in addition to debt to gross book value, do you have a debt-to-EBITDA goal in mind?

[Lenis W. Quan, Chief Financial Officer]

Well, we're currently in and around 7x. So I think it's somewhere in -- we'd like to target being less than 8x for sure on debt to EBITDA.

[Sam Damiani, Analyst]

And you successfully got rid of the converts last year. Is there any desire to put on a different kind of debenture on the balance sheet going forward, unsecured?

[Lenis W. Quan, Chief Financial Officer]

Not in the near future, no.

[Operator]

Our next question is from Brendon Abrams of Canaccord Genuity.

[Brendon Abrams, Analyst of Real Estate]

Brian, when you referenced the Halifax portfolio potential sale, just to be clear, would that effectively be the entire Eastern Canada portfolio or would this be specific properties within Halifax?

[Brian D. Pauls, CEO, President & Director]

We don't know the outcome, Brendon, but it could be the entire portfolio.

[Brendon Abrams, Analyst of Real Estate]

Okay. Just flipping gears to leasing spreads. Obviously, pretty strong for Ontario in 2018 and a good start to 2019. I mean, how should we think about leasing spreads going forward? And just a question in terms of your market rents for Ontario. I mean, the market is so tight, rents seem to be moving so quickly. Like, how do you come up with the market rents, just generally speaking, for your portfolio?

[Brian D. Pauls, CEO, President & Director]

I think we're trying to find -- Brendon, it's Brian. We're trying to find market every day. We're pushing in the market. As occupancy has gotten -- our Ontario portfolio, the occupancy has gotten into the very high 90s, 99%-plus. We're pushing to the point where we're actually creating more vacancy in our portfolio to find market. In some instances, that's 30%, even 40-plus percent increase in rents. So we're looking for market, but I don't think we have found it. We're pushing every day when we have renewals. Every vacancy, every renewal in Ontario or Québec, we see that as an opportunity to continue to push rents. So it's continuing to go up. It's a moving target, but one that we're pushing every day. We don't think we find it until we've actually created a little bit of vacancy.

[Brendon Abrams, Analyst of Real Estate]

Okay. And then just on the opposite end of the spectrum in terms of Western Canada, renewal spreads were down 4.5% in 2018, but flat in Q4. Should we read into this at all in terms of a reflection in the market or is just too small of a sample size to say things are turning in?

[Brian D. Pauls, CEO, President & Director]

Yes, we're pushing for occupancy very hard in the West. Spreads are probably continuing to go down a little bit as some of the older leases roll. So that's probably a trend that continues, although we're very happy with our second half of 2018 performance as it relates to occupancy.

[Lenis W. Quan, Chief Financial Officer]

Yes, so with each of our deals out West, the NERs are up year-over-year. We're trying to invest less capital, hold on our going in rates and try to put in some contractual increases where possible.

[Operator]

Our next question is from Mike Markidis of Desjardins Capital.

[Michael Markidis, Real Estate Analyst]

Brian, just like -- obviously, a lot of focus on your entertaining offers for all or a portion of Halifax, but I'm just trying to just get a sense of a couple of things. Number one would be, how long has that been listed? And then number two, the comment that you've made in your disclosures regarding expecting to increase your capital recycling this year. Is that tied to an expectation surrounding Halifax or is that also including other potential activity within the portfolio?

[Brian D. Pauls, CEO, President & Director]

So we've talked to -- it's only been a few months since we've talked to potential interested parties in the Eastern portfolio. We have engaged both TD and CBRE to help us with entertaining that interest. Our -- my comment and Lenis' comment about increasing asset recycling is a reflection of that interest. So that's primarily what's driving it. There maybe a few one-offs, but this is really what we're -- in terms of asset recycling, this would be the biggest news we have of potential recycling for 2019.

[Michael Markidis, Real Estate Analyst]

Okay. And the desire to sell that, is that just a function of expectations? I think, you guys have stabilized the occupancy there, just that there's not a lot of rent tension or is it that it's more capital intensive? Just trying to get a sense of the desire because presumably the valuation metrics would be higher than the average for your portfolio as well.

[Brian D. Pauls, CEO, President & Director]

Yes, Mike, it's a reaction to interest from outside parties in the portfolio. We'll not necessarily -- we'd be happy to keep the portfolio. We've created a lot of value there, and we think that it's performed well. Our team there has done very well in leasing up the portfolio. It's doing well. So it's a reaction to market interest and a desire to potentially grow in the markets that we've really targeted, those being Ontario and Québec. So that would be a potential to do that. But it's a -- that's a reaction to the market. It's not necessarily a foregone conclusion that we're going to sell it.

[Michael Markidis, Real Estate Analyst]

Okay. I got it. So you've had some expressions of interest, and that just sort of stimulated your desire to maybe take a more fulsome approach. Does that make sense?

[Brian D. Pauls, CEO, President & Director]

That's right. We'll test the market and see how they react. We don't know what a fully marketed value would produce. We're going to find that out and then decide from there.

[Michael Markidis, Real Estate Analyst]

Okay. Obviously, great results in the GTA. Seems to surprise on the upside every single quarter. I just want to get your views on Montréal because, I guess, if you look at the trend in market availability and absorption and just supply or lack of a supply response, one might make the argument that Montréal is maybe 18 to 24 months behind the GTA from a rent growth perspective. Do you have any thoughts on that or do you have any expectations for additional runway in Montréal as we move forward?

[Brian D. Pauls, CEO, President & Director]

Yes, we're very optimistic for Montréal. That's why we keep mentioning it in kind of the lumpy and with Ontario. It's maybe not as capable of growing quite as fast as Ontario, but the supply is -- the math doesn't lie. I mean, there's just very, very little supply, very little vacancy. We're going to continue to push rents there. It has historically been behind Ontario and probably will lag a little bit here, but we think there's a long runway of rent growth there as well.

[Michael Markidis, Real Estate Analyst]

Okay. And then so for the commentary that your 2% to 3% same property expectation for this year, seems like it might be back-end loaded. Is that just because you expect to continue to lose a little bit of occupancy in the short term as you guys keep pushing in those 2 markets?

[Lenis W. Quan, Chief Financial Officer]

That's a fair comment. We would definitely see occupancy come down a little bit in the first half for Ontario. Québec has just sort of caught up in occupancy. So we will see some occupancy gains sort of flowing through NOI on there. But, yes, some of that -- some of the leases that we've been doing, it's going to be on the back half of the year, where you'll see the income coming in.

[Michael Markidis, Real Estate Analyst]

Okay. And last question for me before I turn it back. Just if you look at back at the history of the Western Canadian portfolio, it seems -- it sounds like you guys had some early terminations, but it really was an occupancy issue that crept up in late 2017 and maybe early 2018, which you guys have now successfully backfilled. Do you see that as being an isolated occurrence or is that something that could be a risk going forward, just given where the market is today?

[Brian D. Pauls, CEO, President & Director]

Mike, we're fighting every day for occupancy in the West. I think we're -- we've got some great tenants. We've had some tenants related to homebuilding that have had trouble in that market, and that's where we've had some exposure. The rest of the portfolio has done well. So I think we're going to continue to push for occupancy there. I think the team has done a good job. I don't know if we'll see the same trends that we saw before, but I think our team has done a good job, really stabilizing that market and positioning that portfolio well going forward.

[Operator]

Our next question is from Brad Sturges of Industrial Alliance.

[Bradley Sturges, Equity Research Analyst]

Just in terms of the $200 million acquisition pipeline, just wanted to get a little bit more of a sense of are those all stabilized assets or would you be considering assets that have value creation, whether it's development or expansion?

[Brian D. Pauls, CEO, President & Director]

The $200 million is all stabilized assets and almost entirely in Canada, Ontario and Québec. We do have opportunities within our portfolio to potentially add value to existing assets. That's not included in the $200 million, but, for example, there's a tenant in our U.S. portfolio that would like to expand the building. We are in negotiations with them now to expand the building, extend the lease. And there are opportunities, other ones, within our portfolio to do that, that had nothing to do with the $200 million. We're also looking at and entertaining development opportunities. Those are very, very preliminary discussion, so don't have much to report on that. But that was totally independent of the $200 million as well.

[Bradley Sturges, Equity Research Analyst]

Great. And in terms of the -- I guess, within the leasing portfolio, can you quantify what that -- those potential opportunities could be right now?

[Brian D. Pauls, CEO, President & Director]

The -- quantify the expansion opportunities or...

[Bradley Sturges, Equity Research Analyst]

Yes, in terms of size and scale?

[Brian D. Pauls, CEO, President & Director]

The one I mentioned was about 60,000 square foot expansion, which will be similar between -- it's really early stages, but I would say somewhere between $5 million and $7 million of additional investment in that particular property. And that scale is reflective of kind of other opportunities. But that's a specific one that we're entertaining right now.

[Bradley Sturges, Equity Research Analyst]

Okay. And in terms of the acquisitions you're contemplating, can you give guidance or expectations for going in yields at this stage, given it's Ontario and Québec?

[Brian D. Pauls, CEO, President & Director]

Yes, they'll be in the 5s. That's -- pricing is -- yields and cap rates are lower in the markets that I mentioned than they are in the U.S. So it'll be in the 5s.

[Bradley Sturges, Equity Research Analyst]

Great. Last question, just with the recent portfolio acquisition and taking your, I guess, pro forma numbers up to the -- for U.S. exposure to the 20% range. Is that still a range that you're looking to target or could that increase over time?

[Brian D. Pauls, CEO, President & Director]

Yes, we like the balance that we've got now. The portfolio in the U.S. is really complementary to what we have in Canada. It's a very rough estimate, but 80-20 Canada-U.S. is a good ratio that we'd like to maintain. That may flex depending on the timing of acquisitions and that kind of thing, but from a long-term standpoint, long-term target, that would be a good ratio for us.

[Operator]

[Operator Instructions] Our next question is from Pammi Bir of Scotia Capital.

[Pammi Bir, Analyst]

Just on the Louisville property that's part of the U.S. portfolio, what are your thoughts on the lease up timing of that vacancy, and then getting that to -- getting the acquisition overall to that 6.5% stabilized cap rate?

[Brian D. Pauls, CEO, President & Director]

Yes, Pammi, we've got, yes, 302,000 square feet, that building, we've had a lot of tours. We've actually had proposals going back and forth. We're confident that, that property will be leased relatively quickly and that would increase our cap rate or our yield rate as I mentioned on the opening remarks. So we're confident in that, that property is really, really well-located. Louisville has experienced kind of unprecedented absorption and is very healthy. So in terms of having vacancy, this should be the best vacancy to have in that portfolio.

[Pammi Bir, Analyst]

Right. And so maybe fair to -- would it be fair to assume that we could see that get leased up this year?

[Brian D. Pauls, CEO, President & Director]

Yes.

[Pammi Bir, Analyst]

Okay. Lenis, you made some comments about FFO growth. But when you factor in the equity raise and the same-property NOI growth target that you guided to, and of course the $200 million, what do you see as an achievable range of growth for this year? And then second to that is that, do you expect, with respect to leverage, to get to about 47% by year-end?

[Lenis W. Quan, Chief Financial Officer]

So Pammi, on the -- I guess, on our outlook for 2019, we talked about our comparative property NOI growth in the 2% to 3% range. And we've kind of looked down to the FFO line, I think a lot of that is going to be dependent on the amount of acquisitions and the timing of acquisitions. Because as I mentioned, we're probably going to be running at about 43% leverage when we close on the Midwest U.S. portfolio acquisition. If -- we talked about $200 million in the pipeline, and I'm not saying it's going to be that with exact asset, but if we did acquire $200 million by the end of the year, we'd probably be at the 47% leverage. I think in terms of acquisition timing, just -- we're probably looking at the second half of the year.

[Pammi Bir, Analyst]

So I guess, would it be fair to assume then that 2020 should be a better year, I guess, just given the timing of getting leverage back up to your target range. 2020 should be a better year overall for FFO growth?

[Lenis W. Quan, Chief Financial Officer]

Yes, yes, no, absolutely. I think between the stabilization on the -- on the Midwest U.S. portfolio as well as deploying our additional balance sheet capacity, you're going to see 2020 much stronger than 2019 in terms of FFO.

[Operator]

And we have a question from Sam Damiani of TD Securities.

[Sam Damiani, Analyst]

Just one little one left. There was this -- the vacancy in London, Ontario, I was just wondering how much rent you recognized on that building in Q4?

[Lenis W. Quan, Chief Financial Officer]

It's probably about half a quarter.

[Sam Damiani, Analyst]

Half a quarter?

[Lenis W. Quan, Chief Financial Officer]

Yes, half a quarter.

[Operator]

Thank you. I will now turn the call back over to Brian Pauls for closing remarks.

[Brian D. Pauls, CEO, President & Director]

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.