Granite Real Estate Investment Trust

TSX:GRT.UN

Earnings Call Transcript 2018-Q3

[Operator]

Good morning, ladies and gentlemen, and welcome to the conference call of Granite REIT. Speaking to you on the call this morning is Kevan Gorrie, President and Chief Executive Officer; and Ilias Konstantopoulos, Chief Financial Officer. Before we begin today's call, I would like to remind you that statements and information made in today's discussion may constitute forward-looking statements and forward-looking information and that actual results could differ materially from any conclusion, forecast or projection. These statements and information are based on certain material facts or assumptions, reflect management's current expectations and are subject to known and unknown risks and uncertainties. These risks and uncertainties are discussed in Granite's material filed with the Canadian Securities Administrators and the U.S. Securities and Exchange Commission from time to time, including the Risk Factors section of its Annual Information Form for 2017 filed on March 1, 2018. Readers are cautioned not to place undue reliance on any of these forward-looking statements and forward-looking information. Granite undertakes no intention or obligation to update or revise any of these forward-looking statements or forward-looking information, whether as a result of new information, future events or otherwise, except as required by law. In addition to the remarks this morning -- may include financial terms and measures that do not have a standardized meaning under International Financial Reporting Standards. Please refer to the Q3 2018 condensed combined financial results and management's discussion and analysis of Granite Real Estate Investment Trust and Granite REIT Inc. and other materials filed with the Canadian Securities Administrators and U.S. Securities and Exchange Commission for additional relevant information. As a reminder, this conference is being recorded Wednesday, November 7, 2018. I would now like to turn the conference over to Kevan Gorrie. Please, go ahead.

[Kevan S. Gorrie, President, CEO & Director]

Thank you, operator. Good morning, everyone, and thank you for joining us for the Q3 call. In addition to Ilias, I'm joined by Lorne Kumer and Mike Ramparas with our real estate group. I'd like to begin today's call with Ilias going through a review of the financial results and commentary. And then I'd like to follow up with a leasing update, an update on our acquisition and disposition program, and then speak a little bit about, from a high level anyways, our strategic plan. So on that, I will turn it over to Ilias.

[Ilias Konstantopoulos, Chief Financial Officer]

Thank you, Kevan, and good morning to all. Prior to diving into the results for the quarter, I'd like to preface with some overarching remarks regarding the acquisitions and dispositions made during the last year as these impact the results in the quarter and will impact future quarters. Year-to-date, we've acquired approximately $478 million worth of properties at a 5.8% going-in yield. This is in addition to the IDI acquisition of $155 million at a 6.1% yield in Q4 2017. On the disposition side, we have realized on approximately $743 million worth of dispositions when including the 2 assets held for sale at September 30. This significant capital recycling has reduced our overall Magna concentration to 57% and 48% on a revenue and GLA basis, respectively, at Q3. Further, we have contractual commitments relating to construction and development projects exceeding $300 million, which we expect will contribute a stabilized yield in the mid- to high-5 range. These construction and development projects are going to come onstream in Q4 '19 and Q1 2020. Two further items to highlight for the quarter. First, Granite's board has approved an increase to our targeted annualized distribution to $2.80 per unit from $2.72 per unit beginning with a monthly distribution payable in January. This increase marks the seventh consecutive annual increase and represents a cumulative increase of 40%. Second, Granite anticipates it will declare a special distribution in the fourth quarter of '18 as a result of the increase in taxable income generated by the sale transactions completed during the 9-month period ended September and those anticipated to be completed during fourth quarter. Granite intends to make the special distribution payable partly in cash and partially in units to provide unitholders with cash to fund the additional tax associated with the special distribution while preserving most of the net cash proceeds generated by the sale transactions for reinvestment in the acquisition and development of real estate properties in keeping with our strategy. The amounts -- sorry, the amount of Granite's special distribution is expected to be approximately $1.20 per unit, which will be declared in December and payable in January. I'll now briefly summarize the operating results for the third quarter. Beginning with revenue. Revenue in the quarter increased $3 million to $63.8 million from $60.8 million. The main contributing factors to the increase in the quarter include the acquisition of a total of 10 properties since September '17, which contributed an increase of $10.7 million during the quarter. Contractual adjustments comprising CPI inflation and contractual -- 6 contractual rent increases across our portfolio added a total of $0.7 million to revenue. The leasing of most of the space in Novi, Michigan, in January increased our revenue by $1.1 million. And the net favorable impact of foreign exchange during the quarter increased revenue by $1.5 million as the Canadian dollar depreciated against both the euro and the USD. These favorable factors were offset by the impact from the sale of 15 properties in Canada and the U.S., which decreased revenue by $8.6 million. The vacancies from 5 leases -- 5 lease expiries in Germany, Netherlands and Canada decreased revenue by $1 million. And lastly, a lease termination and closeout fees in the prior year period accounted for a further $1.6 million decrease in the third quarter. Turning to FFO. For the third quarter, our reported FFO in accordance with REALPAC's definition was $39.1 million or $0.86 per unit relative to the reported FFO of $40.5 million or $0.86 per unit in the prior year period. In comparison, when we exclude the lease termination closeout fees, FFO would have been $38.9 million or $0.83 per unit in the prior year period. The corresponding FFO payout ratio for Q3 was 80% as compared to 79% in the prior year period after making the above noted adjustment. The slight increase in FFO was attributable to the revenue increase discussed earlier that was offset primarily by higher G&A -- slightly higher G&A, higher interest and an FX loss. Turning to AFFO for the third quarter. Our reported AFFO was $37.7 million or $0.82 per unit relative to the reported AFFO of $40.1 million or $0.85 per unit in the prior year period. The corresponding AFFO payout ratio for Q3 was 82% as compared to 80% in the prior year period after making the adjustment in connection with the lease termination closeout fees. Fair value gains in the quarter were recorded at $141.6 million and were largely attributable to increase in market rents and compression in discount and terminal cap rates for the GTA in the U.S., Germany and the Netherlands. Turning over to the balance sheet. The IFRS value of our portfolio stood at $3.2 billion, implying an overall cap rate of 6.8% and remained entirely unencumbered by any secured debt. Our income-producing portfolio of 85 properties at quarter-end comprised 32.5 million square feet, had an occupancy of 97.3% and a WALT of 5.9 years. Our total debt stood at $716 million, was comprised only of unsecured debt with a weighted average term to maturity of 4.2 years and a weighted cost of 2.53%. Our net leverage stood at 16%, which gives us debt capacity in excess of $1.25 billion at a 40% net leverage ratio. Our liquidity at September 30 was approximately $700 million and included $193 million of cash. Our credit rating remains at BBB mid with a stable outlook by each of DBRS and Moody's. We did not make any purchases under our NCIB program during the quarter. Our units were 45.7 million basic units outstanding at quarter-end. And finally, the distributions for the remainder of 3 months of 2018 are expected to continue at the current monthly rate of $0.22 per unit. I'll now turn the call back to Kevan.

[Kevan S. Gorrie, President, CEO & Director]

Thanks, Ilias. So to recap our 2018 expiries, there were a total of 30 leases encompassing 4.8 million square feet, generating approximately $25.4 million in annual revenue that expired in 2018 or will expire by the end of the year. As of today, we have renewed or are finalizing renewals on 3.6 million or 75% of the expiring space at an average increase in rental rate of 7.2%. On the remaining expiries, roughly 700,000 has or is in the process of being sold, leaving 500,000 square feet to be leased in Vaughn in Rotterdam on which we are currently in discussions with multiple prospects. Based on our leasing activity, we expect to finish 2018 with occupancy above 98%. For 2019, we have approximately 2.3 million square feet of leases expiring. And we have, to-date, renewed roughly 950,000 square feet or 40%. We are working on a number of leases currently and expect overall the rental rate to be flat to slightly positive for those expiries. On our last earnings call, we mentioned that one of our major tenants in Columbus, Bon-Ton; and 744,000 square feet in West Jefferson, was in liquidation. But that leasing activity was strong, and we expect it to be able to re-lease the building in short order. By way of update, the lease has been assumed in full by Torrid, a creditworthy tenant on the same lease terms at no additional cost and no loss of rent to Granite. We acquired the building in May on a vacant basis for $48 per square foot. And with the new tenant in place, the fair market value of the asset is now estimated to be approximately $63 per square foot, adding approximately USD 11 million or CAD 0.30 per unit in NAV. On the acquisition front, in addition to the closing of a 700,000 square foot acquisition at Erfurt, Germany, for $83 million, we made a $20 million deposit in connection with the acquisition in Texas. Subsequent to the quarter, we closed on a 13-acre parcel of land adjacent to one of our properties in West Jefferson, Columbus. And we are in various stages of the process on approximately $225 million in acquisitions in Canada and the U.S., and we hope to provide further details sometime in the fourth quarter. On the development side. We recently received site plan approval on our proposed 500,000 square foot development in Plainfield, Indianapolis, on a 29-acre site adjacent to our all points property, and we hope to commence construction in Q2 of 2019 and generate an expected development yield of 6.6%. Since June 30, we have sold $342 million in noncore assets, representing roughly $23 million in annual revenue. In addition, we expect to close on the sale of a 9-acre parcel of land in Renton, Ontario, in the first quarter of 2019 for $13.4 million. I am pleased to report that the Board of Trustees has approved our new strategic plan, which effectively sets the course for organizations through 2023. I would first like to thank all of our trustees and those involved in the development of this plan. It was a true team effort. The process of developing a plan included and involved consultation with many important stakeholders, including unitholders, investors, our tenants, brokers, analysts, logistics and e-commerce providers, a number of property and market tours, and detailed research and analysis. We will endeavor to communicate more details on our strategy over the coming months. But from a high level, the strategy is grounded in maximizing total return for investors. That means taking a long-term view, focusing on NAV growth and platform value to create value for investors while maintaining our best-in-class financial flexibility. Growth will occur through thoughtful deployment of the balance sheet by maintaining conservative leverage and payout ratios throughout the process. This growth will include a combination of core, value-add and opportunistic investments, including an increased focus on development, all with a goal -- a common goal of continuing to build an institutional-quality portfolio that will generate superior total return over the long haul. Our focus will be to acquire and develop modern distribution and e-commerce product in core and emerging distribution and e-commerce hubs in the U.S., Europe and Canada with a goal of achieving scale on our target markets. We will build on our existing platforms in Canada and Europe and plan to introduce a dedicated U.S. platform beginning in 2019 to deliver on that plan. As a result, we expect to reduce our Magna exposure through acquisition and select dispositions as well as exiting noncore markets. And as was the case this past quarter, we hope to continue to realize on the embedded value of our assets through independent valuations, disposition of noncore assets and active asset management. And on that note, I will open up the call to questions.

[Operator]

[Operator Instructions] The first question comes from the line of Howard Leung with Veritas Investment Research.

[Howard Leung, Investment Analyst]

Just wanted to ask about those developments and construction projects. You said back there, over $300 million and kind of cap rates at mid- to high-5s. Any chance that those might also be sold? Or do you plan to really develop and hold them?

[Ilias Konstantopoulos, Chief Financial Officer]

Yes. The intent, Howard, is to develop each of those projects and hold them. That's our current intent. And we expect those to come onstream later in '19, 2020. And the thinking, of course, is to replace income that was sold, if you will. So our current intent would be to hold.

[Howard Leung, Investment Analyst]

Right, right. And I guess that's related to my next question about special distribution. You had said that you want a key part of that and distribution and unit to preserve cash. So some of that cash, I guess, is used for the construction projects?

[Ilias Konstantopoulos, Chief Financial Officer]

Yes. It's not only those construction projects but the pipeline that Kevan referred to. I think the stage of evolution for Granite is we're in deployment mode to optimize our balance sheet. And therefore, from our perspective, the highest and best use, as we see it, is to deploy cash back into the business. We need to be thoughtful and consider tax implications across our unitholder base, and we're giving a lot of thought to that. We expect we're not going to be able to please everybody, but we're trying to find a balance to meet the company's strategy on the one hand and meet any tax obligations that might exist for the base of unitholders that we have.

[Howard Leung, Investment Analyst]

Right. That makes sense. And then on the Magna properties, I saw that there, you were able to get them to, I guess, take back the right of first offer. Just want to find out how that happened or why they might have done that?

[Ilias Konstantopoulos, Chief Financial Officer]

Sure. I won't speculate as to why Magna did that. I can tell you what we did, though, is Magna is an important tenant. We're sensitive to their needs and objectives. When they approached us, we consented to the decision of Magna's exercise of its ROFR and agreed to complete the sales with the original third party on terms that were, frankly, a little bit more favorable as it turned out. That met the objectives of Magna. In met our objective in that, the color of the money is the color of the money. And ultimately, the terms were slightly better. And in the end, we completed our objective, which was to recycle those assets, which we viewed were not core to us.

[Kevan S. Gorrie, President, CEO & Director]

Howard, it's Kevan. I would just add to that. We're -- we don't know. We are not privy to what deal Magna would have worked out with the buyer on this transaction.

[Howard Leung, Investment Analyst]

Okay. No, I understand. So they just came back to you and said, "Okay. We'll -- we'd rather have it resold to the third party." That's kind of what happened?

[Kevan S. Gorrie, President, CEO & Director]

Yes. Exactly, yes.

[Howard Leung, Investment Analyst]

Okay, okay. It makes sense. And then the cap rates on the multipurpose, I saw that over the quarter. It looks like it compressed by about -- almost 60 bps. Is anything there that -- anything special there that drove the compression?

[Kevan S. Gorrie, President, CEO & Director]

Yes. I think as -- it's Kevan. As Ilias referred to, a lot of that was in the GTA. I mentioned the Bon-Ton assumption to Torrid, which drove value there. But the bulk of it is in the GTA. And I think when we looked in the third quarter, we endeavored to have independent valuations of all our real estate. It's clear to us that the market has continued to strengthen significantly in Toronto, both in terms of cap rate and market rental rate. So we went through that process, and I think we landed on a reasonable increase in values. But I think we're still within the conservative range there.

[Howard Leung, Investment Analyst]

Yes. Your weighted average is still above 7. So that's still -- I'd say that's still fairly conservative.

[Operator]

Our next question comes from the land of Pammi Bir with Scotia Capital.

[Pammi Bir, Analyst]

Just in terms of the strategic plan, and I realize we'll probably get some more color, I guess, over the next few weeks or months. But can you give us a sense of how you're thinking about some of the assets or markets that you might lighten up on over the next year or so, if any?

[Kevan S. Gorrie, President, CEO & Director]

Well, it's a fair question. I don't want to go into too much detail. And I think it is important for us to be as clear as we can be on our strategic plan of where we're going without compromising any competitive advantage we may have. But saying that, there are markets where we don't feel it would be worthwhile to try and build scale. We won't be able to build scale. I think of the U.K., potentially Spain, Portland, and there are other markets. But those would be 3 where I think it would be very difficult and not very worthwhile for us to spend a lot of time and try to aggregate scale in those markets.

[Pammi Bir, Analyst]

And would any additional special purpose assets be part of this program? Or are you fairly comfortable with what you're currently holding?

[Kevan S. Gorrie, President, CEO & Director]

Well, I think overall, we -- and I think I said this on the second quarter call. We love the cash flow. This, for me, continues to be a very good problem to have with this covenant and the stickiness of this tenant. But that being said, it's hard for us to point to these to be core. Now saying that, we will look at an asset like Karmax and Modatek in Milton because of the location. That's something we would be comfortable holding for a very long period of time. I think what's important is as we move down this road and reduce the concentration to a single tenant that we have to execute as well as possible. So we have to -- to the degree that we can influence the conditions or wait for the right conditions, it's important that we have optimal conditions on which to dispose of assets if that's what we decide to do. So the most important thing is we're making the right real estate decisions. But I believe, overall, the progress we're making on that front in diversification by tenants is the right one. We'll continue to do that and follow that path.

[Pammi Bir, Analyst]

Got it. That's helpful, Kevan. Just thinking about the Magna exposure. You're sitting at, call it, 57%, I think, at the end of this quarter. How do you see that playing out, call it, over the next 12 to 15 months as again thinking of the broader strategic plan?

[Kevan S. Gorrie, President, CEO & Director]

I think that's -- I'm glad you phrased it that way because I would be -- I think I would be a little nervous talking about 3 years, 4 years out now. But I would say, in the next 12 to 15 months, I will be comfortable projecting that our Magna concentration will be below 50% by revenue by the end of 2019.

[Pammi Bir, Analyst]

Okay. And then just lastly, I guess, on the balance sheet, can you provide some color on how we should think about your target leverage going forward? Was there any change in terms of the target range?

[Kevan S. Gorrie, President, CEO & Director]

I don't know if there was. I'm looking at Ilias now. There's been a lot of discussions at the board. I think Ilias and I both -- and the board both agree firmly that we don't want to give up what is really a differentiator for our company. So that 35% to 40% range is still there, and I think that's important to us. There may be opportunities that will push the leverage up on a short-term basis about 40%. But on a normalized basis, we're more comfortable, I think, in the 35% to 40% range. And I think the -- if you look at the distribution increase, the decision around that, on the payout ratio as well, it's important to us on an AFFO basis that, that payout ratio be maintained on a normalized stabilized basis in the 75% to 80% range and give us the opportunity to increase the distribution on an annual basis. That's our goal. I don't think that that's changed.

[Ilias Konstantopoulos, Chief Financial Officer]

I don't think it has, Kevan, either. In fact, I would say the only thing I would add to that is that it enables us to execute on the strategy that you're referencing and achieve the objectives within those parameters.

[Operator]

Our next question comes from the line of Mike Markidis of Desjardins.

[Michael Markidis, Real Estate Analyst]

I was just hoping to get a little bit more color on the $300 million of commitments. And when I say color, I don't need you to disclose any more detail on the forward Texas purchase. But just to make sure I've got all the contributors right. So within that $300 million, and I think it was Canadian, correct me if I'm wrong, that includes the forward purchase for the Texas property. It includes the expansion you're doing in West Jefferson. I think that's USD 18 million. And I would assume that also includes the development that you've announced in Plainfield based on 500,000 square feet. I guess, that would maybe be around USD 25 million to USD 30 million of costs. Is there anything else in there? Or would that -- would those be the main components?

[Ilias Konstantopoulos, Chief Financial Officer]

Those would be the main components. There are a few other items in that, but those would be the main components, Mike. And just to be clear, we're not being coy with it. We -- you would appreciate, there's a lot of sensitivity around disclosure with all kinds of transactions. And so we're trying to balance that while being forthcoming. So I think that's implicit.

[Michael Markidis, Real Estate Analyst]

No, no, no. Absolutely. I wasn't trying to go down that path. I just wanted to make sure I wasn't missing anything in terms of other potential projects that were included in that figure. And then just last me a broad question, Kevan, I might add, if you've mentioned that you've got a pretty robust near-term pipeline. If you could just give us some broad comments in terms of where you're seeing the biggest volume of activity today from a deal flow perspective, and then -- that's the first question. Secondly is where you're seeing the best opportunities?

[Kevan S. Gorrie, President, CEO & Director]

It's a good question, Mike. In terms of volume, I think the U.S. continues to lead the way. We are working on an acquisition in Canada. We're very happy about that. You know my goal being more relevant here. But that being said, it's dwarfed by the activity that we're seeing in the U.S. But we have a very disciplined lens. We know the markets that we want to be in. And even that being said, on a disciplined basis, there's quite a lot of volume in the U.S. In Europe, that is a strategy that we still have to finalize on a market-by-market basis. We feel strongly the countries that we want to be in, we have the opportunity to build on scale and use our platform in a number of markets. So that is still being refined, but we are looking at acquisitions in Europe. It's just, right now, I would say most of our focus is with Canada and the U.S.

[Operator]

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

[Sam Damiani, Analyst]

Most of my questions have been answered. But just looking at the strategy for the next few years, what source of -- what sources of debt are you looking at tapping to, to fund that growth?

[Ilias Konstantopoulos, Chief Financial Officer]

Sam, we're looking at all sources all the time. This being said, we have issued historically unsecured debentures. And there continues to be a bias in favor of unsecured debentures as they provide us with the flexibility that we need. And the conditions in the market we continue to believe are favorable. So without limiting our options, I would say that there is a continued bias for those types of securities.

[Sam Damiani, Analyst]

And what type of room on the balance sheet is there for additional euro debentures that you can swap and effectively get a very low coupon?

[Ilias Konstantopoulos, Chief Financial Officer]

Right. And so that would be governed by our exposure in Europe, which we have -- as you've seen in our disclosure, about $1.3 billion, $1.4 billion of assets. And a good chunk of our cash flows is derived from Europe. So there is lots of headroom, more than we would have use for in the near term, if you will. So it'll be governed in part by the natural hedge that you rightly point to and then where we're deploying capital over the course of our strategy. So hopefully, that directionally gives you a sense.

[Sam Damiani, Analyst]

That's helpful. And what's the strategy -- was there a talk of using currency hedges at all to smooth out the earnings?

[Ilias Konstantopoulos, Chief Financial Officer]

Currency -- yes. So we were mindful that, as we've done in the past, if we could naturally hedge our exposure, we will. And so that is definitely something that would be on the table [ as of ] when we tap the debt markets.

[Sam Damiani, Analyst]

Okay. And just finally, have you looked at the data center market as an opportunity for Granite? And if so, just curious what your thoughts are.

[Kevan S. Gorrie, President, CEO & Director]

The short answer, Sam, is no. But the truth is, we do view the data center sector as something that could be viewed as complementary to what we do. It is e-commerce related in a lot of ways. We would understand that real estate as well as most others. I just think, in the short term, it is not the right move for us. We have too much opportunity and too much to do in our core sector, and we'll concentrate on that. It might be something we look at in a couple, few years but not in the near term.

[Operator]

[Operator Instructions] It appears at this time that there are no further questions on the phone lines.

[Kevan S. Gorrie, President, CEO & Director]

Okay. Well, on that note, thank you everybody for joining us today, and we look forward to the next quarter. Take care.

[Operator]

Thank you. Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your lines. Thank you, and have a good day.