Allied Properties Real Estate Investment Trust
TSX:AP.UN
Earnings Call Analysis
Q3-2023 Analysis
Allied Properties Real Estate Investment Trust
The company officials expressed confidence in the impending finalization of a significant deal that they believe will have a favorable impact on office asset valuations. Despite lacking details on what 'positive' entails in this context, the executives conveyed a strong sentiment that the asset in question would not be sold at an undervalued price thanks to its high quality. This development suggests potential upward valuation adjustments for office properties in the near future.
Company executives shared an ambitious target to recover leasing levels to the starting figures of the year, aiming for a 91% lease rate by the end of the current year from the 88% noted in Q3, translating to a significant 300 basis point increase. This target is reportedly based on current negotiations and does not rely on transfers from the property under development (PUD) status. Although the completion of these deals is not guaranteed, a 30% deal closure rate is considered a reasonable threshold for achieving these leasing goals.
The company's retention rates have experienced a recent downturn, hovering around 56% this quarter, as opposed to the historical average of 70%. Looking into 2024, there's an anticipation of an uptick in this figure, though not to historical levels. Moreover, a $46 million development EBITDA (earnings before interest, taxes, depreciation, and amortization) contribution is projected, reflecting positively on the future earnings potential. Furthermore, specifics regarding the funds from operations (FFO) impact of development will be addressed in detail in the year-end outlook to be presented on January 31, suggesting a more nuanced financial state due to variables including the decapitalization of interest.
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Good morning. My name is Rob, and I will be your conference operator today. At this time, I would like to welcome everyone to the Allied Properties REIT Third Quarter 2023 Earnings Conference Call. [Operator Instructions]. Thank you, Cecilia Williams, President and CEO. You may begin your conference.
Thanks, Rob. Good morning, everyone, and welcome to our conference call. I'll discuss Q3 highlights briefly. Michael, [indiscernible] is here with me to answer questions that follow. We may, in the course of this conference call, make forward-looking statements about future events or future performance. These statements, by their nature, are subject to risks and uncertainties that may cause actual events or results to differ materially including those risks described under the heading Risks and Uncertainties in our 2022 annual report and our most recent quarterly report. Material assumptions that underpin any forward-looking statements we make include those assumptions described under forward-looking statements in our most recent quarterly report. In Q3, we accomplished an overriding goal, the successful sale of our UDC portfolio we can now focus exclusively on our workspace portfolio with a view to completing upgrade and development activity, optimizing renewals and leasing vacant space over the remainder of the year through 2024. Our net debt as a multiple of annualized adjusted EBITDA at the end of Q3 was 7.9x, and our available liquidity was $1.4 billion. We expect our net debt as a multiple of annualized adjusted EBITDA will decline over the next 3 years as developments are completed and begin to generate material amounts of EBITDA. We remain committed to our investment-grade rating and to improving it over time. The process of transferring development completion to the rental portfolio continued in Q3, with 365,413 square feet of GLA moving from PUD to the rental portfolio at average net rent per square foot of $34.28, reducing the cost of PUD as a percentage of gross book value to 11.6% at the end of the third quarter. This will add to our annual EBITDA run rate by approximately $12 million during the beginning of 2024 onward. We'll continue to transfer material amounts of GLA from PUD to the rental portfolio over the remainder of the year and throughout 2024 and 2025. This will, one, reduce the cost PUD as a percentage of gross book value to approximately 4.5% by the end of 2025, two, increased average inflation net rent per occupied square foot in our rental portfolio; and three, add to our annual EBITDA run rate by approximately $46 million from the beginning of 2026 onwards. As disclosed in our MD&A, leasing activity this quarter was strong. We expect sustained and successful leasing activity for the remainder of the year and into 2024. We'd now be happy to answer any questions.
[Operator Instructions] And your first question comes from the line of Jonathan Kelcher from TD Cowen.
First question, just in your press release, you talked about not using the line of credit over the next 5 years. Does that contemplate using some of the broader range of funding opportunities that you also talked about in the press release and maybe provide a little bit of color on what those are?
No. Jonathan, it will primarily we'll be using the cash that we currently have on hand and to meet our commitments and we won't have the need to either use our line or tap into other sources of capital.
Okay. Would that suggest that then like if I look at the revenue enhancing CapEx program and that's -- I know you sort of include it with the development, but how much of that is really under your control in terms of being able to sort of slow it down? Or what are you basically expecting to spend on that over the next couple of years?
Yes. That is completely in our control. And like I mentioned, the PUD percentage, which includes that redevelopment activity will be dropping sharply.
Okay. And then just switching gears to occupancy. Based on what you're seeing right now and what you have in your pipeline and what you know about next year's maturities do you see occupancy trending up over the next few quarters.
We do feel that we could be at an inflection point right now. We want to see how deal that we currently have under negotiation materialize over the course of Q4 and in Q1. We have over 1.1 million square feet that we're currently negotiating across the [indiscernible] city portfolio. So we'll see how those could [indiscernible] deals, but we're feeling pretty confident about things right now.
Okay. And that 1.1 million square feet, how much -- how would that break down between renewals and spaces currently unoccupied?
I would say roughly half and half.
Your next question comes from the line of Brad Sturges from Raymond James.
Just to follow on at Jonathan's question, just when you're thinking about your, I guess, taking an early look at your 2024 maturities here, just -- are there any material nonrenewals you're expecting at this point in the year?
No. We're expecting to have a higher rate of renewals in 2024 then what happened in 2023.
Okay. And I think in previous calls, you've talked about lease negotiation time lines being generally more extended. Is that -- has that trend changed at all or are you're talking about perhaps an inflection point on leasing activity. Just curious if the negotiating time lines that you were experiencing have changed at all?
They haven't changed and that they haven't gone longer, and we haven't yet been [indiscernible], but we do expect that to start happening [ in ] the R&D at an inflection point.
And from a capital allocation perspective, I think you've been a little bit active on the [ NCIB ], just given where your stock price has moved. Is that part of the decision-making in terms of maybe being a little bit more active? Or would the strategy be more focused on cash preservation?
No. We have not been active in the [ NCIV ] and we do not intend to buy back stock. We have a capital program that we're committed to that will be yielding committed EBITDA, and that's where we will be focusing our capital.
Last question, just on the comment around committed to the distribution program. Can you just expand upon that comment in the press release in terms of is that just committed to the level of distribution today? Or is there more to that statement?
No. What I would say is that we don't want to reduce our distribution, and we don't need to reduce our distribution, which I think is a very important point. Our decision around how much we are going to increase it by will be made with our Board at our December meeting, which is as per usual, and we will be announcing it at that time based on the decision made. We have been [indiscernible] our distribution for 17 of the last 20 years, only [indiscernible] during the global financial crisis. So I think we have a very strong report of distribution increases, and we do see as an important mandate for us with our unitholders to increase the distribution regularly.
Your next question comes from the line of Pammi Bir from RBC Capital Markets.
Just on FFO, I think you're tracking down about 3% year-to-date but you've guided the year at, I guess, flat to slightly positive. Just to get there, I think you need, I guess, a fairly strong Q4. Can you maybe just comment on what are some of the drivers that you're expecting in order to hit that target for the year?
We're still targeting the outlook of flat to low on both FFO, AFFO and same asset NOI, and it would come from operational results.
So if you're sitting today, I guess, at in-place occupancy of just under 87%. What sort of occupancy would that imply by year-end?
It would imply that we finished the year higher than we started, and we will report on our results at the end of January.
Okay. Just with respect to maybe conversations with tenants at this stage, it sounds like the leasing pipeline, I think you mentioned [ Sicily ] at 1.1 million square feet. What are some of the issues? Or what are some of the maybe feedback you're getting from tenants in terms of getting leases over the line in terms of is it slowing economy, higher rates or just trying to understand their space needs. Just curious what those conversations are like at this point?
Pammi, it's Michael. The feedback is consistent across our markets. And it is quite simply what it has always been the debate or the negotiation is almost never above price and almost always about the suitability of the space for the user's needs. And that is absolutely the overriding consideration of the people we serve. We are not a low-cost provider of distinctive urban workspace. We do not compete based on price. We compete based on the suitability of our space and our mixed-use amenity-rich urban neighborhoods. And that has been the case for years now, and it hasn't changed. As Cecilia mentioned, people are taking a little more time these days to make their decisions and business leaders and Boards are being more focused in terms of giving approval for longer-term commitments. But for us, the differentiator is always the extent to which the space suits the needs of the user and not the price of space. Of course, the users try to use their leverage to extract better financial terms from us. And in most circumstances, we are willing and able to resist that and put them to the choice of choosing our space or cheaper space. So there is nothing new in how tenants are behaving for us. There is only more time being taken in making the ultimate commitment to us because those commitments are big. You extrapolate them out over 5 or 10-year terms, they are significant commitments, but the basis for decision-making hasn't changed 1 iota.
Got it. Thanks Michael. Last one for me. Leasing costs do seem to have on a per square foot basis, did seem to have stabilized a bit in the quarter. I guess, as a percentage of the face rents. Can you just comment maybe on what maybe drove that improvement perhaps relative to last quarter, meaning Q2? And then that may be a one-off? Or do you expect maybe to revert higher over the next, call it, year or so?
Pammi, there was an anomalous couple of deals in Q2 that inflated our leasing costs. So what you see in Q3 is a more normalized level without anomalous transactions inflating the costs. So Q3 is a much better reflection of the normal than Q2 was.
Your next question comes from the line of Sumayya Syed from CIBC.
I just want to start off by touching on some of your renewal leasing in the quarter. It looks like the term was a bit lower and the [ spreads of your lower budgets ] what you've accomplished historically. Any color on renewals in the quarter?
They're pretty deal specific in terms of the renewal that happened in the period. I can't think of anything in particular to highlight the terms of renewals in Q3.
Okay. So over time you expect to revert to your sort of historical 5-year average least in future leasing.
Absolutely. The weighted average term of our leasing has actually been pretty steady over the last few years. So I wouldn't expect the Q3 renewal terms to [indiscernible] that.
Okay. Great. And just to kind of touch more on your comments on [indiscernible] inflection point. What would you say is the biggest change you've seen versus, I guess, recent quarters to sort of -- to support that comment?
We had a very high level of [indiscernible] in Q3, higher than I would have expected given the August tends to be a slower month. So we had 306 tours in the quarter. well above our quarterly average of 250. And so that really for us is something we keep a close eye on because it is a leading indicator for us. And so we continue to be encouraged by the level of interest. I mean, we clearly have the space that employers want and need in terms of attracting and retaining the talent that they need to run their businesses. So -- and it's pretty consistent across the country.
Okay. And just lastly, I wanted to ask about your expectations for development EBITDA and you have line of sight to 2026. Is that based on your original proformas or policing you've achieved? Just wondering how much the current market conditions factor into those development NOI expectations.
Most of that would be legally committed because the developments that we're transferring from [indiscernible] to rental were highly preleased. So there is -- it's mostly legally committed EBITDA.
Your next question comes from the line of Matt Kornack from National Bank Financial.
Just following up on Sumayya's question with regards to the $46 million. Can you give us a little color as to the cadence of how that comes on, maybe for the balance of '23 and 2024. I haven't rolled out by 2025 estimates yet, so I want to ask you for that. But just to get a sense of how much of that $46 million we should see over the next 12 to 18 months?
Sure. It's roughly constant -- at between '24 and '25, leading up to the $46 million by early 2026.
Okay. That's very helpful. And this is a small one. But for -- there's a small residual ground lease, but the ground lease payment seems to have gone to around 0. Is there any residual payment there? Or should we just run that line item to 0 at this point?
Sorry, I'm not sure I understand your question.
Sorry, not ground lease. It's a lease liabilities like the amortization of it, I guess, most of it went away with the sale of the UDC portfolio. But it looks like it was a negative $56,000 maybe in the quarter. Anyway, [indiscernible], if you don't have it in front of you.
Well, okay. Let me check into that and we will call you.
Okay. And then on -- not material. On [indiscernible], I noticed that you've added the residential component of that project. Can you give us a little bit more color on that? And would you do that on your own? And would it be rental? Or would you look to partner with somebody to build that out over time?
Matt, it's Michael. That's a really lovely development site that is adjacent to the [indiscernible] complex, which has unfolded so favorably for us since we acquired it. Initially, we were going to explore the possibility of creating the lab space on that site, and we haven't completely sidelined that possibility. But in order to do that, we would actually need a zoning amendment and that is a rather lengthy and never certain process in the city of Montreal. We do, and we can, as a right build rental residential and that area to the east is evolving as a very significant intercity residential area in Montreal. So we think the better approach and the one that's sort of more consistent with the zoning that's in place is to certainly get approval for rental residential development. And yes, we are more than confident to execute both the development and the ongoing management of rental residential in any of the cities we operate in.
Okay. Fair enough. And just the last one for me, and maybe you answered it in your response to Jonathan's early your question, but I didn't quite catch it. But when you note a broader range of funding opportunities. Is that different types of debt? Or is that dispositions? Or what should we expect on that front?
Again, what we're trying to illustrate is that we are not going to be as dependent on the equity capital markets going forward as we have been historically. There are multiple avenues open to us for other types of funding, selling non-managing half interests in existing assets, of course, is one of them, leveraging our platform is another elaborating with people who have local development expertise, but also who can provide funding to us based on the fact that we own the land and we own the density. So I think these are things we wanted to explore before the pandemic as you know, and we were essentially forced to focus on operations through the pandemic and through the downturn that we're now operating in. But going forward, we want to lever our operating and development platform more efficiently than we have in the past. In the past, we basically levered our access to capital. And we did for a period of time, have good access to low-cost and equity. But we do want to lever our platform going forward, so we can grow without the same degree of reliance on the equity capital markets and the debt capital markets.
That's very helpful. And I guess, should we think of this in terms of maybe sourcing capital from one specific project to invest in others? Or would the idea be that you'd contribute your property as kind of the equity for anything and the partner would put in the capital to build out the project? Or is it any number of potential possibilities?
We actually believe, Matt, that we have incredible optionality in that regard. And so there are assets where we could simply -- our contribution becomes the land and the density and our more passive partner provides the bulk of, if not all of the capital in order to execute on the intensification of the development. So yes, there are there is, in our view, especially when the market restabilizes and it will, there are, in our view, tremendous amounts of optionality that we have by virtue of what we already control and the concentrations we already have. And we are we were intent on exploiting that pre-pandemic, but of course, the pandemic delayed our ability to do that and the current cyclical downturn will delay it further. But as we look out into the future, we're going to be exploring those funding actions energetically, assiduously. And with preference to the conventional form of funding that we've resorted to.
[Operator Instructions]. Your next question comes from the line of Lorne Kalmar from Desjardins.
Firstly, I just wanted to touch on the special distribution. I appreciate you guys included the cash component is expected to be paid. But I was wondering if you could give us sort of an idea of what you expect it to be in aggregate if you factor in the units as well.
We don't think it's relevant to our unitholders now to quantify what I'll call the noncash component, primarily because it isn't a number that can be finalized until we're much closer to the end of the year. And also when we publish that number. We want to make sure that it is the result of the most diligent tax scrutiny possible. PwC has been helping us in this regard. And we certainly are at the point where we feel we can tell our unitholders what the cash component will be. The share component or the unit component has no immediate impact on our unitholders, as you know, it will actually boost their cost base a bit. But again, we don't want to get into giving tax advice to our unitholders, although we're very intent on protecting our unitholders to the extent we can and should with respect to tax liability. So we did discuss that and decided it was most prudent not to disclose it, and it isn't something that is meaningful to our unitholders now or even when the ultimate share of consideration is [ quantified ].
Okay. Fair enough. And then you have talked a little bit at an inflection point. I think Cecilia mentioned you're a little bit more confident in renewal rates or in the rate of renewals in 2024 than 2023 and I was just sort of wondering, with the potential recession on our economic slowdown on the horizon, how does that sort of factor into the outlook? And what do you expect should a recession materialize the impact on office leasing momentum to be?
We always do well in a downturn. We have for years both as a private entity prior to 2003 and subsequent lead. We did well in Calgary during the downturn. We obviously felt it, but we did much better than most. I am not concerned about the pending recession or the recession we're in, having a materially different impact on our users. I think we're seeing real demand, both in terms of actual indicators and leading indicators, and I expect that will continue. Frankly, the environment for demand today is probably as bad as it could be. The sentiment is probably as negative as it could be, the misperception about office space is probably as profound as it could be. And outstanding all that, we're seeing demand. So we expect it to continue unless we enter a depression like we did in the first half of the 1990s. But that is not, in our opinion, [indiscernible] at all. So we expect to continue to do well as we always have in a downturn.
Okay. And then I know -- I'm sure the Moody's downgrade was a bit of a surprise. I know the severity of it was a bit of surprise to us. I'm sure a lot of people on the street. And just given the discrepancy between Moody's and DBRS has there been any consideration to potentially dropping Moody's as a rating agency.
It's Cecilia. There normally is about one notch difference which is Moody's and DBRS. I wouldn't characterize it as a discrepancy. I think that's actually just how those 2 rating agencies normally differ in terms of their assessment. And we remain committed to our investment-grade rating. And like I said in my comments, we will be working towards improving it.
Okay. And then just last one. I'd be interested to get your thoughts on the outcome here, I guess, maybe the lack thereof on Oxford, I guess, attempted sale of 401 West Georgia and 402 [indiscernible] in Vancouver and sort of what do you think maybe the read-throughs are from that on -- for valuations?
Well, I think your question is premature because that deal from what I understand will get done and there will be a positive read through for office volumes. So that deal is not dead. And indeed, there has been a great deal of traction there and from what I understand, and again, I can't corroborate this. But from what I understand from a very good source, that deal is moving inexorably towards finalization and that the read-through will be positive. Now what I don't know is what positive means to the person I was speaking with. But I rather suspect that neither Oxford or [ CPPIB ] are going to let a good asset go at a price that is inappropriate, given the quality of the asset, they're trading.
Your next question comes from the line of Mario Saric from Scotiabank.
Just a couple of clarification questions. First, on the occupancy comment by year-end, getting back to where you started the year which I believe was around 91% leased versus the 88% in Q3, so call it a 300 basis point increase. Is that expected pure occupancy gains? Or could it be influenced by expected PUD reclasses kind of that you mentioned would continue to be active going into '24?
It's Cecilia. It's based on -- it's not based on PUD transfers based on the deals that we currently have under negotiation and just the fact that if they get done, then we will achieve our target. And it's a is because we're still working on it, but there is certainly a possibility that we will still end the year higher than we started.
Yes. I think it's 30% of the deals land. And that's a pretty good ratio. So there's no guarantee. If 30% of deals land roughly, we get where we aspire to be by year-end. If it was 50%, I'd be gasping. 30% is still not in the bag, but it's achievable.
Yes, the square feet that will be transferred from PUD to the rental portfolio in Q4 won't have a material impact on our leased area.
Okay. And then similarly, any potential transfer from rental into PUD would similarly not have an impact in Q4?
No. I can't think of anything that will be going into PUD or...
No.
Okay. And then just coming back to the retention ratio 56% this quarter, 52% last quarter, Cecilia,I think you mentioned your expectation that it's moving higher in '24 relative to '23. Does that plan involves getting back to historical average, which I think has been kind of in the 70% range or just simply kind of higher than '23.
No, it will be higher than 2023, but not point back to our historical average, but moving in that direction. That would be our expectation for 2024.
Got it. Okay. Just on the development EBITDA of $46 million that you referenced at the start of '26 million, how should we think about the FFO impact from that $46 million kind of assuming interest rates remain where they are today for the next 2 years? Just in terms -- I'm just trying to understand of the capitalized interest has kind of moved around a little bit. So if you had an FFO or an expected FFO at the start of '26 from development completions from now, that would be helpful.
Yes. So that's something that we'll be outlining as part of our year-end outlook. I think, January 31 is our call Mario. So we'll be providing more color around the FFO impact at that point.
Yes. And we do have, obviously, an estimate, but there are more puts and takes on FFO, as you know, than there are on EBITDA. So we're very confident about the EBITDA number. But when you get to FFO, you've got to determine the impact of decapitalization of interest and a number of other variables. So there are more assumptions built into the FFO number. That said, we feel for our own purposes and for our constituents we should endeavor to provide that number in conjunction with our year-end statements, and we will.
Yes. I would agree with that sentiment. So thank you for that. And then maybe last question for Michael. You talked about the Vancouver asset and that potentially moving forward. You've also talked about increased kind of appetite or increased sources of funding going forward, part of which could be JVs that you discussed pre-pandemic, the perception, I would say, in the market is that office transactions just can't be done today. So like when you look at your portfolio and you think about bringing on JV partners for select assets, what is the impediment to doing so? Like is it price? Is it just lack of appetite? Maybe just a bit of color in terms of how you perceive institutional appetite for Allied's portfolio.
Yes. It's interesting, Mario. The perception is wrong, of course. Office trades are executable. We sold [ 8 plus the commerce ] in Montreal, which is an office asset. It was part portfolio acquisition we made 5 or 6 years ago, it was a property we didn't like. We love the other 3, but we didn't like [indiscernible]. And we allocated about $8.5 million to that acquisition then and we've sold it for $20 million. So office assets can be sold. There was a trade on King Street West a little building near our key working center that someone tried to flog to us many, many times. It traded [ up ] by, I believe, 4-ish or so and it's nowhere near of the quality of Allied's portfolio. So assets can and do trade, they trade more client than they have in the past. Nobody wants to be in the position we were in with respect to our UDC portfolio, having to tell the world that we're going out and sell something. But there are trades that do occur. But more importantly, when I articulate this aspiration, I see it sort of not even materializing for the next couple of years. The next couple of years, the entire team will be focused deciduously on completing the development and completing the upgrades to which we are you're retrievably committed today. That is our focus as well as leasing the vacant space. So I don't even imagine looking for new capital in '24 and '25. Now look, if some great opportunity comes along, we may look at it, but I don't expect that to happen. And frankly, we're not going to be predisposed to looking at those opportunities in the next 2 years, they won't be forthcoming, and we're not going to be looking for them. We're looking at them even in the unlikely event that they are for coming because the stuff we want is in strong hands. So it's not coming out at a discount. More importantly, our overriding commitment for '24 and '25 is to complete the developments, which are on the cusp of completion now happily and to complete the upgrades. The upgrades, of course, are in Montreal, the developments predominantly in Toronto. And the upgrades in Montreal are going extraordinarily well. but we need to bring them home, and that requires concerted effort. So I don't see us looking for capital in the next couple of years. I really don't. But if we get out 3 years, it would be then that we would be exploring alternative sources of capital. And I do expect the market then will be at least more stable and perhaps more transparent or at least less bad than it is now. But what gives us the most amount of comfort is, really, we've set the stage for 5 years of real stability on completion of growth that's embedded in our portfolio today and in our development program. But -- so assets are trading and assets are tradable. We wouldn't -- other than noncore assets or unique situations, we wouldn't be looking to trade anything in the next couple of years.
There are no further questions at this time. I will turn the call back over to Cecilia Williams, for some final closing remarks.
Thanks, Rob, and thanks, everyone, for joining our conference call. We'll keep you updated on our progress going forward.
This concludes today's conference call. Thank you for your participation. You may now disconnect.