Dream Office Real Estate Investment Trust

TSX:D.UN

Earnings Call Transcript

[Operator]

Good afternoon, ladies and gentlemen. Welcome to the Dream Office REIT Third Quarter 2018 Conference Call for Thursday, November 8, 2018. During this call, management of Dream Office 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 Office 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 Office REIT's filings with securities regulators, including its latest annual information form and MD&A. These filings are also available at Dream Office REIT's website at www.dreamofficereit.ca. [Operator Instructions]Your host for today will be Mr. Michael Cooper, Chair and CEO of Dream Office REIT. Mr. Cooper, please go ahead.

[Michael J. Cooper, Chairman & CEO]

Thank you very much. Good afternoon, and welcome to Dream Office REIT's Third Quarter Conference Call. Today, I'm with Jay Jiang, our CFO. I'd like to make a few comments about the business, then Jay will address our results. And once he's complete, we'll be happy to answer your questions. We're pleased to discuss our progress in our business over the last quarter. We're currently preparing our business plan for next year and the subsequent years, and will have a lot more information for you at our year-end call. Having said that, there's a number of things that had come up that we disclose. We'd like to give you a little bit more information to help understand what's new. Our current portfolio consists of 34 buildings plus 3 that will have development. Of these 37 buildings, 19 are in downtown Toronto, which represents a vast majority of our value. We own 3 in the GTA; 1 in Montréal; 3 in Calgary, although 2 of those buildings make up the Barclay complex; 1 in Ottawa; a parking lot in Saskatoon; and an office building and a very desirable suburb of Kansas City. One of our GTA assets is the Sussex Centre, which is in the heart of downtown Mississauga. There's a building boom all around the building and there will be new train station in front of the building. We are increasing occupancy currently and rates are also increasing. But ultimately, the building will benefit from a substantial improvement as the density surrounding the building increases. In addition, we made an official plan amendment application for Eglinton and Birchmount site, which will benefit from the opening of the Eglinton Crosstown subway and LRT in 2020. The site is in the planning area called the Golden Mile area, and it's adjacent to sites owned by RioCan, Madison, Kingsett, Choice and SmartCentres. This entire area with over 100 acres of land will be redeveloped in the next 10 years or so, and Dream Office will benefit from a higher use of these lands on its 15 acres. We've considered selling 700 De La G because we only have 1 asset in Montréal. It's a large stable asset, but we debate whether we prefer to repatriate the equity to pay down debt and invest in other properties or continue to own the high-class property. We believe that some time in 2019, we'll make a decision on that. In Calgary, we own Kensington House, which is a building and it's just by the river. It's a really cool area. It's our head office in out west for our land and housing business in Dream Unlimited. It will be a valuable residential site one day. It's got a lot of presence on the street. It's got a lot of land. And in the meantime, we're generating very good returns on our cost base. We also own Barclay Square, which is extremely well located, well leased, and we believe it's a good asset to weather the current market disruption. And when things settle down, we think there'll be lots of upside on it. But that's really the Calgary exposure we want to have. We have 19 buildings in downtown, which -- Toronto, which are very much in demand, which we think we can continue to improve upon. We have 9 buildings in the area of Bay and Temperance that we're in the process of improving and to what we think of as luxury boutique office buildings. The first example is 357 Bay Street that we're going to completely gut and renovate and turn in to a building that can attract among the highest rents in the city. We've entered into a lease with WeWork to make this our Canadian head office. And they will also be spending significantly to make the building a showplace for their organization. We are in the process of creating plans for each of the other 8 buildings in this district, so that we can demand similar premium rents over time. Again, we'll have more details for you in our -- on our plans for this area in February. Even prior to transforming our portfolio in downtown Toronto, we have 98% of our space committed, and we're achieving 20% increase in rents and more. However, we believe that there's demand for the type of buildings we own and that capital invested will be well rewarded over the short and long term. We intend to invest in all of our downtown assets as we want excellent air quality, elevators and all other systems and want to create more exciting aesthetics in the public areas. However, our start will be concentrated on the Bay, Temperance assets first. We're making progress on our 250 Dundas Street West application. While they're still a year or 2 away from an approval, our interactions so far have been very encouraging. We're also working on the development plan for 212 King Street West. We hope to have a design created in the next 6 months and then start to work with the city and community to seek approval. This building is at the edge of the financial and cultural centers of the city, and we believe it has very exciting development future. As you know, a few years ago, we started to concentrate our portfolio on very high-quality assets that have a better future than their past. We sold 140 properties since 2015 for almost $3.7 billion and used the proceeds to pay down debt and reduce our units outstanding. We have 4 assets that are under contract, which we'll close shortly and that leaves about 8 assets to sell, including Sherwood Place. We have 6 in Saskatchewan; a $3 million asset in Alberta; 1 asset in Southwestern Ontario. The total value of all these assets is about $150 million at IFRS. And we think that although there are a few type of assets to sell that may take time, ultimately, we don't think the sales price is significant for the company. So we're pretty pleased with the progress we've made.We'll weather the increases in interest rates relatively well as the rental rates in our buildings are driving revenues fast and the cost of debt is increasing. We believe that we'll continue to build value as we seek individual asset optimizations. While we have concerns about the broader economy and we've tried to manage risk by improving the quality of our assets and focusing on our best locations in the best market in the country, we are also looking to reduce our overall debt level. While we will buy some units back over time, we have accomplished our major goal of rightsizing the equity base of the company, so asset value increases are meaningful.Jay, you want to go over the financials?

[Jay Jiang, Chief Financial Officer]

Sure. Thanks, Michael, and good afternoon. Our FFO this quarter was $0.40 per unit, relatively in line with Q2. Our net asset value per unit was $24.40, an increase of 2% since last quarter and up 9% since the same quarter prior year. This increase was mainly driven by a value uplift in our downtown Toronto portfolio due to higher NOI and rental rate assumptions from leasing, while cap rates for the buildings we hold have remained flat.We reduced our shares outstanding from 81 million units this time last year to 65 million as of quarter end, so increases in the value in Toronto have had a more meaningful impact to the value of our company. During the quarter, we sold IBM Corporate Park in Calgary for $97 million or approximately $272 per square foot, with most of the proceeds applied to debt repayment. That contributed to a decrease in our leverage to about 190 basis points since quarter-end to be at 46.2% on September 30. Interest coverage remained flat at 2.8x since Q2 and net total debt-to-adjusted EBITDA fair value declined from 9.3 to 9.1. Over the next few months, we are targeting to close about another $100 million of assets in Western Canada, which has about 50% LTV. The equity repatriated will be mostly used to repay debt. Downtown Toronto represents about 2/3 of our gross portfolio value at quarter-end and the leasing market continues to perform very well. Comparative properties NOI was down 5.6 year-over-year, but that was mainly attributed to the vacancy at 438 University. If we exclude that building and 357 Bay, which is currently under development, the comparative properties NOI would have been positive 4.2 year-over-year for the quarter. Net rents that took occupancy during the quarter were approximately 10% above expiring. Now note that these were leases signed in prior periods, and we currently estimate that market rents are about 17% above in place. We have over 200,000 square feet of positive absorption in 2018 and are currently over 98% in place and committed. In 2019, on 400,000 square feet of GLA expiring at $22.73, we currently have over 70% of that addressed already. Our rents are consistent with the spreads that we reported, and we remain confident in leasing out the remainder in the first half of 2019. In Mississauga and North York, the 240,000 square feet expiries in 2019 represent mainly 1 tenant at 5001 Yonge, which we have already renewed at par relative to expiring and that was about $24. For Q4, we expect our FFO per unit to be around $0.38 per unit. Our 438 University will have infrastructure Ontario taking occupancy just under 200,000 square feet in December. Now 1 month of contribution from that lease is offset by the IBM Corporate Park disposition in August, and also, the properties we expect to sell in Q4. So there will be some variability in the results dependent on if and when the closings happen. As we continue to sell noncore assets to repay debt or reinvest in our core business, our leverage will decline. Our goal is to high-grade average portfolio quality and improve the stability and safety of our business. We'll give formal guidance next quarter for 2019. We have also highlighted 2 of our projects currently in development and provided additional disclosures on the capital requirements and estimated returns. At 357 Bay, we have vacated the building and commenced the full reconstruction. We will invest approximately $29 million into the building and WeWork will also invest a substantial amount of capital into the space. WeWork is expected to take occupancy in the second half of 2020 for a minimum term of 15 years, with net rental rate starting at $45 per square feet. Now originally for -- in 357 Bay, it was partially occupied, and we are already looking at investing a significant amount of capital on spec into the building to elevate it to a best in class. With the WeWork deal, the year 1 cap rate against the current value and incremental capital is about 5.5 or that's higher than the carrying cap rate of the building without the improvements or the lease. With the deal in hand before we commence the work, we have effectively reduced the risk and the downtime. We also introduced the 1900 Sherwood deal briefly in the second quarter. We did a 18-year lease with cooperators to consolidate their operations and over 650 employees in Regina. The capital we put in will change the asset, including a 13,000 square feet expansion, increase about 180 parking stall, a new HVAC system, curtain wall and other upgrades throughout the building. Our estimated year 1 cap rate is approximately 8%. Now the return on equity is attractive because it creates above-average cash yield for a very long period of time if we choose to hold the asset. Or if we choose to sell in the future, we think it'll be much more desirable for a perspective buyer because of the quality of the building, the wall and the covenant. We believe each deal improves the value and the long-term cash flow profile of the building and collectively contribute towards making our company better and safer over the long term. We will continue to have a financially prudent and holistic approach to our capital program and provide additional guidance on capital allocation on our next call. I'll now turn it back to Michael for the Q&A.

[Michael J. Cooper, Chairman & CEO]

Thank you, Jay, for your premiere performance. If there are any questions, we'll be happy to answer them now.

[Operator]

[Operator Instructions] And we have a question from Mike Markidis.

[Michael Markidis, Real Estate Analyst]

Jay, can you remind me what the gross rent on 438, the Infrastructure Ontario lease is going to be when that kicks in, please?

[Jay Jiang, Chief Financial Officer]

Sure. It will be in the low 20s for about 7 years. The incremental contribution in income on an annualized basis is about $7.5 million starting in 2019. The building has some tenants in there, but because the occupancy was low, we couldn't get much back in terms of recoveries and insurance taxes. So that will be a delta for next year.

[Michael Markidis, Real Estate Analyst]

So $7.5 million is the NOI upside that you see in 2019?

[Jay Jiang, Chief Financial Officer]

Yes, that'll be the run rate.

[Michael Markidis, Real Estate Analyst]

Okay -- from that lease. Great. Okay. Clearly, there's a very strong rental market. And in downtown Toronto, I see that your market rent estimates are rising. Just curious what you guys have seen as well from a landlord and TI package perspective and sort of what range that would look like for a 5-year lease today?

[Michael J. Cooper, Chairman & CEO]

They've come down a lot. So on renewals, there's almost nothing except for the commission. And then for new tenants, it really varies based on how much they want us to contribute, but I wouldn't be surprised if they're down 1/3 or more from 2 years ago.

[Michael Markidis, Real Estate Analyst]

Okay. 250 Dundas West, it sounds like you think is still another a year or 2 away from getting appropriate zoning there. I think there was a -- I don't know if it's going to help out or what's happening there, but what would be the next major milestone? Is there a community meeting that you have to have or -- just curious.

[Michael J. Cooper, Chairman & CEO]

Yes. I think that -- my kid goes to a school and they weren't able to get the school open in time for September because they couldn't get a permit. My neighbor's doing an extension, can't get a permit. The city is pretty much completely useless. So when we talk about times, you should know that it's -- I mean, look everybody is dealing with this. It is impossible to get things done. But when you get them done, they're very, very valuable. So -- like I'm not even going to pretend to say that we're in charge of the timing. But we've been meeting with the city and we've gotten good feedback on our plan. So that's very encouraging. And we are having the community meeting in the next couple of months, and we're -- we've gotten response from the city on our plan. So it's coming together. But yes, it will probably be a year or 2 before we have significant progress.

[Michael Markidis, Real Estate Analyst]

Okay. And last one for me before I turn it back. Jay, just with respect to the -- I think it's 434,000 of NOI from the properties that are now under development. Is that going to trend lower or evaporate as we go through 2019? Will it stay relatively stable? I'm just thinking -- I think in the -- one that you have in Saskatchewan, the existing tenants are going to stay in place while you do that work, but I'd assume there's some loss there from 357?

[Jay Jiang, Chief Financial Officer]

Yes. So I'll break it out in detail. I mean, 357, we -- it was already partially occupied. So in Q3, I think the income including PM recoveries is only about $120,000. The building is fully vacant now, so that'll just be down over the course of 2019 until the second half of 2020. The 1900 Sherwood, I think, there was still income in there. It's half occupied, and those tenants will stay in place, while we redevelop the building. So that'll still be there.

[Operator]

And our next question comes from Mark Rothschild.

[Mark Rothschild, MD & Real Estate Analyst]

In regards to the asset sale, so you had spoken in the past about additional asset sales in Calgary that you sold to IBM. Was that the last one you anticipate selling and you had indicated you planned on keeping a core portfolio in Calgary? And if you could also comment on the likelihood if anything has changed about selling your property in Montréal, which I think had been reported, it was listed for sale.

[Michael J. Cooper, Chairman & CEO]

So in Calgary, I think, what I said was we're looking to Barclay Square and Kensington being our only assets there. So I think, they're all done except for a partial interest in an asset for $3 million. So we're just going to have Barclay Square and Kensington. Is that a complete answer on that?

[Mark Rothschild, MD & Real Estate Analyst]

Yes.

[Michael J. Cooper, Chairman & CEO]

Sorry. And then on 700 De La G, we have been marketing it selectively. We took it out during the sort of peak of the NAFTA uncertainty, and there has been some stuff going on with tenants that are coming up. Andrew is working way on that. So we're going to see how things settle and then decide whether we sell it or keep it.

[Mark Rothschild, MD & Real Estate Analyst]

Okay, great. And then with the move into IFRS NAV, which is up once again, do you believe that the appraise are gradually catching up to the rising value of office properties in downtown Toronto? Or do you think that it's the -- are the increase in rental rates fully captured in that or how do you look at that?

[Jay Jiang, Chief Financial Officer]

Yes and no. I think, in general, in a hot market there's probably going to be a bit of a lag. I think the cap rates are there. The cap rates haven't really changed since we appraised the entire portfolio in 2017. I think what will happen is typically at year-end when they look at stabilized NOI or, I guess, let's call it 10-year DCF model, you'll drop the first year, you'll add in 10th year on top of that. So that's where you will see a lot of the pickup in NOI. So the way things are and the spreads that we're seeing, it'll probably still have a bit of tailwind on the NAV.

[Michael J. Cooper, Chairman & CEO]

I would look at it a bit different. Not disagreeing, but differently. I think that the question becomes what's going to happen going forward with the interest rates rising and stuff like that. So I think, we're in a good position right now. The rental rates are increasing much faster than interest rates, but we could see some increase in cap rates and the valuation will have to do with how much the rent goes up. So we could end up crossing -- like, I think the appraises are catching up, and we'll see what happens to values going forward.

[Operator]

And our next question comes from Matt Kornack.

[Matt Kornack, Analyst]

Just with regards to next year and this may be premature because it sounds like you're going to provide guidance. But other than the $7.5 million that's coming online, are there any other major leases that are coming online or any major ones coming offline outside of the development portfolio?

[Jay Jiang, Chief Financial Officer]

No. I think, on my prepared remarks, I gave some commentary on all the expiries that were going to happen in downtown Toronto and in the GTA, so if you apply those assumptions that will help you on the NOI side. But we also commented that we're looking to sell some assets, so that will be offset. But with the proceeds used to pay debt, so you might lose a bit of spread there. We'll give more fulsome guidance in February.

[Michael J. Cooper, Chairman & CEO]

Yes. We didn't broke it down. I'll remind you like the downtown Toronto portfolio. What it's going to do? It's going to add a lot more than just 438 University. And I think that what Jay is saying is you take a look what the -- we're not being certain which assets we'll have in for both periods. It's a little hard to tell what the overall one is. But as far as the core goes, this can be a lot more increases than just 438 University.

[Matt Kornack, Analyst]

And with regards to 700 De La G, if you do end up selling that, it sounds like the near-term net proceeds will be used to repay debt. Would you entertain buying incremental assets in this market with some of those proceeds?

[Michael J. Cooper, Chairman & CEO]

The only assets we would look at are ones that are additional to our development or existing assets. I mean, I'm not saying this flat out. But generally, when we see transactions now, we wouldn't use our cash -- we wouldn't buy another asset downtown at where they're trading. I don't think it works for us, but we would look at paying down debt, putting it back into our properties or buying back stock. I think those are the 3 uses we would see.

[Matt Kornack, Analyst]

Okay, fair enough. And with regards to the WeWork space, if I understand, that's their corporate head office, that's not a WeWork co-working property?

[Michael J. Cooper, Chairman & CEO]

It will be both. It will be their corporate head office and there'll be space there. But from what we believe, there'll be space there as well for co-working.

[Matt Kornack, Analyst]

And I know when the initial -- sort of when you guys were looking at taking the space, you were adding to the top. Is there any addition as part of the renovation or is it just within the existing frame?

[Michael J. Cooper, Chairman & CEO]

There is going to be most likely some work on the roof to make it a nice space. I'm not sure if it's going to be enclosed or not. And we're not -- we're finalizing some of the plans inside, but there won't be really more office space added because another 3 floors anything at the existing space.

[Matt Kornack, Analyst]

Okay. And Jay, I apologize if you mentioned this in your beginning remarks, but do you have a sense as to what the capital outlay is for the anticipated near-term projects over maybe the next year?

[Jay Jiang, Chief Financial Officer]

Outside of 357 and 19, we're doing that as part of our December strategic meeting. We're not quite done the work yet, but -- so that will also be in February.

[Matt Kornack, Analyst]

Jay, congrats on the appointment, well deserved.

[Jay Jiang, Chief Financial Officer]

Thank you.

[Operator]

And our next question comes from Sam Damiani.

[Sam Damiani, Analyst]

Just on the dispositions, just trying to understand the high level. So you've got $100 million on the books held for sale. Those are ultimately gone. There's another $150 million beyond that I think is what I had earlier, and then there's 700 DLG. Does that basically complete the picture on sort of disposition potential over the next couple of years?

[Michael J. Cooper, Chairman & CEO]

Well, it's by far the vast majority, for sure. Because that will take us to $4 billion. We'll look at every asset. The 19 downtown, we're keeping for sure. But we might sell a different one, keep one, but that will be substantially, substantially complete.

[Sam Damiani, Analyst]

Okay. And then what sort of leverage do you envision sort of operating the REIT at given it sounds like a steady and maybe growing component of development activity. So are there percentage LTV or debt to EBITDA, where would you like to see the balance sheet over the next couple of years?

[Jay Jiang, Chief Financial Officer]

Sure. I won't commit to a time line, but I think, long term, if we had around 40% on the leverage and preferably get it down there through debt repayment and increase in the income on the properties as opposed to cap rates. On the cash flow side and income side, probably be closer to 8x and 3x.

[Sam Damiani, Analyst]

Okay. Appreciate that. And then, would you be capitalizing interest as part of these development initiatives?

[Michael J. Cooper, Chairman & CEO]

Sure. On the developments, we will.

[Jay Jiang, Chief Financial Officer]

Yes.

[Michael J. Cooper, Chairman & CEO]

Like, what I'm damn sure is like we haven't done it before. No. I just don't know why you would expense it when it's a proper interest incurred to as part -- when you do a development pro forma, you got the interest in it. It's part of the overall cost of development, but we'll let you know next quarter.

[Sam Damiani, Analyst]

Yes. It's not entirely unprecedented, so I've seen both.

[Operator]

[Operator Instructions] And we have no questions at this time. I'll hand the call back to Mr. Cooper.

[Michael J. Cooper, Chairman & CEO]

Thank you very much. I'd like to thank everybody for spending some time with us when you got so many other things to do this quarter. Thanks a lot. And if you got further questions, please don't hesitate to call Jay or myself. Thank you.

[Operator]

Thank you. Ladies and gentlemen, this concludes today's conference. Thank you for participating. You may now disconnect.