European Residential REIT
TSX:ERE.UN
Earnings Call Analysis
Summary
Q3-2023
European Residential REIT (ERES) demonstrated a strong operational performance in Q3 2023, with residential occupancy reaching 98.7% and monthly rents increasing by 7.1% to EUR 1,053. Despite this, the fair value of its portfolio dropped slightly by 1.2% to EUR 1.7 billion, mainly impacted by inflation and interest rate pressures, which also led to a net asset value (NAV) decrease to EUR 3.05 per unit. Financially, ERES saw a 7.8% rise in same-property net operating income (NOI), with NOI margin improving to 79.5%. The funds from operations (FFO) per unit decreased by 4.5% to EUR 0.042, and the adjusted FFO (AFFO) payout ratio stood at 77.8% for the quarter, within its target range. Debt-to-market value ratio was up to 57%, but liquidity remained strong at EUR 188 million, with no immediate debt maturities threatening the balance sheet.
You don't have any saved screeners yet
Hello, everyone, and welcome to the European Residential Real Estate Investment Trust Third Quarter 2023 Results Conference Call. My name is Emily, and I'll be coordinating your call today. [Operator Instructions] I will now turn the call over to Nicole Dolan, Investor Relations. Please go ahead.
Thank you, operator, and good morning, everyone. Before we begin, let me remind everyone that during our conference call this morning, we may include forward-looking statements about expected future events and the financial and operating results of ERES, which are subject to certain risks and uncertainties. We direct your attention to Slide 2 and our other regulatory filings for important information about these statements. I will now turn the call over to Mark Kenney, Chief Executive Officer.
Thanks, Nicole, and good morning, everyone. Joining me this morning is Jenny Chou, our Chief Financial Officer; and Karim Farouk, our Managing Director. Let's turn to Slide 4 to get started. ERES' operational performance was strong this quarter. Residential occupancy rose to 98.7% at period end. Structurally speaking, we're effectively at our lowest possible vacancy with the majority of our vacant suites only off-line temporarily for value-enhancing renovation.
This reflects continued tightening of the rental market in the Netherlands, which has also had the effect of higher monthly rents. Our occupied AMR grew to EUR 1,053 as of September 30, 2023, which is up by 7.1% versus the prior year period. This resulted from market-driven uplifts on turnover as well as our most recent indexation, which had a weighted average increase of 4% as compared to 3% in 2022.
Slide 5 provides a brief business update for Q3. We're continuing work with CBRE on our previously announced strategic review, and that remains a top priority for us as we see the maximization of value for our unitholders. In the meantime, we're making progress on our suite-by-suite privatization program, having sold 3 individual residences closed during this past quarter for aggregate sales price of EUR 1 million. This represents a premium to IFRS fair value.
The fair value of our total investment portfolio declined by 1.2% to EUR 1.7 billion at quarter end, primarily due to persisting inflationary and interest rate pressures as well as ongoing ambiguity around potential changes to Dutch Rental Regulations. This contributed to the decrease in our NAV per unit to EUR 3.05 at. I will now turn things over to Jenny to go through our financial results in detail.
Thanks, Mark, and good morning, everyone. Slide 7 summarizes our quarterly performance. As Mark mentioned, our residential occupancy is holding high at 98.7%, while our monthly rents grew by 7.1% since the comparative period. Our same-property NOI result only increased by 7.8% in this past quarter as compared to Q3 of 2022, which also includes the impact of slightly lower property operating costs as a percentage of operating revenue. This reflects the acknowledgment of the landlord levy tax, partly offset by increased R&M costs.
On the whole, compared to the prior year period, our same-property NOI margin expanded by 110 basis points to 79.5%, although this does include service charge income expense, which has no impact on NOI. Excluding service charges, our same-property NOI margin increased from 84.2% to 84.5%.
Incorporating the impact of rising interest rates and higher current income tax, a quarterly diluted FFO per unit decreased by 4.5% versus the prior year period to EUR 0.042. However, it increased from EUR 0.041 achieved in the second quarter of 2023. This reflects our ability to remain operationally tight, which offset higher interest costs incurred since our most recent mortgage financing that closed at the end of June. With diluted AFFO per unit down compared to Q3 of 2022, our AFFO payout ratio are currently increased at 77.8% for the 3 months ended September 30, 2023.
Turning to Slide 9 -- sorry, turning to Slide 8. You'll see our financial results for the 9 months ended September 30, 2023. Total portfolio operating revenue and NOI increased by 7% and 8.2%, respectively, primarily due to strong rent growth we've discussed combined with lower property operating costs driven by the acknowledgment of landlord levy tax. Our NOI margin increased by 80 basis points to 78.4%. Diluted FFO and AFFO per unit were down by 4.7% and 2.6%, respectively, which again reflects the impact of higher current income tax and higher interest on our mortgage portfolio and credit facility. Our AFFO payout ratio increased to 80.6% quarter year-to-date, which is within our long-term target range of 80% to 90%.
Slide 9 presents our financial position and liquidity. You can see that our debt-to-market value ratio increased to 57% at year-end, primarily due to the decrease in fair value of our property portfolio. This metric remains below our cabinet threshold, and we will continue to actively monitor and manage our financial structure and leverage to ensure we will remain compliant.
We have available liquidity of EUR 188 million at period end, comprised mainly of unused credit on our revolver and the EUR 165 million through the pipeline equipment or alternative promissory note arrangements with cap rates. This features financial flexibility going forward, though our priority at present is the fortification of our balance sheet. Our debt service and interest coverage ratios are 2.5x and 3x, respectively, which are down compared to -- which are down due to the higher interest costs we're absorbing, but again, still above prescribed minimum.
Finally, Slide 10 presents our staggered mortgage renewal profile. Following our most recent financing, which closed at the end of June, we have no mortgages maturing for the remainder of 2023, and only 9% of our portfolio maturing in 2024. Our latest financing include a principal amount of EUR 76.5 million at 4.66% interest and yet weighted average effective interest rate remained low at 2.07%. This reflects our mitigation of interest rate volatility risk through fixing interest payments on 100% of our margins.
I will now turn things back over to Mark to wrap up.
I'd like to remind everyone that our Dutch property portfolio is deeply diversified as you can see display on Slide 12. 2/3 of our portfolio is currently liberalized, and half of our suites are located in the highly populated Randstad region in the Netherlands. In addition, approximately 1/3 of our portfolio is comprised of single-family units otherwise known as Dutch row houses, which typically have higher margins.
This allocation means our portfolio providing a home to a very broad diverse tenant base, and we'll continue to prioritize our commitment to providing all of our residents with a safe and enjoyable living experience in the Netherlands. At the same time, we're working hard to determine the best way forward in seeking to maximize return for our unitholders.
While that strategic review remains underway, we're continuing to execute on our core strategy, which is outlined on Slide 13. Our robust rent program, which is predicted or Suite Reletting has been tried and tested. Our consistently strong operational results are a testament to that. We are also now acting on the additional opportunity to privatize individual suites, where that proves to the best option for value maximization. Although we're just starting to make progress on this initiative, its pipeline of possibility is significant. We'll continue to methodically evaluate each suite, each opportunity, case by case, to ensure we're leveraging all of the available avenues for value creation.
That brings me to our investment highlights on Slide 14. I'd like to take this opportunity to thank all unitholders for your support, patience, and engagement. We faced unprecedented operating conditions in our short history, but we remain dedicated to our strategic, financial and operational objectives.
And our overarching responsibility to act in the best interest of our unitholders, and that's exactly what we'll continue to do. With that, I'd like to thank you for your time this morning. We'll now be pleased to take any questions that you may have.
[Operator Instructions] Our first question comes from the line of Frederic Blondeau with Laurentian Bank Securities.
Just two quick questions for me. First question, looking at the turnover year-to-date, I was wondering if you could give us a bit of color on the trends so far in Q4, and I guess, your expectations for the rest of the year? And also, what would be the main drivers here at this stage?
Yes. The conditions, Frederic, are exceptional. The operating performance of ERES is unquestionably strong. There is very much a live housing crisis there. The trend is, as you've seen, the low turnover that will ultimately hold back to a certain extent, the true value release.
But we've got some very strong indexation increases coming up here, too, which is encouraging. So from an operating point of view, we couldn't be more pleased with how ERES is really doing. It's really a simple matter of the interest rate environment only.
That's fair enough. And then along those lines, I mean, how should we view your maintenance CapEx for, I guess, for the rest of the year?
In using the run rate of last year is a reasonable assumption, although we are pulling back wherever we possibly can. We've actually taken a revised look at what we're going to do this year. But if you were going to model I used last year as a good example. Again, there's low turnover here. So there's limitations, at least on the suite what can actually be done. But using last year as a kind of a ceiling would be a good approach.
Our next question comes from the line of Jonathan Kelcher with TD Cohen.
First question, just on the operating front. A little surprised the strength in the suite turnover on the regulated suites. I know that obviously, 0.3%, not a lot did turnover, but maybe like I thought that was based on some sort of point system with a maximum rent. So maybe a little color on that.
Sure. Jonathan, this is Karim Farouk. I'm going to answer that one. So what we're seeing is when we're able to do some renovation and get a few points in, we do it when the payback is good only. So what we're trying to do now to the question before is maintain that 20% split by spending less capital. And so that's our approach. So we're looking to regulate, and we're looking to liberalize, and we're trying to get a little bit more evolving units being very, very cautious on payback analysis and so we're finding some incremental gains.
Okay. So on the regulated, there's an opportunity on turnover to get the points up, but I guess not enough to push it over into liberalized. Is that kind of the way to think about it?
That's correct. So renovating a kitchen or one back room doing it smaller right now that gives you a little bit of uplift, gives you the payback, but doesn't convert the unit.
It's points enhancement person is getting to the liberalized market.
Okay. Fair enough. Secondly, on the individual suites, I know it's early days on that or individual suite sales. I guess it's early days on that. But how big a program do you think that can ramp up to? Like right now, it's pretty insignificant, but can that get to something?
Okay. Well, I guess I will give some better clarity on what we're doing. We started off by looking at the units that are not fully owned, the buildings that are not wholly owned, where the financing allows us to do something. We will be approaching existing residents, super interested in buying their home.
Again, you've got the sale of 2 real estate issues in the Netherlands home prices have actually held up quite well and income value properties have not held up pretty well. So I think that people will embrace the opportunity to potentially buy their home. And so we're talking for now just that bucket of buildings where we don't own every unit, so that we're not disturbing the valuation of the wholly owned buildings for now.
And it takes probably, call it, 90 days from first client tap to closing. So what you're really seeing driven in here is the initial outreach, very, very small. But we do expect to see a bit of a slight uptick in that in Q4 and ultimately Q1 of next year.
That's the approach for now. We're also -- remember, we've been extremely conservative to try to weigh the highest and best use of each unit, whether it's best in the rental pool as a liberalized unit or if it's best we're going into end-user hands in the regulated space.
Our next question comes from Kyle Stanley with Desjardins Capital Markets.
I mean there's likely not much more of an answer you can provide to this, but I'll ask anyway. I'm just wondering, are there any other thoughts on the strategic review, progress, potential timing? Anything else you might be able to provide?
No, there's really nothing more to report on that front.
Fair enough. That's what I expected. We talked about it a little bit, but I guess with the focus, obviously, on the strategic review and then privatization wherever possible, have you thought about adjusting your capital investment strategy, does continuing to invest and convert units? Did that make them more desirable from a privatization standpoint or maybe an entire portfolio transaction? Or how are you balancing that, I guess?
It's a case-by-case basis. But yes, of course, it's no different than you sell your home, the appropriate renovations to maximize value, but we're doing it on a case-by-case basis, Kyle. The real criteria that we're eyeballing quite frankly though, is premiums to NAV, which we have been able to achieve on our most -- sorry, our least desirable suite.
So the three that were sold were highly CapEx-deferred regulated units required significant investment with limited rental upside, and we were able to achieve a significant premium to the valuation in the NAV. So that's extremely encouraging.
What's discouraging is the pace of progress here. So we're trying to play with that usage of valuation and getting, I'll say, far more educated on how to do this process, how to run it and what's in the best interest of ERES unitholders in the end. Very encouraging.
Yes. We're very -- like I've always been very optimistic about the alternative value of privatization. It is just a very long process to go through to pull full valuation out.
Right. Okay. And then just the last one. I think you did -- the last mortgage financing that you did back in June was, call it, in the 4.6%, 4.7% range. How maybe 5- and 10-year rates moved since then?
Kyle, it's Jenny here. I would say today rate, it would be somewhere high 4, low 5, that's probably where the rates are right now.
Our next question comes from Himanshu Gupta with Scotiabank.
So just on the CBRE sale process, so Mark, is the mandate to sell the entire portfolio at one go? Or are you considering selling parts of the portfolio as well?
All options are on the table. The strategic review was to find out and discover best value maximizing approach given the current environment. And really, that's all I can really say at this point.
Fair enough. And maybe how far along are you in that process? I mean it's early days? Or are you getting to like a decision-making stage now?
Well, I think we're several months in now since the announcement. It's obviously a big portfolio with wide coverage around the Netherlands. The process again, it's been extremely thoughtful in terms of managing even communication. So I would say we are at the stages that we expected to be at this point in time.
Okay. Okay. Fair enough. And then maybe on the -- in terms of the suite-by-suite privatization process, I think you mentioned pace of progress is a bit discouraging there. Do you still have a target of how many units you can sell by the year-end? I think last time you mentioned something like 100 units you can sell by the year end?
Yes. Again, we are evolving our approach. We started with such a conservative decision tree as to not disturb the value of the portfolio, since the last call, we've taken a broader look at the units that already have individual units sold in them. So properties that we don't do 100% of the units in.
And what we've tweaked now is an outreach to selective residents within that subgroup of buildings. And that is a different approach, that goes beyond vacant possession, that goes to connecting with existing residents that are interested in buying their home.
And so again, early days, we're not curably at a point right now, a terrible experience, at least, I would say, to give a run rate because we're ramping up pace. But we've changed our approach slightly since the last call. And I'm hopeful to announce more unit sales at a premium to NAV. Again, the numbers are so small right now, it would be misleading to try to give additional color on that.
Okay. And just a last question in terms of fair value adjustments, I mean, this quarter, it has come down in terms of the adjustment you have taken compared to the last few quarters. So are you done in terms of making the fair value adjustments almost on this portfolio?
Well, we rely very much on third-party appraisals to guide us in that process. Management doesn't like to interject too much discretion outside the appraisal process. The appraisal process, I think, is yielded the results it has. No different than other places in the world. Everybody is looking at the forward curve -- forward yield curve in terms of cost of funds.
That appears to be delivering some hope in terms of where rates are going, and it's a wait and see now. But there have been a few transactions in the Netherlands, very difficult to benchmark against our portfolio, but we're seeing some transactions bleed through now, and those deals would have been in at the height of sort of interest rate tightening. So I think that we're getting on the other side on at least the interest rate environment, and that should stabilize value.
The next question comes from Jimmy Shan with RBC.
So just on the 60% debt-to-market value of assets covenant. I guess 2 questions there. One, I assume that's related to the credit facility; and two, sort of how comfortable are you in maintaining a covenant given you are at 57% and market value remains within the range. So can you give us your thoughts about that?
Jimmy, the first part is, it is on our revolver. We're getting close to -- obviously, we're very actively in monitoring where we go. But even though you'll see this quarter the cap rates went up by about 6 bps, but the net impact is fairly mild just given how strong our NOI growth has been. And continue to be.
The other thing that Mark mentioned is even though we have pressures on fair value because of all the interest rate hikes, single-unit home prices are really keeping up the Netherlands, and we're continuing to see that, which also helps sort of soften that decrease. So I wish I have a crystal ball to say where fair values are going to be in the future, but do we see a very immediate risk to the covenant? No. Can I predict where our values will be in 3, 5 years' time? Also, no.
I was just going to say, it's encouraging way the appraisal work in the Netherlands is that they will take some degree of consideration to the privatization of vacant possession units only, not telling to residents, but vacant possession. And it's not specific to the property. It's sort of a generalized number.
What's encouraging is the initial test of home sales in, again, our least desirable homes is producing quite a significant premium to those valuations that already incorporate some privatization value. So if the program proves to be successful, although we're going into a bad sell season right now in terms of Christmas and that kind of thing. But if the program is successful, you continue to pay down that revolver debt. And as Jenny said, the income results are incredible.
So you've got this late, again, building factors. You've got business that's doing great, that you've got less interest in income property right now because of where rates are, and you've got evaluation of individual home searching but that's not a big part of the program right now. So there's extreme good -- and good news, and there's headwinds in the results in terms of what's happening on the valuation front. Operating results are fantastic. We're very, very pleased.
Yes. So on the revolver covenant and the interest coverage ratio, you're probably more than fine. There's definitely room for error there. I guess here, it's just fairly close, right? Have you had any kind of discussions with the lender or any sort of contingency plan that you may be thinking about? Or is it too early to be thinking about that?
Yes. We genuine constant discussions with the lenders. All I can really say is we are not alone in the environment there, and lenders fully appreciate the environment that we're in. I can't speak on the optional lenders, but we're in discussions there.
Again, very grateful for the fact that our operating results continue to produce the way they're producing to keep things flow.
And Jimmy, as we continue to privatize a bit portion of those proceeds are being used to repay the revolver and will help the leverage or where we are.
Yes. That makes sense. The three assets that were sold, are they with the single-family home sale?
Yes, they were.
Or Dutch row houses? Yes, they were. Okay.
Yes. houses.
No, we're doing obviously a strategic review. We're really priming the pump here for a program. But obviously, in the context of the strategic review, we're also being very cautious on our privatization program. But we are definitely learning where the opportunities are in the portfolio.
And the Dutch row house component of this portfolio is another characteristic that's probably not fully appreciated. These are very, very salable and highly desirable. And we're -- we've built a portfolio with a large component of those Dutch row houses, which should give investors a lot of confidence.
Our next question comes from the line of [ Stephen Sadler ], who is a private investor.
Okay. I'd like to congratulate you on your operating performance, I think it was quite exceptional. In the next 2 years, you have about $300 million of debt maturing at very low rates under 2%, which would -- if rates don't go down and stay the same, would imply an increase in interest expense of somewhere around $8 million or $9 million. Do you think you have enough growth in your revenue and the way you're handling everything to compensate for that or part of that?
Well, where we keep going to is the exceptional operating results are definitely mitigating interest rate impact. So we do have a point of attractive debt pool and where rates go and our ability to privatize or sell assets to pay down maturing debt. We'll have a huge influence over your question, okay?
So we do have very good confidence now in the single-family home sales market. That's encouraging. Housing prices in the Netherlands. We have liquidity on that front, unlike our North America and apartment years, we have alternative liquidity at side and selling income assets.
We have individual home attribute. So I have good comfort. There's 2 fundamental things going really well; a, results are great. The operating margins are hitting really incredible level base to the hard work of the team, and there's housing prices going on, and they're just about building homes in the Netherlands.
So that just keeps the embedded value in our portfolio going up. So these are achievements that are really working in our favor. Whether rate is going to go down. We're all watching that carefully. I hope anybody has a clear answer and where liquidity comes from, the team has been confident at liquidity in the portfolio to deal with debt that might be down too much for the debt service.
I'm sorry, could you say that again, you were breaking up a bit?
Well, I'm just saying we have good liquidity options in the event that debt becomes to expenses, and we see a further erosion, we have other options to deal with that desk.
Those are all the questions we have. So I'll turn the call back to the management team for any closing remarks.
Well, thank you, everybody, for your time today. And we appreciate your ongoing interest in ERES. If you have any further questions, please do not hesitate to contact any of us at any time. Thank you again, and have a great day.
Thank you, everyone, for joining us today. This concludes our call, and you may now disconnect your lines.