Automotive Properties Real Estate Investment Trust (APRUN) Earnings Call Transcript & Summary

Good morning, and welcome to Automotive Properties REIT 2022 Second Quarter Financial Results Conference Call. My name is Sylvie, and I will be your conference operator today. [Operator Instructions] Please be aware that certain information discussed today may be forward-looking in nature. Such forward-looking information reflects the REIT's current views to -- respect -- views with respect to future events. Any such information is subject to risks, uncertainties and assumptions that could cause actual results to differ materially from those projected in the forward-looking information. For more information on the risks, uncertainties and assumptions related to forward-looking information, please refer to the REIT's latest MD&A and annual information form, which was available on SEDAR. Management may also refer to certain non-IFRS financial measures. Although the REIT believes these measures provide useful supplemental information about financial performance, they are not recognized measures and do not have standardized meaning under IFRS. Again, please refer to the REIT's latest MD&A for additional information regarding non-IFRS financial measures. This call is being recorded on Tuesday, August 16th, 2022. And now I would like to turn the conference over to Mr. Milton Lamb. Please go ahead, sir.

Great. Thank you, Sylvie. Good morning, everyone, and thank you for joining us today. On me on the call is: Andrew Kalra, our Chief Financial Officer. We continued our track record of solid financial performance in the second quarter with growth in all of our key performance measures compared to Q2 of last year. Property rental revenue grew by 6.5%, cash NOI increased by 6.7%, same property cash NOI was up 2.3% excluding bad debt recovery from last year, and AFFO per unit diluted, increased to $0.229, up from $0.221. Our valuation of investment properties remains consistent with our prior quarter. The capitalization rate applicable to our portfolio was 6.3% at quarter end, up from 6.25% at the end of Q1, as NOI increases from the investment properties were offset by adjustments to valuation endpoints to reflect the current market conditions, including rising interest rates. In April, we also extended one of our credit facilities to 2027, and increased the non-revolving portion to $22 -- sorry, to $226.3 million, retaining the same credit spread. We subsequently entered into interest rate swaps that reduced our interest rate risk. We have strong liquidity, and at quarter end, we had $24.2 million of undrawn credit facilities, and 10 unencumbered properties with an aggregate value of approximately $122.3 million. Our debt-to-GBV ratio at quarter end was 41.2%. With our solid balance sheet and the annual contractual rent increases across our portfolio, we are well-positioned and continue delivering solid financial performance to unitholders, while pursuing attractive acquisition opportunities. According to DesRosiers Automotive Consultants, new light vehicle unit sales in Canada were down 11.8% in the first half of 2022 compared to the same period of last year. This was primarily due to the supply chain constraints experienced within the retail automotive industry. We believe these supply chain constraints will continue into the foreseeable future and will not have a significant impact on our tenant's ability to pay rents, as new car margins, used car sales and overall service levels remain strong. I'd now like to turn it over to Andrew Kalra to review our financial results and position in more detail. Andrew?

Thanks, Milton, and good morning, everyone. Our property rental revenue for the second quarter totaled $20.8 million, a 6.5% increase from Q2 a year ago, reflecting growth from properties acquired subsequent to Q2 last year and contractual annual rent increases. Total cash NOI and same property cash NOI for the quarter totaled $17.1 million and $16.1 million, respectively, reflecting increases of 6.7% and 2.3% compared to Q2 a year ago. Growth in cash NOI was primarily attributable to acquisitions and contractual rent increases. Growth in same property cash NOI primarily reflects contractual increases across our portfolio. Our G&A expenses in the quarter were in line with our expectations and growth. Net income for the quarter was $31.2 million, an increase of 74.6% compared to $17.9 million in Q2 last year. The increase was primarily due to higher NOI and non-cash fair value adjustments for interest rate swaps, Class B LP units and unit-based compensation. FFO and AFFO for the quarter increased by 2.1% and 3.8%, respectively, compared to Q2 last year. FFO per unit diluted was $0.241 in the quarter compared to $0.236 in Q2 a year ago, and AFFO per unit diluted was $0.229 compared to $0.221 in Q2 a year ago. This growth was primarily due to properties acquired subsequent to Q2 last year, and contractual rent increases. The REIT paid total distributions of $9.85 million or $0.201 per unit in the quarter, representing an AFFO payout ratio of 87.8%. This compares to total distributions paid of 9.85% or $0.201 per unit in Q2 of last year, representing an AFFO payout ratio of 91%. The AFFO payout ratio was lower this quarter primarily due to properties acquired subsequent to Q2 a year ago and contractual rent increases. We had $454.4 million of outstanding debt as at June 30th, 2022, with an effective weighted average interest rate of 3.8%. We have a well-balanced level of annual maturities, and our weighted average interest rate swap and mortgage term is 5.2 years, with a weighted average term maturity of 4.2 years. Currently, 91% of our debt is fixed to interest rate swaps and mortgages. In April, we extended the maturity of Facility 1 for a 5-year term to June 2027 with the same credit spread, and increased the amount available under our non-revolving component of the facility by $50 million. Immediately thereafter, we completed $40 million of swaps for an average term of 8.5 years at a blended rate of 4.75%. The balance of $10 million remains at floating rates. We continue to have strong support from our lenders, and remain well positioned to deploy capital on growth opportunities. I'd like to turn the call back to Milton for closing remarks. Thank you very much.

That's great. Thanks, Andrew. In response to rising inflation, the Bank of Canada has raised overnight rates, and this has resulted in the 10-year Bank of Canada bond rate moving approximately 100 basis points in 2022. We've consistently completed longer-term swaps and mortgages to insulate our existing debt from future interest rate increases. We continue to monitor the impact of the rising interest rate environment and inflation on our property portfolio, and the overall real estate industry. The contractual annual rent increases across our portfolio partially insulate us from the rising inflation. The increases consist of CPI adjustments or set annual rent increases. They drove same property NOI -- cash NOI increase of 2.3% in our second quarter. We're further insulated from inflation due to our triple net lease structure, as our property level operating and energy costs are the responsibility of tenants. Given our strong balance sheet and the strength of our existing portfolio, we'll continue to pursue acquisitions on a strategic basis. That concludes our remarks. I'd now like to turn it -- open for questions. Sylvie, Please go ahead.

[Operator Instructions] And your first question will be from Sairam Srinivas at Cormark.

Congrats on a good quarter. Just looking at the numbers, Milton, could you just speak about the capital allocation opportunity you're seeing in front of you from a growth perspective?

Yes. Last year, with the extremely low interest rates, you saw a lot of -- very low cap rates. We're starting to see that kind of spread get a bit more normal right now. Last time we saw interest rate increases. We're able to take advantage of that and be active. So we are still looking ahead and very intrigued by what we're going to see over the next 18 to 24 months.

Next question will be from Mark Rothschild at Canaccord.

Maybe just follow -- maybe to follow up on those comments. Can you just expand a little bit on just deal flow in general? Do you see that there is going to be a lot of product or this amount of product coming to market? And does the way the dealers are operating now and their profit impact that at all?

I think some of the profits may have delayed things slightly because, obviously, dealers have been doing very well over the last 2 years plus, and that just continues to trend. But what we're seeing is -- with the supply chain, we're expecting to see that open up a bit over the next 12 to 18 to 24 months. And so that's probably going to result in the continued acceleration of the consolidation, and we tend to work with the groups that like to take advantage of that consolidation to build up a significant portfolio, either regionally or nationally. So we certainly see -- and traditionally, we've seen more deals occur in Q4. We've talked about that previously. In real estate, it tends to be 2 seasons. In auto real estate, it tends to be -- or auto M&A, it tends to be in Q4, and maybe linking into Q1 with deals that were actually done in Q4. So we're still expecting to see that. There has been a bit of a lag as well, as people calibrate what does it mean with the higher interest rate environment. We were always competing against very short-term capital, and when short-term overnight 90 days were as low as they were, it was tougher to compete than when they're -- there's less of a spread between long-term and short-term as there is now.

And then maybe just to try to put some numbers on your comments about spreads. Are you expecting to see deals happen at maybe the low 6%s or even lower on the cap rates? Or with your comments, should we assume that you'll be able to maybe get properties closer to a 7%s?

Well, outside of BC, we never have really broken below 6. So we kept everything pretty close last year. You could argue, with the lower interest rates, you could have gone lower on the cap rates, but we've kept things pretty consistent on what our expectations are, as these are long-term commitments that we're making. So I mean, the money that used to be interest rates or mortgage rates of 2.5%, are now up at 5%, 5.5%. So that certainly allows us to get a spread of the 6% plus, and that's what we certainly want to do. And so we've traditionally bought in that 6.25% to 7.25% range, and I still think we'll see opportunities in that range.

Next question will be from Scott Fromson at CIBC.

So just wondering, have you seen a -- just following on, on Mark's comments on M&A. Have you seen a change in the tone of conversations with potential vendors just in terms of generational wealth transfer, perhaps wanting to get ahead of a potential recession that could depress auto sales or anticipation of lower valuations?

Not the first one, not on the auto sales side, but we have certainly had some inquiries, further conversations, deeper conversations with groups that I thought that -- if you look at the housing market, if you waited every single month, it seems the house was worth more. Whereas that's plateaued or come off a bit. It's the same sort of thing. We've been in a 20-year bull run on real estate. Some people are scratching their heads saying, is it plateauing? Is now a good time to look at a state planning, look at taking some money off the table? So we're certainly seeing it more on the real estate side where everything gets not euphoric at all times. So what do you want to do longer term. So that, I think, will continue to be some interesting conversations, and should lead to some good opportunities.

And has there been a change in tone of conversations on alternative real estate use, basically the highest and best use?

I think your remaining alternative is in the auto versus retail, because they're -- and the fact that once upon a time, we are known as cyclical. And because of COVID and even global financial crisis, people are now looking at us as a lot more secure and essential retail. So that's certainly given us an advantage and allowed us to get rewarded a bit for what we've talked about before. I still think there's room for that to continue to kind of digest and get more investors on site. On the highest and best use, we work with our tenants. Most of these assets are longer term. As the industry continues to evolve on the auto dealership retail side, there may be opportunities to work with some of our existing tenants, because we certainly do have sites out there that are in great locations and could certainly have density opportunities. But we are long-term leases with high-quality tenants.

Next question will be from Frank Liu at BMO Capital Markets.

Just want to touch on the auto sales figures. I understand like the first half of 2022, the decline year-over-year was mostly driven by the supply constraint. Just looking forward -- because I read about some news online about some cars, new models in 2023 are with interest rate of over 7% or lease interest rate over 7%. Just wanted to understand the broader macro of the auto retail industry. Have you heard anything about like declining sales or customers not really looking to gather long-term loans for car loan? And do you expect that will attribute to continue the declining auto sales?

Yes -- No. The short answer is, pick up a phone and call a dealer and ask for a car, see what their reaction is. Their reaction is, the model has changed a bit from walk in and buy, so you've got a pre-order. The supply chain issues that have gone on for the last 2 years have created a dent in supply that is going to take a while to absorb. So I don't disagree with you that higher interest rates may change behavior on some consumers, but the overall matching of supply and demand still remains very tight on the supply side, and still remains lagging on the ability to fulfill the demand that still exists. So I mean, you've seen some movement in used car prices where a year ago, you could potentially see a 1-year-old car selling for more than a new car because there was no new cars available. So that's plateaued a bit to being very profitable as opposed to ridiculously profitable. But it's still going to take a while to catch up for that lag in supply and meet the demand that already exists.

Next question will be from Jonathan Kelcher at TD Securities.

First question just on acquisitions, assuming they do pick up in the latter part of this year, and the leases you negotiate, are you going to be more inclined to try and get CPI-based leases? Or are you still sort of agnostic between that and a set fixed rate?

I don't think we've ever been agnostic. We've looked for a bit of a balance between some with CPI and some with fixed. It also comes with what's the deal. There's only so many levers that you can talk about on the long-term kind of sale-leaseback situation. So are you looking more at cap rate or are you looking more at your rental escalations, and how do you balance the 2. So I think it's going to be a bit of bucket A and a bit of bucket B.

And then just on the debt side and the floating to fixed. And I guess the terms range from half a year on out, roughly how much comes due over this year and next? And based on where current rates are, what are your expectations on the impact on your overall interest rate?

Andrew, do you want to take this?

Yes, sure. Jonathan, over the year, it's going to be about approximately, let's say, $20 million to $30 million coming due. And that's...

Is that over the back of 2022?

Back to 2022, yes. And that's based on all 3 of the facilities. And then our approach has always been to ladder, and we've taken 3 to 10-year laddering. And we'll watch that as rates move. Right now, obviously, short being the same as long. But what we did in the past, just in April, we went to blended 4.75% with 8.5-year of maturity. So we'll kind of follow that strategy and see where the rates fall.

And where would the rates be right -- where would rates be right sort of 5 to 10 years?

Well, 10 years probably north of 5% all in where the interest rate was.

And 5% about the same, you said short-term...

Yes, I would say... Yes, I would say, within that bandwidth.

And just -- the other thing is, there's some conversion of Class B units in the quarter. Is there any color you can or care to give on that?