Baltic Horizon Fund (NHCBHFFT) Earnings Call Transcript & Summary

Good afternoon. This is Tarmo Karotam presenting the First Half of 2022 of Baltic Horizon Fund's results. So let us kick this off as usual with 40, 45 minute presentation and then some Q&A later if there are any questions. I received quite a few questions over e-mail. So thank you for that. I will try to respond to those during the course of this presentation. So hopefully I will get them all covered. So let's start with what we consider the notable events for our fund during the first half of 2022. So of course, we were happy to see the restrictions dropped in the end of March, in early April across the board in the Baltic States. And as we had continued already last year with our shopping center concept removals -- sorry, renewals, then we continued as well during the second -- the first half of 2022, finished dialogue. And now we have also finished, by summer, most of the major construction works in Europa. So there are still some facade grades to be done in August, September, but we're happy that now the major demolition and reconstruction works of new amphitheater and new escalators have been finished. And of course that gives us a good potential to see better results in Europa during the second half of this year. But I will talk about that a bit later in more detail. Also we have, by today, fully commissioned and completed Meraki first tower, and it's ready for the first tenants to move in. We have clinics there, and then [indiscernible] back with its retail units and as well [indiscernible] and a couple of more smaller tenants. So we are still in search for the large anchor. But again, I will then come back to it later on during this presentation. For us, throughout the COVID period, lockdowns have been affecting the funds, retail assets, mainly in the city center, which is clear. But regardless of all of these difficulties, we have maintained great relationships with our banks. And we have, over the course of the 2 years, only bridged, I think, 1 or 2 soft covenants rebating the net rental income clauses. But other clauses have not been affected at all. And as a result, Standard and Poor's has given us a stable rating despite of the challenges that we've had during the lockdowns.

There's been quite a few questions over the years that when we did the bond in 2018 at 4.25% coupon, then was that a good idea? If you could finance from the bank at, let's say, 2%? And we still believe it was a very important move for us. First of all, we were able to, with a slight increase in cost of debt due to the higher coupon bond, to remove all the amortization that we would have to otherwise pay back to the banks. And second most important aspect was that we lowered the LTVs that we had with the banks to the level of around 35%, 40%, 45%. So also during the lockdown period, especially for shopping centers, we had that LTV buffer in covenants, which otherwise potentially could have been breached due to the decrease in values and the decrease in the NOI. And that has given us sort of fixed cost of debt and quite good foreseeable cash flows over these years. And now in the second half of this year, we are continuing to refinance our loans and the bond. Again, I will come back to later during this presentation. Then just touching upon the buyback program. And I will explain a bit more, as I've also done before, but the reason for this buyback program was to first and foremost have a tool in the management toolbox to use when the time is right and when the combination of aspects in the fund sort of demand it. And it was put in place so that we can act quickly and over the next 3 years, to expect that all of our free cash flow will now pulled into buybacks. It's, I think, ungrounded because cash needs we also use for other things. But again, we will have the opportunity to buyback units on the regulated rules. And I think we will do that when the time is right. And -- but we haven't done it yet, now during the summer as we believe that the cash that we have at hand can be used for other purposes to create the long-term shareholder value even at the current market price that is there. So I think the large, of course, exercise that we have undertaken is to refinance our loans over the past couple of years, and we have successfully ground already our shopping center loans. And for the remainder of this year, we will continue to renew some of our office building loans, but as well find a solution for the bond. So these are the main topics that I would like to talk about today. So going into more detail. And I think overall the fund has been stable. I think the Europa construction works maybe taken a bit more time than we expected. So it still will receive its finishing touches now over the coming months, but major reconstruction has been finished. So the reason why June we had slight drop of occupancy and the net rental income was mainly because of Europa shopping center as we had recorded one-off bad debts, written off those, but also given discounts to our tenants. Also to note that the food hall, which has been opened since January, and many of the tenants have received large rent discounts for the first month. So only now the rent is kicking in there. And we know that by September, official occupancy of Europa will be more than 90%. This is already contractually also covered. So new tenants are moving into the premises. And also the other premises are opening up again and direct discounts because of the reconstruction works will decrease. So that should show an increase over the next third quarter, and we do expect that. And there's been some questions around our stock price and as well as we made a table here, which compares us to some of the local other listed funds, but as well to the European property or ETF index and generally because of what's happening in the market and the geopolitical world, all of the real estate funds have been affected one way or the other. And as you all know, there are risks of increasing construction prices, risks in increasing Euribor, inflation being very volatile, increasing risks in geopolitical tensions and availability of materials. So it's -- there's a lot of volatility in the market. So the way we look at it as what the pricing today overall is planned for the best, planned for the good times, but be prepared for the worst. And in that sense, the volatility, I haven't seen such volatility probably since last financial crisis. So yes, everything may be turn out to be better, but we'd rather be more cautious and plan for the worst. So now I think, overall, there was a question about fund strategy. So let me just reaffirm this. Baltic Horizon is a commercial real estate fund, focusing on the capital cities. As we still believe that over long-term, the capital cities will hold the highest value. Yes, there's been COVID impact. Yes, there's flexible working now, that's for sure. Yes, there's some, let's say, deurbanization as one may say. And yes, there's not that many tourists as they were in 2018-'19 due to all of these tensions and still COVID aftermath. But again, over the long-term, we at Baltic Horizon, believe in the long -- in the value of our shopping centers in the city center. We do believe as well in the office segment. And what we see when we talk to our tenants that, yes, flexible working is here to stay, but very few tenants are thinking about decreasing their premises. There are some, yes, in our portfolio tenant, which was at least Lithuanian tax also gave back some space after COVID started. But many companies are still preparing for growth and they're holding on to the square meters that they have and -- but then flexible working is here to stay. Now when you look at the valuations of Baltic Horizon, then we had a boost in values in most of our properties, especially in the Office segment, and that is mainly to do with the higher forecasted inflation for this year and next year. And there's been quite a lot of questions about how much can we index. And so the answer there is that we can index as much as the contract allows. And yes, it's not 20%. And many cases, it is kept at 5%. In some cases, it's not capped at all. So then we have special negotiations with that. But for us, it's again to have rather than maximize short-term income by squeezing the most out of our tenants, we still talk to them. We find the best way forward sometimes instead of applying full indexation, we have prolonged the lease agreement. So we want good relations with our tenants and our tenants being happy. So again, it's not as straightforward as one would maybe expect. Still in the first half of the year, we were able to index like-to-like in Office segment more than 2%. And in the second half of the year, the indexations are continuing. So we're doing what we can according to agreement. And I think that's been quite effective. Now you can also notice that Meraki value was restored here because the development is ready and some additional improvements in value are expected in the coming quarters, that's not all of the reconstruction value has been accounted for. Then we did have quite a solid increase in Sky Shopping Center tenant in value. And also in the tenant mix, we had some new tenants coming in SKY Supermarket has been performing well. We've owned it for almost 10 years. And we expect actually Domino's Pizza to open there in the coming weeks. So yes, it is also true that the Sky Shopping Center is for sale. And since we are looking what sort of portfolio we would like to hold on a long-term basis. And that process is in its final stages. Now it is important to note that the biggest decrease came from Postimaja's evaluation. And that was a long discussion with the valuators. It is mainly due to the fact that for valuators, this time around, it was almost impossible to estimate what sort of construction cost would there be for the expansion. And what sort of level of rental income they should assume. So they decided to actually remove the development value from the valuation this time altogether. So I'm not saying that this will not come back, but I think definitely, we need more stability in the market to better estimate the overall -- the price of the expansion and the value of it. In addition, we have actually planned to start very shortly the new detailed plan, actually, Postimaja and Coca-Cola Plaza have the construction permit based on the design criteria, but no detailed plan yet. So with that I think it is also very important for us to pursue the maximum value that we can get from the construction rates and the new detailed plan. Yes, it may take time. Yes, it could actually include residential to some extent. But again, we have this location on a long-term perspective, and we aim to expect the maximum value out of that. So this is about valuations for half a year. Overall from a portfolio perspective, they were quite stable. There's not a lot to update on the tenant mix in retail. In terms of the share of rental income, expected to increase over the second half of the year. Europa's discounts are finished. And we expect some improvements also in Pirita and Sky. In regards to the occupancies, they have remained stable over the past quarters. And again, 2 properties effects, currently, the returns or the recovery of the funds. And it is clear that this is Europa and then this is Galerija Centrs. So I think the -- as I mentioned before, the occupancy of Europa contractual is already above 90% today with the new lease agreement sites, so the tenants will open up the stores now in the coming months and that should also recover the NOI and the same is expected with Galerija. However, for the second half of this year and the reconstruction of the food hall on the second floor will happen. So that's now the main focus of the Europa and Meraki from the fund perspective. And then after that, the major sort of reconstruction works within the fund have been finished. Now if you look at the NOI development and compare it to last year, then most of our properties have shown improvement and like-for-like, even without G4S Headquarters, the result is better than last year's first half. And there's been this question again, why robust first half was lower than it was precisely to do with the reconstruction period discounts, but as well that the larger vacancy due to the reconstruction, which, as I mentioned before, will be turned around and the expectations on the second half is considerably stronger. Galerija Centrs did much better as well the Postimaja complex than last year. And we do expect as well Meraki to start contributing to the rental income flow. And I think that would mean that expected results from -- for the second half will be better than the first half of this year. So now more details and some more illustrations, as also a request for that on what we have actually been doing over the past 1 year, 1.5 years, the during the lockdowns, the difficult times has been to reinvest and revitalize our city center locations. And when tenants are opening stores again and people are coming back to the city centers, then we already with the new attractions. And [indiscernible] has definitely been a major success if anybody that's been in Europa lately than we have now also the outdoor terrace ready and finished and there's some again happening. So it's really becoming a social hub in the city center. So we're really excited about that. And we want to copy paste that for similarly in Galerija. And I think I've mentioned this as well several times. Now if you ask me about the market in general and where are we with our city center properties. Then actually in tally in Postimaja and the cinema, the footfalls and the turnovers are quite close to the levels of pre-COVID. However, in Galerija and Europa, we are still about 20%, 25% below the levels of 2019 overall. Of course, this is due to the fact as well that we have larger vacancies currently. So not all -- premises currently are delivering turnovers. But -- and that we expect to improve now in the second half of the year when people are returning again more to the offices. So -- but flexible working is yet to stay. However, it is also clear that people visit shopping centers less, but buy more. Average checks have been increasing and considerably also during the COVID years and then post-COVID as well. So -- and the tourists are not back to the level of 2019, especially in Riga. But again, we believe in this location long-term perspective. And I guess the war has definitely affected tourism into the Baltics, that's clear. But we also know that people want to travel, we see that and -- and I think when more stability is expected from the geopolitical zone, I think positive news to the region is that Finland and Sweden are joining NATO, hopefully now very soon. I think that should definitely bring more and more focus to this area. But unfortunately uncertainties currently still prevail. But that's when we have -- that's when we, as a fund management team, have to be ready for anything. So this is one of the latest pictures of Meraki on the right as well. Today, in August, actually the occupancy rate is 23%. Maybe I can comment more about why the tenanting of the building has been as quick as we all are hoping for. I think, first of all, now we have a great building. So it makes it still easier to find a tenant who -- how many times need to go more very quickly. I can also share that over the past 6 months, we have participated in a tender to get the anchor tenant, a local tenant looking for 3,000, 4,000 square meters. Unfortunately, in both of these cases, we have finished second. And one reason -- one, I think what I can say is that one tender we lost because of location. There was another location that the tenant eventually preferred. And the other, I think the tender was most likely lost because of heavy dumping on rental level by this other office building, which is much older than ours. We expect EUR 12.5 per square meter here. Yes, there's potential to negotiate some of that level. But we also know that in the market currently, we are the cheapest brand new, pretty excellent building, which is looking for tenants. So on a long-term basis, again, we rather wait for the right tenant and really fight for it and try to fill in the building now as soon as possible. But the building is fully commissioned. It really -- it's a beautiful building being inside there. And I think the grand opening was also now happen in September when the grass is green. And so we do expect higher buzz in the market of our property and some new tenants. Then a few more words about the -- a few words about the Tallinn city center. And there's a couple of things I think important to mention. First thing is that the cinema property and operations have been taken over by Apollo Group and so it's a well-known name cross the Baltics. It's a very strong name. It's not the strongest. So we've had several discussions with them about the takeover and their plans for the future. So they are -- they believe in this location, again, to become the flagship property. And so we're actually quite happy that we have such a strong path there. Currently, they are operating under the old lease agreement that they took over, which is up until 2028. But we are in cooperation discussing what to do with the property and how to break the development into stages. So I think the first stage would be looking at cinema operations from the second floor up, and we would renovate the first floor. So these discussions are actively ongoing now with the Apollo and new entrants to the Rotermann Square. So this is something definitely actively on the discussion. We have started as well to upgrade Postimaja, Reval our first new premises are being built as we speak. We expect it to also be a very attractive, Reval with a big cluster seats and the opening date is end of September. Now there's been questions again asked about the middle of the part and are we constructing that, then I would say this is Stage 3. The market is very volatile today. So we rather do what we can, which is upgrading the cinema and Postimaja. Also, we are in discussions with Postimaja with the new international brand. So Stage 3 is currently postponed. And as I mentioned earlier, we have in parallel plan to start the new detailed plan to have the building rights also on top. So then a few words about Galerija, more details. The place for the food hall is the fourth floor of the new part, and it's currently closed down. It's fully vacant. So we have secured the contractor. And we have 90% of the area leased out. So -- let me see there's some pictures here on Europa and the sort of the new social spaces in Europa. Some of the investors did ask for some illustrations. And as well, this is quite a large space now in Galerija food mall. So these are the visualizations of our interior architect, a brilliant local company. So we are -- this is -- again, we have the construction company offer, we are basically ready to go. If you ask me the budget increase here to the -- given the uncertainties, and I would say no, because this is mainly interior fit out, interior sort of development. So no major sort of reconstruction and materials related to that is needed. So it's mainly furniture and interior fit out with new kitchens and new stores. Now coming back to the figures. And so as one can see, we did have a slight increase in the values of the properties, but not as high as we hoped. Cost of Postimaja's valuation and the uncertainty around the expansion there and construction prices. As you all know, through the roof, 30% to 50% more expensive, question is that is that sustainable? Is that is that the new level for the future? As well, there's been several arguments against that, that this is also because of the temporary restrictions or, let's say, what's happening in geopolitical world, and then again, how temporary they are. So it's difficult to estimate what would be new level. But of course, as we all know, it will never be as slow as it was before. Now I would also maybe comment on the rental income of commercial real estate in this environment. And many people see what's happening in the residential sector, so that if construction prices increase, then automatically, the sales prices increase same amount for the developers to sustain their profit margins. Yes, it is weaker in residential segment to push the cost of increase in construction prices to the end buyer. And -- but this is also due to the fact that the buyers are willing to buy, and it could be as well a bit of rare in these prices. But what I'm saying is that commercial real estate due to long-term lease agreements, it is more difficult to push the increase in construction prices right away to the level of tenants. However, I do believe that it will happen over a period of time in case the construction prices remain at the level where they are or even increase further. And that's for a couple of reasons. One is that new development, new competition will be smaller, especially in the Office segment. And in case new developments are happening, they're happening at a totally different price levels. And there's definitely -- I believe there is a different long-term push for the rental levels in case such inflationary environment stays. And -- but yes, there are also several discussions that potentially the economic downturn due to all what's happening and also increase in Euribor may actually happen. And that, again, with fewer constructions happening should also bring down the demand and then that means also lower construction prices. So it remains to be seen, however, as in commercial real estate to push the sort of quick increase of shopping and construction prices to the tenant level, it's not that easy. Well, as I mentioned before, indexation is happening and to the level which we have contractually possible to do, but it may be so that the only bigger hikes in rental levels could happen when the lease agreements become for a new one. So of course, we are monitoring the situation on a regular basis. When it comes to the estimate of the rental income for this year and compared to last year, then as I mentioned before, we -- our estimate at beginning of the year was that when we should recover the NOI in our portfolio within a couple of years. So I still believe that this year will be better like-for-like than last year, but perhaps, but it remains to be seen, but perhaps is not as good as we estimate at the beginning of the year. And of course, there's a lot of volatility. We don't know what energy prices will do. So let's say, we see -- turnover is coming back. But then again, the cost base of tenants, especially in the Retail segment is also expected to increase. So we are a bit, let's say, less optimistic about recovering half of the NOI that we lost this year. But I think 25%, 30% would be a good estimate. And again, it depends on what's happening with all the risk factors, I think we do as much as we can to restore the values in our shopping centers as soon as we can and if Europa is fully open and fully completed in Q3 and the Galerija renewed, as we already moved to Portland from the fourth floor to the third floor and the new foothold will be a traction on the third, fourth floor. So end of this year, so next year should actually, I think, be quite exciting for these properties. One thing I haven't mentioned is that we have a serious and -- let's say, serious discussions with absolutely new international retail brand to come to the first floor of Galerija Centrs. So there will be news definitely announced when we have signed that long-term agreement with them. If everything goes well, then they will probably as well move into Galerija Centrs end of next year. So I think lots of lots of work, but I personally considering all the risks and volatility that our portfolio has potential, and we continue to execute our plans. Then yes, these tables on the results also in front of you. And I think most of what we already discussed, the cash position for us, yes, has been decreasing due to the investments into Meraki and Europa, but we do believe we have sufficient liquidity. So let me then move on to a couple of things, which I think are still very important in the commercial real estate world for all of us. And one thing is cost of financing and Euribor. And the other thing is definitely cash flow production potential in our fund going forward and dividends. So these 2 things I would like to focus on in the remaining part of our presentation. So we have, since beginning, considered that hedging should be part of our strategy. We don't want to take financial market risks. And yes, over the past, I would say, 6 to 8 years, Euribor has been quite favorable and even negative. So when we had bought some of our properties in 2016 and '17, then we hedged -- and also '18, then we hedged for 5 years, the interest rates basically effectively fixing them without almost any cost, and there was actually one hedge that even -- the cost was basically 0. So the market expectations back then when Euribor will be negative for a very long time. And however, some of the hedges and caps that we've had in our later acquisitions, yes, they have costs on tens of thousands of euros. But I think it's definitely been worth it. We still have hedging in our portfolio for more than 1 year, I think 1.3 years. And we have taken some steps and like to take in Q3 to prolong that. And one of the things that we are planning to secure for us is that we are not affected by Euribor if it decreases by more than 3%. So again, planning for the worst. And now if you look at this chart, then you can easily see what Euribor used to be during even the financial crisis years. So it is always so that the central banks seem to be either ahead of the curve or behind the curve. And this time is certain they seem to be behind the curve. When about 6 to 9 months back, I thought that increasing Euribor is not going to happen because of the government debt of Southern European countries. And I think that was a prevailing thought. And today, already for about 3 to 6 months, I've been much more pessimistic about that. Regardless of inflation not being really sort of influenced by this. So that's a day that will actually increase in Euribor or influence inflation. And there's many reasons to say that not -- so we may be in the environment where inflation remains high and Euribor is being checked up. And as we all saw the increase in the ECB rate during the -- during July was higher than expected. And we do believe in house that within the next 12 months, Euribor will be 3%. So yes, it may trigger the issues in the economies. And yes, Euribor may also even be higher than that. But -- and it may come down 2, 3 years from now. But during these volatile times, we want to make sure that we always remain cash flow positive, and that's why our plan is to have a majority of our portfolio continue to be safeguarded if in case Euribor increases by a higher to higher level than 3%. Now major action, which is currently in the making is prolonging some of the loans and the bonds. And so in -- in this year, we have Meraki bonds, but also Lincona at beginning of next year, the [indiscernible] office buildings and Postimaja to be prolonged, we plan to execute this together with the bond, the large bond, which is also due May next year, but we aim to execute this already during the fourth quarter of this year. So now that we have new valuations in place, we are approaching the banks, and we are asking for final proposals for our office buildings. And then we are looking at our bonds and seeing what the market thinks about that. It is clear that 4.25% today is not the right valuation for the bond that in the market, especially during the -- before the summer estimate that it could be as high as 7%. However, I think the market has come down a bit. And with our top investors, we have already started discussions in the early spring. And now we'll see what we can agree with them in terms of the cost of the coupon for the next couple of years to roll it over. And for us to also optimize the cost of financing, we are thinking to decrease the bond from EUR 50 million, probably to around EUR 30 million level and then increase some of the LTVs of our office buildings from 35 to 40 -- from 40% to 45%, 50% and get cheaper financing from the banks to balance out the cost of debt for our funds. So currently, regardless of the quite difficult situation in the debt capital markets, we don't see our cost of debt increasing considerably over the next couple of years. It will probably increase some basis points. It remains to be seen what offers we get now from the banks and bond. But regardless, even if despite the debt capital markets are very volatile, then the banking sector in Baltics is very competitive and the initial offers that we see are very competitive. So we're happy about that. But that's definitely a major activity apart from the operations, apart from opening up Europa and finalizing the works in Galerija this second half of the year. And then finishing off with some words about the dividend. So as you can see, during the volatile times and unfortunately, after COVID, we got this geopolitical crisis by the way. So even though that we wanted to be more optimistic and forthcoming as we know that higher dividends are highly valued by our investors and -- but I think to be cautious during these times is probably more important when times get better. There's been a lot of questions, okay, when are we increasing dividends back to the maximum levels or close to 100% of the generated cash flow. Then the answer is, I don't know. It depends on the environment becoming definitely more predictable -- so can you sell thing in those lines. And unfortunately, this is the case. I think it's important to note that the fund is continuing to generate positive cash flow, and we have not stopped dividend payments even the most unpredictable times, and we are not planning to stop. And now we are -- actually, I can say that we have -- we are planning to keep stable dividends at these levels, not lower than currently. And we have changed the frequency from quarterly to semiannual -- also because of the uncertainty in the market also to have better cash flow planning for the fund, that doesn't mean that, again, we can to sort of cut the dividend in half. So it just means that 2 quarters will be paid out in one go. And now the question is that is that written in stone now forever and ever? And the answer is that, no. It's just a temporary measure. When we may go back to the quarterly, but if things worsen even more, let's say, if we see Euribor at 5%, then I think you can only imagine what sort of chaos would be in the markets. We may become even more defensive and pay annual dividends. But we know what investors expect and investors expect recurring cash flows. But -- and I think as well that compared to some other dividend payers in the market, even semiannual dividends are attractive and especially at the current market price level, which we have in the stock exchange today. I'm still cautiously optimistic about the results of the fund over the next 6 to 12 months, not worsening. So -- but rather improving. So that's definitely sort of what we are working towards. And I do hope that the investor base also appreciates the dividends that were paid out even during the more difficult -- during the more difficult periods. So to summarize, again, the priorities for the coming periods is refinancing of the loans and the bonds definitely by November, December this year to have also good predictability in terms of cost of debt and safeguards from very potentially very volatile Euribor over the next 2, 2.5 years. So that's something that we want to control. And then hopefully, after 2.5 years, come back to the markets when they're more stabilized and then refinance again, at hopefully better levels. But again, Euribor may stay high for quite a long time. So we need to be prepared for that. Meraki first our anchor tenant, a priority. We are working on, again, participating in any tenders that are there and negotiating best possible trends for us to get the property filled and get additional NOI to the portfolio. But then again, finalizing of the Europa reconstruction, the Galerija Centrs food hall this year, and that should increase both the occupancy, but also improve the footfall and NOI for the year for year 2023. And Postimaja, we talked about Reval and Apollo to understand what Apollo is planning there. I think they are planning investments and long-term stay in the location as they do believe it will become their flagship cinema, that's been very exciting to hear. And last, but not least, focusing on keeping our office buildings full, prolonging to lease contracts. And we have -- as I noted before, we are selling Sky. And we are thinking what -- maybe one other property to sell. I think I can reveal that today that property would be Lincona. Some investors have also mentioned that why don't we sell Pirita. I think we could sell that as well, but maybe not right now. I think for Pirita's value to be there where we want, we need additional 6 months. And last, I think, note that I have is that we have worked on a brand-new website, which is, I think, a good complement -- will be a good complement to the Nasdaq announcements. And where we can share as well in a channel way more detailed and more sort of everyday news about the fund. So it will be quite interactive and hopefully we can already launch that in September. So much more, I think, news will be available to the investors, which are maybe not that critical that we only need to announce through Nasdaq. So yes, there will be definitely more information about that in coming 4 to 6 weeks. So that concludes my presentation. So I hope I answered the questions that I received and gave some perspective, some view on where we are and where we want to be and how we foresee our portfolio and how we are ready for the risks and volatility ahead. So unfortunately, not the best of times, but again, we believe in our site locations, we believe in Office segment, and that's where we will mainly remain also in the coming years. So thank you once again, and have a good remainder of the summer.