Canadian Apartment Properties Real Estate Investment Trust (CARUN) Earnings Call Transcript & Summary

Good morning. Thank you for attending today's Canadian Apartment Properties REIT Second Quarter 2022 Results Conference Call. My name is Alexis, and I will be your moderator for today's call. [Operator Instructions] I would now like to pass the conference over to our host, David Mills.

I'm the host, but thank you, operator. Before we begin, let me remind everyone that the following discussion may include comments that constitute forward-looking statements about expected future events and the financial and operating results of CAPREIT. Our actual results may differ materially from these forward-looking statements. As such, statements are subject to certain risks and uncertainties. Discussions concerning these risk factors, the forward-looking statements and the factors and assumptions on which they are based can be found in CAPREIT's regulatory filings, including our annual information form and MD&A, which can be obtained at SEDAR. I'll now turn things over to Mark Kenney, President and Chief Executive Officer.

Thanks, David. Good morning, everyone, and thank you for joining us. Stephen Co, our Chief Financial Officer, is with me this morning, as is our new Chief Investment Officer, Julian Schonfeldt. We are very pleased to have Julian join our team. He brings a wealth of strategic, capital market and property investment experience to CAPREIT, and we welcome him to our first investor conference call. Welcome, Julian. Turning to Slide 4. Despite the lingering issues related to the pandemic and inflationary pressure on our cost structure, we are pleased to see solid increases in our NOI and NFFO in the second quarter. NFFO per unit was impacted by the 1.7% increase in the number of units outstanding in the quarter. Driving this improved performance was a 10% increase in revenues due to the contribution from our acquisitions, increased monthly rents and much stronger occupancy at 98.2% compared to 97.2% last year. In May, we began purchasing our Trust units for cancellation under our approved normal course issuer bid. At the end of the second quarter, we have purchased approximately 1.4 million units, which has since increased to approximately 1.8 million units as of the end of July, for an aggregate purchase price of $85 million. We believe, given that our units are trading at a significant discount to our net asset value, these purchases are another way we are enhancing long-term value for our unitholders. Turning to our 6 months results on Slide 5. You can see all of our key performance benchmarks were up, including revenues, NOI and NFFO. Most importantly, market rent recovery is well underway. From an operations perspective, our ability to generate solid and resilient performance through all economic cycles is clearly demonstrated by the strong, consistent occupancies and growing revenues across our portfolio, as you can see on Slide 6. Occupancies approved again in the second quarter, while net average monthly rents continue to increase. Our same-property NOI is being impacted by the increased costs we are experiencing, with higher maintenance costs, increases in utilities and higher realty taxes. We believe such inflationary cost pressures will impact our NOI over the next few quarters. In addition, CAPREIT has an experienced team that is exploring alternatives to minimize usage and exposure to operating expenditures, including hydro submetering. As of quarter end, approximately 64% of the 59,635 suites in Canada are submetered or direct meters. Additional suites and sites have submetering or direct metering in place that will be assumed by new tenants on turnover. CAPREIT will continue to evaluate implementing submetering in the remaining suites and sites. Submetering lowers consumption, resulting in a smaller environmental impact, lower operating costs and lower inflation exposure. Similarly, to protect against rising water and natural gas rates, our utility teams continue to evaluate effective alternatives to mitigate our risk to rising utility costs. Our leasing and marketing programs continue to generate increasing occupancies and average market rents, as you can see on Slide 7. After 2 years operating under significant pandemic restrictions, our occupancy continues to strengthen, rising to 98.2% in the second quarter, up from Q1 and 97.2% in last year's second quarter. You can also see that rents for the total portfolio have risen 4.4% compared to the same time last year. Tenant incentives are continuing to decline to pre-pandemic levels, and we expect the majority of the amortization to be completed by the end of 2022. We experienced a solid and positive trend in rent increases on turnover each quarter since we bottomed out at the height of the pandemic in Q1 last year, as you can see on Slide 8. While turnovers were impacted by the pandemic over the last 2 years, we are now starting to see solid increases as we move rents closer to market. A 10.6% increase on turnover in the Canadian portfolio is a solid result, and we expect to see this continue in growth through the balance of the year. Our churn rate remains strong and are tracking at the historical trends of seasonal variations. Looking ahead, we are experiencing more in-person and online visits, and we expect we will start to see more higher mark-to-market increases in the quarters ahead, moving us toward the higher levels of increases we generated prior to the pandemic. I'll now turn things over to Julian, to outline how we are repositioning and strengthening our property portfolio.

Thanks, Mark. Turning to Slide 10. We continue to focus on increasing the quality of our portfolio through our active asset management program. Through 2021, our strong acquisitions team added 3,744 high-quality suites and sites to our portfolio, focusing on our key markets. Another 1,237 suites and sites have been acquired to date in 2022 with a further 300 suites subsequent to June 30. Importantly, almost all of our acquisitions in 2022 represent new build assets in our targeted geographies. These new additions to our portfolio are in line with CAPREIT's strategy of rejuvenating its asset composition and increasing our geographic diversification into desirable major markets in Canada. Additionally, we're happy to be contributing to stimulating the market for new build multifamily assets, contributing to the increase of new supply in Canada. Looking ahead, our acquisition pipeline remains strong, and we intend on leveraging our best-in-class acquisitions and operations platforms to generate further accretive portfolio growth in the quarters and years ahead. In addition to acquisitions, CAPREIT is also using dispositions to advance its core capital allocation strategy. CAPREIT's $18 billion asset base is the result of 25 years of acquiring, operating and enhancing multifamily properties. Some of our assets were bought decades ago with strategic criteria that no longer perfectly align with our current strategic objectives, making some of these assets noncore. Many of these noncore assets continue to attract premium pricing and generate bids that are above our IFRS NAV. As shown in Slide 11, we've been selectively executing dispositions which have so far amounted to approximately $350 million in 2022. These strategic dispositions not only enhance the quality of our overall portfolio, but also result in disposition gains and introduced an incredibly attractive source of capital to fund our capital deployment priorities, which we previously discussed being our new build acquisitions, MHC sites and NTIB program. We're committed to increasing the quality of the portfolio and enhancing returns and unitholder value. As you can see on Slide 12, we are making real progress in repositioning our portfolio to reduce our exposure to older value-add properties while increasing our presence in new build properties and MHC sites in markets where CAPREIT wants to increase exposure. Our strategy is enhancing our portfolio quality, diversifying our tenant base and geographical exposure, decreasing our operating expense and capital expenditure exposure important in these inflationary times, and ultimately enhancing our risk-adjusted return profile. With that said, I'd like to thank you for your time this morning, and I will now turn things over to my partner and CAPREIT's new full-time CFO, Stephen Co, for his financial review.

Thanks, Julian, and good morning, everyone. As you can see on Slide 14, our balance sheet and financial position remains strong and flexible at quarter end with a conservative debt to gross book value and continuing high liquidity. Our $1.2 billion in Canadian unencumbered properties, which includes the majority of our MHC properties, provides additional liquidity should it be needed. Looking at our financings in the second quarter, we locked in interest rates of 3.4% on our re-financings and extended our term to maturity. We expect to finance a total of $1.1 billion in mortgages and top-ups in 2022. Importantly, over 99% of our mortgage portfolio incurs a fixed interest rate, protecting us from potential future interest rate increases. In total, if we were to access all our available sources of debt capital, we would have approximately $1.4 billion available at quarter end. Slide 15 shows we are successfully managing our interest costs in Canada and extending the term to maturity. And in fact, our strategy to leverage 10-year CMHC insured mortgage debt has resulted in CAPREIT having one of the longest terms to maturity and lowest weighted average interest rate among our publicly traded peers. This provides us with a strong protection against renewal risk given where interest rates are at today. Additionally, another benefit of our disposition program is lower reliance on debt. As I mentioned, over 99% of our mortgage portfolio incurs a low fixed interest rate, protecting us from expected future rate increases. As of today, we have locked approximately 72% of our 2022 maturing mortgages at a 3.15% interest rate. Further to our strong and flexible financial position, looking back over the last few years, you can see on Slide 16 that we have met our goal of maintaining a very conservative debt and coverage ratios even through the pandemic. This conservative approach underpins the stability and resiliency of our business and the sustainability of our monthly cash distributions to unitholders. This focus on maintaining one of the strongest balance sheets in our business will continue going forward. Our mortgage portfolio remains well balanced, as shown on Slide 17. As you can see, in any given year, no more than 14% of our total mortgages come due, thereby reducing risk in the rising interest rate environment. Looking ahead, our current ability to top up renewal mortgages through to 2036, will provide further significant liquidity in the future. As we expected, interest rates have risen after the Bank of Canada announced its 4 policy rate increases so far this year. In anticipation, we moved up the refinancing opportunities for our 2022 matured mortgages from second half of the year by paying some hedge costs and prepayment penalties. And we're able to achieve financing cost savings through closing on all pre-locking rates for those 5-year and 10-year mortgages. Their rates were 2.8% and 3.3%, respectively, lower than the current 5-year and 10-year estimated rates of approximately 3.6% and 3.7%. I'll now turn things back to Mark to wrap up.

Thanks, Stephen. Looking ahead, we continue to see a number of very positive value drivers that we are confident will generate strong and growing returns for our unitholders over both the short and long term. We will continue to focus on our proven asset allocation strategy as detailed on Slide 19. On the apartment front, we are targeting the acquisition of new build, modern properties in well-located markets in Canada's strongest centers. Yields are attractive. Growth is strong and stable and CapEx is modest. We also see condo rental rates increasing significantly in major urban centers, increasing the appeal of our more affordable rental rates. With respect to our MHC focus, revenue and revenue growth are as robust as our apartment properties and have a very low risk profile. With residents owning their own homes, CapEx needs are significantly reduced. Additionally, with homeownership costs rising significantly across the country, CAPREIT's large MHC portfolio provides an affordable alternative for families looking for quality residences at a truly affordable cost. Our third focus is on our NCIB program. While our unit price remains disconnected from the strong pricing we are seeing in the private markets, we will continue to crystallize the value spread and execute instant value creation for our unitholders. Key to our growth in the coming months will be our ability to capitalize on a number of market trends. Demand for our quality properties is growing as immigration accelerates with new Canadians seeking affordable homes in our largest urban markets. The return of international students is also contributing to the increased demand. The pandemic generated what we call household consolidation, as young students and young people return to home to save costs and seek safety. These young people are now moving back to rental accommodations as offices reopen and in-class learning returns. Demographics are also on our side as the growing seniors population looks to the rental market to meet their needs. We believe our quality and well-located properties, offering more space on one floor at affordable rates will see increased demand by seniors, looking to capitalize on the significant equity in their homes. We also see families looking to quality rental accommodation, including our MHC properties as a highly affordable alternative to the increasing cost of home ownership. These are excellent solutions. Additionally, cash flows will increase as we prudently and responsibly increase rents. Finally, on our ongoing property investment, as outlined on Slide 21, are reducing our cost and reducing our exposure to commodity prices through energy saving and other initiatives. Our technology solutions are increasing our operating efficiency, enhancing resident safety and making our properties more attractive and helping us meet our ESG commitment to enhance environmental performance. We issued our most recent ESG report on June 10. In it, you will see significant progress that we are making with our environmental, social and governance performance, as detailed on Slide 22. On the environmental front, our investments in energy efficiency have generated an 11% reduction in consumption and a 10% reduction in greenhouse gas emissions since 2010. Not only are ESG programs improving our environmental footprint, they are also reducing costs. Looking ahead, we remain committed to our ESG program and look forward to keeping you updated on our progress in the years ahead. To further strengthen our operating platform, we have added significant depth and experience to our senior management team over the last few months. The new members joining our team -- on Slide 23 -- and other additions reinforce our ability to capitalize on opportunities in our markets, ensure continuing strong and resilient operating performance and build on our track record of generating long-term value for our unitholders. In summary, we remain very excited about our future. Our strategy of acquiring new build properties increases portfolio quality, diversifies our asset base, reinforces revenue growth and reduces our CapEx exposure. Our focus on high-demand locations in strong major markets across Canada is responding to the strong population growth and is meeting the need for more housing space. We continue to leverage our best-in-class acquisitions and operation teams to create value throughout our portfolio. Our industry-leading balance sheet, leverage and liquidity position provide stability and the ability to grow going forward. And with demographic trends and increasing immigration, we are confident we will continue to drive value for our unitholders in the years ahead. Thank you for your time this morning, and we would now be pleased to take any questions that you may have.

[Operator Instructions] The first question comes from the line of Jonathan Kelcher with TD Securities.

First question, just on the mark-to-market turnover, the turnover uplifts that you're getting. It looks like they're sort of trending back to 2019 levels. Do you think you get there over the course of the next couple of quarters? And really, do you think the market might be stronger now than it was pre-pandemic?

Yes, I think our predictions are coming through. I think we called Q3 as the strong quarter. The evidence is clear. The rule or analogy that I've given in the past still holds true. And we're getting very, very quick uptake. And our pricing teams are obviously looking at inventory and adjusting pricing relative to inventory by the day. So we're very, very encouraged that it's feeling more like the first quarter of 2020.

And then just, I guess, the new slide that Julian spoke to, just on the portfolio repositioning. Do you have targets, do you have set targets for value-add versus new build versus MHC?

No, we just remain opportunistic. At the end of the day, you can only buy what's in the market and you can only buy what makes sense. So we're extremely conservative as you have heard us say in the past, Jonathan, with our underwriting practice. So it's a matter of things panning out. We are not -- we do not have ambitions of CAPREIT to grow bigger. We have ambitions of CAPREIT to become a higher quality portfolio with stronger earnings per share. And if we have to do that through recycling, we're going to do that.

And where would the development fit into that?

Again, it's opportunistic by site because every site is a little bit different, but we're extremely open to still looking at development, providing it pans out. And we are very ambitious on growing our development team. The development team has now grown to the largest size in CAPREIT's history, but extracting value through the sale of land or the sale of assets once we can recognize and crystallize density, we'll do that as well. But it's on a property-by-property basis. I can tell you that we are a cautious organization, as we've always said. And the first few projects you see come to market for us will probably not be the biggest projects we'll do in CAPREIT's history. We want to weigh in slowly. Very open to selling our land as much as we are building on it.

The next question comes from the line of Kyle Stanley with Desjardins.

So you've made a really strong headway on the capital recycling program year-to-date. I'm just wondering, do you believe there's still a decent amount of wood to chop on that front?

We'd like to chop that wood all day long. We'll stay opportunistic with sales, and where we're seeing very strong pricing in some of the value-add assets. The wonderful matching exercise of buying our stock on super sale is an easy one to pan out. So we really are embracing the notion of high-grading the portfolio through either acquiring new assets or buying back our own stock. As Stephen talked about, we've got this tremendous debt ladder of low interest rate, long debt. And if I can buy that at significant discounts to NAV, it's what you call in real estate a complete no brainer.

And I mean you mentioned the various kind of strategic uses of capital you have, including the buyback and rotating into newer build assets. I mean, how do you make those decisions? And has that criteria shifted at all? Obviously, I mean, with the stock trading at a discount to book, obviously, that pushes you more into the NCIB. But just wondering how you kind of balance those things.

Geographic diversification is one criteria. We do try to pan out return on assets 5-years out. We say 10, but really you can only count on 5. So you take into account CapEx type investments. We look at the maturity of the asset, how long we've held it for, how optimal we think it is. And we look at fit. We sold a couple of 1.5 caps last year to developers. It just wasn't in our wheelhouse of expertise. So again, if I can match a 1.5 cap sale with buying back CAPREIT stock in the low to mid-4s, I'm comfortable doing that. So there's just a variety of factors. You have to match the buyers with the ability to deploy the capital, and it will be a real mixture. We've seen some very interesting new-build assets that we'll have to really make the decision. Do we buy back our high-grade stock or do we buy into high-grade properties? Not a bad problem to have.

Just one more, this is probably for Stephen. I'm just wondering if you could provide some color on the sequential decline in the other OpEx line. Was this just seasonal? Or were there some other factors there?

Sorry, are you saying the sequential decline in OpEx?

In the other OpEx line.

On the other OpEx line. Yes, they are basically seasonal decline. But it's -- if you look at the normalized NOI margin going forward, I mean, that would be a good run rate for you to project out for the future quarters.

The next question comes from the line of Johann Rodrigues with Industrial Alliance.

Just further on the asset sales, are you listing those? Or are they unsolicited bids? And if you can maybe give a range of the cap rates of the stuff that you've sold in Toronto, East York and Ottawa?

Well, it's always a mixture. They were listed, the deals that we did to the buildings in Ottawa, we came to agreement with a joint venture partner to take those to market. We did that in a listed process. The same thing happened in Toronto. Cap rate wise, we targeted assets that we think, again, we've maximized value where we can recognize high 2, low 3 cap rate type transactions. And we'll continue to kind of plot around at that pace. The guiding principle just, Johann, on that, is our IFRS values, which you heard Julian talk about. We also get consideration to augment the book at. And when we can exceed those values and achieve all the other objectives, then we've got something that we'll consider.

And then just on the new build versus value add, what is the difference in IFRS if you're buying today like say, you're buying a new build property right next to value-add, what would be the difference in your IFRS?

Well, just go to cap rates and start with, like value-add assets are still selling, and again, the high 2s, low 3s. And if you're looking at low-rise suburban new build, which is kind of what we've kind of targeted ourselves around, you're talking low 4s. Low 4s, and again, another metric that we pay very close attention to is price-per-foot cost in these new builds. And what we've realized is that a lot of the new builds that have come to market are probably a good 20% low replacement cost. That's an unheard of number, to walk into a brand-new asset, low replacement cost without the development risk, again, I think pretty smart real estate decisions.

The next question comes from the line of Jimmy Shan with RBC Capital Markets.

Just wanted to follow-up on Johann's question on the value-add versus the new build. And I guess when I think about value-add, you think about there's a lot of embedded of mark-to-market rent that could come down the road. So I guess the question is like kind of what makes it noncore because, yes, you may be selling them at a low cap rate today, but maybe on a longer-term IRR, it actually looks at the same or even higher than some of the new builds. Maybe you could talk about that. And then the second question is on -- just in terms of what's the expectation for more asset sales for this year?

Yes. I would just say that again, I go back to the starting point is kind of pure -- our number, not broker number, our number cap rate kind of calculations. And again, we shift our mind to looking at what's going on in Canada, what is going on with housing, what's going on with housing supply. And what we see is the tide is rising on rents in all asset classes. So it's not the old game of mark-to-marketing and repositioning and getting those increases. That is still there. But for an asset that we've held for 20 years or more, the reality is we've done a lot of the heavy lifting. So then I look at other brand new assets in a backdrop macro environment where rents are going up and in an environment where, in many cases, the regulatory environment is different to capture those market rents even for renewals, we see opportunity. And this is in a broad-based large sweeping change. We have to stay on this path. And over time, I think, do a better job of geographical diversification and move the quality ladder in the portfolio higher. We've got -- we started with -- looking back a couple of years ago, I would have characterized CAPREIT's portfolio as being one of the highest quality apartment portfolios in Canada to begin with. We're just going to the next level now.

And what would be your expectation for the rest of the year in terms of asset sales?

Again, it's opportunistic. If you ask me what's on our desk today in terms of deals that we're looking at, I have to check with Julian, that's probably $600 million to $700 million. I would say high likelihood that we'll do with 0 with that. So we're always underwriting a pretty robust pipeline of opportunity. And I've never been confident saying exactly what we're going to do. I can only kind of describe the environment, but there's a lot of deals in the marketplace, a lot. Even with these higher interest rates, we do think that there will be the opportunity for yield spread.

The next question comes from the line of Matt Kornack with National Bank Financial.

I guess it's a continuation of Jimmy's comments there. But I think from your answer, you're essentially saying that you can achieve similar type rent growth in the new assets as some of your existing assets given the rent control regimes with the lower CapEx. Is that a fair assumption? I guess it would be more economically sensitive in that it's that market today, but is that how we should think about the rent growth potential within these 2 properties?

I think that's fair. I would add -- just add that we know when your markets are at rent if regulatory intervention does happen, you're in a good spot for maintaining value.

Fair enough. And then on land value within your existing portfolio and how to potentially get at that and provide new supply, is there an opportunity to sell the land to a partner that would develop and then you buy back the asset or a portion of the asset on completion if you don't necessarily want to incur the development risk or dilution associated with that? Or is that something you've entertained at this point?