Canadian Net Real Estate Investment Trust (NETUN) Earnings Call Transcript & Summary

Good morning. I would like to welcome everyone to the Canadian Net REIT Second Quarter 2022 Earnings Conference Call. [Operator Instructions] I would like to advise everyone that this conference is being recorded. I would now like to turn the conference over to Ben Gazith, Canadian Net REIT Chief Financial Officer. Sir, you may begin.

Thank you, operator. Good morning, everyone, and thank you for joining us on our Q2 2022 results conference call. Before we begin today, we are obliged to advise you that in talking about our financial and operating performance and in responding to questions today, we may make forward-looking statements, including statements concerning Canadian Net's objectives and strategies to achieve them, as well as statements with respect to our plans, estimates and intentions, or concerning anticipated future events, results, circumstances or performance which are not historical facts. These statements are based on our current expectations and assumptions and are subject to risks and uncertainties that could cause our actual results to differ materially from the conclusions in these forward-looking statements. Additional information on the risks that could impact our actual results and the expectations and assumptions we applied in making these forward-looking statements can be found in Canadian Net's most recent annual information form for the year ended December 31, 2021, and management's discussion and analysis for the period ended June 30, 2022, which are available on our website at www.canadiannet.ca and on SEDAR at www.sedar.com. We will also refer to non-IFRS financial measures today which are widely used in the Canadian real estate industry, including FFO, AFFO and NOI. Canadian Net believes these financial measures provide useful information to both management and investors in measuring the financial performance and financial condition of Canadian Net. These financial measures do not have any standardized definitions prescribed by IFRS and may not be comparable to similarly titled measures reported by other entities. For more information, please refer to the section Non-IFRS financial measures of our MD&A for the period ended June 30, 2022. I will now turn the call over to Jason Parravano, Canadian Net REIT's President and CEO. Jason?

Thank you, Ben. Good morning. In the second quarter of 2022, we continued to execute our business strategy. We have maintained a portfolio of 101 properties at a near 100% occupancy level. During the quarter, we completed 4 acquisitions while adding a new tenant to the portfolio at Giant Tiger in Truro, Nova Scotia. And in addition, we purchased a Metro anchored property in St-André-Avellin, a stand-alone Metro in Chénéville and a Couche-Tard C-store and service station in St-Jérôme. We continue to add properties to the portfolio that diversify the tenant mix as well as the geographies we are exposed to strong retail properties in A-locations in secondary markets. More so, these properties fall within the category of potential needs-oriented retail. Following the end of the quarter, we purchased our 100 and 101st properties, one of them being the first in the province of New Brunswick. The properties are in Midas in Fredericton, New Brunswick, and a 53,000-square foot Rona in Chateaugway, Quebec, two firsts for Canadian Net REIT. These properties are positioned in irreplaceable locations in high-traffic retail nodes and leased to strong covenant retailers, similar to the composition of the existing portfolio. We will be completing the development of a QSR in the city of Terrebonne in the coming weeks, and we recently began the redevelopment of an old Burger King into a Benny&Co. in the city of Saint-Sauveur. In the next quarters, we also plan to begin the development of 3 previously announced additional locations for the Benny&Co. banner. The REIT has a 40% interest in all the projects mentioned above. Shifting to what we're seeing in the market and the macroeconomic landscape. Popular topic of conversation right now is inflation and interest rates. Our business, which is focused on owning and acquiring properties on a triple-net lease basis, allows us to be somewhat immune to inflation as higher operating costs are borne by our tenants. The REIT's operating costs for our properties are almost exclusively charged back to our tenants under the structure of those leases, with a few exceptions. With respect to interest rates, we have been able to take advantage of mortgage assumptions at pre-hike levels, which has allowed us to take advantage of a meaningful spread between interest rates and going in cap rates on newly acquired acquisitions. I will now turn over the call to Ben Gazith, Canadian Net's CFO. Ben?

Thank you, Jason. We had another great quarter. For the 6-month period ended June 30, 2022, Canadian Net reported an FFO per unit of CAD 0.311 compared to CAD 0.288 per unit for the same period in 2021, which represents an increase of 8%. FFO reached CAD 6.4 million compared to CAD 5 million for the same period, which represents an increase of 26%. These increases were primarily due to the impact of newly acquired properties partially offset by interest on mortgages associated with these properties. During the same period, the Trust's property rental income was CAD 11.3 million compared to CAD 9.1 million for the same period in 2021, which represents an increase of 24%. NOI reached CAD 8.7 million compared to CAD 6.7 million for the same period in 2021, which represents an increase of 30%, and these increases were also primarily due to the impact of newly acquired properties. The IFRS value of our adjusted investment properties, which is the total of our wholly owned investment properties and our proportionate share of the investment properties held in joint ventures, amounted to CAD 332 million, an increase of 33% compared to CAD 249.5 million a year earlier. We continue to maintain a conservative approach with respect to our leverage and our payout ratio, having reduced our debt to gross assets to 56% compared to 57% at the same time last year, and an FFO payout ratio which increased slightly to 55% from 52% a year earlier. With respect to our leasing for the year, we have completed all of our 2022 renewals with no tenant turnover. We have 10 leases expiring in 2023, which represents approximately CAD 800,000 of NOI, of which 50% have already been renewed, and the remainder should be completed by the end of the fiscal year. The portfolio's wealth on our leases is currently 7.2 years. Our properties are typically financed with fixed rate amortizing mortgages. There are 3 properties in the portfolio which are on variable rate mortgages as well as the REIT's line of credit. In addition, bridge loans on our development projects are at a variable rate until converted to takeout financing. There are 3 mortgage renewals remaining in 2022 with a balance at maturity of less than CAD 4 million as of today's date. Over the years, our preference has been to take out the longest term available to us on our mortgages in order to mitigate our rate reset risk. We have CAD 10 million of mortgages rolling over in 2023, excluding mortgages and our JVs, and the bulk of our renewals are not before 2027. The current average term to maturity on our mortgages is 5.5 years. That summarizes our key results for the quarter. We will now open the line for any questions. Operator?

[Operator Instructions] Our first question comes from the line of Kyle Stanley with Desjardins Capital Markets.

So just generally, what are you seeing in your markets right now in terms of acquisitions? I mean, you talked about the interest rate environment and the impact that may be having on operations. Just curious, what you're seeing out there? Have you seen any movement in cap rates or pricing adjustments? And you did mention, and I think we spoke about this last quarter, but your ability to assume mortgage debt at a higher or a lower cost, and the spreads still being intact. So could you just kind of walk through what you're seeing there?

Kyle, it's Jason. Yes, for sure. So if people are able to come to us or vendors are able to come to the table with properties, with great mortgage terms associated with it, for sure. If you're able to maintain a greater spread, they're able to achieve kind of the same pricing that we've seen historically. And on the flip side, if you're looking at properties or we're looking at properties that have no debt associated with them, there has been a little bit of an adjustment. Vendor expectations have changed slightly, but I don't think -- well, I think that a lot of people were expecting a much more material movement in cap rate expectations and cap rates on newly acquired properties. But we haven't seen a material movement in terms of, one, expectations. And two, on the buy side, people have just accepted to, in my opinion, make lesser spreads, and pricing seems very similar to kind of pre-interest rate levels. And I would see probably a difference in 25 to 40 basis points on cap rates, and 40 being on the high end. But just to say, there is product coming to market. There is product on the market right now where expectations are extremely high or extremely low in terms of the cap rates people are expecting to get for them because there is not a lot on the market. There is not a lot trading right now. So there's still a lot of money on the sidelines chasing the same product. But what we have seen, the most important thing is where you have a vast variety of different people chasing the same product. Due to the rise in rates, we're seeing less competition from private capital chasing the same deals due to the fact that the volatility in interest rates is kind of scaring them off a little bit.

Okay. Fair enough. And then I guess, maybe just building on that a little bit with regards to your strategy. So where would you be comfortable taking leverage to facilitate growth? And -- or how are you thinking about your funding at the moment? And I guess maybe, you probably don't want to provide guidance, but just for the balance of the year in terms of total deal volume, what do you think would be reasonable?

Well, total deal volume is all dependent on the capital that we can find to pair it with the potential acquisitions. We're always working on stuff. If you look at our track record, we've always been very active. There's no difference now. We're looking at a lot of deals that are being presented to us between now and the end of the year. Next week, we're already into September, having... [Technical Difficulty] I expect some deal in volumes, but obviously, the most foreign part of it is we see that we get the capital market. But right now, the likelihood of issuing equity is, I would say, not on our kind of priority list. So alternate sources of potential capital could be of interest for us, whether it be debt or debt in the convertible nature.

Our next question comes from the line of David Chrystal with Echelon Wealth Partners.

Do you maybe just build in on Kyle's question there. Like, do you have a firm upper level of debt to GBV or a range maybe that you'd be comfortable taking your balance sheet today?

We never really put an upper level. At the end of the day... [Technical Difficulty] Different from some of the larger REITs that kind of put appraisal at an upper level of -- max level of debt that they put on the portfolio is that all of their portfolio is comprised of unsecured debt or non-conventional mortgage debt. So they're much more susceptible to rate resets when they come to renewal because they also haven't paid down any capital. The beauty of our business or the beauty of the way we structure with our debts is we're all paying our previous [indiscernible], so I'm more comfortable with being at a slightly higher level than the norm. But I don't see us going to 70%, if that's your question. Right now, sitting around the 50%, 55% mark going up to 60%, I wouldn't shy away from it if the opportunities present itself as long as we can pair long-term debt with the properties to ensure that we do what we've done in the past, which is pay down the capital on those mortgages to kind of immunize ourselves from rate resets at time of renewal.

And given that your commentary kind of suggests that you're not actually seeing a whole lot of cap rate expansion, would you look further afield, would you target more kind of New Brunswick, like obviously, your post-quarter acquisition, with higher cap rates to keep -- to maintain your investment spread? And would you consider maybe clipping some assets in lower cap markets in favor of pursuing higher cap acquisitions?

Yes and no. Like, we're always looking in other provinces. And I wouldn't say that the New Brunswick market is that much higher in terms of cap rates on assets. It's probably even more difficult to find the assets in New Brunswick because nothing really trades. A lot of stuff is owned institutionally over there, believe it or not, or owner occupiers that own their properties. So that being said, I think there are lesser opportunities in those markets than there are in, call it, Quebec, Nova Scotia, Ontario... [Technical Difficulty] So that means I think you can be opportunistic you can find the opportunity in that target market. I find when you target a market, in particular, you're kind of handcuffing yourself to that market. So that being said, I think what everyone is just going to expect right now is that spreads are going to be lower between the cap rates and the interest rates on the properties. But it's not that it's at a historical low, is that we're kind of back to where we were in, call it, 2018, where stuff would trade at a 6.5% cap, and you'd put 4.5% debt on it and you had a 200-point spread. What we experienced in 2021 or at the peak of 2021 was the all-time high compression in cap rates and all-time low of interest rates, where you'd be able to put 5-year money at 2.5% and buy something at a 6% cap rate or a 5.5% cap rate. I think those 300- and 350- and 400-basis point spreads were fun for a little while, but the reality is that we're not going to see those kind of spreads again for a long time.

Okay. And then you have some kind of high-level commentary on leasing, obviously. Nothing -- no new vacancies in 2022 and not of next year is addressed. Can you comment on any leasing spreads this year or next year? And if you're -- if there's a gain on any of those maturities? Or are they mostly flat versus expiring?