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

Good morning. I would like to welcome everyone to the Canadian Net REIT's Fourth Quarter and Year-End 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's Chief Financial Officer. Please go ahead, Mr. Gazith.

Thank you, operator. Good morning, everyone, and thank you for joining us on our Q4 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 at 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 December 31, 2022, which are available on our website at www.cnetreit.com 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 December 31, 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 fourth quarter of 2022, we continue to execute our business strategy. We've maintained a portfolio of 101 properties. We worked diligently to optimize the REIT's portfolio, ensure a smooth year-end process and laid the groundwork to start 2023 strong. In addition, we leased out the only vacancy in the portfolio, bringing our occupancy level back to 100%. We completed the development of a QSR in the city of Jonquiere, which opened in mid-December. We currently have ongoing projects, will be coming online within the next few weeks, which is the development of a previously announced Benny&Co. in the city of Mount-Laurie. In the next quarters, we also plan to begin the development of 2 previously announced additional locations for the Benny&Co. banner. The REIT has a 40% interest in all of the projects mentioned. Shifting to what we're seeing in the market and the macroeconomic landscape. The 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 the tenant. The REIT's operating costs for our properties are almost exclusively charged back to our tenants under the structure of the leases with a few exceptions. As the year progresses, this continues to be the case. With respect to interest rates, we had no renewals in Q4 2022, and completed the refinancing of only 1 property. We saw a dip in bond yields at the end of 2022 and a spike in the first quarter of 2023. However, another dip following the collapse of certain financial institutions in the U.S.A. This allows us to take advantage of favorable renewal rates for 2 properties during Q1 2023, where the rate reset was within approximately 100 basis points from the original rates. In 2022, the REIT has put 2 properties for sale, which are still being marketed. Volatility in the interest rate environment has made it difficult for buyers to underwrite assets with such significant swings in the bond yields, even on a daily basis. In addition to the 2 properties mentioned, we will be closing shortly on the sale of a KFC property in Timmins, Ontario. The property was sold at a cap rate, which was about 100 basis points lower than our IFRS cap rate for the property. It continues to show the disconnect that still exists between the public and private markets. We continue to serve the market for opportunities, but volatility in the bond market make it difficult to underwrite assets at this time. We hope to see some stability return in the short to medium term, but different macro environment catalysts out there are working against the sector as a whole. I will now turn the call back over to Ben Gazith, who will discuss our financial performance. Ben?

Thank you, Jason. We had another great quarter. For the 12-month period ended December 31, 2022, Canadian Net reported an FFO per unit of $0.636 compared to $0.581 per unit for the same period in 2021 which represents an increase of 9%. FFO reached $13 million compared to $10.8 million for the same period, which represents an increase of 21%. These increases were primarily due to the impact of newly acquired properties, partially offset by interest on mortgages associated with these properties as well as increases in floating interest rates on the REIT's various lines of credit. During the same period, the trust property rental income was $24.7 million compared to $19 million for the same period in 2021, which represents an increase of 30%. NOI reached $18.4 million compared to $14.3 million for the same period in 2021, which represents an increase of 28%, 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 $326.9 million, an increase of 10% compared to $298.5 million a year earlier. We continue to maintain a conservative approach with respect to our leverage and our payout ratio, having a debt-to-gross assets ratio of 59% compared to 52% at the same time last year. The primary reason for the increase is due to fair market value write-downs during the year on the value of our investment properties. Our FFO payout ratio, which increased slightly to 53% from 52% a year earlier, has remained consistent quarter-over-quarter. With respect to our leasing for the year, as mentioned on our previous call, we completed all of our 2022 renewals, which represent approximately $200,000 of NOI with no tenant turnover. The leasing spreads on those renewals, which included contracted renewals as well as new lease agreements for existing properties was approximately 20%. We have 10 leases expiring in 2023, which represents approximately $800,000 of NOI, of which 90% have either been renewed or we were able to enter into new leases in spaces where the previous tenant was not renewed. The remaining lease renewals should be completed by the end of Q2 2023. Looking forward to 2024, we have 12 leases coming up for renewals, representing approximately $1.7 million of NOI. Approximately 40% of these renewals have already been completed. The portfolios vault on our leases is currently 6.9 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. As Jason had mentioned, we are in the process of selling 2 properties, both of which have variable rate mortgages. In addition, bridge loans on our development projects are at variable rate until converted to take-out financing. Over the year, 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 $15 million of mortgages rolling over in 2023, excluding mortgages in our JVs, and the bulk of our renewals are not before 2027. Included in the mortgages rolling over are $3.5 million of mortgages associated with the properties held for sale. The current average term to maturity on our mortgages is 5 years. That summarizes our key results for the quarter. We will now open the lines for any questions. Operator?

[Operator Instructions] And that question comes from Mark Rothschild of Canaccord.

Maybe in regards to starting off with regards to the leases that were renewed already the 90% for 2023. Can you talk about the spreads you're getting on that and the change in rental rates? And if there's been any changes in escalations that you get through the terms of the lease?

Hi, Mark. It's Jason here. Yes, sure. So the leases that were renewed in 2023 -- we have some on the low ends, which were -- well, we have one of them, which was a flat renewal. And that represent around $80,000 of NOI. And then we have some on the high end with a tenant replacement. We had mentioned that we had one tenant that vacated their space in actually about 3 weeks ago. So the leasing spread on that property on the higher end of 15%. And then the others flowed around between 5% and 8%. And aside from the one, which was the replacement, which is a fair market value kind of new lease, the remainder are contractual rental escalations for the terms of the lease.

Okay. Great. And then on the acquisitions, since lately a little slower, to what extent is that just the markets being a little more difficult on pricing? Or are you being maybe a little bit more careful with just how you spend your capital at a time when equity is a little more expensive or difficult?

I think you hit the nail on the head. It's a mix of both, I would say. You do have to be a bit more cognizant and careful with your capital when equity or debt is even very volatile or tougher to get. But also, we are seeing a significant level of -- in the assets that we tend to purchase, vendor resistance in pricing. Just like if we were to sell something right now, just because the rates are higher than they were, it doesn't mean that we'd be dropping our pants and selling stuff for 8% caps, right? Vendors don't need the capital. Typically, the vendors that own these type of properties don't need the capital. So it's not even a question of price discovery. It's just the gap is too wide to be honest with you. As I mentioned, we're in the process of selling our property right now in Timmins, Ontario, for a 6% cap, or 6.1% cap rate. That property is on our books at an IFRS cap rate of 8%. We're seeing some stuff hit the market. H&R is in the process of selling a portfolio of assets right now in Quebec. It's under contract for what I heard, somewhere in the mid-6% range. Is it going to close? We'll see. But it just goes to show what people are willing to pay and what people are willing to sell assets for.

[Operator Instructions] And our next question will come from Kyle Stanley of Desjardins.

You mentioned 12 leases up for renewal in 2024. And I think kind of 40% of that has been done, $1.7 million of NOI. Can you talk about what the spread achieved was on that, similar to kind of I guess the guidance you provided for 2023?

Yes, they vary. I would say that, on one of them, we sacrificed a little bit of spread to get some term. So if you can sign a 10-year lease with the best credit in the market, you sacrifice a bit of spread, so that was probably on the lower end of around 3.5% spread. And then a couple of others. On land leases, about $250,000 of NOI on land leases. The average spread on those was 5%. And another one -- sorry, one of them that has a CPI link, so we don't even know what the increase is going to be yet. And the other one, the remaining one at 7%.

Okay. Fair enough. You mentioned having the ability to refinance debts early in Q1 at a better rate. Could you just disclose how much debt and maybe what that rate would have been?

Yes. So we just did 2 renewals last week, actually, literally 3 days after the SVB crash when the bond yields dropped down, and we early renewed a couple of properties and that was on a 5-year renewal term at 5.2%, which is, like I said, not horrible, not great. But had it been -- had we not had that financial kind of breakdown in the space, the bond yields were trading 60, 70 points higher. So the renewal rate would have probably been exactly that 60, 70 points higher, closer, just sub-6%. That being said, we're in the process of doing a couple of other bridge to take-out financings as we speak right now. And I suspect the rates to be somewhere in the low to mid-5s. We'll see how the -- we'll see how the bond yields maintain their current position where they're at right now. I think, this morning, they were at the 5-year was at 290 and at some point, yesterday, it even drop to 275, if I'm not mistaken. So still, we're still seeing 15, 20 bps changes on a daily basis, which is unheard of historically. But I -- if you would have asked me 6 months ago, I would have said that most of the renewals this year would have been done closer to a 6%. I'm extremely happy to see renewals being done in the low 5s right now.

Fair enough. And just one more for me. Just do you have any thoughts on what your capital budget for 2023 is? I mean, including, I guess, the new Benny&Co. that you're hoping to start in the near term and any other spending that's required?

Yes. So the Benny&Cos. that are actually slated to start in the near term, the capital is actually funded given the fact that we've already purchased the land and the remaining costs will be mortgage debt to cover the cost of completion. So I don't suspect any material amounts of capital required for those. And if I'm not mistaken, we have about a CapEx budget of approximate $1 million -- $1 million, $1.2 million this year. But the beauty of it is, if I'm not mistaken, $800,000 of that is recoverable CapEx from our tenants due to the lease structure. So we're actually going to make a couple of bucks on that CapEx due to the leasing. Well, I'm sure you're familiar with like the CT and Loblaw spreads on the deferred maintenance chargebacks, how we make a spread on our -- on the interest rate. So we'll make a couple of bucks on some of those same style structure.

[Operator Instructions] And our next question will come from David Chrystal of Echelon.

In Q4, your maintenance CapEx and AFFO ticked higher, and I think there's a note there highlighting it's tied to an expansion. Is the expansion complete? And can you maybe comment on what that property is, what the return is and if there's any more opportunities like it in the portfolio?

Yes, sure. I can give you exact details of it. This is a property that was probably one of the first developments that the REIT did back in 2013. It's a Petro-Canada property with the Tim Hortons and another QSR called Amere. So this is a very strong performing site for us, very consistent, great tenants. It is under the Petro-Canada banner, as I mentioned. C-store does great. This was a site that had 3 pumps at the time that it was built, given the market study that was done at the time. And the beauty of this site is that it's far exceeded our expectations and our tenants' expectations in term of volume. And as a result of just the nature of the site, the traffic is very concentrated at one point in time. So they required additional pumps. So what we did is we actually spent about $200,000 or to be exact about $190,000 to add an additional pump to increase volume. And since the additional pump has been added, we're seeing about 20% to 30% year-over-year volume increases as a result. Our return on this can vary just because of the structure of the lease compensation that we've put in place. But on the low end, returns is 10%, and on the high end or my expectations, the returns are probably going to be about 30% on that $180,000 that we spent.

And that's just based on volume or sales, the variance?

It's based on volumes... Yes. At a minimum 10% return.

Okay. Fair. And I guess, I mean it's a somewhat unique opportunity, but is there any more room for expansion or any other tenants that are looking for more space or more pumps in the portfolio?

I would say for the most part, they were -- the rest of the properties are really well done or serviced to the need that they have. And at the end of the day, like in this situation, it's not us that's going to go out there and say you need another pump. It's the tenant that's going to come knocking on our door and say, we need another pump. So there's probably a couple of other situations like that, but I wouldn't be jumping around to go do these things. Actually, what we're seeing in the portfolio, believe it or not, aside from this is the amount of capital that our tenants are spending on renovations. We currently have, if I'm not mistaking, 6 grocery stores, which are under full rentals right now. And when I say full rentals, I mean like full-fledged $3 million to $4 million or $5 million rentals depending on the size. So it just goes to show the quality of the site and the need for our tenants to invest capital in the properties because they believe that the returns are there with the capital injection. We're seeing on 4 -- sorry, 3 of our properties, conversions right now from the traditional food banner to discount banner. So if you look at like we have a metro property, which is being converted into a Super C, which is the discount banner for Metro here in Quebec. And I'm not going to talk about the other ones because I think they're still in the process and might be confidential from the tenant side. But other similar type situations where property conversions are being -- or grocers are being converted, converting the locations to their discount banners.

And are there any opportunities -- given the shortage of attractive acquisition opportunities, are there any opportunities to be a source of capital for some of these conversions, renovations or CapEx that tenants are putting in and maybe get term or return on those?

I think our cost of capital is a little bit more expensive than Loblaws and Metro right now. So that being said, if they were to be done, it probably will be at a rate that they wouldn't find very interesting, in my opinion. I could be wrong and maybe Eric La Fleche will knock on our door and say, we need X amount of dollars for metro renovations, but -- or some basic renovations, but I highly doubt it. And at that same time, I see -- the plus side of this is when I have a grocery store franchisee or a grocery store corporate store spending $3 million, $4 million, $5 million on a conversion or a renovation and there's only 2, 3 years left on the lease, in my head, well, they just renewed for 10 years because they're not renovating or putting a capital into a store for the short term to write it off in 2, 3 years from now. So I see it more as -- that's the benefit I see from these types of renovations.

[Operator Instructions] And our next question will come from Munish Garg of LBS.

Congratulations on the results. My first question is on the development side. So as you have mentioned, the yield on cost basis contracts. So just a bit of a color over there. Are you seeing any pushback from the contractors on these fixed-cost contracts? And just a bit of a comment on the pipeline, if you guys are looking to expand on the development pipeline or stay on the sidelines a bit till there is more clarity?

Yes. So I guess just a clarification. The yield on cost is not with the contractor. The yield on cost agreement is with the tenant. So regardless of what the cost is, we adjust the lease as a result after to achieve the same yield on cost, and, hopefully, a similar return as originally budgeted when we start the project. And in terms of other development projects that we're looking for, we aren't -- we don't label ourselves as developers. That's not what we do. We are consolidators. We are a financial partner. We are an equity partner to developers. I would say what we're seeing right now out there is a lot of uncertainty, a lot of uncertainty that people wanting to take on new capital projects. People wanting or looking for labor and there's still labor shortage everywhere you look right now. It hasn't disappeared yet. So I would say that, we are looking at the landscape and keeping our eyes open if projects come up. We're always chasing because, at the end of the day, these projects do not -- like if we were to see signing tomorrow, we wouldn't be starting to build this summer, right? These things take years and years. We have a project right now that we're hoping to start in the fall, and we'll see city permits, if it allows us to do it. If not, it goes into the next year, into the next year. So that being said, you always got to keep that pipeline growing and try the time when you do it. We are experiencing, as you know, a kind of slowdown in the market, but it's not going to last forever. So it's just about being ready to gear up as quick as possible when things go back through the way they were?

And just one more for me. In terms of refinancings, so I see $15.5 million debt maturing this year and from what I know about $5 million is tied to some dispositions. And you guys talked about 2 refinancings in this call. So just on the maths over there, would that take care a bulk of remaining $10 million? Or there will be -- just a bit more color on that.

Yes. So remaining, I would say, as of today, excluding the ones that we're taken care of and as well as the ones that are held for sales so with the joint venture, it's a little bit higher. But yes, it would say probably closer to $12 million -- $12 million, $13 million.

And I'm showing no further questions. I would like to hand the call back to management for closing remarks.

Great. Well, thank you very much, everyone, for joining us this morning. And if anyone has any further questions, everyone knows my number. Thank you very much, and have a great weekend.

Ladies and gentlemen, this concludes today's conference. Thank you for your participation. You may now disconnect.