Dream Office Real Estate Investment Trust (DUN) Earnings Call Transcript & Summary

Good morning, ladies and gentlemen, and welcome to the Dream Office REIT Year-End 2019 Conference Call for Friday, February 21, 2020. During this call, management of Dream Office REIT may make statements containing forward-looking information within the meaning of applicable securities legislation. Forward-looking information is based on a number of assumptions and is subject to a number of risks and uncertainties many of which are beyond Dream Office REIT's control that could cause actual results to differ materially from those that are disclosed or implied by such forward-looking information. Additional information about these assumptions and risks and uncertainties is contained in Dream Office REIT's filings with securities regulators, including its latest annual information form and MD&A. These filings are also available on Dream Office REIT's website at www.dreamofficereit.ca. Later in the presentation, we will have a question-and-answer session. [Operator Instructions] Your host for today will be Mr. Michael Cooper, Chair and CEO of Dream Office REIT. Mr. Cooper, please go ahead.

Thank you very much, operator. Welcome, everybody, to Dream Office's year-end conference call. I'm here with Jay Jiang, the CFO; and Gord Wadley, the Chief Operating Officer. We'd like to begin with Jay providing some prepared remarks, then I have a few comments. And then after that, 3 of us are happy to answer your questions. Jay?

Great. Thank you, Michael. Good morning. In the fourth quarter, we reported FFO per unit of $0.40, which was in line with our internal expectations and $0.01 above Q4 in 2018. Overall, we are pleased with our 2019 results. Our leverage declined from 45% to 37.6% due to over $0.5 billion of asset sales. And despite having less assets and lower leverage, our FFO per unit increased $0.01 for the year. Our exposure to downtown Toronto increased from 68% to 83% as we sold approximately 2 million square feet of assets in other markets. We were able to overcome lower leverage and lower yields by generating higher comparative property NOI growth of 12.2% for the year, reducing our G&A expenses and earning extra fees from our property management and construction business. Net asset value per unit at year-end was $26.70, an increase of 3.5% over last quarter and 6.9% for the year. In Q4, our portfolio saw an increase in value of $62 million, of which $28 million are from capital investments and $34 million attributed to fair value increases through higher NOI. We also realized our share of net income from our Dream Industrial REIT investment of $21 million, which is accounted for under the equity method in accounting. Based on current value of approximately $14, the fair value of these units are worth over $60 million or $1 per unit relative to the book value of our balance sheet. Our weighted average capitalization rate used to determine fair value of the income properties did not change. This implies that 2019 total return of 11% to unitholder based on the audited fair value of the company and cash distributions. For 2020, we will provide the following high level guidance, assuming a steady state that is exclusive of potential acquisitions, dispositions and unannounced major capital initiatives. We are expecting diluted FFO per unit of $1.60. We expect comparative properties' NOI of approximately 3%, consisting of 5% increase in downtown Toronto, primarily attributed to higher rents offset by negative 5% in our other markets to reflect continuing market challenges in some of our remaining assets in western Canada, particularly in Saskatchewan. We are working through these assets, and if we are able to sell some of them, we will be able to improve both the return profile and our comparative property NOI in 2020. We are anticipating our average leverage for the year to be below 40%. Within the other market segment, there are approximately $75 million of assets that we are currently working actively on the leasing and asset management front in the near-term in preparation for a sale, but we are currently not making any predictions of our targets on disposition volumes in 2020. With regards to leasing, at year-end, we have 46% of the 157,000 square feet expiring in downtown Toronto this year, already addressed at net rents in the mid-30s per square feet. We expect to have most of these expiries in downtown Toronto for 2020 committed by mid-year. We are also 82% leased on 2020 expiries for our other market segment. Late in the fourth quarter, we renewed 185,000 square feet leased at our [ olney ] building in the United States for 5 additional years with net rents comparable to expiring. This was an important renewal for us as our debt is currently locked up in a commercial mortgage but our security is full until 2021. So adding 5 years of term will help preserve the value and liquidity of this building. As announced in prior quarters, we will be making significant investments in our properties over the course of 2020. We turn over 357 Bay to WeWork in November, and they are currently working on their construction and their fixturing and expect to collect NOI starting in November. We understand that WeWork is leasing the building to an enterprise client, so we would expect to have a creditworthy tenant occupying the space. Similarly, in 1900 Sherwood, in Regina, we expect to finish our construction obligation by mid-year and will turn over our space to the tenant's construction and fit-out program. NOI should commence from the new space in the summer of 2021. In aggregate, we have spent $33 million out of the $55 million allocated to these redevelopments as of the end of the fourth quarter. Both projects are currently at the time and on budget. We also announced a $50 million investment in Bay Street earlier this year to enhance our lobbies, washrooms, facades, lighting program and the alleyway. To date, we have completed all of our design and have commenced construction. We plan to substantially complete the Dream collection Bay Street village this year. In January, we repaid our last tranche of the $150 million unsecured debentures. We currently have about $90 million drawn on our line with $240 million of liquidity and $280 million of unencumbered assets. We have significantly cleaned up our capital and debt structure over the past 2 years. We have only one small mortgage maturing in 2020 and a minimal refinancing or interest rate risk over the next 3 years. Our balance sheet is in good shape and support our capital and development incentives, and we will continue to look for opportunities to improve our assets to the best-in-class standard and deliver solid long-term results for our unitholders. Now I will turn it back to Michael for his thoughts.

Thank you, Jay. I do want to spend a couple of minutes talking about our macro view on valuation and maybe why there is some very significant differences of views about what the value of the company is. And then I won't mind spending a couple of minutes just going over our entire portfolio. On October 15, 2008, the U.S. Fed came out and announced emergency interest rates that were such a tremendous decline in order to keep the economy going. They set this overnight Fed rate of 1.5%. Today, the target is 1.5% to 1.75% 12 years later. So I think that what's really been happening over the last 12 years is something has changed, and the cost of money is a lot less than it used to be, growth is a lot harder to get than it used to be and people are trying to figure out what's a fair return given the risk. So when I look at it, what we started with this -- if you U.S. treasuries as the risk-free rate, we're at 66x cash flow for risk free, and there is no upside or downside in nominal dollars. So I think the main question is how much of a premium should people get from 66x cash flow, as they take on more risk? What we've seen and how we run our business is, we think that even at high prices as it seems historically, high quality assets that produce predictable income that have some upside, are a much better buy today than assets that have unpredictable income. So I would say that today is not a day to buy cheap assets because what we've been seeing is cheap assets get cheaper, high-quality assets have tremendous value. We're seeing rents going up, and we don't see the tenants choking on it. Rent used to be the second highest cost of most tenants and now -- after people, and now there is a lot of other costs that are way up there too. So I -- we're seeing that rental rates in downtown Toronto have gone up. There is lots of reasons for it, but the most important thing to me is, I don't think it is affecting tenant's ability to run their business, attract people and grow given the rents. So we think there is a big backdrop for increasing rental rates to the level they are now and to continue to do so. What we are seeing is that the rental rates are significantly higher than a year ago, 5 years ago, and as I've mentioned before, last year is the first year, we've exceeded 1989 rents. So I mean, we probably have something like 1% rental rate growth over the last 30 years that's just occurred in the last 18 months. We think it's the right thing to do and only fair to provide our tenants with incredible space, incredible buildings, that make it easier for them to attract people, run their business and treat their clients well. So that's why what we're doing is really focusing on how to create better and better experiences in our buildings. In a lot of cases, the rents are more than double than what they were just 4 or 5 years ago, and we want our tenants to have a good experience. Having said that, we believe that we're getting well rewarded for the money we're putting into the buildings. Right now, we're focused on 9 buildings, 8 buildings on Bay Street, and it's very small work. Some of these buildings are as small as 30,000 or 40,000 square feet. We're expecting that by the end of this year, the work will be done. We've got private and public laneways connecting the buildings. We're upgrading everything in the buildings, and we think that for this 2 block area downtown Toronto, we're going to create something that's really special for our tenants, plus for the rest of the city. We're working now with retail tenants that I think are going to be really exciting and animate the space. This isn't just a space that will be accessible from Bay Street or Richmond. This is a space that will be accessible from our private laneways, and we are going to create something that we hope to see you at, and hopefully, we'll have something for you in the spring of '21. When we look at other buildings in downtown Toronto, 438 University, we're looking at some very, very interesting new uses on the ground floor, upgrading it. That's a 700,000 square-foot building at a really great location, and we expect the rents to continue to rise there and our tenants' enjoyment to continue to increase. 36 Toronto and 20 Toronto is the big building that's right beside the 30 Adelaide, 74 Victoria, 6 Adelaide east, I think with a 1.1 million square feet within 100 feet of each other, and that's going to be a real target of upgrading in the future. Downtown Toronto is where most of our buildings are, and we're pretty much full. I think we're going to stay full. And by making special buildings and special opportunities, and things we like to think of as like landmark buildings, we think we can get great rents when the economy is good, and we can keep them full when the economy isn't. When we look -- and I think what's that, Jay? 85% of our value?

Yes. It's most of it. It's within a walking distance.

So then -- I just want to go over the other buildings that we have. And we've got 2 buildings in Calgary. One is Kensington House, which is where Dream Unlimited's head office is, out west. That is a very interesting part of Calgary. There is currently a building under construction just behind it. That really -- the value of the land is -- exceeds the value of the building, and we think that's a great opportunity. We've got Barclay Square, which was the best building when you combine location and quality. It's got a big parking garage on it, plus 2 office buildings, is relatively well leased. I think that, that's the building that we'll probably keep. If there is anybody on the phone that wants to buy it, if it's a good price, we'd sell it. Then we got a parking garage, and 3 buildings in Saskatoon and those ones we're working on, and we hope to sell them over time. We've got a beautiful building in Regina that's got an 18-year lease. I think we're building it to an 8-cap. If we put 3.5% debt on for 50%, it's going to be something like a 14 running rate. And there's green, no capital that's required. We would happily sell that at the price. If we can do better than those kind of returns, we'd sell it. We just did a 5-year lease for our lone building in the states. That building, we would have sold other than the fact that it's part of a collateral -- a CMBS Security with a huge penalty if we sell it, but that comes up in September 2021. So we will sell it then and that's everything we own outside of Toronto. Now we also own Sussex Centre, which is 2 blocks south of Square One, where Oxford announced a new city of 30,000 people. There is also a new train station. And that building, I think, around it, is 30 buildings of 60 stories or more for residential. So we like that building because there is a lot happening there, and the value is going up. I think we're really seeing increasing rental rates, increasing occupancy, and we think there is a lot that we can do with it. The other building we have in the GTA is 16 acres of Edmonton in Birchmount. We referred to many times. It's in the Golden Mile study area. We're working with the city. There is a 100 acres there that will be rezoned for residential and mixed use. On our site, we're expecting to get -- we've got 165,000 square foot office building that's quite well leased, and we're expecting to get approval for at least 2,400 apartment units as well. That's going to be a major undertaking. I like it because it's probably like 15 buildings. So we can do it piecemeal and not take very much risk as we build out to residential on the newest public transportation and that's all of our other category. When we look downtown, we've got 250 Dundas approved, which we're really excited about. That building is really interesting because it's kind of at the nexus of some of the cultural parts of the city, the universities, the government, it's on the subway. And we think it's be attractive to a lot of people as an apartment, and we think the office space is going to be really valuable part of the hospital district. 212 King, we're working very aggressively to get ready within the next 60 to 90 days. It will be unveiled publicly as part of our process with the city, and we're looking forward to showing it to everybody. It's going to be exceptional building and one that I think will add a lot of value to our company. So I mean, I'm pretty pleased that we can talk about our portfolio in a matter of minutes. The last comment I want to make is this one about what our company is worth. And as I said earlier, the multiple on higher-quality assets is double or triple the multiple on lower-quality assets. And our assets, I think, are among the highest quality commercial assets in any Canadian REIT. It's also very concentrated in downtown Toronto. So at our book-to-value worth -- I'm just giving this to you guys as a suggestion, a way to look at the business. We're at about $570 a square foot, based on our book value. Our book value is basically based on historical precedents in our appraisals. Where we are trading now? At $900 a foot, the stock would be worth $45 a share; at $1,000 a foot, it's $51; at $1,100, it's $57. So that's the leverage we have to the underlying market. But I would suggest that, as Jay so eloquently speaks about comparative property, plus 0.00 or minus 0.00, it's really missing the point. The real point is, what's downtown Toronto worth when you've got a high quality income, reasonable growth. And the U.S. treasuries are trading at 66x cash flow, the average risk-free rate around the world is probably 1%. So it's trading at a 100x cash flow. So the question is, if you want to own a significant part of downtown Toronto, what expected returns do you have? And I think that we put our money where our mouth is, and bought back in excess of 50 million shares from the company. I personally -- Dream Unlimited, have bought hundreds of million dollars of stock. And we don't think the company is overvalued, but we're totally open to you all deciding what you think it's worth. And now I'd be happy to answer questions.

[Operator Instructions] And from Canaccord, we have Mark Rothschild.

For 250 Dundas, and the project on Edmonton, can you maybe just give a little bit more color on the timing of actually getting -- going further on development and when you'd actually plan on being investing more material amounts of money in getting development going?

Great. We would say between 18 and 24 months, we'll get the site plan approval and get our drawings done, construction costs tendered, and we'll probably do some of the leasing on the office component. And we view that we'd probably start construction between 18 and 24 months. But until then, we're not going to spend a lot of money. On Edmonton, I've mentioned a few times that it's the Golden Mile study area. That means that the city is looking at how that land should be used. So it's not as if it's just our application, it's all part of how the city works on it. They're probably a year behind where they thought they would be, but I think we would expect that within 18 months or so, the overview of that area should be complete. We put an application in for our site. It will, obviously, be behind that, but we're hoping that we can get some work done with the city at the same time as they're doing the overall plan. So I would say we're probably 2.5 years away from starting there.

Okay. And with quite a bit of time before you're going to need to invest money in these products, with -- and with the enterprise where it is, is stock buyback something that would still potentially be considered? Or alternatively, are you seeing the opportunity to acquire properties in downtown Toronto?

Well, that's a great question. The first thing I would say is, we have not made any decision to stop buying back stock. We'll see what the stock does. We'll see how the company goes, but that's a potential use of cash. And I mean, we are looking at buying some properties. I don't think people realize how impossible it is to buy downtown Toronto properties at prices that we're comfortable with, unless there is something about the future or strategically how it fits with us, but -- I mean, we're currently looking at a number of properties.

From Desjardins, we have Michael Markidis.

Maybe just on the back of Mark's question on the stock buybacks and no real significant use of capital for the next couple of years. How do you marry the DRIP program with Dream Industrial and buying more stock there versus buying more Dream Office stock? How do you look at that?

I would say that for years, we've been saying that Dream Industrial isn't necessarily a strategic investment for us. Most of our shares are 0 cost base, which means every dollar proceed is taxable. The only time we participated in an equity issue was at $108.75. We thought that was a strategic one to get the stock going and turned out to -- and that worked out pretty well. I don't see us buying more of Dream Industrial. I mean, I think, we could sell some.

Yes. Just -- Mike, it's Jay. We did identify a number of uses for the cash over in a couple of years. There is, obviously, the Bay Street redevelopment program. We're finishing up with the construction at the 357 Bay, 1900 Sherwood. We're also looking at other opportunities, as Michael mentioned, within the core of the core to upgrade those assets as well. We're trying to stagger it, so we don't have a huge amount of construction ongoing at the same time. The Dream Industrial units, it provided a pretty good return. Over the last couple of years, one of the best performers, and it's really nice, without the need for cash, they are providing a pretty good CapEx for yield from our perspective. But there are some units that we have -- that we've been collecting through the DRIP that any time if we need the cash, we could sell just a little bit in a pinch. So there is a lot of flexibility there, and we're pretty excited with what they're doing with their business.

Okay. I appreciate that. My question wasn't so much on the -- what the long-term intentions were. I was just looking -- I think you guys are still subscribed on -- it's 100% on the DRIP, correct, on DIRs?

Yes.

Right. So I guess just given Mark's question on the Dream Office, NCIB and re-upping on DIR through the DRIP? Just curious how you balance those two?

Oh. To be blunt about it, we went into the DRIP to support DIR so that they had more cash. And we say it on the DRIP, we're happy to, we get it at a discount. But whether -- I mean, I would just say it's an arbitrage. We're getting a premium to the market value, and we don't need the cash. But those shares, as Jay was saying, we'd be happy to sell them. But I don't see any reason why we'd come out of the DRIP. It's kind of a -- it's an easy way to get a bonus, and then we can either keep the stock or sell the stock, it's up to us.

Okay, fair. Just, Jay, on the 250 Dundas. Maybe if you could just walk us through your valuation of that asset at December 31 and how that's treated and now that you've got a conditional zoning, how you'll be looking to evaluate that, either at the end of Q1 or subsequent to that as the condition on the zoning approvals are lifted?

Sure. As most of you know, we got zoning on January, I believe, 21st. So as of year-end, it was recorded on our books as a income properties as that was the highest and best use at the time. We're actually working through both our underwriting and sort of a long-term development as well as engaging a third-party appraiser to value the property. So by our Q1 results, we'll have a couple of data points to use to derive the fair value of the assets with additional density and the development potential.

Okay, got it. And then if I just -- one more question for me, please. On Birchman Eglinton, I just noticed that you guys moved it from held for development to other. So I guess, clearly, it's not a downtown Toronto asset, but does the re-class to other and from future property held for development, does that alter or signal anything with respect to your desire to be a participant in the development long term? I mean it seems like you're pretty bullish, but just curious on the re-class.

Okay. So let me just say, it has nothing really to do with that. Just as you recall, earlier in last year, we had a couple of different segments. We had Ottawa and Montréal, so there's no buildings there. We had North York and Mississauga, so we have half a building left. And given that all of the rest of the assets can be summarized fairly quickly by Michael, and also it's only 17%, we just figure for simplicity of our disclosures and reporting and how we look at the business, it's really downtown Toronto and then we have the other markets. So that was really the intent of it, to simplify the disclosures. Longer term, like we expect to develop on the site. We could do it in phases or all in one, but it doesn't really have anything to do with the disclosure. .

Got it. And okay, before I turn it back, I just say the simplicity of your business and disclosures is a really beautiful thing from our perspective.

Thank you. Appreciate it.

From BMO Capital Markets, we have Jenny Ma.

So Michael, going to your comments about the value of the stock and looking at it from a per square foot basis, how do you reconcile that with the book value that is being carried at? And then maybe talk about what needs to happen, at least, from an IFRS standpoint, to really see a material change in the way you look at it? Is it cap rates and market transactions? Is it just NOI growth? Maybe expand on how you reconcile those 2 numbers.

I'd start with I don't need any reconciliation. So I don't spend any time on it. I think that the way that IFRS numbers are calculated are historic and institutionalized, and we have a process, and it is what it is. Then there is a portion that I believe -- which is that the value of high-quality things have changed dramatically from what they were, and they're not reflected, but Jay probably has a more technical answer.

Thanks, Michael. I agree with Michael, but we do reconcile it. That's part of my job

That's your job.

I'd like to say -- like -- in the year, 44% of our assets were externally appraised, whether for financing or valuation purposes. So we have to use those data points for the audit in our quarterly statements. The rest of it, we're pretty transparent in how the assets are valued, most of them would be under the direct cap methodology. And then the assumptions I use are -- once again, are disclosed, and they are at market, actually, if we look at the brokerage reports. So some of those assumptions, yes, it is just basically a reflection point of where things are at in terms of the discount rate, the cap rate and the market rent, but over time, as rents do go up, the values will go up. I think it's tough to reconcile it versus the price per square foot today.

Okay. Yes, that's fair. And then going on to some of your downtown Toronto properties, I mean the occupancy is pretty high, but there is a handful of buildings where it looks like there is some room to be had. Is that related to just leasing friction? Or is that related to the -- some of the redevelopment you're doing along the Bay Street corridor? And when should we see those gaps close?

That's a great question. I don't believe there is any space that we have that we couldn't lease if we wanted to. What we decided to do is maybe hold some space off until the adjoining space is available. There is a number of spaces where we think if we combine locations, we could do much better over the long term. So I think that pretty much every vacancy is strategic.

Okay. So I know you said same property NOI growth this year from downtown Toronto will be driven by rent growth. So is this occupancy lift sort of a 2021 event then, after you're done with the work you're doing on Bay Street?

Some of them may actually carry out longer-term after this year. But just on that, you look at the expiry table in the MD&A, less than 5% of the properties roll in 2020. So the pickup is not going to be that high this year, but rents are continuing to go up, and these strategic vacates are actually tied to other spaces that are coming up and most of them are on the ground floor or the retail section in downtown Toronto. So we have bigger plans for those longer term.

Okay. And then it looks like you've made a very good leasing progress on 2021 so early in the year. Just wanted to get some insight on whether or not that's being driven by tenants who are very keen on keeping their space. Is it just -- you guys are either taking what's known right now and rolling over the tenants? Who's really driving the renewal of the leasing and the timing?

So it's Gord Wadley speaking. That's a great question. It's a lot of people wanting to get ahead of the curve. Rates are growing at such a high rate. We've done some government deals. We've done a number of private sector deals along Bay Street for the people that really covet the value that Michael was talking about and seeing what we're doing with the buildings. So we've been able to lock in a lot of deals earlier. And then predominantly, it's just people trying to retain their space. We're seeing a lot of 1.5 years early blend and extends. And it's been positive over the course of the last couple of quarters.

Yes. Just to jump in 2021, there is a tenant -- a large tenant to exercise a renewal option. It's the last one, that one is at flat. The rest of the ones that we're doing are at market or above.

Okay. So is it fair to say then for the downtown Toronto tenants that having access and being able to commit space is more important than the pricing of the space?

I would say, yes. Being able to have a well-located address in downtown core of Toronto is driving a lot of these early decisions, and they're not as price sensitive.

And are they renewing for 5-, 10-year terms to try to max that out? And how are you guys balancing that with getting...

You just want to hear Gordon speak.

So they are obviously trying to max out the terms if they can. We're looking at -- we're being a lot more pragmatic in how we're approaching these leases. We're looking at shorter terms on some for full floors because we really think we can -- at the rate that the market is growing right now, we really think, over the course of the next 2, 3, 5 years, we can capitalize. And we've seen such a positive change on renewing tenants, Bay street collection expiring at $21, and seeing an average growth in the net rent up to about $40. So it's -- we don't -- well, it's not saying that we don't want to do 10-year deals, but we want to be more thoughtful on the deals that we're locking in.