Dream Residential Real Estate Investment Trust (DRRUN) Earnings Call Transcript & Summary

Good morning, ladies and gentlemen. Welcome to the Dream Residential REIT second quarter conference call for Thursday, August 4, 2022. During this call, management of Dream Residential 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 Residential REIT's control that could cause actual results to differ materially from those that are disclosed in or implied by such forward-looking information. Additional information about these assumptions and risks and uncertainties is contained in Dream Residential's REIT's filings with securities regulators, including its MD&A. These filings are also available on Dream Residential REIT's website at www.dreamresidentialreit.ca. [Operator Instructions] Your host for today will be Ms. Jane Gavan, CEO of Dream Residential REIT. Ms. Gavan, Please go ahead.

Thank you, operator. Good morning, everybody. Welcome to Dream Residential's inaugural conference call following the launch of our business in early May. My name is Jane Gavan, and I'm the CEO of Dream Residential. With me today are Derrick Lau, Chief Financial Officer; and Scott Schoeman, Chief Operating Officer. We are very pleased to be here today reporting on the business. And while the public markets and macro environment have been challenging since May 6, the day we closed our IPO, our business is in good shape, with rents continuing to increase and demand for our units remaining strong. It is precisely this type of environment where the resiliency of the U.S. multi-residential market really can be appreciated, and we have as much conviction in our business as we did when we began the process of going public. At the current trading price, the cap rated portfolio is roughly 7.6% or $90,000 per door. That would be a 25% discount from the appraisal we had done in February when cap rates were still compressing. Interestingly, on this basis, the gap to replacement cost, which we estimate at $175,000 to $300,000 per door, is widening, making new supply even less likely. Our rents are growing as we projected in the forecast and the prospectus. Our net operating costs are slightly better than we forecast, resulting in stronger margins. Supplies muted and rising interest rates will likely depress that further. The corollary is the demand for rental living should remain strong, especially for our product, garden-style apartments, not towers, as home ownership has become that much more expensive with higher interest rates. That said, if market pricing for assets fall by the discount implied by our stock price, we're happy to be at the beginning of our company building. We'll buy assets and finance them in the same market with a focus on maintaining positive spreads. We're being disciplined right now, watching how the market develops over the next months. We're seeing that buyers in the U.S. multi-residential space are taking a pause. While U.S. multi-residential fundamentals are still strong, it's likely that some good buying opportunities shake out driven by interest rates. As well, some institutional buyers who have been active in the space are finding themselves overweight real estate as their stock portfolios have declined in value, and that may take some competition out of the market. In the meantime, we're happy running our business. Our value-add program is ramping up, and we're on track to complete anywhere from 150 to 200 units in 2022 with a full 12-month goal of over 300 units. These renovations are producing strong returns as we expected, somewhere in the 12% to 16% return on invested capital. And as a reminder, our forecast doesn't include our value-add program. With that, I'm going to turn it over to Scott to give you more color on the business, our markets and its performance.

Thank you. Echoing Jane, we are excited to be in business. U.S. multi-residential operations are demonstrating both strength and defensive resilience. Dream Residential's portfolio of garden-style middle-market communities is performing in line with expectations year-to-date, and we are well positioned to achieve projected performance over the forecast period beginning July 1 this year through June 30, 2023. NOI for the 7-week stub period was $3.5 million, $94,000 higher than our internal budget. This inaugural success was driven by revenue growth consistent with budget and operating expenses 4% better than anticipated. Our forecast has anticipated the effects of inflation, but nonetheless, we have seen certain savings, property taxes being 1 example. These cost savings resulted in a 52% NOI margin. This compares favorably to the 51% used in the forecast. Gross market rents and ancillary income continue to drive revenue, bolstered by persistently strong lease trade-outs and the resulting in-place rent growth. Q2 stub period new lease trade-outs saw a 21.4% increase equating to a $207 per month per suite lease increase. With 9.5% renewal trade-outs, the resulting blended trade-outs achieved 13.4% growth, outpacing the 12.2% blended rate from Q1. Our Dallas operating hub demonstrated the highest new lease growth at 23.6%, though Cincinnati led during portions of the year-to-date and finished Q2 at 22.2% increases on new leases. Our Oklahoma hub led renewals amongst the 3 regions with 11.4% trade-outs. These combined lease trade-outs caused portfolio in-place rents to grow 6.2% over the first half of the year ending Q2 at $1,018 per month per suite or $1.15 per square foot. DFW led the 3 regions in overall growth at 6.5%. Individual communities in Ohio and Oklahoma posted the top single property rent growth honors with 1 in each region hitting double digits during the first 6 months. Portfolio-wide, the gain-to-lease spread between in-place and asking rent finished at 7.6%. We're pleased to report that over half of the mark-to-market opportunity described in the January investor presentation has now been recaptured in only 5 months. Portfolio occupancy June 30 finished at 95%. I would like to highlight that this is not a slip in occupancy. It is a function of proactively managing occupancy to launch and source suites for our value-add program. The stabilized Ohio and Oklahoma assets maintained higher levels closer to 97% and 96%, respectively, whereas the Texas communities hovered near 93% following this introduction of our value-add program. In that program, our property teams manage vacancy to preemptively make suites available for our interior renovation and work. Those occupancy levels will elevate back as the program stabilizes and builds out. DR's capital investment programs are underway as planned. Our value-add renovation team launched on schedule in Dallas. As of June 30, the team expended $230,000 and completed 24 suite upgrades across the first 3 communities in DFW with another 12 suites under construction across all 4 Texas communities. Preliminary data supports unlevered returns on invested capital within the projected 12% to 16% range or better. We estimate deploying some $3 million more in this calendar year and plan to renovate more than 300 suites over the forecast period. Our overall capital programs are on track and consistent with our forecast, and management is evaluating incremental investments in ESG-related energy audits, and opportunistic washer-dryer value-add opportunities to drive revenue. Overall, resident demand and leasing activity remain strong. Concessions, commonly referred to as incentives, have trended down since January, measuring 0.006% of scheduled rent. This highlights the strength of Dream Residential markets and our assets. Early indications in Q3 point to lease trade-outs consistent with Q2 and rent growth sustaining increases around 1% per month. We will continue to monitor these trends through the coming months. We may cause occupancy to trend lower to facilitate our renovation program, which will result in rental revenue increases as well as OpEx and CapEx savings. We are laser focused this calendar year on establishing the high-return value-add program, stabilizing and scaling it across both Texas and Oklahoma regions. For-sale housing is near all-time high levels of unaffordability. Supply serving the middle market, middle income resident demographic is in structural scarcity. Development and construction are hampered by delays, cost overruns and poor policy. Our vertically integrated platform is fully operational and on plan to achieve double-digit NOI growth this year and in line for the forecast period, targeting just shy of $15 million in NOI by the end of this stub year and over $23 million in cumulative NOI to close the forecast period mid-2023. We anticipate that the transactional market may begin to experience some stability later this year into early next year. We are analyzing those conditions regularly, waiting with discipline for the right timing to begin growing with accretive acquisitions. I will now turn it over to Derrick, who will provide the financial update.

Thank you, Scott. Financial results for the REIT's inaugural quarter were consistent with management's expectations. For the period between May 6 and June 30, 2022, diluted funds from operation was $0.09 per unit. NOI for the period was $3.5 million. G&A inclusive management fees was $584,000. G&A includes an incremental onetime noncash compensation expense totaling $112,000 related to deferred trust units. Interest expense on mortgage debt was $1.1 million. IFRS NAV at June 30 is $14.43 per unit. For the quarter, we marked the initial portfolio to the appraisal value of $410.3 million, resulting in a fair value gain of approximately $45 million. We've seen limited market comparables given decreased market activity, reducing observable data points to support a change to values and cap rates. As a result, we believe this appraisal is the best estimate of fair value at June 30, 2022. We ended the quarter with net debt to net total assets at 29% and below our target range of 35% to 45%. Given recent economic uncertainty and market volatility, we believe that it is prudent to continue to run the company in the near term at the low to midpoint of our target range. At June period, we had mortgages with a face value of $144 million at a contracted interest rate of 3.95% and a weighted average term to maturity of approximately 6 years. We currently have no exposure to variable debt, and our earliest debt maturity is in 2025. At the end of the quarter, we had approximately $86 million in liquidity, comprising $15.7 million of cash and full availability of our $70 million credit facility. Looking at the remainder of the year, we are well positioned to continue to execute on our strategic initiatives, including driving organic growth, expanding our value-add program and executing on focused capital deployment. We have balance sheet capacity and financial flexibility to pursue both internal and external growth initiatives. I will now turn it back to Jane.

Thanks, Derrick. Dream and Pauls, over their long history, has successfully managed through economic turbulence, GFCs, rising and falling interest rates, inflation, even a European debt crisis when we launched Dream Global. But like everything we do, we build with conviction with a view to the long term for years, not quarters. So we're excited about the prospects for Dream Residential as we get started, and we believe we've got great building blocks from which to grow and to deliver strong returns for our investors. So with that, I'd like to open the call to questions.

[Operator Instructions] We have a question from Lorne Kalmar from TD Securities.

Congrats on getting the first quarter under your belt. It looks like a pretty nice and in-line quarter. But I was wondering, there's been a lot of talk about maybe a deceleration in rents, and Dallas-Fort Worth seems to be in the headlines now and again. It looked like you guys did pretty well there. But I was wondering if you could maybe give us a little bit of color on what you're sort of seeing on that front.

Lorne, this is Scott. I have seen articles that talk about the acceleration in rents, and I've seen articles that speak to a deceleration of rents. What I would say is we are seeing consistently across Q1 and Q2, 1% rent growth per month, and we're not seeing that waiver at this point in time. There are no indications in a change of that other than what I'm reading in the media. But our data does not suggest anything -- seeing that just yet.

Okay. And then so you kind of covered off the occupancy drop in Dallas. With you guys starting the program now in Oklahoma City, do you anticipate a similar drop?

We will see our occupancy remain in that target range of 94% to 96%. I think we hit about the middle of that at 95% to wrap up Q2. And I think we'll see ourselves in that collective range. When we initiate in a market or at a property, as we've seen in Dallas, you'll see that open up a little bit by proactively making those suites available. And then if it stabilizes and that program matures over the asset for the next few months, then it will sort of reset towards 95% or so. So I think we'll stay in our range of 94% to 96%.

I would add though, Lorne, I mean, notwithstanding whatever we're doing on occupancy, it's intentional, and are -- we're pretty confident in our forecast.

Okay. And then on the renovations, I know costs kind of went pretty haywire, and I was wondering if you're seeing any sort of relief in terms of cost increases and how that maybe plays into the returns you're able to achieve on the program?

I would start with -- when you say costs went haywire, we didn't see that. I appreciate there's a lot, obviously, with inflation. But I think when we were together, I think one of the things Scott impressed was we had done significant buying. I mean, Scott, I don't know if you're seeing costs come down, but we didn't experience the boost. There was an availability gap for a little while, but we supplemented our inventory.

We have not seen costs escalate beyond what we've projected. In some cases, we've seen the supply chain improve. The appliances being an example. Not long ago, it was taking anywhere from 60 upwards to 90 days to preorder appliances. Now we're probably in the 45- to 60-day range. So that has improved. Our costs are in line with our forecast. And I think those have -- those -- that planning has accommodated where we expected the cost to settle out for the year.

Okay. So everything kind of going according to plan, if not a little bit better. So that's good. And then last one for me. Again, back to the headlines, but have you guys seen any increase in delinquencies in the recent months?

We've seen delinquencies in collections vary throughout from month-to-month from basically March 2020 through this year. And so we're monitoring these very closely as we have over the past 2 years, and we see ebbs and flows. We don't see any true trends or indicators right now, but we're monitoring that very closely as we have over the past 24 months.

The next question comes from Brad Sturges from Raymond James.

Just on the 8% gain to lease at quarter end there, can you break that down by market, what that would look like between Dallas, Oklahoma City and Cincinnati?

Brad, this is Scott. Sure. In Dallas, we saw about a 5% gain to lease present on June 30. And the gain to lease, as you recall, between asking and in-place is a snapshot in time. So in January 31, it was 12%. Now it's 7.6%, but it's a moving -- it's a moving target. But on the snapshot on June 30, it was 7.6% of the portfolio, about 5% in DFW, about 14% in Oklahoma City and about 1% in Cincinnati.

Okay. That's helpful. Just on the leasing spreads. Obviously, a pretty strong number in the partial period for Q2. Just how would that be trending in Q3? Are you still at similar rates? Or are you seeing a little bit of moderation on the spreads?

Our lease trade-outs starting in Q3 are trending very similar to Q2.

Okay. And just on the renovation program, obviously, you're just kind of getting ramped up here, Dallas, now rolling out to Oklahoma City. How should we think about that program ramp up in terms of the number of suites you renovate over the next few quarters? And where does that -- I assume that stabilizes out more in early '23 when you add Cincinnati to the mix. But just trying to get a little bit more understanding of how we should think about that program rollout.

We would anticipate completing 150 to 200 suites this -- through the remainder of this calendar year. And that is subject to some acceleration depending upon things. But we're pretty solidly in the 150 to 200, and we would expect to complete over 300 during -- total during the forecast period.

Okay. And then last question, just back on the occupancy. Obviously, you have a target range. It sounds like maybe you could be trending a little bit at the lower end of the range, short term, just for the ramp-up of the renovation program. Is that a fair assumption that you could be more 94%, 95% instead of 95%, 96%?

I would -- this is a little bit semantics, but I would change the vocabulary a little bit. I was -- it's not that they're trending. It's that we're actively managing occupancy. So we need to preemptively select suites to make them available. And when this kicks off at a particular community, we will introduce that over the first couple of months. And you'll see a proactive selection of suites which is managing occupancy to source that program. And then as that program ramps and that stabilizes out, that occupancy will sort of -- will allow that to elevate back up as we get stabilized in the process.

[Operator Instructions] The next question comes from Dean Wilkinson from CIBC.

Congratulations on the inaugural quarter.

Thank you.

This might be Derrick, might be Jane, might be Scott. Can you just clarify on the fair value adjustment? That was relative to -- was that -- that $45 million, that was relative to the discounted acquisition value, not the appraised value at the time of the IPO. Is that correct?

That's correct, Dean. So the increase reflects the change between the appraisal value and basically the acquisition cost.

Okay. So then the difference between...

[indiscernible]

Right. Okay. So then the difference between the sort of appraised value today relative to the IPO is a more incremental sort of 4-ish percent increase, which makes a whole lot more sense. Is that the same for the fair value adjustment on the Class B units?

So the fair value adjustment on the Class B units is, on acquisitions, those were marked at $13 consistent with the IPO price. And then the closing price of the units was $9.15 on June 30. So the change in that is the fair -- it was [indiscernible].

Difference between 13s -- yes.

Exactly.

Got it. Got it. And then just to clarify that one last point. The 200-or-so value-add programs, those are not in the forecast. So without sort of holding you into the -- to the wall, it would appear that if you add the 200 units, you add the rent at over $1,000 a month that maybe as we look forward the next 4 quarters there, the bias would be to the upside as to what was put in the FO fees?

I would -- thank you, Dean, this is Scott. I would just say that with value-add, it's much like a snowball that the benefit of the program only starts to show itself in the second, third, fourth year. So in this -- in the forecast, we don't show a benefit to that. We do hinder it. In some regards, we penalize ourselves in a positive way. I know that's the wrong term. We do include the vacancy loss in there, but we don't credit ourselves with the rent growth in the first year of the forecast. So we will see benefit from OpEx and CapEx savings, and we'll see vacancy as a result of the value-add program, but the real benefit begins to show itself in year 2 through 5.

As you roll over those rents. Okay. Yes, makes sense. That's all I had.

[Operator Instructions] At this moment, we have no further questions. I will turn the call over to Ms. Gavan for final remarks.

Well, thank you, everybody, for joining us this morning. We're very excited about our first call, and we look forward to speaking to you next quarter. Thanks very much.

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.