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

Good morning, ladies and gentlemen. Welcome to the Dream Residential REIT Fourth Quarter Conference Call for Thursday, February 16, 2023. 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 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. Later in the presentation, we will have a question-and-answer session. [Operator Instructions] Your host for today will be Ms. Jane Gavan, CEO of Dream Residential REIT. Ms. Gavan, please go ahead.

Thank you, operator, and good morning, everyone. Welcome to the fourth quarter and year-end conference call for Dream Residential REIT. Since we launched the REIT last May, we've been very focused on delivering the results we forecast in our IPO, in other words, doing what we said. We're pleased to report another quarter of strong results, growing rents, solid occupancy, good progress on our value-add program and the launch of our NCIB. Our assets and communities are proving to be resilient stores of value and choppy economic times. We remain very focused on disciplined capital allocation to drive returns and NAV growth. But it's a combination of allocation and execution that really are the story for DRR for 2022 and going forward for '23. No doubt, you have to buy well, but you also have to have strong operations, and those are demonstrated in DRR. We bought good assets with embedded upside, and we're running the real estate to maximum effect. Looking at 2023, we'll continue to watch the market for opportunities to add to our portfolio, but only on terms that make the REIT better. So far, activity in the investment market remains cautious. We have yet to see the distress some predicted, and we've not seen volumes that lead to price discovery. We continue to keep our eyes open and underwrite for those properties that are accretive and where we can add value. We're well positioned to do that with our deep knowledge of markets, relationships and a conservative balance sheet. In the meantime, we continue to invest in the properties we already own and where the returns are demonstrably compelling. With that, I'm going to turn it over to Scott and Derrick to give you more color on our real estate and our results. Scott?

Thank you, Jane. Globally, 2022 consisted of volatile capital markets, heightened inflation and uncharacteristic uncertainty. However, Dream Residential REIT apartment operations remain resilient. Our strong submarkets, quality assets and tightly net communities sustain high occupancy and predictable cash flows, providing for safety and values and safety and distributions. Accompanying that safety, DRR's vertically integrated operating and in-house construction teams provide for continuous value creation and organic growth that outperforms national and regional benchmarks. While nationally indexed apartment rents and physical occupancy both declined month-over-month through the fourth quarter. In contrast, DRR rents increased 60 basis points each month in the fourth quarter and advanced occupancy nearly 2 percentage points. Occupancy climbed from 93.7% at the end of September, up to 95.5% at the end of December while still drafting a limited number of suites offline to construct interior renovations. Q4 net operating income grew to $5.7 million, improving 3.7% higher than Q3 and maintaining the growth path set within the IPO forecast. Operating expenses, excluding the impact of IFRIC 21 increased 3% from Q3 due to infrequent overages on contract labor and marketing to ensure that higher suite readiness and occupancy were prepared in the face of economic uncertainties. But the NOI margin held steady, the result of 3.4% quarter-over-quarter revenue growth, driving to better-than-forecast investment property revenue of $11.4 million. DRR's above the line growth is being sustained by seasonally adjusted best-in-class lease trade-outs and our high-margin value-add renovation program. DRR's Cincinnati Hub led new leasing activity, registering 10.5% increases on new leases and DRR's Oklahoma Hub led renewal activity also registering double-digit spreads of 10.4% on renewal leases. Those data points in Cincinnati and Oklahoma do not yet reflect benefit from the value-add program because renovations have not begun in Cincinnati and do not yet influence renewals in Oklahoma. Those organic trade-outs during the seasonally slower fourth quarter are strong indicators of the resilience across DRR's portfolio. When combined with our Dallas region, DRR blended lease trade-outs finished Q4 at positive 8.7% with a 55% renewal rate for calendar year 2022. During the third quarter call, we explained that interior suite renovations would deliberately slow through the fourth quarter, in line with typical seasonality and that construction would pick back up in 2023 timed with the spring leasing season. That is precisely how we executed with 117 suites completing in Q3 and 85 renovations completing during Q4. In total, DRR upgraded 226 suites in 2022 across 7 communities in 2 markets. Since IPO, the value-add rent premium per suite has averaged positive $322, 32% more than the preceding lease. Compared to same-property non-renovated lease-to-lease increases of 15% and $149, our renovated suites are earning a premium 17 percentage points higher than [ classics ]. With returns on invested capital well within our underwriting band of 12% to 16% and renovation lease trade-outs beating 30%, we plan to invest $7 million to $7.5 million to renovate 400 more suites in 2023. Finishing the year with rents of $1,079 per month and $1.22 per square foot, DRR in-place rents rose 1.8% during Q4 and 12.5% since December 31, 2021. This growth was nearly double with the broader markets reported for the year. Our Dallas and Oklahoma communities grew rents 12.7% and Cincinnati rents grew 12.1% without a value-add program yet underway. Q1 like Q4 is historically a slower leasing period. However, early lease trade-outs are showing signs of rebound off the seasonal December deceleration. Interestingly, in Q4, rents in 85 of the 100 largest U.S. cities decreased month-over-month. It is interesting to highlight that of the few cities which did not experience rent decreases each month during Q4, Cincinnati and Oklahoma City were 2 of only 15 nationwide. We foresee sustained performance in Cincinnati and value-add continuing to pull up DRR performance in Oklahoma and Texas, well over and above national and same market indexed data. Our NOI outlook for 2023 is forecast to be in a range from high $23 million range, up to mid $24 million. We are also pleased to share our progress on the sustainability front. Many of you know DRR submitted for a pre-IPO Sustainalytics ESG assessment last year and our resolve to integrate practical and responsible practices into our business fabric continues. We conducted initial energy audits across all communities in 2022 and have budgeted small-scale early-stage efficiency projects beginning in 2023. Physical improvements that reduce emissions, increase efficiency and provide accretive returns on investment. DRR is now an official supporter of the task force on climate-related financial disclosures or TCFD. We have the conviction that inclusive stewardship of our people and residents accompanied by sustainable improvements across our real estate are important themes interwoven into successful operations and growth of business. Transaction volume is still slow. Sellers and buyers are noncommittal and indecisive. The ask-bid spread remains wide. Nominal cap rates and transaction cap rates do not align and are widely varied within local and asset-by-asset circumstances. But we like our markets. We like our assets. The housing fundamentals and economic forecasts point to enduring demand for middle of the middle apartment living. Now I'm pleased to turn things over to Derrick Lau, our Chief Financial Officer.

Thank you, Scott, and good morning. Overall financial results for the fourth quarter of 2022 were consistent with management's expectations. Diluted funds from operations was $0.16 per unit and in line with our IPO forecast. Net operating income and NOI margin were $5.7 million and 50.1%, respectively. This compared to the IPO forecast of $5.8 million and 51.7%. Operating revenue of $11.4 million was approximately $200,000 higher than forecast. Operating expenses, excluding the impact of IFRIC 21 were $5.7 million compared to the IPO forecast of $5.4 million. IFRIC 21 is an IFRS accounting standard that requires us to expense property tax bill as received rather than accrue over time. G&A was $789,000 were slightly over forecast and largely attributed to higher professional fees and nonrecurring costs related to staff placements. Interest and other income of $82,000 was driven by higher interest rates on cash balances. IFRS NAV at December 31, 2022 is $14.50 per unit compared to $14.58 in the prior quarter. The IFRS value of our properties is $418.2 million, representing a 1% increase from prior quarter and reflects $1.9 million of building improvements and $1.8 million of fair value gains. This was offset by a decrease in cash largely due to property tax bills received and paid in the fourth quarter. Net debt to net total assets was 29.7%, which is all fixed rate debt. At the end of the quarter, we had approximately $82 million in liquidity, comprising approximately $12 million of cash on hand and full availability of our credit facility. We intend to take advantage of the dip in the 10-year U.S. Treasury earlier this year through the refinancing of our existing $11 million mortgage at Oak Place. The existing mortgage is scheduled to mature in July 2025 and currently bears interest at a face rate of 4.44% with principal amortization beginning in August. The new 10-year mortgage is interest only and is expected to generate gross proceeds of approximately $14.4 million. The mortgage is expected to commence at the beginning of March at a fixed rate of 4.88%. On an effective rate basis, including amortization of deferred financing charges and mark-to-market, the effective interest rate would increase slightly by approximately 15 bps. We're pleased that following this refinancing, our overall weighted average term to maturity will extend to approximately 6 years, and our overall face rate -- face interest rate is expected to be approximately 4%. In January, we commenced our NCIB given the gap between our stock price and the underlying value of our units. We believe that the NCIB provides an additional capital allocation tool, which we will use opportunistically in conjunction with our value-add program to drive unitholder value. We have purchased and cancelled approximately 22,000 units to date at an average price of $8.20. Looking ahead, we're currently forecasting 2023 FFO per unit to be in the high $0.60 to $0.70 range, excluding acquisitions at our current total unit count and including the Oak Place refinancing. Thank you. I will now turn it back to Jane.

Thank you. Operator, let's open the line for questions.

[Operator Instructions] We have our first question from Sairam Srinivas with Cormark.

Scott, Jane as well as Derrick, thank you for your comments this morning. My first question is on occupancy. Obviously, in Q4, the REIT has seen good gains in terms of increasing occupancy. But going forward, where do you see the occupancy stabilizing for the portfolio? And secondly, how does the REIT think about balancing occupancy as well as rent growth?

Sai, recall that with our value-add program that we're going to drive occupancy in order to optimize operations, but also to optimize our value-add program. In Q4, with typical seasonal slowdowns, we drove down the number of suites that we drafted in to the value-add program. And as a result, we increased occupancy up into the high 95% range. As we move forward, we'll see that fluctuation with seasonality. We're drafting suites into the value-add program for the spring right now that are under construction. So we'll see that occupancy drive down or the vacancy increase as we fill that value-add program up in Q1. I would expect it to be in the 94% range in general in Q1 and Q2 as we ramp up the value-add program. The rent growth question that you had, we saw rent growth decelerate in Q4, in line with seasonal expectations. And I think we're seeing all indications that seasonality is driving most of the trends right now at our communities.

Thanks for that, Scott. And just looking at the IFRS cap rate, I think there's a slight expansion this quarter. Is that something that you're doing based on what you're seeing transactions come in at or is that more of a [indiscernible]?

The increase in cap rates -- the increase in cap rates is based on limited transaction activity. But Sai, as you know, we valued 5 properties totaling $170 million, and we marked our assets and cap rates to those valuations. So we have external valuation and support with that.

We have our next question from Himanshu Gupta with Scotiabank.

So I think you mentioned NOI expectation of high $23 million to mid $24 million in 2023. So just wondering what kind of rent growth is baked in this estimate? And are you doing any occupancy gains here?

The -- we see -- and I didn't quite hear your question, Himanshu, but the rent growth -- the NOI growth is roughly 10% same-property NOI growth, 2023 over 2022.

Okay. Yes. No, thank you. So I'll repeat my question. My question was what kind of rent growth or occupancy gains are you baking into your NOI estimate. But I think since you answered is around 10% same-store NOI growth. Are you doing any NOI margin expansion also or is it mostly occupancy or rent-driven only?

We do see NOI margin expansion over the course of the year, largely as a result of the value-add program taking effect. As you recall, we've been -- in the IPO forecast, there is not a whole lot of gain from the value-add program, but we would expect to see the benefits from the value-add program begin to have an ever-increasing impact on operations over the course of 2023, and that's reflected in our NOI increases over the course of the year.

Got it. That's helpful. And then my last question would be on the balance sheet. If I look, leverage is still low, relatively low. Is there an opportunity to lever up and take advantage of some current pricing or -- and do some acquisitions here? Any thoughts?

Himanshu, it's Derrick. I think we're comfortable where the balance sheet is. It is conservative. We are below our target range. I think if we were to see the right opportunity, we would not hesitate to bring that leverage up. I don't think in the current environment, we bring it significantly higher, but maybe to the low to mid end of our targeted range. So I think we need to find the right opportunity. And yes, if it's there, we would be willing to increase leverage temporarily to pursue that opportunity.

Got it. And maybe just a follow-up, Jane, I think you mentioned in your prepared remarks that you're yet to see any distress in the market. So are the asset value still closer to, let's say, a year or 2 years back or values have come down, say, 10%, 15% from the peak, what are you seeing in the market?

Well, I'll comment and then Scott can jump in. I think what I'm saying is I think people have anticipated with rates rising, there would be vendors who had to sell. We haven't seen that have to sell. We've seen some folks pruning selectively like 1 or 2 assets, but it's not reflected in the pricing. And in fact, for good assets, they're still trading well. So we're patient. We're waiting to see where we can execute on an asset that is accretive, that adds to value. But we just haven't seen it in the market yet where, oh my gosh, that's a screaming opportunity. As Derrick said, we're prepared to use some debt to execute, but it has to be a compelling opportunity, and they just haven't been out there. I don't think there's enough transactions. We haven't seen enough transactions to really have price discovery. Scott, what do you think?

Thanks, Jane. And I would just add a little context to that. So 2022 transaction volume was down 20% year-over-year. But in Q4, it was down 70% year-over-year. So another way to frame that is listed deals were in, say, January of last year might have been [ 40 or 50 ] in a particular market and now it's single digits. So the volume of transactions is down, the volume of deals that are -- that groups are capable of looking at is way down. And so we're going to be very selective. The good opportunities that are out there, Himanshu, it's interesting to note that there are -- there is a lot of capital chasing a very few properties when there is a strong asset out there. So it's still very competitive for the few assets that might be hitting the market. So we're being very selective. We're being patient and cautious. But this week, we have people in all 3 of our markets looking at opportunities. So we're very active looking and underwriting. But to Jane's point, we are not yet seeing compelling things to act on.

We have our next question from Jonathan Kelcher with TD Securities.

Just sticking with the acquisition being here. Do you guys expect or does the market expect, I guess, acquisition opportunities or volumes to pick up as the year progresses?

We're smiling at each other because we ended the year pretty glum. And then it started to look like the market was freeing up and interest rates were going to settle and the Fed was not going to raise interest rates, and there was some optimism in the market. And then over the last week or so, it felt a bit stressed again. So it's really hard to say. I mean, I wish we could say, oh, yes, with a lot of confidence, we think the market is going to x. But I think we're still in a wait and see mode. I think the market is too. I think people are waiting on their asset saying, oh, I'm going to bring it up, no, I'm not going to bring it up.

I think that's a great characterization. Jonathan, last week was the National Multifamily Housing Conference -- I'm sorry, 2 weeks ago, that's a pretty traditional time of a lot of assets hitting the market and a lot of excitement. And that excitement feeling was there for a few days. And then some of the economic data was glum again. So I think sellers are hit and miss and they're indecisive, and I think we're seeing the same thing on the buying end as the bid-ask spread is still there and that uncertainty is not shrinking that. I think it's probably a smaller gap than it was 90 days ago, but it is still there and it's still significant.

Okay. And then how -- when you guys are looking at opportunities, how do you look at your cost of capital right now?

I think, well, in [ value-added customer ], so there's obviously a going cap rate -- sorry, I'll come close to the mic. We look at it basically from the cost of -- well, we have cash on hand and we would have our credit facility. So we have to -- I'm looking at it from a perspective of debt. So we want to balance the cap rates that we acquire on, and we want it to be a healthy spread relative to the debt we're placing on it.

Okay. Fair enough. And then just switching gears. On the value-add program, when do you think the Cincinnati goes into that program?

Well, I appreciate that transition on the cost of capital. The cost of capital is pretty appealing on the value-add program when we can invest the money we're investing for those returns in the 12% to 16% range and those 30% lease trade-outs. So that's a favorable investment and allocation of capital that we'll continue to do as we watch the acquisition market as well. Cincinnati, we will not launch Cincinnati in 2023. What I will say is this. Our significant initiative in 2023 is to bring more of the sub-trades in-house. What I mean by that is we are hiring more of our -- more of the people that do work in each of the suites on to our internal team, and that is really creating some cost-effective savings for us as we ramp that program up. So we like the regions we're in right now. We're going to continue to make our value-add program more efficient in Oklahoma and Dallas. We will open up the Cincinnati region when we feel like we're ready to grow that team, and that's dependent upon our labor force that we can put into place.

Okay. So it's more a function of, I guess, for lack of a better word, capability for you guys to do it in Cincinnati versus the market not there for it?

The market is there for it. It's more about selectability rather than capability. With the economy where it is and still a tight labor force, it wouldn't necessarily be the wisest move to go launch into a brand-new market right now when we can continue to get more efficient and more successful in our existing markets.

We have our next question...

And just...

So sorry.

One thing I just want to reiterate, we finished 2022 with 226 renovated suites. We'll just about double that with 400-plus suites in 2023. So we feel like that's a responsible allocation for -- of the capital that we have right now.

Our next question is from Brad Sturges with Raymond James.

Just to continue on the lines of questions around acquisitions. As opportunity arise, would -- do you foresee still better opportunities within the value-add segment or does your strategy shift a bit, given you have quite a bit of value-added exposure within the portfolio already?

I think you take the market as it comes. Right now, the best allocation of capital is in the assets we know. So that's going to be the value-add program, and we're well allocated there. I think we're -- you've heard Scott say we're in the market. We're looking for opportunities. And if something is really compelling and gives us the returns we need the NAV growth and the FFO growth, we'll pursue it.

And if you find something really compelling, how much capacity do you have on the balance sheet or would be willing to deploy into incremental acquisitions at this stage?

I think -- Brad, getting us to our target leverage, we probably have around $60 million of dry powder to pursue an acquisition.

Okay. Okay. And then just last question, just back to the guidance on NOI there. You suggest that there is some potential margin expansion on the NOI. Just curious of how much margin expansion could there be just given the type of rent growth you're getting right now?

We're going to see the NOI margin go from 50% up towards 51% over the course of the year.

We have our next question from Matt Kornack with National Bank Financial.

Just quickly a bit more on the cadence of the value-add and the associated vacancy. So I guess, you end the year with about 150 units vacant. I don't know if all of those are -- well, I guess some of those are not going to be ultimately in the value-add program. But how do you get to the 400 suites? And is it sort of Q1, Q2, where you'd take it down and then we'd expect leasing in Q3 and Q4 to get back up into kind of the mid-90s or -- yes, if you could give a little bit more color, I guess, it's opportunity driven as well in terms of the turnover be a pretty high turnover?

Matt, I like your word cadence. That's exactly what we overlay through the course of the year. So to get to 400 suites, I'll use the term draft. We draft suites in, in Q1 and Q2. We execute on those suites broadly speaking, in Q2 and Q3 during the high seasonal leasing period. That's the optimum flow. We will keep the value-add program going throughout the entire year, but the cadence surges towards the end of Q1 through the end of Q3 in terms of drafting suites in and leasing those up. But -- so if you were to look at it on a graph, the bell curve would increase from the end of Q1 through Q3, and you would see occupancy vacancy increase in concert with that value-add draft.

Okay. And so I guess, economic occupancy for the average period in Q1 because maybe you don't do it in January, February, may not be as impacted, but you'll see the most acute vacancy impact in Q2 from an economic and total basis and then it gets better from there. And similarly, rent growth wise, I mean you had a pretty strong 9% new leasing spread, notwithstanding obviously some seasonality. It's -- it was better than what we've seen in some of the other guys. Do you have a sense as to how much of that would have been driven by the value-add program versus what you would be getting on sort of normal new leasing spreads?

Well, I think one way to characterize that might be, if you look at across the broader Sunbelt markets, for other groups, their renewal spreads were higher than their new lease spreads by a substantial margin. And the blended rate was therefore below a renewal spread. In our case, the new lease spreads remain on par with or better than the renewal spreads, and that's a result -- a direct result of the value-add program right now.

Okay. Yes. I think we saw sort of like 2% to 5% new leasing spreads versus your 9%, but the renewals were kind of consistent you versus the rest of your peer group. Okay. So that's fair enough. And then just the last one on the refinancing, Derrick, I may have missed it, but -- so there's some incremental capital that you're going to get out of that refinancing. Is all of that sort of destined for the value-add program, because I think you already have cash available or I guess you also have an NCIB outstanding, so would some of it go to the NCIB? Just thoughts there.

Matt, I think you got it. We will continue to use the NCIB opportunistically and remaining amounts would be allocated towards the value-add program. So it's about $3 million-ish of net proceeds.

[Operator Instructions] We have our next question from Jimmy Shan with RBC Capital Markets.

Just a quick one for me. I just wanted to confirm the -- so the higher new lease spreads relative to peers, that is not -- that is a function of the value-add work, right? Because I heard both. It is because of some of the value that you've done that's [ caused a bit ] higher or is it -- or is it those 2 markets having seen rents not drop in Q4 that's caused that?

It's a function of 2 things, value-add and several of our markets still performing above the national benchmarks. You've seen the Sunbelt, new leases across the Sunbelt had a difficult Q4 in general. Our portfolio did not reflect that. Our new leases were strong in all 3 markets. And in Oklahoma and in Texas, they were further strengthened by the value-add program.

Yes. Makes sense. And then in Cincinnati, I'm reading there's a decent amount of deliveries in 2023. Would that at all impact your assets in terms of -- in terms of the location of those new suppliers or is it just that the gap is too wide to new assets that you really have no impact?

Twofold. The first thing is the location and deliveries is primarily in the Central Business District by the river where the down -- where downtown Cincinnati is. And on the south side and across the border in Kentucky, where the Amazon logistics facilities is expanding. There's quite a bit of new pipeline there. There is some new pipeline just to the north of us, meaning just a few miles that is Class A luxury that's probably $700 more rent per suite per month than our middle of the middle. What is interesting also is that West Chester, Ohio, about 5 miles -- 3 to 5 miles north of where a number of our assets are is the #2 in-migration county in the -- in 2022, I believe -- I'm sorry, it's on the list of the top 10 in the country for in-migration county. So it's a pretty healthy area, and it's a good balance of pipeline.

[Operator Instructions] Our next question is from David Chrystal. David Chrystal is with Echelon.

Scott, you had some commentary on year-to-date leasing spreads rebounding from December, I think was your wording. Should we read this as Q1 is kicking off above that 8.7% blended Q4 level or was there a dip in December even within Q4 and Q1 is kind of normalizing back to that 9% blended level?

December is historically the bottom of the Q4 seasonality. That was true for us and it's been historically consistent. And what we're seeing is a rebound from that December bottom, if you will. And that's, again, pretty traditional seasonality. So I think what you -- what is fair to read into it is that what we're seeing in Q4 and again in Q1 is typical seasonality.

Okay. So it sounds like it's not necessarily that Q1 is kicking off above 9%, but the kind of regular seasonality would imply that the rest of Q1 should get you there?

Correct.

Okay. And then just kind of shifting back to the value-add. I think you gave commentary that your expected spend for the year is $7 million, $7.5 million. On 400 suites, this implies a little over [ $17,000, $18,000 ] per suite. Is this kind of reflective of broader increase in cost? And then what kind of savings are you seeing from bringing trades in-house?

It is reflective of broader inflationary costs in the construction environment. The increase in cost per unit that we projected is not anywhere close to where actual construction inflation has occurred in terms of ground up, but it does reflect that increase. When we bring trades in-house, we can save -- we believe we can save anywhere from $500 to $1,000 per suite on average. We have a little bit of that blended into our projections for 2023, but we have not intentionally captured that yet. We're optimistic about what we're seeing right now. I think we're going to continue to pursue that because of the savings opportunity.

And we have no further questions in queue. I will now turn the call back over to Ms. Gavan for closing remarks.

Thank you, everybody, for attending our conference call. We appreciate your interest and your questions, and we look forward to reporting to you next quarter. Thanks very much.

And thank you. This concludes today's conference. We thank you for participating. You may now disconnect.