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

Welcome to the Dream Residential REIT Third Quarter 2023 Results Conference Call for Thursday, November 9, 2023. During this call, management 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 its control that could cause actual results to differ materially from those that are disclosed in or implied by such forward-looking information. Additional information is contained in Dream Residential REIT's filings with security regulators. These filings are also available on its website at www.dreamresidentialreit.ca. Your host for today will be Mr. Brian Pauls, Chief Executive Officer of Dream Residential REIT. Please go ahead, Mr. Pauls.

Good morning, everyone, and thank you for joining us today for Dream Residential REIT's Third Quarter 2023 Conference Call. Speaking with me today are Scott Schoeman, our Chief Operating Officer; and Derrick Lau, our Chief Financial Officer. We are pleased with the operational and financial results for the third quarter of 2023. Net operating income was $6.1 million, increasing 11.4% year-over-year. This was a significant driver to our FFO per unit of $0.18, which represents an 18.8% increase year-over-year. We remain on track to achieve our communicated NOI and FFO per unit guidance for the year. On the value-add program, we completed renovation work on 122 suites, and we remain on track to renovate 400 suites in 2023. The returns continued to be attractive, with a 23.5% renovation premium on these units in Q3. While we are seeing broader macro challenges, we remain optimistic on the long-term fundamentals in our markets. Our portfolio is defensive and geographically diverse. Our value-add renovations continue to be a differentiator, and we are well positioned for the current market volatility. In terms of capital allocation, we were limited on NCIB activity with a goal to preserve capital. We will continue to monitor overall market conditions. And while we view the NCIB as a valuable tool, we continue to prioritize maintaining a safe and flexible balance sheet. This, in conjunction with the strong liquidity position, will prove very valuable in this environment. We continued to assess asset recycling opportunities as well as private capital structures to further strengthen our ability to pursue compelling future opportunities. Looking ahead, we will remain prudent with our capital allocation as we continue to navigate the current conditions. I will now turn it over to Scott to provide an operations update for the quarter. Scott?

Thank you, Brian. Last quarter, we completed the first full year of operations in line with the original IPO forecast. Q3 2023 is our first reporting period that qualifies for a full comparative look at year-over-year public performance, and we continued to generate strong results. DRR ended this quarter consistent with management's expectations. Year-over-year, same-property revenue increased 8.9%, and same-property net operating income grew 11.4% during the third quarter, driven by strong organic performance in our Cincinnati regional communities and sustained value creation within our Sunbelt renovation program. Even as real estate conditions continued to change, demonstrated by interest rate rises and cap rate expansion across the sector, DRR's Q3 revenue and operating expenses were consistent with Q2 2023, absorbing the midyear nondiscretionary cost increases and delivering net operating income of $6.1 million. Q3 vacancy ticked up as planned due to the seasonal summer draft of interior suites into our value-add construction program. This shifted occupancy to 93.4% on September 30, 2023, mirroring the previous year's occupancy of 93.7%. Management is pleased to report that operating margins improved 120 basis points, up to 51.1% from 49.9% last year across the same quarter, also occurring during a value-add seasonal wave. The value-add program remains a distinguishing feature and strong part of our business operation. Our self-perform team completed renovation of 122 suites during Q3, 325 suites year-to-date and is on track to renovate 400 suites as guided for 2023. Year-to-date, upgraded apartments have commanded a 21.7% leasing premium, which is a $231 per month per suite increase in rent. Our construction team's disciplined cost controls and timely execution are driving returns on invested capital upwards of 19%, favorable compared with the going-in target range of 12% to 16%. DRR's market diversification adds to the strength and resilience of our performance. Each of our 3 operating regions outperformed the flat national rent benchmarks as well as their respective local market benchmarks. In-place rent across our Dallas-Fort Worth communities grew 2% in Q3 and 6.9% on the year. And Cincinnati led all regions with in-place rent growth of 2.9% for the quarter and 8.9% over the year. We are expecting lease trade outs and market rents to moderate in the fourth quarter, corresponding with seasonal trends, which emphasize occupancy and renewals during the winter leasing season. DRR NOI will finish the year within the mid- to upper band of our forecast range acquired to Texas property tax legislation adjustments, and we are finalizing renovation studies to refine our value creation business plan for 2024. As Bryan suggested, economic conditions and the supply pipeline are impacting the multifamily operating environment, but these pressures have significant nuance, varying widely from region to region, submarket to submarket and demographic to demographic. DRR assets are located in sturdy neighborhoods with a hardy resident base, safe from the turbulence experienced across the luxury segment and secure within the affordability spectrum of America's middle of the middle labor force. DRR will continue to deliver sustained, safe risk-adjusted returns by way of our diversified geographies, benchmark-beating operations and proven value creation. Looking forward, we anticipate that economic uncertainties and supply pressures will persist into 2024. We also anticipate that 2024 may present unique opportunities. We are actively exploring ways for DRR to capitalize on upcoming market conditions wherein distressed sponsors or discounted assets may present conditions for accretive acquisitions. We will focus on the fundamentals, be disciplined with capital and be opportunistic-minded during such a time as this. I will now turn things over to Derrick Lau, our Chief Financial Officer.

Thank you, Scott, and good morning. Financial results for the third quarter of 2023 were strong, with diluted funds from operations increasing nearly 19% year-over-year to $0.18 per unit. NOI for the quarter was $6.1 million, representing an 11.4% increase year-over-year. Operating revenue and operating expenses, excluding the impact of IFRIC 21, were $12 million and $5.8 million, respectively. G&A expenses were $890,000. This quarter's interest and other income includes $59,000 related to business interruption insurance proceeds. IFRS NAV at September 30, 2023, is $14.29 per unit compared to $14.85 in the prior quarter. The IFRS value of our properties is $414.8 million or a 2% decrease from the prior quarter. The change was due to $13.6 million of fair value losses and $1.2 million of insurance proceeds, partially offset by building improvements of $4.6 million. Our IFRS cap rate increased by 21 basis points quarter-over-quarter to 5.48%. Net debt-to-net total assets was 32% at September 30, 2023. All of our debt remains fixed rate with a weighted average term of 5.5 years and a weighted average contractual interest rate of 4%. At the end of the quarter, we had $76.9 million of liquidity, comprising approximately $6.9 million of cash and full availability of our credit facility. As Brian has noted, we believe that it is important to preserve capital while maintaining a safe balance sheet and liquidity in the current environment. The NCIB remains an important tool, and we intend on renewing later this year. Overall, we continue to expect 2023 FFO per unit to be in the $0.70 range prior to the impact of the Texas property tax legislature. We anticipate that this could represent between $100,000 and $200,000 of savings or approximately $0.09 per unit at the midpoint. I will now turn it back to Brian.

Thank you, Derrick. I would now like to open the call to questions.

[Operator Instructions] The first question is from Jonathan Kelcher from TD Cowen.

First question, Brian, I think you touched on it a little bit in your prepared remarks, talked about maybe working with some third-party capital. And I guess that ties into Scott's comments about seeing opportunities. Like are opportunities starting to present themselves from sponsors that are getting into, I guess, some sort of distress? And do you guys think you have a good chance of taking advantage of some of those?

Jonathan, it's a good question. We -- yes, the short answer is yes. We are seeing pockets of distress mainly from a financial structure standpoint, meaning that the properties themselves that we are viewing are fine, they're operating fine. But the capital structure is what's causing distress, meaning they have high floating rate debt, maybe not the ability to call capital. For example, a closed-end fund does not usually have the ability to recapitalize or to call capital. So that is causing some either for sales or some structural distress. We would like to be in a position to capitalize on that, maybe get properties at a lower basis than what we could, otherwise that may be coming because of the interest rate environment. So we have had discussions or we're interested in potentially teaming up with private capital to use our own balance sheet to capitalize on that. But that's -- it's very preliminary right now, Jonathan, but we're -- that is something we're looking at and in discussions on.

Okay. Is there -- I'm sure you guys aren't the only one seeing that with some capital available. Do you think there'll be a lot of competition for those type of assets where the financial structure is the main issue?

I think the competition is less certainly now. Yield expectations have gone up for private capital, and I think the market is less frothy for acquisitions. But some of these properties are -- it's not like a stock where they're available all the time, any day. So we're looking at properties that are within our target markets, that would be accretive for us, that would be significant for scale and value add and economies of scale reasons. So there is some competition, certainly, but we're in a unique position to capitalize on opportunities given our knowledge of these markets.

Okay. And then I think last quarter, you guys talked about targeting cap rates or stabilized yields in the 6.5% range, and obviously been a lot of volatility in interest rates since then. Can you maybe give us an update on that? And Derrick, maybe where you're seeing where you can get mortgage financing right now at what rates?

Sure, Jonathan. So as already said, interest rates have remained pretty volatile over the last quarter and into now. I'll start off with your last question. So today, we're seeing about 148 basis points spread for both 7- and 10-year money. So the availability is there. That's an interest rate of about, call it, low 6s. In terms of cap rate, I think the last time we were mentioning that going-in versus stabilized is where we differentiate and evaluate opportunities. So I think we have -- say 6.5% last time and probably be that or slightly higher now, 6.5%, 7%.

The next question is from Brad Sturges from Raymond James.

Just following on Jon's line of questions there. As you think about your capital today and your early stages, I guess, looking at this third-party capital opportunity, would it be fair to say though that the preference right now was maybe to preserve capital instead of pursuing any 100% owned acquisitions? Or would that be part of the strategy as well, depending on what opportunity became available?

Yes. Brad, we're -- obviously, we've got a very safe balance sheet. Our debt level is very low. We've got fixed rate debt. We've got term on that debt. We've got a very safe business, a low payout ratio, and we're proud of that and preserving that. We are looking at -- we could make acquisitions on balance sheet. We think a better strategy may be to JV and look at larger scale opportunities but keeping our debt within our target range and keeping our company and liquidity pretty safe. So all of those are factors when we're looking at opportunities, and we're pretty -- I would say we're keeping our discipline in anything that we would buy given the environment and given where we're at.

Okay. Makes sense. I guess switching to -- switching gears to, I guess, the leasing market, and your occupancy had dipped just given the renovation program, some of the seasonal patterns you expect. I think last year, you saw occupancy increased as the renovation program slowed down. Is that something you expect again this year? And where do you see occupancy trending at the end of the year?

Brad, we see occupancy paralleling last year's trend in very much the same way because it is driven by our draft of value-add suites, as you mentioned, Q2 and Q3 are our higher quarters of value-add renovation drafts. We just completed that in Q3 with 122 suites. We'll see that sweep count reduce in Q4. We'll sustain that at a lower level in Q4 and Q1. And the result of that is we will drive occupancy higher in Q4 and Q1.

Okay. Last question, just following on your comment around monitoring and leasing spreads in the end of the year. Is that more reflective of just being more stable -- new leasing spreads with a little bit better renewal spreads? Or how do you see that trend, I guess, in Q4 into Q1?

I think we'll see more of what you just mentioned there, is we're going to see more moderation on the new lease spreads. We're going to see continued strength in the retention. We're going to prioritize occupancy and renewals and retention during the winter season. And we're obviously living in the current operating environment, and it is reverted to the mean of how things have been more traditionally sustained over time. So we're going to prioritize those renewals in Q4, in the winter leasing season and prepare for the spring next year.

The next question is from Sairam Srinivas from Cormark Securities.

Most of my questions have actually already been answered, but I just have one. Considering that the renovation program hasn't yet been started in GCR, and that's a market that sees the normal amount of growth for your base. Is that something that you guys would consider in terms of investing capital there? Or is there no point of business right now?

This is Scott. We are underway right now in finalizing our renovation market studies. That would be every -- really enduring on a perpetual basis in our existing markets. But every year, we reevaluate our existing markets. So we're doing the same in Dallas, where we've obviously had consistent strong returns on our value-add program. We're also analyzing both the Cincinnati operating hub and our Oklahoma operating hub. And when we report in February, we'll have -- we'll lay out the plan for 2024. But yes, we're looking at all 3 markets.

That makes sense. And just looking at your markets right now, are there any signs of concern in terms of any potential -- we see new leasing spreads coming down as such, and here you find that is probably going to be a little lower heading in '24. But are there any signs in any of the markets we are seeing some bit of further slowdown even in renewals?

Sorry, could you just repeat the last piece? Are we seeing any markets that are...

Yes. I mean just going back to comments as [ new links ] have kind of slowly slowed down on quarter-over-quarter basis. As we head to 24, are you seeing any concerns in any of your markets with respective to even the renewals? And what's the churn environment over there?

Thank you. This is Scott again. A couple of things I would highlight. I think what I understand the question to be is are we seeing challenges in the markets or renewals for next year. What I would say is this, there's an interesting piece of data that Fannie Mae, who is an agency public private lender for many of the multifamily assets in the United States. Fannie Mae put out data from June of 2022 to June of 2023, which is net population migration. And in all of our markets, Cincinnati, Dallas and Oklahoma City, inclusive of the submarkets, they are all seeing positive net migration from the Fannie Mae data. And we're seeing the negative net migration from the areas we've always seen that. So the same trends that enabled us to select our markets are continuing to reinforce our markets. So we are very confident in the affordability, the attractiveness of our properties and our submarkets. And we see that sustaining and weathering whatever 2024 may have because the long-term fundamentals remain in place.

The next question is from Kyle Stanley from Desjardins.

Just going back to the pockets of distressed opportunities you might be seeing. Do you think you'd likely see more in terms of existing income-producing assets or more on the kind of recently developed or projects currently in development that need to go through lease-up? And I guess, where would your preference be in terms of target?

Yes. Thanks, Kyle. We are seeing, as I mentioned, it's more capital structural distress. Certainly, we are seeing challenges in merchant developers coming off construction loans, having to refinance and potentially having to come up with a lot of capital to to -- or more equity to get long-term financing. We are basically looking to add properties that are accretive in terms of quality and return. So higher quality than the mean of our portfolio, we're constantly trying to upgrade quality. If we look at recycling, we're looking at getting out of things that are lower than our mean quality and adding things that are above that. So when we look at opportunities and analyze new acquisition opportunities, we're looking at quality of market, quality of product, quality of location, all of those things. I would say the income properties are more prevalent just because they're more of them. But certainly, there could be distress in new build, merchant build kind of areas. But replacement costs are very high. And so the cost of those properties could be significantly higher per unit.

Okay. And I guess as you're looking at the markets where you're targeting some of these potentially distressed opportunities and looking at the JV, would you be targeting your existing markets for this kind of structured transaction? Or would you be looking at some of the other target markets, the Carolinas and Mountain West that maybe you highlighted initially around IPO as future growth markets for the REIT?

Both, both. Those target markets remain our targets for long-term growth. We would obviously love to expand within our current markets. We're seeing maybe some opportunities there, but we're also looking at markets that we have been watching, that are our target growth markets that we've had historical experience in.

Okay. That makes sense. I think in your prepared commentary, obviously, you discussed some of the supply issues that are weighing on some markets and how maybe your portfolio, just given that the positioning in the market, is less impacted. But your day can't go by where you don't read a story about the supply in Dallas-Fort Worth. So I'm just wondering how is that new supply impacting your leasing discussions? We've heard of new concessions on new build product kind of really ramping up over the last little bit. So are you seeing any kind of impact on a broader market basis in Dallas?

Kyle, this is Scott. So Dallas-Fort Worth has 800,000-some units in the market, and it has about 6.5% to 7% of new units in the pipeline. That is a healthy place to be. It's a higher percentage than it has been. But again, they're systemically short of housing in the Dallas-Fort Worth area. So I think we're going to see about 25,000 units have finished in the past 12 months. There are about 50,000 in the pipeline right now. And I think we're going to see that occupancy sort of pressure a little bit for the next 12 months or so in Dallas, but it's a healthy and reasonable balance. And furthermore, in Dallas-Fort Worth, the pipeline, the construction pipeline is really beginning to drop off when you look at permits, and what's going to be coming online in '25, '26, '27. So we're still seeing the fundamentals of population migration coming to Dallas. We're seeing businesses and economic development continue in Dallas. And so the long-term systemic shortfall of housing is still prevalent in Dallas. I would -- in Oklahoma City and Cincinnati, we see that similar -- they're both about 3% of a pipeline, which is very sustainable and healthy and supportive of strong occupancies. And I think you'll see those 3 markets are in the right healthy strike zone as compared with, say, other markets where there might be higher supply percentages. Austin is somewhere near 13%, Nashville and Phoenix are higher as well. So we're very comfortable with where Dallas and our markets set.

[Operator Instructions] The next question is from David Chrystal from Echelon Capital Markets.

Maybe a bit of a 2-part question. But how do you look at balancing capital spend between value-add possible opportunistic acquisitions and possibly buybacks? And then what's your appetite for taking leverage a little higher to execute on any or all of these?

Yes. David. So we're -- we are very careful with our capital allocation. I mentioned that in the prepared remarks. Certainly, value-add is investing in our current properties and has a great return on it. It's a priority for us for sure. Leverage, we're happy with where it is now, although we're below our targeted range. So we do have balance sheet capacity to increase that, where we -- to find a very accretive and attractive acquisition opportunity. So we will continue to look for that. We will continue to shoot for the target leverage. We're happy where it is now, where -- we would be happy if it ticked up for the right opportunity. So we'll prioritize value-add investing in our own properties first. We have an NCIB in place. Our intent is to renew that. That is an option, an attractive option for use of capital as well. And then we do think we will continue to see some acquisitions opportunities. And as I mentioned, pockets of distress. So we're allocated across the 3 years, as you mentioned, but I would prioritize them in terms of value-add investing in our own properties as the highest priority.

Okay, fair. And you gave some good color on the potential acquisitions or partnering with third parties. Would this be a kind of joint venture structure? And would there be any fee stream to the REIT unitholders in that event?

It's too early to say the structure right now. I would say that we'll -- the goal is to make it accretive to unitholders, for sure, allow us to expand our holdings and our diversity of product and geography without stretching the balance sheet.

The next question is from Paul Walker from Drummond Point Capital.

Just a quick question on the credit facility. That's going to mature in 2025 in May. I'm just wondering, are you looking with what you guys have been saying about potential opportunities in the market kind of coming forth in 2024? Is this something that you guys should be maybe terming out and getting like an accordion feature on and stuff like that out to like '27?

Paul, it's interesting to ask. In fact, we'll be looking at both after this quarter's results. We're working with our lenders to look at both options.

Okay. Great. Other question, just could you maybe articulate the dollar size of the potential acquisitions if you were just using your own balance sheet versus JV? Just to kind of understand the range of like structures and -- that you're looking at, basically. Just I can say like, okay, like the average is a $15 million property on balance sheet or $50 million with the JV, just to kind of understand some color there.

Yes. I think, Paul, in broad strokes, $50 million to $55 million on balance sheet would be certainly within our capacity. When we look at JVs, there's somewhat endless possibility depending on how we structure it and how much we participate. So we could do a large portfolio acquisition in a JV structure and something smaller than that on balance sheet. We're certainly looking at both.

There are no further questions registered at this time. I will turn the call back to Mr. Pauls.

Thank you, everyone, for participating in today's call. We look forward to speaking again soon. Take care.

Thank you. The conference has now ended. Please disconnect your lines at this time, and we thank you for your participation.