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 15, 2024. 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 risk 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. [Operator Instructions] Your host for today will be Mr. Brian Pauls, CEO of Dream Residential REIT. Mr. Pauls, please go ahead.

Good morning, everyone, and thank you for joining us today for Dream Residential REIT's fourth quarter year-end 2023 conference call. Speaking with me today are Scott Schoeman, our Chief Operating Officer; and Derrick Lau, our Chief Financial Officer. Despite rapidly changing market conditions, we had a strong inaugural year as a public company. We successfully delivered on operational and financial targets, meeting our IPO forecast by achieving the top end of our annual NOI guidance of $24.5 million and meeting our FFO target of $0.71 per unit for 2023. For the fourth quarter, net operating income rose by 9.3% from Q4 2022 to $6.2 million. Comparative NOI growth was over 10% with operating comparative NOI margin improving to 52.1%. These were large drivers to our FFO per unit of $0.18, which increased 11% year-over-year. During the year, we completed renovations on 410 suites, achieving an average lease trade-out of 21.6% on renovated units and a return on capital invested, exceeding our targeted 12% to 16% range. We are planning on renovating approximately 350 suites next year, focusing on larger renovations, including opening up kitchens and living spaces. Following our success so far, we are excited to expand the program to the Cincinnati region in 2024. Our value-add program continues to be a differentiator, and we expect the renovations to continue to yield attractive returns. During the quarter, we completed the sale of Forrest Grove, which resulted in the proceeds of $5 million after debt repayment. We are very pleased with the pricing we achieved, which was 3.3% above Q3 IFRS value and provide support for NAV book value. This was a good opportunity to recycle proceeds from a noncore asset limited value-add potential. We have earmarked net proceeds for investment in other existing assets to improve rents and enhance their value. We expect that the reinvestment will be cash flow neutral in less than 1 year, and we are earning interest income of 5.5% as the net proceeds are deployed to the renovations. We continue to focus on preserving capital for our value-add renovations as our best use of capital. We continue to maintain the NCIB and plan to use this tool selectively as we prioritize maintaining a safe and flexible balance sheet. We will continue monitoring overall market conditions and opportunities as we prioritize capital and balance sheet strength. We ended 2024 with a net total debt to net total assets ratio of 31.6% and a weighted average term to maturity of 5.3 years on our mortgages. We believe DRR is a compelling investment opportunity with embedded long-term value. Our business and distribution are very safe, backed by the stability of our portfolio and a strong balance sheet. We are well supported by a conservative payout ratio of 60% on 2023 FFO, and our growth outlook remains strong. In 2024, we are focused on surfacing this embedded value for our unitholders by increasing investor awareness of DRR and through prudent asset and property management. Overall, I'm very pleased with our financial and operations performance for 2023. As we look to uncertain conditions and economic environment, our portfolio, capital structure and platform are well positioned to deliver attractive returns. I will now turn it over to Scott to provide an operations update for the quarter. Scott?

Thank you, Brian. Our team is pleased to report fourth quarter results, including $6.2 million net operating income, 51.9% operating margin, 85 newly renovated suites and a successful disposition of Forrest Grove apartments at a sale price higher than book value. NOI rose 1.8% quarter-over-quarter and year-end NOI of $24.5 million achieved the high end of forecast range, representing 9.3% growth year-over-year from Q4 2022. Since the 2021 DRR pre-IPO audit baseline 2 years ago, REIT NOI has compounded at a 13% annual growth rate, boosted by 19% in-place rent growth and a 380 basis point buildup in operating margin efficiency. We drive revenue and control costs. Multifamily conditions across the United States moderated in 2023 due to the elevated new housing supply, restraining rents and sustained inflation pressuring costs. Rent growth and vacancy rates have stabilized around the long-term means and are projected to idle during 2024 as the remaining pipeline of nationwide apartment completions peak. Dream Residential is not immune to these macro conditions, but our geographic diversity, value-add program and middle market demographics insulate us from real estate cyclical valleys and provide leading performance. We ended 2024 with level quarter-over-quarter same-property rents, 5.9% year-over-year same-property in-place growth and 93.7% occupancy with suites continuing into the renovation draft. The Dallas-Fort Worth metro area remains a national leader in economic and population growth and accompanying apartment demand. Near-term new supply eased leasing activity and unwound the historic Sunbelt rent run-up experienced over the past several years. However, DRR metrics outperformed market-wide benchmarks in Dallas-Fort Worth with blended trade-offs leveling during Q4 and annual rent growth continuing positive at 4.0%. Our Midwest communities centered in Cincinnati outperformed even as the winter leasing season took hold. Cincinnati trade-outs blended to 4.0% in Q4 and annual rent growth double that of Dallas-Fort Worth at 8.2%. I believe we will see fits and starts of leasing activity over the first half of the year, varying by market and likely normalizing later in the year. Early thus far in 2024, new and renewal trade-outs indicate Dallas-Fort Worth may be picking up, potentially hinting at a trough behind and a measured spring leasing season ahead. The long-term fundamentals in each DRR market holds strong and the advantages of our geographic diversity and operating hubs allow us to serve as a capital safe havens. DRR's renovation program and internal property and construction management continued to add value and growth in unique and expected ways even within the current market conditions. DRR has experienced replacement cost increases in line with peers. However, we have been able to manage operating expenses with cost control initiatives and in-suite upgrades. This combination has resulted in 8.8% compounding revenues, offset by 4.7% compounding expenses for 13% compound NOI growth 2 years running and improving margins noted at the beginning of my remarks. In 2023, our construction teams renovated 410 suites in two markets. These upgrades led to $223 lease trade-out premiums, a 21% increase above the expiring term and it generated 19% returns on invested capital. Further, by virtue of expanding our self-performed construction teams, we were able to reduce per suite construction costs by a cumulative $400,000 and reallocate these funds to mitigate replacement cost escalations that the entire industry had experienced. The renovation program is boosting revenue, abating costs, attracting residents, enhancing quality and value across the portfolio. Dream Residential showed the strength of our assets and platform during the high watermarks of 2022. And we have demonstrated the resilience, safety and substance of our portfolio and operations during the cyclical and uncertain conditions of 2023. Looking forward, DRR's specific markets are expected to enter a favorable transition down from peak supply headwinds into demand-driven tailwinds over the next 3 years. While other Sunbelt markets must lean into gusts -- or gluts of supply for several quarters or more still ahead, our markets pipeline cumulatively peaked last quarter and last year. According to CoStar, Dallas-Fort Worth delivered a crest of 9,400 suites in Q4 '23 and 31,000 suites in calendar year '23. In 2024, CoStar projects a graduated 13% reduction of deliveries across Dallas-Fort Worth and nearly 30% reduction in new deliveries across Cincinnati. Absorption is positive but takes time. Our team forecasts a more balanced leasing environment taking shape later in 2024. In the interim, we see 3% to 5% same-property NOI growth during 2024 weighted towards the latter half of the year. Margins may compress early but hold over the duration as management prioritizes retention early and value-add increases later in the year. Our construction manager launched a new team in Cincinnati this year, and projects to invest $7 million to $7.5 million over 350 suites across three markets, focusing our renovation scope on opening up floor plans and fine-tuning cosmetic finishes, all the while with 12% to 16% returns projected to continue. 2023 transaction volume nationwide was choppy and off 70% from 2022. Q1 could be equally quiet as investors await stabilizing interest rates and economics. Values decreased as interest rates ran up in Q3, Q4 last year. Early feedback hints at a narrowing bid-ask spread wherein institutional capital begins to renew investment across the sector later in the year. Experts point to a modest increase in trading over the year ahead. Forecasts and predictions are still widely buried. Most sentiments speak to stabilizing our expectations later in the year. DRR is exploring external growth with a disciplined eye being mindful of potential pockets of distressed opportunity. Today, our best investment continues to be our internal value-add investment. Present day surplus supply and high interest rates create demand for proven operators, disciplined managers, diversified markets and value creators. At the same time, U.S. housing remains systemically undersupplied and historically unaffordable. Household demand for middle to middle multifamily remains strong. The fundamentals and multiyear outlook are well suited for our vertically integrated leadership and platform growth. Dream Residential is excited about our track record, safe in our position and prepared to grow forward when the time is right. I will now pass the lead to Derrick Lau, our Chief Financial Officer.

Thanks, Scott, and good morning. Financial results for the fourth quarter and year ended December 31, 2023, were consistent with management's expectations. For the quarter and year, diluted funds from operations was $0.18 and $0.71 per unit, respectively. Compared to the prior year quarter, FFO per unit increased 10.6%. Net operating income and NOI margin for the fourth quarter was $6.2 million and 51.9%, respectively. Same-property NOI increased by 10.3% compared to the prior year quarter. Operating revenue and operating expenses, excluding the impact of IFRIC 21 were $12 million and $5.8 million, respectively. G&A expenses were $912,000. This quarter's interest and other income totaled $59,000. During the quarter, we sold Forrest Grove for $9 million or approximately 3.3% above Q3 carrying value. Net proceeds of $5 million provide additional financial flexibility and are expected to be invested in our existing assets. Net debt to net total assets was 31.6%, which is all fixed rate debt. We have two mortgages totaling $15 million maturing in January 2025 at an average rate of 4.05%. We plan on extending these in the latter half of the year. At the end of the quarter, we had approximately $81 million in liquidity, comprising $11 million of cash on hand and full availability of our credit facility. IFRS NAV at December 31, 2023, is $13.50 per unit compared to $14.26 in the prior quarter. Excluding Forrest Grove, the IFRS value of our properties is $398.3 million compared to $406.1 million in the prior quarter. The decrease reflects $13.2 million of fair value losses, excluding Forrest Grove, partially offset by $5.4 million of building improvements. Our IFRS cap rate increased 15 basis points quarter-over-quarter to 5.63%. For 2024, Scott has provided comparative property NOI guidance of 3% to 5%. We are currently forecasting 2024 FFO per unit to be in the low $0.70 range, excluding any acquisitions in our current total unit count. As we intend to deploy proceeds from the sale of Forrest Grove to our value-add program over the year, we expect to start seeing the benefits from this investment toward the latter part of the year with FFO per unit expected to accelerate over the back half of 2024. Thank you. I will now turn it back to Brian.

Thank you, Derrick. We'd like now to open up the call to questions.

[Operator Instructions] Our first question comes from Jonathan Kelcher of TD Cowen.

First question, I guess, just on the mark-to-market that you have in your disclosure at 8.3%. I'm just trying to square that with kind of the 3% to 5% same property NOI guidance and the fact that the Q4 renewals were 3.5%. New leases, slightly negative. 8.3% seems a little on the high side.

This is Scott. Thank you for the question. In 2023, we launched a lease and revenue management program that is based upon artificial intelligence. And what it does is it adjusts real time, meaning by the hour, to market conditions. It factors in our value-add program. It factors in current dynamics in the market that day, even that hour. And so what you see there is a snapshot in time at the end of December. We would expect to capture that loss to lease or that gain to lease, if you will, over the course of probably 18 months. And that would be the market rent for a newly leased value add in many cases. So I think we're -- our property -- our community directors are continuing to see opportunity to grow rents, whether that's a blend of renewal or new or value added. But it's pushing the envelope in some regards, but we're going to get there over the next 18 months.

Okay. Fair enough. And then just on the 18% that you did on trade-outs with the OKC and the Dallas repositionings, was that equally weighted? Or with Dallas being a little bit softer market, is it more heavily weighted one or the other? And looking ahead, what's your expectation of Cincinnati versus the other two markets?

Right. I'll address a couple of things there. So the 18% that you noted was in Q4. We typically see Q4 exhibit that trend. Over the course of the year, we saw about $220-plus trade-outs for about a 21% trade out. Dallas was stronger than Oklahoma over the course of the year in terms of trade-out percentage. I would expect to see that continue. What I would say is that in both Oklahoma and Cincinnati, we are tailoring and focusing our value add on larger on floor plan -- on opening up floor plans. Brian and I mentioned that. We typically open up kitchen floor plans to be more open with the living space. That's been the most in-demand resident request in all of the markets where we've been renovating, and so we're very excited to be doing that in those two markets. We're already doing that in Dallas. I think Cincinnati could potentially see our strongest return on invested capital because of the significant movement we're making in between the kitchens and the living areas.

Our next question comes from Brad Sturges of Raymond James.

Just within the same-property NOI growth guidance for this year. Just to follow on Jonathan's question. Just curious to get thoughts on what that would assume in terms of NOI margin and what would be the occupancy range within the guidance?

With the 3% to 5% NOI growth, I think we'll see occupancies hover in the 93% to 94% range with our value-add draft continuing. I think it will probably be aggregating or growing over the course of the year and stronger later in the year. I mentioned that we're going to -- that we're prioritizing retention during the first half of the year and value-add program during the latter half of the year. And I would forecast that our NOI growth and our revenue growth will follow that same pattern weighted later in the year.

Okay. Great. That's helpful. Maybe switching gears. You completed the sale of the Kansas asset. Is there anything else that you're looking at from an asset sale or [ however ] segment point of view at this stage?

Brad, it's Brian. So we're constantly looking at the whole portfolio. I would say we're -- we've got a model for all of our assets and look at whether the best days are behind us or ahead of us. We've kind of weighted those in the high quartile, medium and then in the lower ones. We do have properties that we would look to recycle. There's nothing held for sale or anything like that, but we are looking to continually trade out into opportunities that show strong growth and then cycle out of ones where maybe we've realized the majority of that. There's nothing imminent that I would like to announce, but certainly, we reevaluate the entire portfolio regularly.

Sure. And Brian, just last question for me. On the, I guess, the last call you talked about potentially looking at JV strategies for acquisition and -- to help fund growth. Just wanted to get an update in terms of where you might be from that initiative.

You bet. We've had multiple discussions with private capital partners about pursuing opportunities together. We have not found the ideal opportunity or the perfect structure that's accretive to our company and our unitholders. So that's very much in ongoing discussions. We believe there may be opportunities coming up, large ones that we may want a JV with because of their scope or their scale or whatever. And we've had inbound calls and requests from companies that would like to be a part of our management team or team up with our management team to go do something together. So we're -- we've had discussions, nothing to announce, nothing really that has advanced to any serious level, but we do believe there may be opportunities together as other companies who are less strong in their balance sheet or maybe less well positioned as us that may need to sell that we could look at.

Our next question comes from Kyle Stanley of Desjardins.

Scott, I appreciate all your market level commentary. I'm just wondering, could you elaborate a little bit on your comment about leasing dynamics in Dallas-Fort Worth and having picked up early in the year so far?

Sure, Kyle. So one of the things that each of you or everyone's seeing in the newspaper is that the Sunbelt has been experiencing a reset of sorts. That's not due to demand. Demand in the Sunbelt remains high. Household growth, job growth and all the dynamics in the Sunbelt remain very strong. But what has happened is supply -- new supply and construction has peaked. We're seeing that peak in Dallas-Fort Worth in 2023. It will peak in some of the other Sunbelt markets in 2024. So what I would say this is that over the course of 2023, Dallas-Fort Worth has outperformed the other Sunbelt markets, and we're continuing to see that happen. Even so, I think Dallas rents on a market-wide basis were minus 1% for 2023. DRR Dallas rents on a market basis were plus 4% on rent growth. And Dallas rents were decreasing month-over-month through much of the latter half of 2023. We saw that little tick in Q4. What I'm experiencing -- what I'm seeing right now halfway through Q1 is both new and renewal lease trade-outs in the positive. So I don't want to read too much into that, but I'm excited to see that, and I'm excited to continue our value-add program in Dallas riding that wave.

Okay. Perfect. That's good color. I think you discussed obviously rolling out the value-add program to Cincinnati and gave some good disclosure there. But I guess one of the limiting factors in rolling it out earlier was completing that market survey. Just wondering, is there anything that came out of that, that would indicate differences in the value-add market or opportunity in Cincinnati versus some of your other markets? Like I think you mentioned obviously opening up kitchens and potentially driving a higher ROIC. But just curious if there was anything -- other interesting things that came out of that.

Kyle, I would love to take you to Cincinnati with us this spring. Cincinnati, I've actually had to moderate back our team's optimism in Cincinnati because I want to be realistic about it. But we're very excited about the value-add potential there. We're actually doing one of the larger floor plan adjustments, and we're combining that with capital investment on the outside on roofs, external painting, and some external envelope work. So we're actually -- we would see Cincinnati being on the high side of the return profile of all of our value add in 2023 -- I'm sorry, 2024.

Okay. That is great. Good to hear the optimism. And then just lastly, Derrick, you mentioned obviously the 15 basis point cap rate increase in the quarter. Just wondering, were there transactions in the market that help inform that? Or can you just talk about maybe what drove the change?

I think in terms of transactions, it still has been light. But in the limited transaction activity that we saw in reading market reports, and also we did do a separate appraisal within the quarter. So I think we've done, what, five this year. It was -- we saw kind of a small increase in the cap rates that we were -- in the limited data that we saw. So we thought it was appropriate to reflect that kind of increase. Over the year, I think market data has been staying around -- it's been around 60 basis points. And over the year, we've done about 40, 45. So I think we're keeping in line with what we have seen, albeit limited activity in the market.

[Operator Instructions] Our next question comes from Jimmy Shan of RBC Capital Markets.

Just a quick follow-up for me. I'm not sure if you mentioned the cap rate that you were able to achieve on the Forrest Grove asset sale?

The cap rate on trailing 12, NOI was around 6%.

6%. Okay. And I guess in terms of the acquisition opportunities that you're potentially looking at, where are asset pricing today? And I know there's not a lot, but as you -- I think you -- in the past, you've talked about sort of what you're seeing, what your hurdle rate is. Maybe you could maybe give us your latest view on that.

Yes, I'll start, and I'll let Scott elaborate. We're seeing pricing that's all over the place depending on the type of ownership structure there is and financing that's in place. We're seeing pricing, I guess, diverge based on quality. So quality prices -- quality products are probably trading at prices that are higher than what people are expecting. And that's dropping off as you get to lesser quality in terms of functionality and locations and those kinds of things. So I'd say pricing has been all over the place. We've evaluated all kinds of individual properties as well as portfolios. And the pricing is surprised on both ends of that. And Scott, you can elaborate on maybe our markets or some of the things that we've underwritten.

Sure. Jimmy, I would just amplify Brian's remarks there. There's been a wide divergence. And we are seeing some assets with a 70% drop off in trading volume, that's reflective of fewer assets being offered. We are spending a fair amount of time on marketed circumstances or border lines, either stressed or distressed. But as Brian mentioned, we want to be mindful of quality and mindful of the fact that we would like to see a stabilized cap rate in our portfolio in the high 6s or into the 7s. So we are just pursuing those with discipline. But I don't think there's a lot on the market. And what is on the market is widely divergent. Whether it's a broker opinion, a value, an appraisal or an asking price, there's just a widespread there.

Our next question comes from Paul Walker of Drummond Point Capital.

Just wanted to ask a quick question on the credit facility again for kind of last quarter. Just wondering with the impending maturity there in '25, if you have gone and explored any other options there for extending that?

Yes, we've actually had a couple of discussions with the bank. We're well in the process of that. We hope to extend it later this quarter in Q1. So we plan on terming it out by another 3 years. So we should have news to report in our Q1 results.

And from your discussions, is there any kind of changes in spread or anything there that the banks are accounting for? I just -- I know you can't get too granular here, but just versus what the current facility is?

From our initial discussions, it's going to be close to -- it's going to be a similar spread to what we've had previously.

This concludes the question-and-answer session. I would like to turn the conference back over to Mr. Pauls for any closing remarks.

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

This concludes today's conference call. You may disconnect your lines. Thank you for participating and have a pleasant day.