European Residential Real Estate Investment Trust (EREUN) Earnings Call Transcript & Summary

Good morning. Thank you for attending today's European Residential Real Estate Investment Trust Second Quarter 2022 Results Conference Call. My name is Francis, and I'll be your moderator today. [Operator Instructions] I would now like to pass the conference over to our host, Phillip Burns, CEO. Please proceed.

Thank you, operator, and good morning, everyone. Before we begin, let me remind everyone that during our conference call this morning, we may include forward-looking statements about our future financial and operating results. I direct your attention to Slide 2 and our other regulatory filings. Joining me today is our CFO, Stephen Co. After I provide an update on our operational progress during the quarter, Stephen will provide an overview of our financial results and position. ERES once again grew stronger during the second quarter of 2022. As displayed on Slide 4, our suite count increased by 12% over the past 12 months, including 3 acquisitions, which we completed so far this year for a combined 356 suites across 6 additional multi-residential properties throughout the Netherlands. The market value of our property portfolio increased by more than double this, having grown by 27% during the same period. This was driven by continuously strong market and portfolio fundamentals, the successful execution of our value-enhancing capital expenditure program and our exceptional operating metrics, which we will highlight to you in the coming slides. Further to this, given the uncertainty provoked by recent macroeconomic developments and potential regulatory evolution, we conservatively held the fair value of our residential portfolio steady this quarter despite the 2% depreciation that was assessed by our external appraiser for the period. Our net asset value per unit reflects the growth, which we achieved to date and notwithstanding the absence of any fair value gain on paper during this past quarter, NAV per unit still increased by 25% versus the prior period end. Contrary to our results, our market capitalization is down by 17% since the prior year period. Albeit a direct product of external factors, which are unrelated to the REIT's intrinsic value or operational performance, this decline has a silver lining in its creation of the opportunity for our investors to capture this value. In this regard, we reiterate their uniqueness of the REIT's trifecta of value growth and income. Slide 5 contains an overview of business development during the second quarter of 2022, starting with our latest acquisition of 5 multi-residential properties comprised of 110 suites located in Rotterdam, which we acquired for a purchase price of EUR23 million, excluding transaction costs. With the vast majority of its suites regulated, the portfolio provides significant potential for uplifts on conversion. Also during this past quarter, the REIT secured mortgage financing for its 2 acquisitions, which closed earlier this year, alongside early refinancing of certain existing properties, which had mortgages maturing towards the end of this year and the total principal amount of EUR118 million. After all refinance activity during the quarter, which Stephen will elaborate on shortly, the REIT has approximately EUR165 million of available liquidity through a combination of cash as well as capacity on its credit facility and pipeline or promissory note arrangements with CAPREIT that translates into acquisition capacity in excess of EUR350 million. Although we currently are approaching new acquisitions cautiously, our available liquidity will support our external growth ambitions for the remainder of 2022 and thereafter. Our strong operational and financial results are [ aided ] through the continuous increases to our key FFO and AFFO metrics. Quarterly FFO per unit was up by 13% to EUR0.043, while AFFO was up by 15% to EUR0.038 per unit, both positively driven by our accretive acquisitions and an increase in stabilized NOI contribution since the prior period end. Slide 6 showcases another quarter of strong operating metrics with the REIT again surpassing its targets. Rental revenues continued to increase significantly, with total portfolio net average monthly rent of EUR936 as of June 30, 2022, and EUR952 on an occupied basis. For the stabilized portfolio, net and occupied AMR increased by 4.6% and 4.2%, respectively, as compared to the prior year period. These increases are attributable to the REIT's trifold rent maximization strategy comprised of its value-adding capital expenditure program, including the conversion of regulated suites to liberalized as well as increasing rents on indexation and turnover. For rental increases due to indexation effective July 1, 2022, the REIT served tenant notices to 96% of its residential portfolio across which the average rental increase due to indexation was 2.95%. Even more meaningfully, average rental uplift on turnover in the current quarter was 22.4% on turnover of 2.6%, which compares exceptionally well to the change in monthly rent of only 17.1% realized in the prior year quarter despite its higher turnover of 3.6%. Specifically on conversions, ERES achieved rental uplift of nearly 61% for the past 3-month period compared to 49.5% in the 3 months ended June 20, 2021, evidencing the effective execution of the REIT's value-enhancing conversion program in parallel with the untapped uplift potential inherent throughout our portfolio. The REIT's ability to achieve rental growth and rental revenues in excess of its target range of 3% to 4%, as I've just outlined, demonstrates its ability to consistently and profitably operate in a challenging macroeconomic environment and a complex and fluid regulatory regime. Although the Dutch government is currently investigating several proposals for regulatory development affecting the regulated rental market, such as the proposed mid-market regulation and various sustainability measures, we emphasize the fact that the regulatory environment in the Netherlands has historically been iterative in nature over short- and long-term periods, including over the past few years since the REIT's inception. We have been able to successfully navigate this dynamic and evolutionary regulatory framework to date, which constitutes one of our distinct competitive advantages and that will continue into ERES' future. Moving to Slide 7. Occupancy for our commercial properties remained strong at 99% at current period end, while occupancy for the residential portfolio increased to 98.4% compared to 98.0% at Q2 2021 for both total portfolio and on a stabilized basis. A significant portion of residential vacancy in the current period is due to renovation with 70% of vacant suites offline for that reason, which should provide for further rental uplifts once the suites are leased. For the 3 months ended June 30, 2022, net operating income increased by a significant 17% compared to the prior year period, up to EUR17.2 million as a result of contributions from acquisitions, higher monthly rents, unstabilized properties and strong cost control. Total portfolio NOI margin, as shown on Slide 7, was 77.3% for this past quarter, which includes the effect of recoverable service charges that have recently increased due to rising inflation. Importantly, the net amount of service charge income and expense during the quarter and year-to-date was 0, given that costs are fully recoverable from the tenants. As such, we also evaluate our NOI margin, excluding service charges, which was 83.3% for Q2 2022, up from 83.1% in the prior year period. This increase in NOI margin was due to higher monthly rents combined with a decrease in operating costs as a percentage of operating revenues primarily due to lower R&M as well as reduction in the landlord that he expects that Stephen will elaborate on shortly. This demonstrates large extent to which the REIT is insulated from inflation as tenants are responsible for the majority of their own energy and other utility costs. Further, the REIT has no employees and therefore, no wage costs and property management fees are a fixed percentage of operating revenues. Our overhead is also protected from inflation with the largest contributor being asset management fees, which are based exclusively on historical cost with no allowance for inflation. Slide 8 serves as a reminder of the unique diversification that characterizes our high-quality portfolio. We maintain an approximately 60-40 split between liberalized and regulated units, providing balanced growth in rents on turnover and indexation as well as the opportunity to liberalize more units. In addition, you can see that over 40% of our current properties are located in the high-growth [indiscernible] in the Randstad with an approximately 1/4 of the portfolio directly located in the cities of Amsterdam, Rotterdam, the Hague and Utrecht. The rest of the portfolio was situated in smaller urban areas throughout the country. And further to all of this, approximately 1/3 of our portfolio was comprised of single-family homes, also known as Dutch row houses, a segment which represents an additional unique contributor to our portfolio mix and one that is even further protected from inflation with tenants performing the majority of the R&M work themselves, thus resulting in higher margins. With that, I will now turn the call over to Stephen.

Thank you, Phillip. As you can see on Slide 10, we continue to deliver on all our key financial and operational targets. On a total portfolio basis, operating revenues and NOI both increased by 19% and 17%, respectively, versus the comparative quarter, primarily due to accretive acquisitions since that period as well as increase in monthly rents on the stabilized portfolio, as Phillip already mentioned. This contributed to the increase in NOI margin, which was 83.3% in the current quarter, excluding service charges, up from 83.1% in the prior year period, which demonstrates the REIT's strong cost control and the extent to which it is protected from inflation. Excluding the impact of these service charges that are fully recoverable from tenants, property operating costs as a percentage of operating revenues decreased this quarter and year-to-date as compared to the prior year period, driven by lower repairs and maintenance costs as well as a reduction in land or levy expense. This was due to the utilization of a larger government rebate this year for landlord levies payable. With the REIT's intention to consistently purchase landlord levy rebates, along with the potential abolishment of the landlord levy tax rate, the REIT expects to realize improvements in NOI margin permanently, which is further reinforced by the fact that the REIT's property operating costs are largely insulated from inflation, as Phillip explained. This all translates into accretive operational results, which continue to strengthen quarter-over-quarter. FFO and AFFO per unit were up by 13% and 15%, respectively, compared to Q2 2021, with both increasing by significant 15% on a year-to-date basis, driven by the positive impact of increased stabilized NOI and accretive acquisitions. Despite our regular increases to monthly distributions, the REIT's AFFO payout ratio was at the lowest end of its long-term target range at 80% for the 3 months ended June 30, 2022, down from 83.3% for the prior year period. Moving to Slide 11, we can see that the REIT outperformed on a stabilized basis as well. Similar to the total portfolio, stabilized residential occupancy increased to 98.4%. Stabilized occupied AMR and operating revenues increased by 4.2% and 5.2%, respectively, which is again in excess of the REIT's target range of 3% to 4%. Stabilized portfolio NOI increased by 3.9% for the quarter ended June 30, 2022, with NOI margin, excluding service charges increasing to 83.4% in the current period, up from 83.1% in the prior year period with the same reasons as explained earlier for the total portfolio. Slide 12 demonstrates the continuous growth of our accretive operational results and strong financial management. FFO and AFFO for the quarter were both up significantly to EUR0.043 and EUR0.038 per unit, respectively. As mentioned, these large increases were driven -- primarily driven by higher stabilized NOI, profitable acquisitions, margin expansion and strong cost control. Our AFFO payout ratio also remains strong, even in the context of the REIT's growing distributions. This preserves ERES' reputation for its relatively high and regularly increasing distribution yield, which was 4.5% as at June 30, 2022. While the REIT has been able to continuously pass on its accomplishment to its unitholders with increases in this distribution rate, it also simultaneously has maintained a strong and flexible financial position and consistently conservative debt metrics as displayed on Slide 13. Inclusive of our latest mortgage financing, the REIT's adjusted debt to gross book value was 48.8% as at June 30, 2022, remaining within our long-term target range of 45% to 50%, which we have historically been able to maintain. We also had immediate available liquidity of approximately EUR165 million as of period end, comprised of cash on hand in excess of that set aside for ongoing operational and capital expenditure requirements as well as unused capacity on the REIT's revolving credit facility and its pipeline of promissory note arrangements with CAPREIT. As Phillip mentioned, we currently are approaching new acquisitions cautiously. Nevertheless, assuming on an LTV of 55%, our liquidity provides capacity to acquire in excess of EUR350 million that will support the REIT's growth endeavors. Furthermore, you can see the REIT's demonstrated track record for maintaining its extremely conservative debt metrics. Both its debt service coverage and interest coverage ratios have remained significantly higher than the minimum thresholds prescribed by our revolving credit facility. This illustrates the REIT's ability to successfully execute on its strategic objectives on the back of a robust flexible financial position. And finally, on Slide 14 evidences the staggering of our mortgage profile, inclusive of our latest mortgage financing, which was secured on our Q1 acquisitions combined with refinancing of certain existing properties. The combined financing was in the total principal amount of EUR118 million, excluding transaction costs and carried the effective interest rate of 3.29% over the term of 6 years. Our well-staggered mortgage profile not only reduces renewal risk, but also stimulates liquidity as the majority of our mortgages are non-amortizing. Importantly, in light of the recent turmoil disrupting the economy, ERES remains well positioned to absorb the volatility with the weighted average term to maturity of its mortgage profile being 3.94 years. Further to that, we have no mortgage financings coming due for the remainder of 2022 and less than 10% of our mortgage debt maturing in each of the following 2 years. On that note, I will thank you for your time this morning and turn things back over to Phillip to wrap up.

Thank you, Stephen. ERES did not just have another quarter of strong results. The REIT exceeded expectations in prior quarters and yet still its results for Q2 2022 have again eclipsed its prior outperformance. ERES has been growing both in size and in fundamental strength and expect to be able to continue along this flight path even amid the macroeconomic and regulatory turbulence. Of course, the current environment requires us to exercise heightened scrutiny towards external growth and regulatory evolution and continued vigilance around operational performance. Even in today's environment, however, our optimism towards ERES' future remains undiminished. The immense value which is offered to the REIT's platform, as presented to you today and summarized by our investment highlights on the next slide is proof of the robustness of our platform and strategy. In this context and in summary, during the second quarter of 2022, the REIT grew in every capacity and we are confident in its ability to continue to navigate forward in each quarter to come. With that, I would like to thank you for your time this morning, and we would now be pleased to take any questions which you may have. Operator, back to you.

[Operator Instructions] Our first question comes from Jonathan Kelcher with TD Securities.

First question just on the -- I guess in the MD&A, you talked about potential changes to the regulatory environment pertaining to the mid-market. Can you -- and I know you said it's a little early to quantify, but could you maybe give us some color on what those might be and how many suites of yours could be impacted?

Actually, I mean the government announcement so far have been very high level and lack any level of specificity. So it doesn't allow us to come up with a quantification or sensitivity. The government in parallel with having to execute its supply increase program where they want to provide another 1 million houses by 2030, which require EUR100,000 a year, they're also trying to, again, consider how to slow down house price inflation as well as rental price inflation, but they have not given any guidance into what it might be. They said that they would like to provide or they would consider stretching the regulations to include mid-market up to EUR1,000 or up to EUR1,250. In parallel, they've also said that they want to consider revising our "modernizing" the points calculation and they've also said in parallel that they want to encourage people to increase the energy efficiency measures as we approach 2030 because of EU directive. So they've put out a lot of really broad statements and it's unclear how they're going to tackle it at this point in time. Having said that, historically speaking, as they have always been consistently tweaked and pushed and pulled on the system, over time, we find that it is reasonable and manageable. Two years ago, they put rental inflation at the regulatory environment at 0. And then the very next year, they've now allowed us to get 2.3% for regulated and 3.3% for liberalized. So I think there's generally a level of pragmatism that has historically shown through, and we would expect that to be the case today. And they also cannot lose sight either from common sense or the uproar that would transpire with the populist if they don't start delivering more supply. And so I think that will deter them from doing anything too draconian.

Switching gears, just on the acquisition, I guess you said a couple of times you guys are being more cautious. Is that more internally driven? Or has the pipeline slowed down? Maybe give us an update on what you're seeing out there and what you -- what we could expect for the back half of this year for you guys?

Yes. I mean that caution is driven really by the market, one being patently aware that interest rates have gone up. And so that needs to be reflected in anything that we would underwrite. And then also going back to your first question, with some level of regulatory uncertainty, we would not want to be increasing our exposure to that uncertainty if we can avoid it. So to the extent that we are reviewing acquisitions currently, we're looking at acquisitions that would be 100% regulated with limited conversion ability, again, those are like the bond light assets that we've always had as part of our portfolio. We continue to believe that those are attractive, even though they're lower growth. Historically, the pricing on those is much more attractive. So those are things that we're looking at. And then we would say on the other side, if you have a portfolio that is very much liberalized, i.e., high levels of points that you wouldn't think would be subject to any regulatory risk, we would be keen on looking at those. There are a lot of portfolios in the market today, but the acquisition activity or the closing of acquisitions has slowed down dramatically in Q2 as a result of the 2 things that I just highlighted that's precipitating our caution.

Have you seen people walk away from acquisitions?

It's hard to know if people walk away. We have seen portfolios come that haven't closed. And just the nuance being I don't know if they were closed with somebody else and then they didn't close or if they just didn't get any interesting bids. The 2 biggest portfolios that were on the market this year, which you all would have heard us talk about is, there was a EUR700 million all Dutch deal and then there was over EUR1 billion, 50% German, 50% Dutch deal that were pulled from the market just because the bids weren't interesting vis-a-vis the seller's expectations. But again, I can't say people are walking away, but I can say that there are portfolios that have been marketed that have not closed.

Our next question comes from Brad Sturges with Raymond James.

Maybe just to follow on to Jonathan's questions there. I think you talked about a $200 million acquisition target for the year. But given, I guess, a little bit more of a cautious approach, would you be revising that target down from the $200 million mark? Or how do you think about the volume for ERES in the second half of the year?

I mean we've already got in close $85 million, $90 million. So directionally speaking, we're halfway there. Again, I would hope that we do acquire more assets this year. But again, we are exercising more caution. Will we hit that $200 million? Not certain. But again, we're still in the market. We're still looking. CAPREIT is still supporting us. We're still underwriting portfolios. But again, we just need to be aware of certainly the interest rate environment, which affects pricing and the sellers have to come to terms with that. And then the regulatory thing, again, I mean, that is uncertain, but that is something that we can manage as well. So I can't tell you what I think our new revised number is. But again, I'm optimistic that we will find things to acquire in the second half of the year.

And just to go back to the mid-market regulation commentary you had, I guess if there were changes to be made or new regulations, would that be more of a 2024 event at this stage?

Yes. I mean everything the government -- well, not everything, there's many things that they're processing through. You've heard us talk about cap on [ liberalized ] points, et cetera. That's now in effect. It has a de minimis impact on us. But as they're talking about the bigger potential changes they've already articulated that, that would be for 2024 and onward.

And then given some of the uncertainty and maybe the expansion in the mid-market, does that change your thinking around suite renovations or conversion from regulated to liberalized?

No, it doesn't. I mean, again, #1, it's 2024. So that's 18 months away. You guys can see in our MD&A, our uplift on conversion are extraordinarily high, extraordinarily profitable. What we will do or are doing is, again, there are expected energy measures that the government is going to push through. So as we are refurbing our suites, we're ensuring that we upgrade the energy diagnostic levels. We're ensuring that we get deeper into the liberalized points calculations as they exist today. But no, we would not expect to significantly change our regulated to liberalized conversion strategy.

Our next question is from [ Himanshu Gupta with [indiscernible].

So I see the new debt financing done at over 3%. So just wondering how is the availability of credit for your asset class? And have you seen any change in terms of lending EBITDA aid from the banks?

So I would say there's been acute increase of interest rates since our Q1 conference call. It pretty much peaked in the month of June. And then we actually have seen rates come down. It is a very rapid and changing environment, but there is significant appetite from our banks and our lenders to secure especially for multi-residential assets. So what we are doing internally is really seeking best execution. And if we look at our debt maturity profile, we don't have much coming up for 2023 and 2024. As I already mentioned in my conference call, it's less than 10% of our debt maturity turning in the next 2 years. But to your point, what we have seen is rates have come down. There are abundant liquidity for multi-residential product and we don't see any problems with our lenders if we were to secure financing.

And just to clarify this 3.29%, this is a 6-year term and fixed interest rate?

That's correct.

And then how will the cap rates get impacted as a result of the new debt financing? The question is, will you see the first impact on regulated non-Randstad like the lowest quality or it will be the other way round, like liberalized Randstad is likely to see first impact in terms of cap rates?

For us, we -- I guess there's 2 things to it. There's the discount rate and growth rate. I mean for us, as you've already seen in our operational results, they're very strong. We actually see growth rates increasing. That's with our discussion with our evaluators. I don't think right now, we see much impact on cap rates due to the acute financing increasing, but we also have seen rates come down. So I think we're in a very transitory environment in terms of where cap rates and interest rates are going to converge. But I think right now, from what we see in our portfolio, cap rates is reflective of what the market is.

And the other thing that I would add just going more back to the financing component as well. Again, it is a rapidly changing environment. But even with our new financing, if you compare that to the blended cap rate at which we bought those assets that were refinanced, we're still delivering positive yield spreads, not to the magnitude that we were before, but leverage is still accretive for us even at that level. Again, we would like to see it come down again, but there is still positive yield spreads for us in our market.

And then just a follow-up on the additional regulations. So the cap on the WOZ value, I think now that is an effect. And you mentioned there's pretty much no impact or de minimis impact on you. Why is that? I mean, would that change or limit your ability to convert a regulated suite into liberalized like how the impact will unfold there?

I'm sorry. It wasn't -- your question wasn't clear, Himanshu. What's the question?

So Phillip, the question is the cap on WOZ value that change in regulation is now in effect from May 2022, I think. And you said there will be minimum impact on your portfolio. So can you elaborate on that? My understanding is that it will limit the ability to convert a regulated suite into liberalized.

Not so much really. I mean not so much. It will have virtually no impact. What that's trying to do is, in certain areas where you would have high-value areas where you had small suites because the values have been going up so much that the WOZ contribution, which is the second largest contributor after the size of the flat was overly contributing. They originally installed the WOZ component in 2013, 2014 just because it wasn't making a differentiation geographically where you have higher values generally in the Randstad versus in the other areas. But then unintended consequence of that was, if you add small, flat in these high-value areas, they were going up quite dramatically and the WOZ value were contributing more than people had anticipated. And when they put it in place in 2013 and '14, it was expected to be 25% to 30%. So what they're really doing is trying to bring it back. So if you had a significant number of small-sized flat in the Randstad area that were in your liberalized component, then those would be at risk, but those aren't -- we don't have a lot of those, #1. And the stuff that we're converting is generally not small flats. The stuff that we're converting are larger, bigger flats. So I truly across all components of our business, don't see any material impact from this WOZ value cap.

Last question from me. Rent growth target range was 3% to 4%. I mean clearly, you exceeded in Q2 and Q3 is likely to be even higher, just by virtue of better indexation. So are you increasing your target range what you had provided, 3% to 4%?

I think -- we're not explicitly moving our targeted range or guidance, but I mean, you all are very smart people and you can see that we are beating our target and there is no reason to believe that our performance is going to change. So we feel very confident being at or above our target.

Our next question comes from Kyle Stanley with Desjardins.

Just looking at the macro headwinds in Europe, high rates, energy crisis, do you expect this to have any impact on leasing demand or activity? I mean that turnover spreads have, of course, remained very strong as we saw this quarter. But do you expect these factors to start impacting spreads maybe as we advance through the year? Or is the supply/demand imbalance just too acute?