H&R Real Estate Investment Trust (HRUN) Earnings Call Transcript & Summary

Good morning, and welcome to H&R Real Estate Investment Trust 2022 Second Quarter Earnings Conference Call. Before beginning the call, H&R would like to remind listeners that certain statements which may include predictions, conclusions, forecasts or projections in the remarks that follow may contain forward-looking information, which reflect the current expectations of management regarding the future events and performance and speak only as of today's date. Forward-looking information requires management to make assumptions or rely on certain material factors and is subject to inherent risks and uncertainties and actual results could differ materially from the statements in the forward-looking information. In discussing H&R's financial and operating performance and in responding to your questions, we may reference certain financial measures, which do not have a meaning recognized or standardized under IFRS or Canadian generally accepted accounting principles and are, therefore, unlikely to be comparable to similar measures presented by other reporting issuers. Non-GAAP measures should not be considered as alternatives to net income or comparable metrics determined in accordance with IFRS and as indicators of H&R's performance, liquidity, cash flows and profitability. H&R's management uses these measures to aid in assessing the REIT's underlying performance and provides these additional measures so that investors can do the same. Additional information about the material factors, assumptions, risks and uncertainties that could cause actual results to differ materially from statements in the forward-looking information and the material factors or assumptions that have been applied in making such statements, together with details on H&R's use of non-GAAP financial measures are described in more detail in H&R's public filings, which can be found on H&R's website and www.sedar.com. I would now like to introduce Mr. Tom Hofstedter, Chief Executive Officer of H&R REIT. Please go ahead, Mr. Hofstedter.

Good morning, and I'd like to thank everyone for joining us today to discuss H&R's second quarterly financial and operating results. With me on the call are Larry Froom, our CFO; and Philippe Lapointe, President. I'm delighted to share with you today our strong second quarter results. Our results highlight the quality of our properties and embedded growth within our portfolio. The portfolio's organic growth, coupled with unit buybacks and creating value for our unitholders, dispositions announced to date furthering our portfolio simplification strategy. Capital allocation is our utmost most top priority and where our focus remains. Year-to-date, we have recycled capital out of or have under contract to sell, $406 million of office, retail and other noncore assets and repurchased and canceled $250 million of our units, highlighting a few key dispositions is $120.7 million agreement executed in July to sell the Canadian office property located at 100 Woodford Drive in Toronto. H&R will have an option to repurchase the property, thereby retaining future redevelopment optionality at no cost to our unitholders. We also entered into a $47 million agreement to sell the second Canadian office property in Calgary and 2 Canadian retail properties in line with our RPS values, providing further support to our net asset value. The closing of these sales remain subject to certain customary conditions being satisfied and are expected to occur in September 2022. Our net asset value per unit grew to $21.06 at Q1 to $22.14 at June 30 of 2022, driven by the 10.5 million units that we purchased and canceled with our SAB during the quarter, organic net operating income and the growth of and strengthening of the U.S. dollar. Year-to-date, we have bought back $22.1 million units at a weighted average cost of approximately $13 a unit representing a substantial 41% discount to our NAV per unit of $22.14. Our active unit buyback, a very strong same-property net operating income growth are driving NAV growth and financial results. With today's strong quarter results, we are on our way to creating a simplified growth-oriented company that will serve a significant value to our unitholders. And with that, I'll turn it over to Philippe to discuss our residential platform, Lantower.

Good morning, everyone. I'm happy to be on this call to discuss the Q2 update and to go over our quarterly highlights. But before I do, I want to thank our investors for their time, generosity and feedback over the last 90 days. While the team and I are encouraged as H&R has been among the best-performing Canadian REITs year-to-date, we still have a lot of work to do and look forward to share more exciting updates before year's end. The U.S. Sunbelt and gateway markets continue to experience amplified population and income growth, driving affordability in our rental portfolio. As of Q2, our rent-to-income ratio sits at approximately 20%, well below the standard benchmark for affordability. And so we are confident that we will continue to see strong future rental growth however, not at the detriment of a resident's ability to pay. Inflation is undoubtedly another area of conversation regarding how the overall economy will impact multifamily fundamentals. The common thinking goes that with inflation comes equivalent expense increases. While we do expect some increased cost creep in the future, we have experienced only marginal increases in most expense categories through operational efficiencies stemming from our smart technology initiatives, self-guided leasing and negotiated national accounts. Our quarter-over-quarter and 6-month year-to-date expenses have actually decreased slightly compared to the same time period for 2021. And more good news, as we have seen in previous quarters, we are continuing to experience substantial rental rate growth in all of our U.S. Sunbelt markets. That we, as an example, during Q2, our new lease trade-out for the entire portfolio, excluding Jackson Park, was approximately 16.6%. Moving on to Jackson Park. We continue to see positive trends in the amount of traffic, renewal rates and number of leases executed. At the end of the second quarter, Jackson Park's occupancy was 97.2% and the percent of residents renewing their leases during the second quarter hovered in the high 50% range, which reflects another quarter of continued strength in demand fundamentals for the New York City submarket. On to dispositions. In June, we strategically disposed of our only asset in San Antonio, Texas. Given that San Antonio did not fit in our long-term growth strategy, we felt it prudent to dispose of that asset at a premium to our fair market values, further reinforcing our conviction in our now. We intend to reinvest the proceeds in our core markets and to transfer the equity in a tax-efficient manner into more accretive long-term investments. On the portfolio valuation front, considering what is occurring in the capital markets and the ongoing adjustments to monetary policy, we erred on the side of caution regarding valuation cap rates. While we are still witnessing competitive sale processes and believe in the sustainability of our values, we have elected to increase our portfolio's cap rates by 0.125. However, in light of our rent and NOI growth, our overall portfolio value actually increased slightly in Q2. We feel confident that our strong NOI growth fundamentals will support our valuations despite the potential headwinds of future cap rate expansion. On the JV development front in Hercules, California, Phase 2 of our development name, the Grand at Bayfront received its final certificate of occupancy in March and is currently 59% leased. Shoreline Gateway or Long Beach tallest residential tower at 35 stories has seen strong rent demand and is now 69% leased. On the wholly owned development front, Lantower West Love in Dallas, Texas is on schedule as we expect to lay the foundation for the [ tower crane ] in the coming weeks. Also in Dallas, Texas, Lantower and Midtown recently broke ground with site work well underway. And lastly, in Tampa, Florida, we are wrapping up the building permit for a development called Lantower Bayside. This development will consist of 271 units and is expected to break ground in the coming months. More good news on the development front. Again, during the second quarter, we successfully rezoned a 5.8 acre land site from industrial to multifamily. This project will consist of 430 apartments and is adjacent to Downtown Dallas. Also in Dallas, we closed on [ Clin ] Phase 2 land site, which will accommodate 250 apartments on made story podium development next to our currently planned 295 apartments, 5-story graft developments in North Dallas. In April, we closed on an infill cycle on Highway 19 in Clearwater that will accommodate a 400-unit 5-story wrap development. Lastly, in late June, we closed on a 381 apartment garden-style development site in South Atlanta, Florida that sits in the entrance of Neo City, a mixed-use development anchored by a planned research book. Our residential development platform is supported by our WAM pipeline of over 5,000 potential units at a basis of approximately USD 28,000 per unit, which is a substantial discount to the 50,000-plus per unit pricing that we are seeing in the sum of markets for similar A+ sites such as ours. In summary, we have continued excitement about the future value creation opportunities at H&R. And with that, I will pass along the conversation to Larry.

Thank you, Philippe, and good morning, everyone. As Tom mentioned, we are excited to report our results this quarter, which reflect our simplified portfolio strategy and alignment with properties producing higher growth. That growth is clear from our year-to-date results of same-property net operating income on a cash basis, which grew 19% compared with the first half of 2021. Q2 total same-property net operating income on a cash basis continued to be strong and grew 18.8% compared to the same quarter last year. Our residential division led the way with a 43.7% increase or 39% in U.S. dollars for the quarter primarily due to an increase in occupancy at Jackson Park in New York, which was in lease up last year. Excluding Jackson Park, growth was a very healthy 20.8%. As Philippe has already discussed, Lantower Residential continues to see significant increases on new leases and renewals. Same-property NOI cash basis from office properties increased 23.2% for the quarter, primarily due to the burn-off of Hess Corporation's rent-free period that expired in June 2021. Excluding the rent-free period, the increase is 1.5%. Our office properties are located in strong urban centers with a weighted average lease term of EUR 8.5 and leased to strong creditworthy tenants. I would like to point out that only 5% of our total office footage is subject to lease expiries between now and the end of 2023. And 23,000 square feet expires during the remainder of 2022 and 349,000 square feet expires in 2023. Retail same property NOI on a cash basis decreased by 3.5% for the quarter, driven by higher nonrecoverable property operating costs at River Landing Commercial, which is in lease-up. Two major tenants are expected to commence occupancy in the near term, a 49,000 square foot lease in Q4 of this year and another 63,000 square foot lease in Q1 2023. And lastly, Industrial same-property NOI on a cash basis increased by 4.9% for the quarter, primarily due to increased occupancy and contractual rental escalations. During the quarter, we leased the vacant 314,000 square foot industrial property at 2121 Cornwall in Oakville, Ontario, which will commence in Q3 2022. H&R has a 50% ownership interest in this property. We also completed a 5-year lease renewal on a 371,000 square foot Montreal property at our ownership interest with rents set to increase by 125% in January 2023. Overall, FFO for Q2 2022 was $0.284 per unit and AFFO per unit was $0.257. Based on our distributions of $0.135 per unit for the quarter, our AFFO payout ratio was a very healthy 52.5%. Debt to total assets at June 30, 2022, was 44%. We finished the quarter with cash on hand of $71.7 million and $619.6 million available under our unused lines of credit. Our net asset value per unit grew from $21.06 at March 31, 2022 to $22.14 at June 30, 2022, primarily due to the purchase and cancellation of 10.5 million units under our NCIB and the strengthening of the U.S. dollar. We repurchased these 10.5 million units at a weighted average price of $13, a 41% discount to $22.14 NAV per unit at June 30, 2022. And so in summary, we are very pleased with our Q2 results. Our high-quality portfolio of properties are well positioned to produce strong operating results going forward. And with that, I will turn the call back to Tom to open up for questions.

Operator?

[Operator Instructions] Our first question comes from Sam Damiani from TD Securities.

Congratulations on the solid results. First off, just on the dispositions, Tom, perhaps, with the agreements set on these latest acquisitions set in June, obviously, the process was underway in the spring during the market volatility, I wonder if you could tell us how that went, what sort of buyer you're working with? And how -- how the pricing compares to the fair values at Q1?

Are you referring to the U.S. retail results?

No, I'm referencing, sorry, specifically 100 Wynford and the 3 other assets that are also under contract.

I said in line with our averse values, the right to purchase is because it has residential intensification potential, although that's down the road. We control the rezoning, and that's why we gave ourselves the right to buy that.

And was there any fair value change on them during the quarter to true them up to the sale price?

No.

Okay. That's good. But overall, the process -- like how would you characterize the process given the market volatility.

It was an off-market deal. So I can't respond to your question on market volatility. If we would have gone to the market, I can't speculate. But since it was off-market deal, it was very fluid. It was not an issue.

And just on the leasing in the residential and industrial side, have you seen any deceleration of momentum that would indicate slowing of the economy in your portfolio?

Sam, it's Philippe. No, not yet. We're still having, obviously, a record level of renewals. As I previously mentioned, we're seeing a rental rate that is in line with what we've seen in the last 3 quarters. And so obviously paying close attention to the data, making sure that we're not increasing our rents at the detriment of our residents' balance sheet. But no, we're not noticing any slowdown whatsoever.

And just on the same property for Lantower excluding Jackson Park, it was over 20%. I guess how does that how does that portfolio do that at stabilized? I guess? I'm just trying to struggling a little bit with the math.

Sorry, Sam, one more time -- how does the -- is that coming across clearly...

Sorry, 1 second Sam. Let's just -- increase the volume. Sam, do you mind repeating the question?

Oh, sure. Yes. Just wondering, how does a portfolio that's mid- to high 90s leased? How does it generate 20% plus same property? I guess, was there some properties that had an occupancy increase year-over-year. just I guess, help us understand how the occupancy and the rent change would triangulate into a 20% plus same property NOI.

Yes. I mean, Sam, the math is really simple, right? So if you're looking at -- if you think about our NOI margins of the upper 50s, I think it's 57% or 58%. And as I previously stated, no significant expense creep in year-to-date, yet we -- I can't recall what we did last quarter, but we did 16.6% this quarter. The math is ultimately simple, right? And so it doesn't time perfectly, but no, it's not an occupancy thing. It's purely a matter of revenue is growing at a very fast clip and expenses are somewhat muted.

And the muted expense experience that you're enjoying right now, is that something you see somewhat sustainable just given the specifics of the portfolio? Or will you see ultimately the portfolio being impacted by the macro inflation that we're seeing?

I think 95% of the expense creep that folks are experiencing, we've abated through us leveraging, and it's not just us, right? So some of the larger publicly traded REITs in the U.S. have done the same. But utilization of technology is really muted that expense creep that are the folks who haven't made the investment in the last 18 months or now, I guess, wishing that they have. Having said that, I think there's nothing that technology can do to help our property taxes and insurance. And I would anticipate that we're obviously accruing for it, but I would anticipate there being year-over-year some significant increases especially on property taxes as you would imagine, given that our values are obviously skyrocket as a result of our very healthy NOI growth. But [indiscernible] answer your question, no. I mean, not surprised to see that there hasn't been much of a change because of the monumental investment we made on that side of the house few years ago and last year. And credit goes to the team in Dallas who were really pushing that through. I mean we're in the middle -- on the back end of COVID, it's a very difficult setting. Some groups have done it that haven't been completely proven yet despite that, there's a tremendous amount of leadership in Dallas that show through and the execution was in your flows. And so much credit goes to the teams of the implementation of the tech packages.

Our next question comes from Jenny Ma from BMO Capital Markets.

Maybe just expanding on the multifamily metrics. Philippe, did you say that there was 16.6% same-property rent growth in the portfolio?

That's right for the quarter.

Okay. Great. Can you talk to us about how you are raising rents on renewals on your tenants? Obviously, there's the technology yield management software angle. But given how tight the market is, are you leaning on that? Or are you looking at the tenant's individual financial situation, trying to push as far as you can without losing them? And how does that rent growth differ across the markets you're in?

Great question. I think generally speaking to the last question first. Generally speaking, we see the same thing across the board. I mean, because we have a Kasai Jackson Park, we happen to be in the Sunbelt markets. And so the story is similar in North Carolina, Florida and Texas. As it relates to the renewals in the first quarter, I'm using round numbers, but in the first quarter, our renewal rate was about 4.5% in terms of the increases that we are asking over current residents. And the reason we have done that was a self-imposed governor. And so in Q1, much of the growth came in new leases. And so the delta between new leases was probably to volume, but my guess is anywhere between 12% and 15% because we're seeing some very healthy 18%, 20% increases in the first quarter. This quarter, I think the delta is 1% to 2% so we took the governor off. And I think our renewals are somewhat in the ballpark of 14% to 16% as is our new leases. It's on a blended basis, it's a much more balanced increase that we're seeing. In some respects, unexpectedly, our renewal ratio is also at an all-time high. And so last quarter was in the low 60s. This quarter, it was approximately 60%. Historically, we've seen anywhere between 40% to 50%. And so not only will be increasing at a very healthy clip, but also doing renewing at a healthier clip than we've seen in the past. And so my biggest concern and what keeps me up at night is ultimately the balance sheet and the credit of the residents as we're increasing rents, whether on a renewal or new leases is they're really coming at a detriment of the other balance sheet more important than their ability to pay. And I feel comfort in knowing that the 20% -- the rent-to-income ratio of 20% is almost identical to what it was in '18 and '19 in pre-COVID, which leads me to believe that there's still a ton of runway left.

Okay. Are the tenants willing to pay these higher rents because market rents are just going up across the board? Or is there any element of the housing market cooling down with affordability actually getting worse and maybe some tenants that may have bought, let's say, last year or earlier are more inclined to stay. Is there any element of that in your markets?

Yes. I mean it's a great question. I think just to summarize the question, there's an enormous shortage of housing period, right, apartments and loans in the Sunbelt markets. And there's -- obviously, it was true before COVID with COVID and the migration patterns within the U.S. that just exacerbated the issue. Obviously, with interest rates rising, I don't know what the latest was but a couple of weeks ago, you can get a mortgage for about 5%. And ultimately, what that made was an otherwise already expensive purchase that much more unattainable for resins. And so what we're seeing and what the data would suggest is that the -- on the right side of the standard deviations, our residents are staying longer, but they're also a little bit older in our communities. And I think that's because of the lack of opportunity for them to move up to another house or frankly, there's just a lack of supply for them to move from 1 community to another. And so I think all of those factors play or come into play, but the truth of the matter is there's an enormous under suppliable apartment in the Sunbelt. And frankly, the staff that we're seeing is 23, 24, we think construction starts, we are going to start plummeting. And so it's going to exactly further exacerbate the issue. And so I think that it is more a supply issue. There's a ton of demand, there's just not enough supply to meet the demand. And therefore, what we're seeing is obviously the very healthy increases across the board.

Okay. Great. Turning to the development. Is the intent of H&R still to eventually sell the partial interest that you have in Shoreline and Hercules Phase 2? And just wondering if you could comment on whether or not the buyers of previous partnerships might be interested in coming back for these ones.

I think the answer is yes. There's definitely meant to be sold. They're not -- they weren't meant to build to core. They're also in markets that we're not in. So from an operational standpoint, I don't know that it would make a ton of sense but we want to be opportunistic. And frankly, we think that perhaps now is not the right plan to be selling those assets, but in short order, they will be sold. Now whether to our partners as a third party, my guess is it's probably going to be a third party, there's going to be no shortage of the buyers for that type of product.

When you say now is not the right time, do you mean just given the uncertainty in the market or the fact that it's a partial interest makes it harder to unload, like could you expand on that point?

No, it's not a partial interest because we're all in the same page. We're selling it as one. So we really is [indiscernible] lack of liquidity for that discounted interest. No, I think it's more along the lines of given the potential headwinds that we thought that the fact that the property is not stabilized, we believe we could be wrong, we believe that to get maximum pricing, they can probably be best that we waited for the assets to be leased about 80%. And so we're sure that we're at 59%. Hercules, we're a little bit behind that and say in Q4, Q1 feels like just about the right time to put what we believe to be a best-in-class asset to the largest audience possible.

Okay. Okay. Got you. On the dispositions, for the 1031 like-kind exchange, I think your sales exceeded the land purchases in Florida. Does the 1031 like-kind exchange apply to land acquisitions? Or is it just for IPP? I'm just trying to figure if you could maximize the room that you have on 1031.

No, you absolutely can do it for land. We still have proceeds left to deploy. And as Paul mentioned, we're obviously very busy on the disposition side, both in Canada and the U.S., and we're exploring a variety of opportunities. And so whether those funds are coming to other disposition proceeds are in of itself, they will be reallocated to either land for development or income-producing assets within Lantower.

Okay. Great. And then my last question is when looking at the leasing activity, particularly with the industrial assets in Oakville and Montreal, just wondering if you can give us a bit more guidance on how to model that income coming in, in, I guess, Q4 and perhaps Q1 of next year?

Jenny, it's hard to say because it's single tenant assets, and I don't want to be cute, we have confidential agreements with our tenants. And to give you the rents and what the increases are, I think, is a bit unfair on that. But I can, there are substantial increases, ballpark they are coming off -- the one in Montreal is coming off about $5 per square foot rent you can model it that way. I think we said a 125% increase.

Jenny, we were all leased in the relationship with the market. There was no discounts or it was really it's a very vibrant market, and we got the market for.

Right. So Montreal is going to have a big step-up. Oakville, remind me, was it vacant throughout Q2? It's going to be a big step.

Oakville was vacant for about 9 months.

Our next question comes from Matt Kornack from National Bank Financial.