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

Good morning, and welcome to H&R Real Estate Investment Trust 2022 Fourth Quarter Earnings Conference Call. Before beginning the call, H&R would like to remind listeners that certain statements, which may include predictions, conclusions, forecasts and projections in the remarks that follow may contain forward-looking information, which reflect the current expectations of management regarding 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 and 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 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 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 the 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 the statements in the forward-looking information and the material factors or assumptions that may 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 at www.cedar.com. I would now like to introduce Mr. Tom Hofstedter, Chief Executive Officer of H&R REIT. Please go ahead, Mr. Hofstedter.

Good morning, everyone. I'd like to thank you for joining us today to discuss H&R's fourth quarter financial and operating results. With me on the call are Philippe Lapointe, President; Larry Froom, our CFO; and Matt Kingston, Executive VP, Development and Construction. 2022 was a very important year for us despite the volatility in the public markets, our teams accomplished many substantial milestones aligned to our simplification strategy through capital recycling, stock buybacks, a 9.1% distribution increase and a new focus on our investment communication program. Through these actions, we have enhanced our geographical exposure, asset mix and tenant diversification, driving strong operating and financial results while also strengthening relationships with the investment community. In 2022, we sold over $463 million in noncore properties, reallocating that capital to buy back stock through our NCIB. During the year, we bought back and canceled almost $300 million of our units or 22.9 million units at a 39% discount to our net asset value, creating 63% per unit in NAV increase. On the development front, our $370 million of industrial and U.S. Sunbelt residential properties are progressing well and embedded value and growth to be realized over the next 2 years. Given the current macroeconomic environment and keeping with our prudent capital allocation strategy, we've taken a conservative approach and have paused the majority of our development projects until we have more visibility into future stability. As a result of the heavy lifting, our teams have completed during the year to streamline and simplify this company, our 2022 financial and operating results are very strong. In 2023, we plan to continue to recycle out of the noncore office and retail properties and off to a great start with anticipated $277 million sale of 160 Elgin Street in Downtown Ottawa, which is expected to close in April of this year. The disposition program will continue to carefully synchronize property sales to match our capital funding requirements. With today's strong quarterly results, we are on our way to creating a simplified growth-oriented company that will service significant value for our unitholders. And with that, I'll turn it over to Philippe.

Thank you, and good morning, everyone. I'm happy to be on this call to discuss our Q4 update and to go over our quarterly highlights. But before I do, I'd like to take a moment to specifically highlight the progress to date of our strategic repositioning plan released in October of 2021. Since announcing our strategic plan, H&R has sold off or spun-off over $4.2 billion worth of office and retail, including the primary spin-off and over $1.8 billion, excluding the spinoff, all figures in Canadian dollars. This includes 21 office and retail assets, encompassing over 4.2 million square feet of space when excluding the primary spin-off. Our office portfolio garners a lot of attention as a legacy asset class at H&R REIT. And thus, I'd like to take a moment to help unpack the remaining office portfolio. From our perspective, H&R's office portfolio consists of 3 segments totaling approximately CAD 3 billion. The U.S. office segment almost exclusively consists of 2 high rises in New York City and Houston, representing approximately $1.3 billion or approximately 42% of the $3 billion office portfolio. The second office segment is Canadian office currently undergoing rezoning, representing $750 million using current office cap rates, which will be inapplicable once the rezoning is complete as the value created will push the entire property to be mostly valued on a developable square foot basis. And lastly, our Canadian office segment, not subject to rezoning represents the remaining $1 billion. Of this $1 billion, 160 Elgin represents 27% of that office segment's fair value and is the only office property located in Ottawa, which is not considered a core market for H&R. On a square foot basis, 160 Elgin represents nearly 1 million square feet out of 3.2 million square feet, or said differently, 160 Elgin represents approximately 30% on a square footage basis of our Canadian office, not currently being rezoned. Furthermore, 160 Elgin sale price of $277 million is in line with our IFRS value, further underscoring our conviction in our office IFRS values. It is important to remind that this transaction has not closed, and while we cannot share any more details about the transaction, we look forward to disclosing relevant details post-closing. However, we hope that this potential transaction further demonstrates to our unitholders of our tireless and steadfast commitment to simplifying our company despite the challenges and headwinds that the market is currently experiencing. Now moving on to Lantower Residential's results. When excluding Jackson Park, same-asset property operating income from our portfolio in U.S. dollars increased by 11.8% and 13.6%, respectively, for the 3 months ending on December 31, '22 and for the full year '22 compared to the respective '21 periods. When including Jackson Park's same-asset property operating income from our portfolio in U.S. dollars increased by 6.9% and 27% -- 25.7%, sorry, respectively, for the 3 months ending on December 31, 2022, and for the full year '22 compared to the respective '21 periods. In recent reports, we have read headlines describing the deceleration of rents in many of the U.S. Sunbelt markets. While we are no longer seeing 25% to 35% rental rate increases, we are still experiencing healthy and above historical rental rate trade-outs. For context, our trade-outs and rental rates in the fourth quarter was nearly 11% when excluding Jackson Park. We do expect this to revert to more sustainable and historical levels in '23. However, it is important to remember how healthy historical rental rate growth has been in our Sunbelt markets. And secondly, the fact that our rent-to-income levels still have been increased by any meaningful measure since the beginning of COVID, allowing for future headroom and rental growth. Moving on to Jackson Park. At the end of the fourth quarter, Jackson Park's occupancy was nearly 99% occupied and experienced a retention rate of over 50% for the fourth quarter, which reflects another quarter of continued strength in demand fundamentals for the Jackson Park submarket. On the development front, Lantower West Love in Dallas, Texas is on schedule and on budget and started framing work this quarter. Also in Dallas, Texas, Lantower Midtown is on schedule and on budget with the first building foundation were expected at the end of this month. West Love's hard costs are 99% bought out, while Midtowns are approximately 90% bought out, and we have entered into guaranteed maximum price contracts with very reputable general contractors. Based on this, we expect limited bearings in our in our hard cost budget and time line. Lastly, a comment on disclosures, as Lantower and multifamily division of H&R continues on its path to becoming the majority asset class of the REIT, we wanted to provide more visibility into the platform. And to that end, we have expanded the level of disclosures, which can be found in our investor deck posted online as of yesterday. For 2022 year-end reporting, we are providing additional visibility into our operating fundamentals such as occupancy, average monthly rent, lease trade-outs and retention rates on an individual market basis and compared to the respective metrics in '21. 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. Our strategy of increasing exposure to residential and industrial properties is bearing fruit. H&R's same-property net operating income on a cash basis in 2022 grew by 14.9% compared with the year ended December 31, 2021. Q4 2022's growth over the same quarter last year was 10.9%. Breaking the growth down between our segments. Our residential division led the way with a 30.7% increase for the year and a 16% increase for the quarter compared to the respective period in 2021, primarily driven by an increase in occupancy at Jackson Park in New York and good growth in rents from our properties in the Sunbelt states. Industrial same-property NOI on a cash basis increased by 7.2% for the year and 12.1% for the quarter compared to the respective periods in 2021, driven by increased occupancy and rent increases for new and renewing tenants. Office same-property and net operating income on a cash basis increased by 13.3% for the year and 3.8% for the quarter compared to respective periods in 2021. Our office properties are in strong urban centers with a weighted average lease term of 7.5 years and leads to strong creditworthy tenants. I would like to point out that only 346,000 square feet of our leases in our office properties expire during 2023, which is approximately 5% of the total square footage in our portfolio. And lastly, retail same-property NOI on a cash basis increased by 5.8% for the year and 18.7% for the quarter compared to the respective period in 2021, primarily driven by the lease-up of River Landing in Miami and the strengthening of the U.S. dollar. For 2023, we are expecting same-property net operating income to grow in the range of 2% to 5%. Q4 2021 FFO was $0.35 per unit. Primaris had contributed $0.10 towards that. Excluding Primaris, FFO in Q4 2021 would have been $0.25 per unit compared to the 31% -- $0.31 per unit for Q4 2022, a 24% increase. For 2021, FFO was $1.53 per unit. Primaris had contributed $0.39 towards that. Excluding Primaris, FFO in 2021 would have been $1.14 per unit compared to $1.17 per unit for the year ended 2022, -- sorry, a 2.6% increase. Our 2022 FFO payout ratio was a very healthy 50% and our AFFO payout ratio was 60%. For Q4 2022, FFO was $0.31 per unit and AFFO was $0.22 per unit. Our net asset value per unit decreased from $22.58 per unit in September 30, 2022 to $21.80 at December 31, 2022, primarily due to Q4 fair value adjustments to our properties, which resulted in our real estate assets decreasing by $187 million. Most of the decrease in value came from our office portfolio, which now has a weighted overall capitalization rate of 6.43%. Debt to total assets at December 31, 2022, was 44% compared to 46.6% a year ago. At year-end, liquidity was in excess of $1 billion. Last month, we borrowed $250 million on our line of credit to repay the Series O senior debentures. The only remaining debt maturing in 2023 on 9 mortgages totaling $144.7 million. These 9 encumbered assets have a weighted average loan-to-value of 25% at December 31. In terms of development spending for 2023, we expect to spend approximately USD 140 million on our U.S. development projects and approximately $65 million on our Canadian development projects. So in summary, we are pleased with our 2022 results and confident that our high-quality properties and strong balance sheet will continue producing good results for 2023. And with that, I'll turn the call back to Philippe.

Operator, please move on to questions.

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

First of all, thanks for the guidance for '23. Just on that same-property outlook of 2% to 5%. Can you give a breakdown or a sense as to how it's going to look by quarter and by segment?

I don't know if you want to give specific numbers per segment, but maybe I can just share some color that will help you. That cost is going to be driven by our residential division, which we're expecting, call it, low teens growth in 2023, followed by our industrial division, which we're probably expecting the same kind of growth as we saw in 2022. And then we expect in our office and retail divisions to probably be pretty much flat. Hopefully, that helps, but I don't want to give specific numbers to specific segments.

Okay. And then kind of the unusual things that were driving some tailwinds, frankly, in 2022 on the same-property. Are those going to be continuing at all into the early part of '23? Or is all that pretty much in the past now?

I mean the first one that comes to mind is Jackson Park, we anticipated that to be somewhat normalized by now. I don't know, Sam, are you thinking about any particular tailwinds?

Well, just with, I guess, River Landing and obviously, the free rent that you had to. So just -- there's sort of the 3 factors that drove some unusually high same-property last year.

So most of those factors are not going to be there. We're not going to have the same growth in Jackson Park as we had this year. We're not going to have the same 2021, we had that free rent period on Hess in Houston. So that led to growth in 2022. We're not going to have that. But all in all, we are still expecting good growth from residential, from industrial and increasing rents on both those divisions that will lead us to that 2% to 5% overall growth that we are expecting in same asset.

Okay. That's helpful. And just over to the dispositions, obviously, great to see another significant office transaction on the block and ready to close. Most of the dispositions thus far have been in the office sector. Just wondering how you see the retail portfolio potentially being part of the disposition execution in the near term?

There's no urgency. As we said, we are going to be matching our dispositions where we have required funds. So if we pull through on the office, we have a little bit of retail that we expect to sell and then it will be slow and steady. There's no reason to sell preemptively at this point in time, and we'll do that as we hire funds.

That makes sense. Last one for me is just on capital allocation. With this disposition expected to close in April, how do you -- and you've got some development spending, but how do you view that versus hitting the leverage or even unit buybacks? How are you looking at 2023 capital allocation?

That's a good question, Sam. Our first course of action, we'd like to buy back our units, but we want to ensure we do that in a responsible manner. And when I say responsible manner, that's ensuring our balance sheet stays strong and that we have enough liquidity for all our needs going forward. So for example, in 2022, as you know, we bought back almost $300 million of units, but we improved our debt to assets to 44%, and we maintained our liquidity. So we'd like to do that, but again, in a responsible manner, and that's really going to depend largely on the amount of dispositions that we are able to achieve in 2023.

But again, our paranoia is, as you'll find the sector is really on our balance sheet, protecting our balance sheet first and foremost. When we're comfortable, we protected our balance sheet for 2024, then we'll be loosening up and going back to our [ JV ].

Your next question comes from Mario Saric with Scotiabank.

Just coming back to those 2 topics, the guidance and then the disposition outlook. What are the primary drivers that comprise the gap in the 2% to 5% range in that 300 basis points? Like what are some of the uncertainties that can result, do you think in the low end of the range 2% versus the higher end of the range of 5%?

The different property segments that consist of H&R REIT. I mean they have 4 very different growth profiles. And as such, next year, they'll offer different NOI growth percentages. But to be honest, we're also, as you've noticed from previous calls, we're also very, very conservative. And so we've given a conservative range as best as the visibility has given us.

But Mario, just remember that contractually, the long-term leases in office, ironically, it's the reverse. When you have office and industrial with long-term leases, that's contractual. And historically, it's always been 2% on a lumpy basis, 10% over [ 5% ]. So that you can actually predict and as you well know, we have very few lease rolls coming off in office industrial. That's not really an issue. The drive we are now is where you get to month-to-month, which is more residential oriented, and therefore, you need to have some -- you just know where the economy is going, coming off of healthy growth over the past 3 years of residential, you need to put some type of a range in there because you just don't know what the 2023 is going to look like. So office is no lease rolls, office is very steady. Growth is very tempered, that's your 2% level. And anything about -- as is industrial and is retail, in our case, we have -- in retail is very solid. So it's really just mostly residential that creates that fluctuation. And you need to have that in gap, you just can't predict what the world is going to look like over the course of the next 12 months.

I would just add. We're seeing good strong growth right now in residential. And we just hope that continues throughout the year, but we're not sure that's going to flow all the way throughout the whole year.

Got it. So the paraphrase, kind of the 2% to 5% range is really kind of predicated on the uncertainty associated with the U.S. economy in '23?

I would say, yes.

Okay. And then just coming back to, Larry, maybe your comment on the growth being good thus far. I appreciate the new disclosure on Lantower in the investor presentation. Can you -- I think the lease trade-out data was for '22 in total. Can you provide what those numbers were? It doesn't not be for each market, but can you give us a rough sense of what the new renewal and blended lease spreads were in Q4 for Lantower and how those are looking in January?

Mario, we want to stick to annual '22 over '21 metrics. This is the first time of us giving guidance for Lantower. Like I said in the speech, and I think I reiterated in some calls, we will look for additional opportunities to add quarter-over-quarter disclosures throughout the year. But as of right now, other than to say somewhat counterintuitively that the renewal rate has been by a multiple higher than new leases. I think that's what we're going to limit ourselves to on this call today.

Got it. Okay. And then stepping back more of a broader question. Heading into '22, you announced this transformational plan steadily executing on that sense. What would you identify as the key 2 to 3 tangible goals that you've set for the organization for 2023?

I think in summary, it's a continuation of our plan. I think we were very meticulous and careful and taken out the plan on October '21. I think today's results of today's call, yesterday's results are further evidence of our conviction in that plan. On a relative basis, we had a very strong year last year. We'd like to continue that momentum going into '23. All the while, despite the fact that we may be in turbulent times, still creating a tremendous amount of value, both in Canada through our rezonings with Matt Kingston and our development pipeline, both on the 2 properties that we're developing now, but also the advancement of the selective [ by reward ] development readiness of our remaining pipeline.

Okay. Great. Maybe one last one for me. On 160 Elgin, I appreciate you provide additional disclosure or detail going forward. But can you give us a sense of what the disposition price was in relation to the Q3 '22 IFRS fair value for the asset as opposed to Q4?

Yes, we have -- we [ hear ] that we've not been able to give all the disclosures we would like to be able to give now. So yes, I will answer your question, just a bit of back front, fair value adjustment in office was $194 million for the quarter. That was over 18 properties. 160 Elgin was one of those properties, and we wrote down 160 Elgin by $25 million in Q4.

Your next question comes from Matt Kornack with National Bank Financial.

With regards to -- I appreciate the guidance for 2023, but looking past that to 2024, you have a fairly sizable amount of industrial lease maturities. And I think about 1/3 of it maybe 7900 Airport Road. Can you give us a sense as to what you're expecting mark-to-market on that? And is there a chance to get to market? Or is there a fixed renewal there?

No. We -- that's a complicated transaction. I can't give you too much details on it, but we are working on it. So we're not concerned about the vacancy, we're not concerned about the rental rate is significantly -- market is significantly higher than what we're currently leased at. Regressively, like since we are currently working on the transaction and talking, we're not -- we can't give you too much color on that. That is our significant role. But again, it's no concern of ours. And state of our buildings that we have in our portfolio.

Just generally our market rental on industrial are way below our average rents that are currently in the market. So we would expect to get good growth coming forward from that division all the way out while we're...

Outside of Airport Road, is it a few other assets in the GTA that would make up the remaining sort of 600,000 square feet or so?

There's no concern to us. We're not losing sleep.

Okay. Fair enough. And then with regards to some of the -- well, the Dallas High School transaction and the opportunity there on the adjacent land, can you give a bit more color? And then maybe also with regards to the Cove if there's been any progress on that project?

The Cove is -- we're in the final stages of completing drawings. We're going to go for permit application, but we're going to put pencils down after that. We're not allocating any funds into development at this point in time, as we mentioned in our speech until we see a bit of visibility into the economy. So its zone is always was zoned. It's ready to go, but we're going to wait and see so we're going to pause on that. And that probably be in the next 30 days that we shall complete all the drawings and do our submissions on the Cove. Dallas High School, we purchased the land around Dallas High School for high-rise residential. There is a -- to be built sometime in the future not willing to pull the trigger right now on that development as we are not pulling the trigger really on any development. We -- there's a part that's been newly completed across the street. It's a historical office building. There's historical tax credits involved. It is Lantower's head office. Perkins & Will is -- has significant architecture firm, has a long-term lease on substantially most of the balance of the space. And the parking lot that is part of the office building is adjacent to the balance of the lands and should be integrated into a high-rise development in the future. High-rise residential development in the future.

And I noticed the description of your sort of target markets in the U.S. now includes Sunbelt and Gateway markets. I guess you've always been in Gateway markets. But is that sort of other than buying land in Miami, do you anticipate expanding kind of the residential investments in some of these Gateway markets?

No, I think there's more commentary on what we currently owned and perhaps anticipated developing. But for all -- for own such purposes, the growth in the U.S. residential segment will be predominantly, if not exclusively, some of our markets other than what we currently have.

We do have relationships with Ledcor, Qualico, our partners in Canada in the gateway cities. We never actually went to the gateway cities with our partners. So where there are -- and it's been opportunistic. So we're not turning down any opportunity that may come up into the future for the long term strategically, but we do have relationships and we do have landholdings with Ledcor, Qualico.