Dream Global Real Estate Investment Trust (OTC:DUNDF) Q3 2018 Earnings Conference Call November 9, 2018 11:00 AM ET
Executives
Jane Gavan – President and CEO
Rajeev Viswanathan – Chief Financial Officer
Alexander Sannikov – Chief Operating Officer
Analysts
Sam Damiani – TD Securities
Pammi Bir – Scotia Capital
Himanshu Gupta – GMP Securities
Sumayya Hussain – CIBC World Markets
Operator
Good morning, ladies and gentlemen. Welcome to Dream Global REIT’s Third Quarter 2018 Conference Call for Monday, November 12, 2018. During this call, management of Dream Global 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 risks and uncertainties, many of which are beyond Dream Global REIT’s control that could cause actual results to differ materially from those that are disclosed or implied by such forward-looking information. Additional information about these assumptions and risks and uncertainties is contained in Dream Global REIT’s filings with securities regulators, includes latest annual information form and MD&A. These filings are also available on Dream Global REIT’s website at www.dreamglobalreit.ca. [Operator Instructions]
Your host for today will be Ms. Jane Gavan, President and CEO of Dream Global REIT. Ms. Gavan, please go ahead
Jane Gavan
Thank you, operator. Good morning. Welcome everyone to the third quarter conference call for Dream Global REIT. It’s our first call, with our new CFO, Rajeev Viswanathan, and our newly appointed COO, Alex Sannikov. As our business has grown over the last year, we’ve taken the opportunity to realign roles to focus on growing the long-term value of the business, particularly our approach to asset management, capital allocation, redevelopment opportunities and creating new sources of revenue.
With an already strong stable operating platform in Europe, Alex is going to be additive to help drive asset strategies, capital allocation, and growth. And Rajeev is going to focus on IR, reporting, managing the balance sheet and leveraging his experience with technology to help build a stronger operating platform in Europe.
I’m going to make a few summary remarks and then you’ll hear from Alex and Rajeev, and then we will open the call to questions.
For the third quarter, we continued the positive momentum from the first half of 2018, with solid operating performance and continuing balance sheet improvement. The REIT delivered strong quarter-over-quarter and year-over-year net operating income, driven by occupancy gains in the Dutch portfolio and strong rental rate growth in Germany.
This quarter, the REITs year-over-year comparative NOI growth of 3.8% surpassed last quarter’s mark by 10 basis points, primarily on the back of strong rental growth in Germany, indexation increases in the Deutsche Post leases and leasing activity. Following deployment of the proceeds from the June equity offering, our leverage continues to sustain our historically low levels. This quarter, the REITs FFO per unit was driven by the strong operating performance of our portfolio and offset is expected by the temporary diluted impact associated with deployment of proceeds from the June equity raise.
Those proceeds are now fully invested in high-quality office and industrial assets in Germany and the Netherlands. The assets are well located in markets with strong fundamentals, largely in top markets where we already have a presence. We see opportunities to use active asset management strategies in some of these assets to deliver stronger NOI growth and valuation upside over the near term.
Absorption in our German and Dutch assets has been strong year-over-year driven by continued leasing momentum in the Dutch portfolio and the lease-up of our value-add portfolio in Germany. On a comparative basis, our value-added properties in Germany improved committed occupancy by slightly over 10 percentage points compared to the third quarter of 2017, and over the same period, our Dutch portfolio has improved committed occupancy by over 300 basis points.
A little over a year since the Merin transaction was completed, we are really pleased the portfolio is performing better than our underwriting. We continue to see cap rate compression this quarter across the investment markets, despite cap rates already being at historic low levels at the end of the first half of 2018. While this poses some challenges in finding high-quality acquisition opportunities in our top markets, the sales of the properties and our capital recycling program have continued to reap the benefits of the strong investment markets, and we expect to exceed our target volume of sales for 2018.
Our assets in the investment portfolio have also been benefited from these developments registering a valuation increase of more than $56 million in the quarter.
So with that, I’m going to turn it over to Alex to provide an overview.
Alexander Sannikov
Thank you, Jane. Good morning, everyone. The continuous strengths of the economic environment in Germany and the Netherlands has supported the improving real estate fundamentals in our key markets. In Germany, office vacancy rates fell further across the big seven markets and now stand at 3.9%, a decline of 120 basis points year-over-year and 40 basis points from Q2 2018.
New supply is moderate and mostly spoken for. The Dutch occupied markets continue to improve in 2018, with limited supply coming online and office vacancy rates in the G5 cities are at historic lows of 7.1% at the end of Q3.
Rental rates have been also rising. The vacancy rate in Amsterdam market continued to decline and is at 4.5% at the end of Q3, representing a 30 basis points decrease from the second quarter.
In Q3, we completed 315,000 square feet of new leases in addition to 479,000 square feet of renewals. This translated into occupancy gains predominantly in our value-add assets, which are up 8.1% from December 31 on same property basis. We operate in a highly competitive investment environment, but our portfolio strategy remains focused and on a very disciplined and deliberate allocation of capital.
In Q3, we acquired or firmed up on 5 assets totaling €219 million, including 4 closed transactions for €139 million, and one property under contract for €80 million. It is closing today. In line with our overall portfolio strategy, these assets will further improve the risk profile of our portfolio and offer us the opportunity for NAV growth through active asset management. 90% of these acquisitions by value are high-quality core and core plus office assets with an average occupancy of roughly 97%. They will deliver rental growth through rental uplift on lease rollover.
The remaining 10% consists of a value-add property in Utrecht, one of the best-performing office markets in Europe and logistics assets in Randstad in line with our strategy of incrementally growing our exposure to this attractive and high-yielding asset class. The weighted average cap rate – going in cap rate of these 5 acquisitions is 5.5%. The largest asset we acquired this year is Podbi Park in Hannover, previously announced in the second quarter and closed on September 28. We financed this asset with the proceeds from the equity offering, as well as a non-recourse secure debt, which Rajeev will speak about shortly.
Today, we also closed on Innovum 212, a 380,000 square-foot office complex consisting of eight buildings located in Nuremberg. Nuremberg is Germany’s ninth largest office market and has strong macro level and occupying market fundamentals. Multitalented with a weighted average lease term of 3.4 years, this property is 95% occupied, has a subway station at the front door and is part of a well-amenitized mixed use neighborhood. As with Podbi Park, we believe that active asset management can favorably impact both revenue and NAV growth over the short term.
We intend to drive 4% to 5% average annual NOI growth over the near term via rolling rents to market and other initiatives. Together with three other assets we already own in Nuremberg, we expect to unlock operational synergies with this acquisition.
Moving onto the Netherlands, we acquired our second logistics property of the year, increasing our total volume of industrial acquisitions in 2018 to €25 million. Located in Bleiswijk in the center of Randstad metro region, this asset is fully occupied by a high covenant food distribution tenant, who has made significant investments in robotics and automation within the property. Purchased for €12.1 million at a going in cap rate of 9.3%, we anticipate steady growth of NOI from annual rent increases. We intend to invest about €700,000 in the new roof for the asset in 2019.
On September 20, we acquired Gaudi, a Core plus office asset in Southeast Amsterdam, one of the hottest office locations in Europe at the moment. This will be our eighth building in this submarket and we intend to capitalize the management synergies and our leading market position in the submarket. Gaudi is fully occupied by the municipality of Amsterdam. It is located adjacent to Apollo, one of our top Dutch asset and now also fully leased. With in-place rents that we estimate as 15% below market, prospects for rental upside can be enhanced through introduction of our boutique office concept at a future date. We purchased the asset for €23.8 million. That translates to a going-in cap rate of 5.8%, with near-term growth through annual indexation. Upon repositioning, the asset should generate an unlevered NOI return closer to the mid-7% range.
On September 21, we acquired Yin Yang, a value-add property in Utrecht, the second largest and strongest office market in the Netherlands after Amsterdam. The property is currently 70% leased with a weighted average lease term of 5.6 years. We view this asset as an ideal ultimate manage to Core plus asset and expect to stabilize occupancy within 12 to 18 months.
The lobby has been recently renovated and is ideally suited for our boutique office concept, as well some of the vacant office space have already been prepared to accommodate our smart office concept. At a purchase price of [€12.5 million], the property generates a going-in cap rate of [6.5%] with near-term growth through vacancy lease-up and contractual rent increases. We expect to stabilize the asset within an NOI yield north of 10%.
Today, we closed an opportunistic disposition of our 50% interest in Werfthaus, Frankfurt. Together with a JV partner, POBA, at a 14% premium to the last book value. Werfthaus is a high-quality office asset that we acquired in 2013 as part of the [SEB] portfolio. However, as many of you remember from our property tour, it is located in Westhafen, approximately 2 kilometers from the banking districts where our other Frankfurt property K26 is located. The main tenant in the property already vacated their space in advance of the lease expiry at the end of 2019, and sublet the premises to another tenant requiring swing space for a short term.
As we expected in our acquisition underwriting in 2013, this main lease is over-rented and although the market trends have been catching up on Frankfurt over the past five years, the in-place rents are still 15% to 20% above our estimate of market. We exercise the dual-track approach to this asset plan for Werfthaus. In addition to repositioning and re-letting plan, we explored the possibility to opportunistically recycle capital from this asset into assets offering stronger return prospects.
We were very pleased with the feedback from the market and the pricing for Werfthaus. The sales price reflects an unlevered yield on our estimate of stabilized NOI of just over 4%, taking into account their required leasing costs and downtime. The cap rate on the current above-market NOI is approximately 5%. The transaction was structured as a shared deal with limited transaction costs and no tax on the embedded capital gain.
Turning to our [indiscernible] sales. For 2018, we expected to sell approximately €100 million of non-core assets in Germany and the Netherlands. So far in 2018, we closed or have under contract €106 million of dispositions. The capital from these sales has already been allocated to the acquisitions we spoke about earlier and value-add projects.
Lastly, we continue to advance our redevelopment projects. As previously discussed in Q2, we have prioritized five sites for work in 2018. Two of these sites Offenbach and Bonn in Germany were vacated this quarter, and as expected is reflected in a slight decline in occupancy for the portfolio. We continue to pursue the rezoning and repositioning process and will report back next quarter, as we make additional progress.
I will now turn the call over to Rajeev to discuss our financial results.
Rajeev Viswanathan
Thanks, Alex and Jane, and good morning, everyone. This is my first quarter with Dream Global and I look forward to continuing to support the long-term value creation strategy for unitholders of the REIT.
Let me talk about some results. Diluted FFO per unit was $0.25, a decrease of $0.01 versus last quarter and flat versus the same quarter last year and in line with our expectations with a temporary dilution from the June 2018 equity raise, accounting for the $0.01 difference from Q2.
For the full year, we expect diluted FFO per unit of [$0.25], which is an almost 10% increase relative to $0.95 in 2017, largely attributable to the Merin acquisition last year, continued positive performance from our German assets and favorable FX. Merin will be included in our comparative numbers next quarter, the results from which will continue to support our positive comparative NOI growth trend over the last few quarters.
Our upper NAV per unit in euros increased from €9.27 to €9.48, as a result of €37 million of fair value gains owing to the completion of certain value-add initiatives, continued strength in our German key markets and market rent growth, as well as some cap rate compression, but was flat on a Cad dollar basis at $14.24, as unfavorable FX offset the aforementioned fair value increases.
Consistent with prior year, we obtained third-party appraisals on all the properties in our portfolio at year end. For context, a 25 basis points change in cap rates would result in a $1.25 change to our NAV per unit. The lending environment in Europe remains attractive as we place the €47 million, 10-year fixed rate debt on Podbi Park at a rate of 1.84% relative to going-in cap in the 5%.
Additionally, we expect to close on the $80 million – actually, we’ll close on $80 million acquisition of Innovum later today, where we secured a €33 million mortgage that’s incremental, a 7-year debt at 1.5%, again, relative to a going-in cap of in the 5%. Further, as part of this financing on Innovum, we transferred €15 million mortgage with the same lender from one of our other German assets onto Innovum to continue to build our unencumbered asset pool.
What is particularly interesting for me from a Canadian context is the non-recourse nature of our mortgages and the ability to buy 5 and 6 cap high-quality assets and place sub-2% debt providing a much wider margin of safety for the balance sheet and yield. With the funds from our June 2018 equity raise now full deployed, our debt to gross book value is 45%, an almost 400 basis points reduction relative to year-end and a ratio of now within our target range.
We expect our leverage metrics will continue to trend down over time, as we continue to dispose our non-core assets, achieve continued comparative NOI growth and generate value from our redevelopment and value-add assets. And now I’ll turn the call back over to Jane.
Jane Gavan
Thanks, Rajeev. Operator, we’re going to open the call now to questions.
Question-and-Answer Session
Operator
[Operator Instructions] And our first question is from Sam Damiani from TD Securities.
Sam Damiani
Thank you and good morning everyone.
Jane Gavan
Good morning Sam.
Sam Damiani
Alex, congratulations. I’m sure no one’s surprised to see you were recognized with the new title. Congratulations.
Alexander Sannikov
Thank you very much, Sam.
Sam Damiani
It was good color on the disposition in Frankfurt that was interesting. Just curious if you’re looking at potentially similar dispositions within your joint venture with POBA. I know earlier in the year, you talked about potentially buying in some of the interest yourselves. But I guess, obviously, a third-party buyer came up with a more attractive bid, but what can we expect in future with the POBA joint venture?
Jane Gavan
Well, I mean – I think, Sam, that one asset, Werfthaus, always probably the one we had least liked in the portfolio. And so we were – as Alex mentioned pursuing that double track. We’re delighted with the price. I think, we really like our other assets in that portfolio. So we’re looking at deploying capital and value-add assets. We’re looking at recycling. We still have some non-core assets to dispose off. But for right now, I think, the POBA stuff is still in our whole bucket.
Sam Damiani
Thank you, and just on the market rents in the Netherlands. They’ve stayed relatively flat versus in-place rents whereas Germany they’re higher, obviously. Do you see the market trending to a point where you’ll start to see meaningful rent – market rent inflation in the near term?
Alexander Sannikov
Yes, indeed Sam. So we’re seeing that in Amsterdam in Utrecht. And we’ve been gradually updating sort of the market rents and the portfolio. You see that on the blended basis, the rents didn’t move that much because we added Atoomweg as you remember that’s significantly over-rented. So that sort of impacts the average. So we see it – we’re kind of growing market rents in Utrecht in Amsterdam. The Randstad on average is flat, but we’re starting to see signs that it’s going to – will start trading upwards.
Sam Damiani
All right, good. And just finally, Rajeev, first of all, congratulations on your new role, with the debt costs so attractive as you pointed out, are you seeing any change sort of rate today versus let’s say a month or two ago in the market for debt in either Germany or the Netherlands?
Rajeev Viswanathan
Maybe pricings – maybe 10 basis points wider, but no. I think it’s still a very healthy market and lots of liquidity out there looking for attractive opportunities.
Sam Damiani
Great, thank you. I will turn it back.
Operator
Our next question is from Pammi Bir from Scotia Capital.
Pammi Bir
Thanks, good morning. Just looking at the Dutch industrial property that was acquired I think in Bleiswijk, sorry, if I’ve butchered the pronunciation there, but even after a factory and some of the additional Capex for the roof, the cap rate still looks like it would be close to 9%, just curious if there was anything else unique about this asset that pushed that up, or is that where our comparable sales are?
Alexander Sannikov
Look, it is nothing unique. We think the asset is sort of a very high-quality property. As I said, the tenants invested a lot in automation and robotics in the premises. The weighted average lease term is a bit shorter. It’s about 4 years, and we think the rents are at market. So that probably affected the cap rate plus the size – it’s not of a size where large logistics players will go after something like this. So that probably affected the cap rate as well.
But we obviously had to take the view on the probability of reletting the assets and the prospects for that, even the tenants were to vacate in four years. So we’re very comfortable with that, given the asset’s location and the quality. And obviously, we expect that the tenant will – is more likely to stay than not.
Pammi Bir
All right. It’s good color. I guess, if just looking at the asset mix today and where the cap rate differentials are between office and industrial, particularly I guess – opportunities in the Netherlands. What are your thoughts with respect to raising the industrial exposure from where it is today at, call it, around 6%?
Jane Gavan
I think we like to selectively pick off assets like this one we did in the Netherlands and increased our exposure to industrial. I think we have said that a couple of times that if we took it up a couple of percentage points, it gives us nice diversification. And we feel comfortable, obviously, with the asset class.
Pammi Bir
Could you at some point maybe – would you consider, I guess, larger portfolio transactions that would push that into maybe the mid-teens, or is that just not something that you’d be looking at this stage?
Jane Gavan
We haven’t seen any portfolios, by the way, that really look that attractive. But you could see it going somewhere, I don’t know, up to 10%, perhaps. And what we’re doing is we’re recycling proceeds from sales of assets into these – into the industrial class.
Pammi Bir
Right, okay. You’ve had some nice same profit NOI growth this year and I guess good disclosure on the breakdown. But if we look towards 2019, how are you feeling about the outlook between the German assets and the Dutch portfolio?
Rajeev Viswanathan
Hey, Pammi, it is Rajeev here. If you think about our German portfolio, the occupants pretty much fully left. What are you going to see on that is market rent growth. And if you think about the Dutch portfolio, it’s really occupancy growth. And I – when I think about our comparative NOI growth, turning around 3%, I think that’s a trend that we see continuing. We’re going into our business planning sessions in December, and we will give a lot more color on that stuff on our year-end call.
Pammi Bir
Great. Thanks very much.
Operator
Our next question is from Himanshu Gupta from GMP Securities.
Himanshu Gupta
Thank you and good morning. Just to follow up on the disposition question, just wondering will you opportunistically sell any core assets into the strong markets? Do they get advantage of the low cap rates and perhaps recycle in Core plus or value-add strategy? I know the Frankfurt disposition was not the most desired property there.
Jane Gavan
I think we look at – if you want us to look at everything, we’re focused on the building a company that has a lot of long-term value. So I don’t want to let go of the assets that we think are going to appreciate in value, are really well located. As you’ve heard us over the last several quarters, it’s hard to buy assets. So I think we would only do it really selectively, and only if we sort of thought well we’ve capped up the value in that building.
Himanshu Gupta
Fair enough. And just moving to the Dutch portfolio, Jane, you mentioned that portfolio was better than the initial underwriting. So what has led to the upside? Is it the recovery in the overall market, which surprised or is it the specific assets or the strategy, which drove the gains?
Jane Gavan
I think it was all of the above. I think the market – I think our timing was good. I think the market has performed better. I think the teams worked really hard to over deliver on the underwriting. I think, as one might expect when you’re doing a transaction of that size, we were conservative in our underwriting. So all of those things, I think, the market has maybe accelerated a little bit more than we thought.
Himanshu Gupta
All right. Okay, thank you and maybe just one last question on the balance sheet, and obviously, the lending environment is fairly attractive. I was just wondering what – and leverage is fairly low relative to historic levels, so what is the target leverage ratio? And are you ready to take advantage of these low rates, and perhaps, pump up leverage in the near term?
Rajeev Viswanathan
Yes. Look, I think, we’re sort of in our target range. If there’s something amazing, we’re looking to trend leverage down and really protect the balance sheet.
Himanshu Gupta
Okay, thank you. Thank you for the color. I will turn it back.
Operator
Our next question is from Sumayya Hussain from CIBC.
Sumayya Hussain
Good morning. Thank you. Just firstly on your Atoomweg property and the upcoming lease, no expiry there, what’s the extent of repositioning you tend to do and what kind of downtime do you expect before the asset is leased up there?
Rajeev Viswanathan
So I think, you’re referring to the two properties Dutch Post vacated this quarter.
Jane Gavan
Atoomweg.
Alexander Sannikov
Atoomweg, I am sorry. So for Atoomweg, as we announced at our AGM, our base case plan is to convert the assets into one of our boutique office concept. So with that, we expect to invest about €1 million in upgrades and then about a couple of million euros in leasing costs. So that will take about 12 to 18 months after the tenant vacates in May 2019. And as stated in our investor presentation, we expect to stabilize the asset with €1.2 million of NOI. We’re looking at other alternatives for the asset, maybe, to increase density and increase NOI, but that would be sort of a side that is going to more of development side then repositioning. Right now, our base case continues to be repositioning of the asset.
Sumayya Hussain
Okay. So pretty much a 12 to 18 month…?
Alexander Sannikov
Correct, yes.
Sumayya Hussain
Okay. And then just Jane in your market commentary, you noted a slight decline in investment volumes on the Dutch side over last year. Can you give us some context around what you’re seeing in the market and is it just mainly a function of flapping a really strong 2017?
Alexander Sannikov
2017 was indeed very strong and as a result, we just – 2017 was almost a record year. So the 4% decline is a pretty strong market from our perspective, and we’re seeing lots of demands. But with that increased demand, there’s maybe not as much supply of investment opportunities as it was last year to meet that demand. So that’s from our perspective pretty normal and reflects a very strong market.
Sumayya Hussain
Okay, great. I will turn it back.
Operator
And we have another question from Sam Damiani from TD Securities.
Sam Damiani
Thank you. Just some headlines on, sort of, global economics maybe growth slowing even in Germany, specifically. Just curious if you’re seeing any difference in demand or traffic or discussions with your leasing staff in terms of what they’re seeing on the ground if there’s any sort of sign of a slowdown.
Jane Gavan
Yes, that’s just a good question. No – I mean, as Rajeev said in his comments, we’re going through our business planning right now. So the leasing pipeline looks very robust. I mean, I wish we had more space in some of our properties. So no, it’s been – we haven’t seen any evidence of a slowdown. You’re at such low vacancy in the markets, so we’ve got one and two people lined up for space.
Sam Damiani
That is great. Thank you very much.
Operator
[Operator Instructions] And we do have a question from [Philip Whitworth] from a private investor.
Unidentified Analyst
Hi. I am sorry I joined the call a little late, so I might ask a question, which may have already been asked. Your ratios seem to be quite sufficient, especially comparable to most other companies, which use similar ratios. When it came time to consider increasing their dividend, I was just wondering since your ratio is at the most bullish level, have you had any consideration for that?
Jane Gavan
Thanks for the question. I think, over the last couple of years, we’re still pretty focused on bringing our ratios, lowering our debt, making this company safe for the long-term. I think, we also have pretty interesting opportunities to reinvest the money. So as long as we’re getting good return out of that reinvestment, I think we would prefer to do that.
Unidentified Analyst
Do you think that any appreciation on price of the stock would be more consider it concerned with your – as long as it’s profitable in your investment portfolio or the return because really outside of many institutional investors, which – not so much longer a whole period but the individuals, such as myself, although I’m a very, very substantial shareholder from day 1. If the return that seems to be a determining factor, so is either buying, selling or maintaining a position in the company, especially with interest rates rising?
Jane Gavan
Yes. I mean, I think, that’s why we’ve been sort of focused more and more on total return, sustainable distribution and then growing the value of the NAV.
Unidentified Analyst
Okay. It is a competitive business. So I insist – I’m trying to talk about in terms of return.
Jane Gavan
Yes, absolutely. We want to outperform and make sure that we’re outperforming our peers in the index, which we’ve been, sort of, doing the last two years. We’re very focused on, yes, maintaining that competitive investment – competitive advantage for investors capital. We get it. You have a lot of choice about where you put your money. But we think this portfolio, the opportunity in front of us to grow NOI, to grow value, is going to produce that return for you.
Unidentified Analyst
Okay. You have done a wonderful job in increasing the value. Now it’s just a matter of increasing investor interest.
Jane Gavan
Yes.
Unidentified Analyst
You see what happens is, when there’s more buying than selling the stock goes up.
Jane Gavan
Yes. That’s true. Thank you very much.
Operator
And there are no further questions at this time.
Jane Gavan
All right. Well thank you very much everybody and we look forward to reporting our quarter – our year-end results. Thanks a lot.
Operator
That concludes today’s conference. Thank you for participating. And you may now disconnect.
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