Centerspace (CSR) Q4 2018 Earnings Report, Transcript and Summary

Good morning and welcome to the IRET Fourth Quarter 2018 Earnings Conference Call and Webcast. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Mark Decker, President and Chief Executive Officer. Please go ahead.

Thank you and good morning. IRET's Form 10-K was filed with the SEC yesterday after the market closed. Additionally, our earnings release and supplemental disclosure package have been posted on our Web-site at iretapartments.com and filed yesterday on Form 8-K. Before we begin our remarks this morning, I want to remind you that during the call we will discuss our business outlook and we will be making certain forward-looking statements about future events based on current expectations and assumptions. These statements are subject to risk and uncertainty discussed in yesterday's press release and Form 10-K and in other recent filings with the SEC. With respect to non-GAAP measures we use on this call, including pro forma measures, please refer to our earnings supplement for a reconciliation to GAAP, the reasons management uses these non-GAAP measures, and the assumptions used with respect to any pro forma measures and their inherent limitations. Any forward-looking statement made on today's call represent management's current opinions and the Company assumes no obligation to update or supplement these statements that become untrue due to subsequent events. With me today are John Kirchmann, our Chief Financial Officer, and Anne Olson, our Chief Operating Officer. I'd like to start the call by congratulating Anne in her new role as Chief Operating Officer. It's a role that's been well-earned and I know she will be instrumental in driving results for the Company. I'd also like to thank Andy Martin, who until recently served as our EVP of Operations, for his many years of service to IRET. We simply wouldn't be where we are today without him and I wish him the best in what comes next. Thanks for everything, Andy. Fiscal 2018 was a big year for IRET. We refined our business focus to apartments. It's easy to show our progress through the transactions we completed, with 50 properties sold for $515 million and four communities purchased for $373 million, but transactions don't make a transition and our transition to a premier multifamily company will continue. This year we'll build on the momentum we created over the last 12 months by focusing on enhancing our operations platform, and while we are always seeking to add strategic and accretive communities to our portfolio, we're centering our efforts on value creation, specifically growing cash flow per share as we come off the trough of our transition from this past March. We remain committed in addition to a flexible balance sheet, meaning we are not likely to incur meaningfully more leverage than we have today. We do believe there will be a time in the future when having capital at the ready will be a real advantage, but today the robust amount of capital seeking multifamily investment creates an environment where strategic and accretive investments are very hard to find. So, our primary focus is inward where we have outstanding opportunities to expand our margins and make revenue-generating investments with higher risk-adjusted returns in the product we already own. First, on the margin front, we're focused on how we fundamentally run our properties, how we staff and train our people, how we're equipped to deliver service and track progress from leasing and maintenance calls to turning an apartment upon move-out. We are committed to constant improvement of our operations with a keen eye on expense containment and we are identifying and tracking improvements with a program we've dubbed internally, 'Rise by 5', where 5 represents 5% of the communities' operating margin. We're working to take our Multifamily margin from the 56% we just reported for fiscal year 2018 to greater than 60% on a portfolio basis. If you take fiscal 2018's Multifamily top line revenue of $160 million, 5% of additional margin would've resulted in an extra $8 million of cash flow. Some of these improvements will be immediate, others will take time, perhaps as long as three to five years, but we believe our goals are realistic and achievable. Second, on the value-add front, we know that over 5,000 apartment homes have had no renovation other than standard turns since 2008 and we are currently embarking on a program to redevelop our portfolio in a disciplined and thoughtful manner. A year ago we had talked about stopping that program to make sure we were monitoring properly and hitting our returns. Today we've identified underwritten and begun on improvements that will affect more than 1,000 homes and several amenity spaces in our communities. We're approaching our value-add program with method and accountability and have developed a team and a strategy that will be nimble enough to change as market circumstances dictate. Between value-add and stabilization, results will naturally lag. For example, in this last quarter we had two months out of three where we had $116 million in restricted cash and only one month of NOI from our most recent acquisition, Westend Apartments in Denver. We also have two projects at the tail-end of lease-up, Oxbo and Dylan, as well as 71 France where we took over management in February with the asset occupied in the low 80's given pressure from new supply delivered to that submarket. We can be sure that there will always be challenges and opportunities but between transactional activity, operational improvements in the works, value-add initiatives, and stabilizing recent investments, the full earnings power of this company has not yet been realized. Turning to our markets, we're excited where we sit today and we believe in markets. Market selection gives us our best chance to succeed, and while it sounds obvious, market selections played a huge part in the changes we've made in the last 12 months. If you review our portfolio, past and present, we flipped from North Dakota to Minnesota as our base, with a focus on Minneapolis, and we added Denver, a market that like Minneapolis we believe holds great promise over the long-term. Our exposure to and focus on these markets sets us apart from our public peers, providing a differentiated strategy that's still focused on top 25 markets. As we outlined at NAREIT REITweek a few weeks ago, we expect 30% of our NOI this year to come from the Twin Cities and Denver with over 50% coming from Minnesota and Colorado. So, looking at those markets in a little more detail, the focus on what drives the portfolio management strategies, the Twin Cities and Denver served as our top institutional markets, Twin Cities' economy supported by large corporations, diverse industries generating stable job growth. 19 Fortune 500 companies and eight of the largest private companies including Cargill at #1 are headquartered in Minnesota. Statistically speaking, when you look at the top 25 largest MSAs in the country, the Twin Cities ranks among the top seven markets in occupancy, unemployment rate, median household income, and percentage of adult population with bachelor's degree or higher. Denver's economy has seen significant growth over recent years and in particular since 2010. The metro area's advantageous location, proximity to outdoor amenities, livability, workforce, attractiveness for doing business, have all prompted job creation throughout the metro as employers and employees relocate to the area and entrepreneurs create new ventures. This virtuous cycle has led to the creation of 305,000 jobs since 2010. Statistically speaking, again when looking at the top 25 MSAs, Denver also ranks among the top seven in unemployment, median household income, and again, percentage of adult population with bachelor's degree or higher which in this economy is incredibly important. Looking at a few of our secondary markets, Rochester, Minnesota, Grand Forks, North Dakota, Omaha, Nebraska, St. Cloud Minnesota, and Bismarck North Dakota, which comprise 45% of pro forma NOI, we have communities that feature unemployment that compares favorably to national average, high median household income, good occupancy, and balanced local economies with major employers including Mayo Clinic, IBM, Union Pacific, University of Minnesota, University of North Dakota, and several health systems including Sanford Centra Care and Altru. We believe these markets have solid fundamentals and that our product is well-positioned there. We also understand data is hard to come by in these markets and we will be working to provide more information to the investment community in the future. So, with fiscal 2018 behind us and the New Year underway, we feel very fortunate to have a great team and a platform that can take advantage of whatever lies in front of us. And with that, I'd like John to summarize our financials and talk a little bit about expectations in 2019.

Thank you, Mark. I am pleased to elaborate on how our transformation is reflected in our reported financials and balance sheet activities. Last night we reported core FFO for the fourth quarter of fiscal year 2018 of $0.08 per share, a decrease of $0.03 from the prior year quarter. For fiscal year 2018, core FFO was $0.38 per share, a $0.09 decrease from the prior year. The decrease was primarily due to reduction in NOI from the sale of commercial and non-core multifamily assets and our previously announced CapEx policy changes. Moving to our same-store results, year-over-year same-store revenues grew 5.2% for the quarter and 4.3% for the year. Revenue growth was driven by increases in occupancy, rental rates, and other resident-based rental revenue. Our weighted-average occupancy in our same-store portfolio increased 380 basis points to 95.1% for the quarter and 240 basis points to 93.7% for the year. We achieved our goal to have a weighted-average occupancy of 95% by April 2018, a goal we believe increases our efficiency, drives pricing power, and expands our margins. Having arrived at this goal, we have begun to shift our focal point from occupancy growth to increasing asking-rent. We anticipate more moderate revenue growth in fiscal year 2019 as we transition from a focus on occupancy gains to a focus on rent growth. Same-store expenses for the quarter increased 5.8% compared to the prior year, which when combined with our 5.2% revenue growth resulted in a 4.7% increase in NOI for the quarter. For the full fiscal year, same-store expenses increased 9.5% compared to the prior year, resulting in a 0.4% increase in same-store NOI. Both the expense and NOI results are in line with our expectations and reflect our strategy to build our operating platform, increase efficiency, and improve financial reporting. The primary components of the $4.9 million increase in same-store expenses for fiscal year 2018 were; an estimated $2.7 million increase for the aforementioned capital expenditure policy changes; a $1 million increase in labor cost, primarily related to higher wages plus increases in labor costs related to occupancy growth and the suspension of redevelopment activities in the current year; and a $900,000 increase in real estate taxes due primarily to higher levy rates. We expect lower expense growth during fiscal year 2019, primarily due to fiscal year 2018 including the full-year impact of the capital expenditure policy change. Other factors expected to impact fiscal year 2019 expense growth include continued pressure on labor costs from lower unemployment levels across our markets offset by expense containment initiatives to be undertaken by our operations team during the year. Moving to capital expenditures, as presented on Page 16 of the supplemental, for the current year, same-store CapEx was $11.8 million as compared to $12.1 million in the prior year, for an aggregate decrease of $300,000. Turning to value-add, our same-store value-add capital expenditures decreased from $16.5 million during fiscal year 2017 to $400,000 for the current fiscal year. As Mark mentioned earlier, after a year-long evaluation and with a new asset management team in place, we have identified 1,000 apartment homes in our portfolio as redevelopment candidates. We do not anticipate our value-add program will add significantly to our FFO results for fiscal year 2019 due to the upfront time and cost in launching these programs, including additional vacancy loss and unit turns, resident disruption on renovations of facilities, and the ramp-up required to rollout the program across the portfolio. Looking at our general and administrative expenses, total G&A was $4.1 million for the quarter, a $600,000 decrease from the prior year, which is primarily due to lower compensation cost. Fourth quarter G&A increased $1.1 million from the third quarter. The following items contributed to this increase; $400,000 in legal fees associated with our pursuit of recovery under a construction defect claim; $300,000 of severance costs; and higher compensation cost due to the filling of a number of open positions during the third and fourth quarter. For all of fiscal year 2018, G&A expense totaled $14.2 million, a $1.7 million decrease from the prior year. The decrease was primarily due to reduced salary cost related to lower headcount plus a number of open positions during the year as we completed the buildout of our team. Adjusting for year-to-date transition cost of $900,000, G&A for the year would have been $13.3 million. Looking at fiscal year 2019, this amount is expected to increase to $15 million, primarily due to a $900,000 increase in legal fees related to our pursuit of a recovery under a construction defect claim. Other factors impacting the increase are; an increase of $500,000 in compensation cost related to both the expectation of fewer open positions and the implementation of an incentive plan for non-executive management, as well as $300,000 for planned transition costs. We believe the new incentive compensation plan further aligns our team to a shared set of goals and performance expectations. Turning to our balance sheet, we continue to improve our flexibility. As of April 30, we had $194 million in total liquidity, including $176 million available on our corporate revolver. This year we have also made significant progress in strengthening our balance sheet. We issued 4.2 million shares of Series C preferred shares for $103 million in gross proceeds. We redeemed all of our Series B preferred shares for an aggregate cost of $115.8 million, which when combined with the Series C offering reduced our obligation to preferred shareholders by $2.3 million. We also expanded our unsecured line of credit to $300 million of total commitment while adding a $6 million operating line that will allow us to reduce our average balance of cash on hand. As mentioned last quarter, we closed on a $70 million unsecured term loan with a swap agreement to synthetically fix the interest rate. This flexibility allows us to continue to work toward increasing our unencumbered NOI and achieving debt metrics in line with investment grade benchmarks. During the quarter we also took impairment charges totaling $18.1 million, with $12.2 million on an apartment community in Grand Forks, plus additional charges totaling $5.9 million on non-apartment assets. In addition, as we transformed to a fully focused multifamily company, we have started a cost containment initiative to identify and drive operating expense savings at our communities to create better scalability and reduce the rate of expense growth. Finally, with regards to guidance, with the uncertainty surrounding the impact of the cost containment initiatives, we are not providing guidance at this time. However, we have provided some insight on some of the metrics and we recognize the importance of robust disclosure, including guidance, to the investment community, and so we'll re-evaluate this decision next quarter. For now, as previously mentioned, our fourth quarter core FFO was $0.08 per share, which includes only one month of Westend results. Adjusting for a full quarter of Westend results, core FFO would increase to $0.085 to $0.09 per share. We believe this to be a reasonable quarterly run rate for fiscal year 2019. Obviously, the timing of additional transactions, including potential dispositions or acquisitions, will affect this run rate. With that, I will turn the call over to the operator for questions.

[Operator Instructions] The first question comes from Jim Lykins with D.A. Davidson. Please go ahead.

First of all, can you just give us a little more color on Andy's departure, if there's a succession plan that is in place and if this could be something that could set you back at all over the near-term?

So, the succession plan is really Anne is taking the role of COO, and Shawnee Tharp who was one of our VPs of Operations has stepped up to SVP of Operations, and Su Picotte who was in Asset Management is now Asset Management and Operations Support, so dealing with functions that are really kind of whole portfolio-centric collections, procurement, marketing, et cetera. So, both of those two will roll up to Anne. And Andy did a great job and I'm very happy with where we are, I don't think we’ll miss a beat.

Okay, so it sounds like no additional hires. Is that correct?

Correct.

Okay. And also, you talked about, switching gears a little bit, to a planned 1,000 units for the rehab program. Can you just give us a sense for timing for those units and I mean how should we think about this? I mean, as you roll this out, will it kind of be a wash this year with incremental revenues, with cost? You say you don't see a benefit this fiscal year, but when do you think that we do start to see a benefit from that and how should we be thinking about this for fiscal 2019?

This is Anne. We have identified underwritten and we have started in on the 1,000 units that we're going to be looking at over the course of this year, but this year, you're right, it will probably be a wash. We probably think beginning of fiscal year 2019 we're going to start seeing the additional revenue from those, as John mentioned. We have some under renovation. We have three properties where we have actually started the unit turns, either kind of in trial area or where we're full-on renovating. But the lag time and the upfront costs and time it takes to get those going will mean that the results will lag a little bit into early fiscal 2019.

Okay.

I want to clarify there, Jim, the net gains, you'll see those in fiscal year 2020 and in fiscal year 2019 we'll start the program. The other thing is, as Anne alluded to, when you start this, you start slow, we’re doing unit turns. We're not going to drive our occupancy to 80% at any of these assets. And so, doing a few units you're evaluating, you are adjusting to the market, and then it's probably could be three to six months after you start before you really start ramping up.

Sure. And beyond the initial 1,000, how are you thinking beyond that? I mean, is there another 1,000 or is there another 5,000 out there, how do you think this might evolve over the next two or three years?

We've taken fact of the whole portfolio looking at all the opportunities and then we've prioritized them. As we mentioned, there is including this 1,000 that we've identified and started on, there are 5,000 units that just haven't been touched since 2008. There are more units than that that obviously have been renovated since 2008 but do still have value-add opportunities. Our plan is to continually – we are pushing out the program that we have, getting it rolling on those first 1,000 units, but we're continually looking at underwriting on value-add investments at a pretty good pace. So, we're developing a long pipeline that we think will probably be three to five years worth of value-add improvements within the portfolio.

Okay. One last one for me and I'll hop back in the queue, but just any color on how rents are trending so far into the fiscal first quarter, and then specifically how your two new Denver properties are performing?

So, in Denver we underwrote no or very slight rent growth and we've seen good rent growth in those markets. So, at the Dylan asset, we've seen good occupancy trends and we're happy with the rental rates we're getting there. On the Westend asset, we underwrote no rent growth during the first year and we are seeing pretty significant rental increases both on new leases and renewals. So, we're happy with that. I think we're very happy with having stabilized the portfolio during fiscal year 2018. As Mark mentioned, now is our opportunity to really push rent growth and we are seeing rent growth in the first two months of fiscal 2019.

And any more color on the portfolio overall, revenue growth?

Yes, I think that goes across the board my statement. We are seeing rent growth across the portfolio in the beginning of May and June.

Okay, all right. Thanks everyone.

The next question comes from Drew Babin with Baird. Please go ahead.

A quick question, a follow-up on the renovation program, can you talk about what markets those 1,000 units are predominantly located in, and you mentioned you won't drive occupancy down to 80% but might we expect some de-leasing with kind of not all the renovations just happening on [indiscernible], so can you give some color on that?

Yes, with respect to whether or not we're going to drive occupancy down, you might see some increase in vacancies as we roll this out, but we definitely want to keep doing it on the turn to the extent possible. With respect to your question on where we focused our value-add efforts, we really started with our focus on Minneapolis in the Twin Cities. We started with the portfolio and prioritized the Minneapolis and Minnesota assets first because those are a market we believe in and where we see the best fundamentals. We think that that's the best opportunity to achieve good risk-adjusted returns. So, we really started with Minnesota and we're going to work from there.

Okay, that's helpful. And then the Grand Forks impairment, I was hoping you could talk about what asset that is and what triggered it as well as – I'm sorry, if you could just talk about that, that would be good.

Sure. John? The asset is Cardinal Point. Go ahead, John.

Yes, the asset is Cardinal Point. It's a recent development. It just stabilized this year and had its first full year results in fiscal year 2018, which was really the driver of the valuation, and it was both from an expense and a revenue side that it didn't meet what the cost of the asset was. So, that is really about the last development we had, one of the last developments we had in North Dakota.

Yes, and I mean I'll add a little bit to that, Drew, because it's tied to some of what John talked about in the G&A, which is we're in a lawsuit there, we're the plaintiff in a lawsuit. There were some construction defects that caused overrun. That feeds into it as well. So, it's sort of two-parts, looking at our basis when we consider the overruns and looking at the performance of the asset relative to what we perceive to be the finite life of it. So, it is a good asset. It's probably the best asset in that market. If not the, it's one of the top three, and it's performing pretty well. But the reality is, it's on our books for more than it's worth.

Great. That was a question I was stumbling over, so thank you for answering that as well. I guess last question, Williston clearly bouncing back there both on the occupancy side and rate. Are you seeing that kind of momentum in any of the other North Dakota markets, particularly Grand Forks and Bismarck?

We aren't yet seeing that kind of momentum in Grand Forks and Bismarck. To the extent we will see, it will take time. I mean, our experience in looking historically, that oil activity that drives rent growth and occupancy in the Williston market does take time to work its way across the state. I think we would first expect to see it in [indiscernible].

Also, I think in Williston, this cycle or this up-cycle, it's been a little more disciplined as far as the wildcatters and the number of people coming in. So, it is nothing like it was previously.

As we said on the last call, these guys didn't waste a crisis. They have gotten a lot more efficient and lot less people-intensive.

That's good to hear. That's it for me. Thank you.

This concludes our question-and-answer session. I would like to turn the conference back over to IRET CEO, Mark Decker, for any closing remarks.

Super. As always, we appreciate everyone's interest in the Company and we look forward to talking to you in three months. Thanks very much.

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.