Granite Real Estate Inc.

Good morning and welcome to Granite REIT's second quarter 2023 results conference call. As a reminder, the conference today has been recorded on Thursday, August 10, 2023. Speaking to you on the call this morning is Kevin Gorey, President and Chief Executive Officer, and Teresa Netto, Chief Financial Officer. I will now turn the call over now to Teresa Netto to go over and start advisories.

Good morning, everyone. Before we begin today's call, I would like to remind you that statements and information made in today's discussion may constitute forward-looking statements and forward-looking information, including but not limited to expectations regarding future earnings and capital expenditures, and that actual results could differ materially from any conclusion, forecast, or projection. These statements and information are based on certain material facts or assumptions, reflect management's current expectations, and are subject to known and unknown risks and uncertainties. These risks and uncertainties are discussed in Granite's material filed with the Canadian Securities Administrators and the U.S. Securities and Exchange Commission from time to time, including the risk factor section of its annual information form for 2022 filed on March 8, 2023. Readers are cautioned not to place undue reliance on any of these forward-looking statements and forward-looking information. The REIT reviews its key assumptions regularly and may change its outlook on an ongoing forward basis if necessary. Granted, it undertakes no intention or obligation to update or revise its key assumptions, any forward-looking statements or forward-looking information, whether as a result of new information, future events, or otherwise, except as required by law. In addition, the remarks this morning may include financial terms and measures that do not have standardized meaning under international financial reporting standards. Please refer to the condensed combined unaudited financial results and management discussion and analysis for the three and six-month periods ending June 30, 2023 for Granite Real Estate Investment Trust and Granite Read, Inc., and other materials filed in the Canadian Securities Administrators and U.S. Securities and Exchange Commission from time to time for additional relevant information. I will commence the call as usual with financial highlights, and then Kevin will follow with an operational and strategy update. Granite posted Q2 23 results below Q1, but overall in line with management's annual forecast and guidance. Granite reported strong NOI growth, offset by higher interest costs and G&A expenses. FFO per unit in Q2 was 121, representing a 4 cent or 3.2% decrease from Q1 23, and slightly below our own internal forecast of 123, and is an 11% increase relative to the same quarter in the prior year. The growth in NOI is derived from acquisitions, developments, and expansions that came online since the second quarter of 2022 and strong same-property NOI growth enhanced by double-digit leasing spreads in the U.S. and inflationary increases in Europe. While foreign exchange was relatively flat overall compared to Q1, in comparison to the prior year, the euro was 8% stronger and U.S. dollar 5% stronger, resulting in a positive 7 cent impact to FFO per unit. Offsetting the favorable Q2 2023 NOI relative to Q1 is the impact of higher interest costs resulting from draws made on Granite's credit facility during Q2 and lower capitalized interest of approximately 0.9 million relative to Q1 as a result of the substantial completion of the majority of Granite's active developments during Q1 and early Q2, as well as incremental foreign exchange losses on the settlement of foreign cash which can fluctuate quarter over quarter. In addition, due to the timing of certain activities, FFO-related G&A expenses were approximately $1 million higher than in Q1. Granted, AFFO on a per-unit basis in Q2 2023 was $1.09, which is 9 cents lower relative to Q1 and 5 cents higher relative to the same quarter last year, with the variances mostly tied to FFO growth offset by higher capital expenditures, leasing costs, and tenant allowances incurred due to the timing of leasing turnover and seasonality. AFFO-related capital expenditures, leasing costs, and tenant allowances incurred in the quarter totaled $4.5 million, which is an increase of $3.4 million and $3 million over Q1 in the prior year, respectively. For 2023, we are estimating AFFO-related maintenance capital expenditures leasing costs coming in at $25 million for the year, which is $3 million higher than our forecast provided in Q1. The $3 million increase relates to a tenant allowance and leasing costs tied to a new lease on a previously vacant space at Grand Heights Novi, Michigan property. The increase in maintenance capital expenditures, tenant allowances, and leasing costs relative to the past couple of years is a direct result of the approximately 9.7 million square feet of GLA turning this year. Same property NOI for Q2 2023 was very strong relative to the same quarter last year, increasing 7.7% on a constant currency basis and up 13.2% when foreign currency effects are included. Same property NOI was driven primarily by higher than previous year CPI adjustments, positive leasing spreads, contractual rent increases across all of Granite's regions, lease renewals in the U.S. and Canada, a free rent period in the prior year at our property in the U.S., and includes the impact of completed expansions in GTA in Indiana. G&A for the quarter was $8.9 million, which was $2.9 million higher than the same quarter last year, and $5.8 million lower than Q1. The main variance relative to the prior quarter and Q1 is the change in non-cash compensation liabilities, which generated an unfavorable $2.1 million fair value swing relative to the same quarter last year, but a favorable $6.8 million fair value swing relative to Q1, as we recognize fair value gains on these liabilities due to a 5.7% decrease in Granite's unit price during the quarter. These fair value adjustments do not impact our FFO or AFFO metrics. Stripping out the fair value adjustments, as mentioned earlier, G&A expenses that impact FFO and AFFO were approximately $1 million higher than Q1, which is mostly tied to costs pertaining to the AGM and timing of consulting and travel expenses, as well as higher compensation costs directly linked to non-cash compensation and the upward valuation of its performance-stapled units. For the remainder of 2023, we expect G&A expenses of approximately $9.5 million per quarter or roughly 7% to 7.5% of revenues, excluding any amounts for fair value adjustments related to non-cash compensation liabilities. On income tax Q2, 2023 current income tax was $2.1 million, which is $0.2 million higher than the prior year and $0.2 million lower than Q1. The movement in current tax relative to Q2 last year is mostly attributable to the strengthening of the euro relative to the Canadian dollar as all of Granite's current tax is generated from its European region, as well as slightly higher taxes in the Netherlands due to depreciation limitations on certain assets. The decrease in current tax relative to Q1 2023 is mostly related to the timing of accruals. For the remainder of 23, we estimate current tax to run approximately 2 million per quarter, assuming no significant change in the Euro FX rate, which is slightly lower than the past two quarters due to lower required provisions on tax positions taken going forward. As with the past few years, Granite has the potential to recognize the reversal of tax provisions in Q4 relating to tax positions taken on taxation years, which will go statute barred, totaling approximately $1.8 million. However, we cannot assess whether these reversals can be realized at this time. Interest expense was higher in Q2-23 relative to Q1 by $1.4 million as a result of borrowings made on the Granite's credit facility to fund development. interest on the secured construction loan, which was repaid in full late in Q2, and lower capitalized interest by approximately $0.9 million due to the substantial completion of the majority of Granite's developments. The draws on the credit facility in Q2 were higher than we had anticipated last quarter due to the delay in cash repatriation from Europe that was resolved in July. For the remainder of 2023, we are assuming no additional draws on the credit facility and that the $400 million debenture maturing November 23 will be refinanced and swapped to Euro at the beginning of Q4 with an estimated interest rate of 4.75%. Therefore, for the third quarter, we estimate interest expense consistent with Q2 and then interest expense will increase to approximately $21.5 million in Q4. Granted, weighted average cost of debt is currently 2.27%, and it is expected to increase modestly to approximately 2.6% pro forma the 2023 debenture refinancing. Looking out to our estimates, our 2023 estimates, granted earlier guidance to FFO remains unchanged, which estimates FFO per unit within a range of 490 to 505, but we are currently expecting to be closer to the midpoint of this range. This still represents an approximately 11 to 14% increase over 2022. For AFFO per unit, we are lowering the forecast range by 5 cents to 425 to 440, representing an increase of 5 to 9% over 2022. The $0.05 reduction is entirely due to the increase in forecasted AFFO-related capital expenditures discussed earlier due to the leasing of vacant space at our Novi Michigan property. The foreign currency rates driving the high and low ranges remain unchanged from last quarter. For the high end of the range, we are assuming foreign exchange rates of the Canadian dollar to euro of 1.48 and Canadian dollar to USD of 1.37. On the low end of the range, we are assuming exchange rates of the Canadian dollar to Euro and Canadian dollar to USD of 1.42 and 1.32, respectively. Lastly, our forecast assumes that approximately 20% of the forecasted stabilized NOI relating to our recently developed properties in Houston Phase 1, Nashville, and Indianapolis will be realized mostly throughout Q4. Granite will provide updates to guidance next quarter as warranted based on new leasing activity executed as well as any changes to foreign exchange assumptions. The trust balance sheet comprising of total assets of $9.1 billion at the end of the quarter was negatively impacted by $14 million in fair value losses on Granite's investment property portfolio in the second quarter and was further compounded by 142 million of translation losses on Granite's foreign-based investment properties. And that was due to a 2.1 and 1.8% decrease in the spot USD and Euro exchange rates, respectively, relative to Q1. The fair value losses on Granite's investment property portfolio were primarily attributable to the expansion and discount in terminal capitalization rates across selective Granite markets, in response to continued rising interest rates, partially offset by fair market rent increases across the GTA and selected U.S. and European markets, as well as the renewal of one industrial property in Germany and the appreciation of land values at grants development properties and land held for development in Brantford, Ontario, and the stabilization of four properties under development in the U.S., which were completed and transferred to income-producing properties in early on in the second quarter of 2023. The Trust's overall weighted average cap rate of 5.09% on in-place NOI increased eight basis points from the end of Q1 and has increased 59 basis points since the same quarter last year. Total net leverage as of June 30, 2023 was 32%, and net debt to EBITDA was 7.6 times, which has improved from Q1 and Q4 as a result of the completion and stabilization of the majority of grants development properties. Granite continues to expect its debt EBITDA to decrease to low seven times by the end of this year and to improve thereafter into 2024 as the EBITDA from completed developments comes online. The trust's current liquidity remains at $1 billion, representing cash on hand of approximately $120 million, and the undrawn operating line of $910 million. As of today, Granite has $87 million, or Euro $59 million, drawn under the credit facility, and there are $2.7 million in letters of credit outstanding. I'll now turn over the call to Kevin.

Thanks, Teresa. Morning, everyone. Thank you for joining our Q2 call. As usual, Teresa and I are joined by Lorne Coomer and Michael Remperis. I would concur with Teresa's characterization of our results, being more or less in line with our internal expectations when accounting for FX and some timing-related issues in the quarter. I will be brief in my formal comments, as usual, and as before, I'll provide an update on our current development pipeline, our ESG program, and our leasing program year-to-date, then provide an overview of the leasing and investment market fundamentals we're seeing across our business before taking your questions. Beginning with development activity in the quarter, we achieved substantial completion of our development project in Lebanon, a suburb of Nashville, Tennessee, comprising roughly 500,000 feet over three buildings on April 6th. And to date, we have executed two leases totaling approximately 180,000 feet at rates roughly 30% above our original underwriting and 6% ahead of budget for 2023. We also completed the build-to-sue development of our 220,000-square-foot property in Bolingbrook, a suburb of Chicago, on April 12th. And as you can see, the building is fully leased for a 12-year term. Our current construction pipeline includes two projects in Brantford and Ajax. Firstly, the 410,000-square-foot build-to-sue project for Barrie Callebaut continues to progress on schedule, with substantial completion expected in the first quarter of 2024. Similarly, the 50,000 square foot expansion of our existing property in Ajax is underway with substantial completion scheduled also for Q1 of next year. I'd like to note that as disclosed in the MD&A, our projected unlevered return for the small expansion project has been reduced considerably to 5.6% due to a combination of higher construction costs, additional scope, and the incorporation of some major base building improvements in the expansion project. As per our MD&A, we are in the approval process for the next phase of our grant for development, which will include a single 730,000-square-foot building to enable us to efficiently respond to suitable build-to-suit opportunities that may arise in the market. But we currently do not have any plans to commence with the construction of the building on a speculative basis. As mentioned previously, Collectively, these projects and stabilizations are expected to contribute strongly to NOI and cash flow growth in future quarters, and all are expected to achieve green building certification in accordance with our published green bond framework. In addition to the projects just discussed, we have 160 acres of land remaining for development across Brantford, Houston, and Columbus, which can accommodate up to 2.4 million square feet of space once constructed. As outlined in our MD&A, six lease maturities representing just over 1.9 million square feet that occurred in the quarter were renewed at an average increase of 15%. However, keep in mind that that included the expiration of a termination right by a tenant in the U.S. and the renewal of a Magna facility in Germany. Excluding those two properties, the average rent increased by 23% on average. As of this call, we have also executed renewals on 735,000 square feet of subsequent 2023 expiries and 2024 maturities at a weighted average increase in rent of 34%. Included in the numbers I just mentioned are extensions on 645,000 square feet of magna leases across three properties, one located in the GTA and two in Austria, at an estimated average increase in rent of roughly 22%. As a reminder, we do not anticipate any leasing costs or capex associated with these renewals. We are also finalizing lease extensions on another 1.1 million square feet of 2024 maturities, which, when combined with our renewals to date, would represent over 70% of our 9.7 million square feet in overall maturities in 2024. At this point, we expect to achieve an average increase of 20% to 22%. on the outstanding maturities in 2024. As Theresa mentioned, same property in Hawaii increased by 7.7% in the quarter on a constant currency basis within expectations. Same property in Hawaii was positive across all of our geographies once again, led by our portfolios in the US and Germany, driven by strong renewal spreads in North America, development stabilizations, and strong CPI increases year-to-date in Europe. We expect St. Baroque NOI growth to moderate slightly in Q3 and Q4 and will likely come in at the lower end of our range of guidance, our Q1 forecast guidance for 2023 St. Baroque NOI growth at 6.5% to 7.5% as we release our current availabilities. Vacancy increased to 3.7% from 2.2% last quarter. due to the addition of a 630,000 square foot space in Louisville, as was expected, and the addition of roughly 500,000 feet of new development space in Nashville, 180,000 square feet of space of which has since been leased, as mentioned earlier. And I'm happy to answer specific questions on leasing following my comments. We have now published our corporate ESG plus R report for 2022. And as you will see, we have made significant progress in a number of key initiatives of our program, including significant reductions in energy and GHG emissions intensity within our portfolio. Additionally, as of December 31st of 2022, we had achieved operational or new construction green building certification on roughly 24% of our portfolio. and we have achieved green building certification on an additional 21 properties totaling 11.3 million square feet so far this year. We have made a number of improvements to the report and I invite all of you to review it at your convenience as posted on the sustainability section of our website. As you can see from our disclosure, and as mentioned, we adjusted cap rates and discount rates further, but only slightly in the quarter. as transactional data suggests that pricing has begun to firm up broadly across our markets in the U.S. and Europe, more so, I think, than we anticipated. Excluding FX movement, the roughly $210 million in negative fair value adjustments associated with TCR and discount rate adjustments year-to-date has been partially offset by $116 million in gains from a combination of development stabilizations an increase in value resulting from the long-term renewal of three properties in Austria and one in Germany, and an increase in the fair market value of our land for development in Brantford. As for a general market update, I would once again characterize leasing activity in the second quarter broadly as lower than in the past two years, which was exceptional, but in line with 2019 or pre-COVID levels. Notably, our markets represented the top eight markets in the U.S. for net absorption, totaling just under 46 million square feet, with Dallas once again leading the country at 9.2 million square feet of net absorption. Net absorption also turned positive in the GTA in Q2 at 2 million square feet, but still well below the 10-year quarterly average, similar to the Netherlands and Germany. Availability rose in most of our markets in North America as new supply outpaced demand in the quarter. We do expect this trend to continue for the next two to three quarters as a backlog of current projects are delivered. However, we project that availability will begin to fall in early 2024, as I said on the first quarter call, as the pace of new starts has already begun to decelerate acutely from past quarters and a number of planned deliveries this year are being delayed. In most of our markets, we are witnessing a drop of 40% to 75% in new starts from Q2 versus Q2 of 2022. As for rents, the data suggests that market rents increased roughly 5% on average over the first quarter across our U.S. markets, with the I-7881 corridor in Louisville leading the way at a staggering 19% and 11% respectively quarter over quarter. Quarter-over-quarter rent growth in the Netherlands and Germany came in at 6.7% and 5.9% respectively. So although demand has reverted to pre-COVID levels, the spread to market on our in-place rents continues to widen in the quarter. And a substantial contraction in new starts we believe should support continued rent growth over the near to medium term. Correspondingly, although the delayed completion of our developments in Indianapolis and Nashville to the second quarter of this year may result in a longer stabilization period, the expected rents today are frankly much higher than they were at underwriting and even one year ago. With respect to investment market conditions, transaction volumes remain lower year over year but are beginning to recover, particularly in the U.S. and the Netherlands. and data suggests that prices have begun to stabilize. Logistics clearly continues to be one of the preferred sector destinations for investor capital, and flows appear to be improving. With private equity funds, save obviously for the $3 billion U.S. prologis acquisition of the Blackstone portfolio, remaining as the most active buyers both in North America and Europe. In closing, I think that Teresa outlined her financial performance very well. Save for minor timing issues, FX movement, and as mentioned, non-cash compensation for value adjustments, our results were in line with our expectations for the quarter as our Indianapolis and Nashville developments reached substantial completion and the associated costs, such as interest, TMI, et cetera, are now being expensed. In addition, I realized that the drop in occupancy to 96.3% was noticeable in But it was in line with our expectations, given the addition of vacancy in the short term from the delivery of the Nashville and Indianapolis developments and the expected turnover of 600,000 square feet in Louisville. And in no way does it alter our trajectory. Looking forward, as Teresa mentioned, we are maintaining our FFO guidance for 2023, and that is based on our projections for FX and leasing activity for the remainder of the year. I'll repeat, once stabilized, the new developments will, of course, be a strong driver of NOI and cash flow growth for us in future quarters. I will now turn the mic over for questions.