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Investors Real Estate Trust (NYSE:IRET)
Q1 2019 Earnings Conference Call
Sep. 11, 2018 10:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator 

Good morning and welcome to the Investors Real Estate Trust first-quarter 2019 conference call. [Operator instructions] Please note, today's event is being recorded. I would now like to turn the conference over to Mark Decker Jr., president and CEO. Please go ahead, sir.

Mark Decker Jr. -- President and Chief Executive Officer

Thank you and good morning. IRET's Form 10-Q for the first quarter of our fiscal year 2019 was filed with the SEC yesterday after the market closed. Additionally, our earnings release and supplemental disclosure package have been posted on our website at iretapartments.com and filed yesterday on Form 8-K. Before we begin our remarks this morning, I need to remind you that during the call, we will discuss our business outlook and we'll be making certain forward-looking statements about future events based on current expectations and assumptions.

These statements are subject to risks and uncertainties discussed in our release and Form 10-Q 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 statements 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.

OK. Let's dive in. In the last 90 days, we've continued to make great strides as an organization that is focused on operations, capital allocation, and balance sheet strength. Let me hit a few highlights.

As reported, our same-store portfolio NOI grew 2.8% year over year on strong revenue growth and expense growth that was within our expectations. This represents our third consecutive quarter of same-store NOI gains, demonstrating our capacity to generate internal growth. In July, we exited the Williston, North Dakota, market, and I'd like to amplify the positive impact this had on our company. Selling the homes in Williston furthered several important objectives: first, the Williston market is not consistent with our strategy based on size and demand drivers.

We sold the assets at a sub-5% cap on our forward and trailing numbers. It is our view that Williston will require a sizable risk premium in the future and we were very happy with the execution. In addition, with this sale, IRET eliminates three third-party joint venture properties, cutting our exposure to JVs by half; eliminates $29 million of recourse debt, and lastly, by recognizing the investment loss that we already booked on our balance sheet in the form of an impairment in September of 2016, we were able to offset the remaining $30 million capital gain from our fiscal year 2018 medical office building sale. Each of these individual improvements is worthwhile.

Accomplishing them all in one fell swoop was outstanding for our shareholders and our team. Just a few weeks ago, subsequent to quarter end, we amended our revolving line of credit, improving our terms, flexibility, and adding a new seven-year unsecured term loan. This recast represents a meaningful rerating of our portfolio from the lending community. The rerate occurs in the loan documents where we define how asset values are calculated.

In summary, when we embarked on the unsecured path two years ago, our business was mixed and our apartment portfolio quality was not as high as it is today. As a result, the multifamily cap rates required to calculate total asset value were 6.5% to 8.25%. Today, the cap rates are 6% to 7.25%, a big improvement in terms that has real money behind it. Also worth noting on this quality of income point, 12 months ago, our multifamily portfolio was less than 70% of NOI for the first quarter.

And today, it's greater than 95%. As we've said, we are building a balance sheet that gives us capacity to be opportunistic in support of our strategic objectives, and this has continued movement forward in that regard. Most importantly, last quarter, we made significant changes to our operations team, flattening our organization and lowering G&A going forward. And while we're moving quickly to alter how we do many things operationally, these changes will advance the speed at which we can harness the full earnings power of our business.

This is the biggest and most exciting thing we're working on and this further illustrates the support our highly respected board has provided in helping me put a team in place to capture the opportunity. Our operational changes further our focus on one of our main goals, expanding our profit margin across our portfolio. We call this initiative Rise by 5, and we've challenged all of our people to improve their margins by 5%. Let's put some math around why we're so excited.

In this most recent quarter, we reported same-store NOI of $20.6 million on $36.7 million of revenues. Rising by 5% would take us to an NOI of $22 million, a $1.4 million NOI improvement that, all else equal, drops to the bottom line $0.01 of FFO. $0.01 on the $0.09 we just reported is greater than 10% growth. This math is particularly compelling given that we control the bulk of this opportunity within our four walls.

And at this point in the economic cycle, that's growth few can match. The results of this initiative will not happen overnight, but we make progress every day. Turning to our markets. As mentioned last quarter, we have traded North Dakota for Minnesota as our largest economic base and entered Denver approximately one year ago.

Focusing on Minneapolis and Denver, two top 25 markets differentiates us from our public competitors and we believe provides great promise for cash flow growth and operational efficiencies over the long term. We commented on Denver and Minneapolis more specifically last quarter, but taking a moment to look at recent near-term activities in these markets, they continue to inspire confidence. Denver's job growth and unemployment continues to outpace national averages and the city notched a big win in August when VF Corporation, parent company of North Face, JanSport, and Timberland, announced they were relocating from North Carolina to Denver, bringing 800 high-paying jobs and Denver's 11th Fortune 500 company. There's been a lot of talk about Denver recently among REIT investors.

If you like Denver, IRET is the way to play it, making up 10% of NOI versus 6% for the next highest competitor. In Minneapolis, the market has generally kept pace with national job growth metrics while unemployment is the lowest in the nation among large metros. Minneapolis realized 2.9% effective rent growth in the second quarter of '18, outpacing 2.5% at a national average. And marketwide occupancy sits at 96.8%, ranking eighth among top 120 apartment markets.

These performance indicators, along with historical performance, solidify our belief in Minneapolis and inform our view of the long-term market strength. Looking at our secondary markets, we continue seeing unemployment comparing favorably to national averages, favorable relative incomes, and occupancy levels, and have recently seen strength in rent growth results. However, a few markets, in particular, are showing softness due to supply, such as Rochester and across North Dakota, and we are monitoring these closely. So, as we sit here today, we're fortunate to be in good markets and a good economy, with improving operations and a sound balance sheet.

These are the ingredients for a good business. If we can take these ingredients and put our customers at the center of everything we do, we will have a great business. With that, Anne, why don't you talk a little bit more about operations?

Anne Olson -- Chief Operating Officer

Thank you, Mark, and good morning, everyone. We continued to see improving -- improved operating performance with strong revenue growth, and we're making progress on continuing expense growth. While our same-store weighted average occupancy dipped 1.4% from fourth quarter of fiscal year 2018, we did experience revenue growth of 70 basis points quarter over quarter. With 10 of our 11 markets experiencing year-over-year revenue growth, our same-store revenue year over year increased 3%.

The primary driver of this increase was rent growth. We experienced a 2.4% rental increase year over year. This is positive news, and we also recognize that there is additional opportunity to increase revenue through occupancy gains. Our same-store weighted average occupancy for the quarter was 93.5% and we ended the quarter at 91.9%, as we experienced approximately 45% of our portfolio expire in May through July.

We're focused on increasing occupancy over the course of the second quarter, so we can carry that through our lower expiration winter months. The variances in our occupancy are a result of efforts to optimize revenues and manage our lease expirations. We've previously talked about the need to shift our lease expiration timing, and we will continue to refine both the number of expirations in each month and the timing of our expirations within the month. Looking at our expenses, the same-store expenses increased 3.3%. Minneapolis had uniquely high expense increases as we saw an increase of $150,000 in operating expenses and $80,000 in real estate tax expenses due to recent development stabilizing at the end of fiscal year 2017 that had lower operating expenses through the first quarter of fiscal '18.

These increases, paired with the severance costs of $110,000 associated with the staffing reduction at our sites, make up the majority of our overall expense increases year over year. As Mark mentioned, we continue to focus on our margin, and a large part of that is management of expenses. We're focused on smoothing the historical volatility we've experienced quarter to quarter and year over year. We have and continue to implement changes in our operating platform and best practices that we believe will assist us in the management of expense growth.

Some examples of this are the reorganization of our site staffing in July, which we believe will reduce our rate of expense growth beginning in the second quarter, and we've been closely monitoring utility cost, tenant billbacks, and have completed an LED retrofit at three properties, consisting of 414 units, with the goal of reducing our utility expenses and improving sustainability in our communities. Our margin expansion efforts also focus on ensuring we're capturing market rent growth and other revenue opportunities. We looked across the portfolio at our other revenue categories: administrative fees, exclusive amenity use charges, pet rent, garage rent and storage rent, and we adjusted them all to market. Year over year, our same-store other revenue has increased 14%.

We expect that the results of our value-add projects will also favorably impact our margin. We have several projects underway and our pipeline continues to grow. We anticipate that we will begin seeing the results of our initial investments in value add in the third quarter of this year. Mark mentioned the sale of our Williston portfolio.

We also continue to complete sales of our commercial assets, selling two commercial properties and one parcel of vacant land in this quarter. Since quarter end, we sold an additional land parcel. These sales allow us to continue to shift our focus through our multifamily operations and new investments. We're getting better and more efficient every day.

I'm grateful for how hard our team is working to identify and execute on opportunities to be innovative for our customers, to pull together as a team, and to provide good results for our investors. I'll turn it over to John Kirchmann for a discussion of overall financial results.

John Kirchmann -- Chief Financial Officer

Thank you, Anne. Last night, we reported core FFO for the first quarter of fiscal year 2019 of $0.09 per share, a decrease of $0.01 from the prior year. The decrease is primarily due to a reduction in NOI from the sale of noncore assets, partially offset by reduced interest cost from redeploying a portion of the proceeds to pare down debt. Looking at our general and administrative expenses, total G&A was $3.9 million for the quarter, a $100,000 decrease from the prior year and a $200,000 decrease from the fourth quarter of fiscal year 2018.

The current quarter includes $510,000 of severance costs related to a realignment and reduction of corporate officers. As mentioned in our prior quarter's call, we continued to experience elevated legal costs associated with our pursuit of a recovery under a construction defect claim. Moving to capital expenditures, as presented on Page F 14 of the supplemental, for the current quarter, same-store capex was $3.5 million, a $600,000 increase from the prior year's quarter. Higher capital expenditures are mostly due to timing, including expenditures originally planned for the fourth quarter of fiscal year 2018, which were postponed due to April's unusually high snowfall. Turning to our balance sheet.

We continue to improve our flexibility. As of July 31, we had $190 million in total liquidity, including $170 million available on our corporate revolver. As discussed earlier on the call, debt proceeds from the Williston disposition were in part utilized to further reduce our recourse debt. As of July 31, our recourse debt totaled $37 million or just 6% of total debt versus $173 million and 21% from a year ago.

As mentioned earlier by Mark, in August, we recast and expanded our unsecured credit facility, including reducing the pricing spread by approximately 25 to 35 basis points, increasing the overall commitment from $370 million to $395 million, reallocating a portion of the line balance to a $75 million term loan maturing in 2025, extending the current $70 million term loan to 2024, reallocating the current revolver capacity from $300 million to $250 million while extending it to 2022 and maintaining the $200 million accordion option to expand the revolver. Concurrent with the recast, we synthetically fixed both term loans for their full duration, further decreasing our floating rate debt exposure. The effect of the swaps and the recast of the credit facility increases our weighted average maturity from 4.2 to 4.9 years and takes our fixed rate debt as a percent of total debt from 80% to 92%. All of these actions continue to improve our balance sheet, increase liquidity and financial flexibility, and further our goal to attain investment-grade metrics.

With that, I will turn the call over to the operator for questions. 

Questions and Answers:

Operator 

[Operator instructions] Today's first question comes from Jim Lykins with D.A. Davidson. Please go ahead.

Jim Lykins -- D.A. Davidson -- Analyst

Good morning, everyone, and just a few for me. First of all, can you give us a little bit more color on the Rise by 5 initiative? And, Mark, you mentioned how that could end up paying the FFO. I know you said not overnight, but any sense for how quickly that could begin to positively impact margins so we might be able to see that incremental penny?

Mark Decker Jr. -- President and Chief Executive Officer

Good morning, Jim. Well, we can't give you the amount and the timing. We can only give you one. Listen, there are a number of items that are pretty low-hanging fruit and then there are some items that require more investment, such as some of our back-of-house systems that would enable us to-- I mean, really, what we're trying to do is put our team members in a position to spend more time with the customer and less time filling out TPS reports, as I'd like to joke.

But there are a number of items. I mean, the first one is occupancy. As you can see, this quarter, we really have been working to optimize revenues, and we had a lot of volume. I think in past calls, we talked about our lease curve and how we shifted it.

We may have overdone it and shifted a lot into this quarter. So we had, as Anne said, almost 45-plus percent of our leases in the last three months, and we made a decision to stay on rent instead of pushing occupancy, but-- so, occupancy is the first one. Let's run the portfolio at full and with good pricing power. And then after that, there are a bunch of little things.

I think realistically, it's a three- to four-year timeline to get all of it done. John and Anne would like me to say three to five. I'd like to say 12 months. But in truth, it will take some time.

Our hope is that we can kind of check in every quarter with some progress. And in our shop, this is something we're spending a lot of time on communicating with the team and so forth.

Jim Lykins -- D.A. Davidson -- Analyst

OK. And you also said with the value-add program, there are several units underway. Can you give us -- and I know, you said results won't -- or you won't expect seeing the results until the third quarter, but can you tell us how many units you anticipate being -- is part of the program at that point? And how you see that trending for the remainder of this fiscal year?

Mark Decker Jr. -- President and Chief Executive Officer

Yes, I'm going to ask Anne to answer that one. Go ahead, Anne.

Anne Olson -- Chief Operating Officer

Yes. So as we've stated, I think, last quarter, we have about 1,000 units that are, I would call, underway, whether they're small renovations or full-unit renovations or buildings that we put into test, where, let's say, we've done three full-unit renovations just to test to make sure that our underwriting is sound. And of those 1,000 units, probably 240 of them are really close to coming online with smaller than full-unit renovations, where we add just a few amenities or backsplashes, UBS ports, things like that. Those -- some of them are close to coming online.

So as I said, in the third quarter, we are going to start being able to report results on those. And then some of our full-unit renovations, these just take a little bit longer time to ramp up and then run through the portfolio. We're not going to be -- as Mark mentioned, we're pushing on occupancy right now. And so we're not going to be giving up occupancy, emptying out large blocks to renovate.

We're doing the renovations on the turn. And we want to be careful and make sure that we're getting the rent and the premiums that we expect and meeting the underwritings. So, we're taking a pretty methodical approach, but a lot of the value-add that we see in the pipeline is also common area renovations, and those take a little bit longer to get underway as well.

Jim Lykins -- D.A. Davidson -- Analyst

OK. And one last one for me. Can you just give us any color on how rents and occupancy are trending so far into Q2?

Mark Decker Jr. -- President and Chief Executive Officer

Yes. I mean, Anne, do you want to take that?

Anne Olson -- Chief Operating Officer

Yes. So, as we mentioned, we had about 45% of our leases expire in the first quarter, and we're looking at about 30% of our portfolio expiring in the second quarter. So, with this big bunch of expirations, we really wanted to push rent. We gave up a little bit on occupancy.

And now we're pushing occupancy. Those -- the gains that we saw in rent were really volume driven. So while we have an opportunity to gain revenue by pushing occupancy, we may see some softness in the rental increases as we do push forward on occupancies.

Mark Decker Jr. -- President and Chief Executive Officer

Yes. I mean, I'll just add to that, Jim. It's a 10- to 12-month revenue optimization cycle that we're on and if you think about our company and this team sort of in the fullness of time, we've only been under LRO for a couple of years. This full team has only been kind of at the helm for a year and a half.

And so we're going to -- it'll probably take a few years to get it completely optimized the way we like it.

Jim Lykins -- D.A. Davidson -- Analyst

OK. Thanks, guys.

Mark Decker Jr. -- President and Chief Executive Officer

Thank you.

Operator 

[Operator instructions] Today's next question comes from Drew Babin of Baird. Please go ahead.

Drew Babin -- Robert W. Baird & Co. -- Analyst

Hey, good morning.

Mark Decker Jr. -- President and Chief Executive Officer

Good morning, Drew.

Drew Babin -- Robert W. Baird & Co. -- Analyst

Question on the first quarter leasing performance and sort of early in the second quarter. With heavy expirations going on, I guess, we obviously see the decline in occupancy sequentially, which sounds like a lot of that was strategic. But can you talk at all about kind of realized renewal and releasing spreads experienced during the first quarter and early second quarter, and how that will eventually have a lag in benefit through revenue?

Anne Olson -- Chief Operating Officer

Yes. I mean, I think on our leasing spreads, our new leases were seeing about a 2%, 2.5% increase. On our renewal rates, we're seeing about 3.5% increase. As I mentioned in response to Jim's question, I think we may see some pressure on rental rates as we try to drive occupancy.

But I think we feel good about the rental increases that we got in the first quarter and we haven't seen them drop significantly so far this quarter.

Mark Decker Jr. -- President and Chief Executive Officer

Yes. I mean, look, this is a bit not on your question, but I just wanted to add. One of the comments we read last night, not from you actually, Drew, was -- I mean, it was you. It was about Minnesota, Minnesota weakening.

And from our perspective, that's not what we saw. We really-we actually saw rents grow on a sequential basis in Minnesota. So, the revenue falloff was occupancy related. It wasn't you Drew, sorry.

But sorry, did you have any other questions?

Drew Babin -- Robert W. Baird & Co. -- Analyst

Yes, sure. Just talking about that decline in occupancy sequentially, and I guess, at 7/31, I think, Anne, you mentioned it was 91.9%. Is that surprising? Was that a little more occupancy decline than was expected once you kind of began to push rate more on a decreasing season? Or is this kind of fully consistent with the strategy?

Mark Decker Jr. -- President and Chief Executive Officer

Yes, go ahead. Anne, you start.

Anne Olson -- Chief Operating Officer

Yes, this is-- it was purposeful. I mean, I don't think we're surprised by it, but we do need to focus on it in the second quarter and this was part of the strategy. We're not going to get an opportunity again to have-- nor do we necessarily want an opportunity again to have 45% of our leases expiring in one quarter. And what we want to do too is really push the rates so that we can hold that rent through the next 10 to 12 months.

And if we can now drive occupancy in the second quarter, we're going to have-- we're going to be in a really good position as leasing season ends and we go into our low-expiration months, which are the months we typically see less traffic during the winter.

John Kirchmann -- Chief Financial Officer

Yes. And just to clarify, so the lower occupancy wasn't from us pushing rent, it's-- we sat around and we saw this bubble coming up and we decided we wanted to hold rents as opposed to using pricing and sticking on course with occupancy. And as Anne said, a big piece of that is with 45% of our leases expiring, we weren't going to get a lot of opportunities the rest of the year to be able to get rent growth

Mark Decker Jr. -- President and Chief Executive Officer

Yes. So I think, Drew, in the future, we will-- we are seeking and we will be altering our expiration schedule to not be quite as thick through the three months. So, when you say it wasn't on purpose, I mean, I would say it wasn't on accident, but we are going to change our lease curve over time.

Drew Babin -- Robert W. Baird & Co. -- Analyst

OK. That will make sense. And one more question on North Dakota, you mentioned there is some supply popping up in some markets. And I know some of the markets still had a lot of supply, I mean two, three years ago, and then somewhat of a dropoff.

And I guess, where are you seeing it come back specifically? And I guess, are there any markets that where you worry the barriers to entry just might be a little too well?

Mark Decker Jr. -- President and Chief Executive Officer

Yes. I mean, I think we always worry about the barriers around our property. I think we are seeing some supply. For example, in Grand Forks, there is 400 units going up right across the street from one of our properties, and the builder there is giving away some pretty spectacular concessions, $2,000 gift cards or-- so I mean, these are things that are tough to compete with.

So, this is the sort of paradox of small markets. I mean, in Rochester, as an example, there is about 400 units coming this year. There is 800 coming next year. That doesn't sound like a lot, but that's one-- that's 2% to 3% given the size of the market.

So, one project can certainly affect things when the markets are this small. And the economic drivers that an investment group may be focused on keeping the construction crew busy or building on a piece of land they own. They just-- sometimes our competitors don't cost things the way we do. And then I'd say in a couple of spots, we've-- we aren't seeing necessarily supply, but we are seeing just a falloff in demand.

John Kirchmann -- Chief Financial Officer

Yes. So, a good example would be in Minot. And in Williston, there's -- even though the Bakken is now taking off and there's actually some jobs going in there, there's nothing like there was before and it doesn't like there is going to be and there is already supply-our infrastructure and supply being delivered. So, even Minot, which in the last cycle got some residual bump from that, it's not going to get that or is not getting that at this point.

And so, we're seeing struggle there, not from supply in Minot, but from supply coming into Williston.

Drew Babin -- Robert W. Baird & Co. -- Analyst

Sure. That's all from me. Thank you very much.

Mark Decker Jr. -- President and Chief Executive Officer

Thanks, Drew.

Operator 

And ladies and gentlemen, this concludes our question-and-answer session. I'd like to turn the conference back over to the management team for any closing remarks.

Mark Decker Jr. -- President and Chief Executive Officer

Thanks, Rako. We appreciate everyone's time and interest, and we'll talk to you next quarter. Thanks very much.

Operator

[Operator signoff]

Duration: 28 minutes

Call Participants:

Mark Decker Jr. -- President and Chief Executive Officer

Anne Olson -- Chief Operating Officer

John Kirchmann -- Chief Financial Officer

Jim Lykins -- D.A. Davidson -- Analyst

Drew Babin -- Robert W. Baird & Company -- Analyst

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