Preferred Apartment Communities (APTS) Q3 2018 Earnings Conference Call Transcript

Preferred Apartment Communities (APTS)
Q3 2018 Earnings Conference Call
Nov. 6, 2018 11:00 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Good day, and welcome to the Preferred Apartment Communities third-quarter 2018 earnings conference call. [Operator instructions] Please note this event is being recorded. I would now like to turn the conference over to Mr. Jeff Sprain, executive vice president and general counsel. Please go ahead.

Jeff Sprain -- General Counsel

Thank you for joining us this morning and welcome to Preferred Apartment Communities' third-quarter 2018 earnings call. We hope that each of you had a chance to review our third-quarter earnings report, which we released yesterday after the market closed. In a moment, I'll be turning the call over to Dan DuPree, our chairman and chief executive officer, for his thoughts. Also with us today are Lenny Silverstein, our vice chairman, president, and chief operating officer; John Isakson, our executive vice president and chief financial officer; Mike Cronin, our executive vice president and chief accounting officer; and the leaders of our various business subsidiaries.

Following the conclusion of our prepared remarks, we'll be pleased to answer any questions you might have. Before we begin, I'd like everyone to note that forward-looking statements may be made during our call. These statements are not guarantees of future performance and involve various risks and uncertainties and actual results may differ materially. There's a discussion about these risks and uncertainties in yesterday's press release.

Our press release can be found on our website at pacapts.com. The press release also includes our supplemental financial data report for the third quarter with definitions and reconciliations of non-GAAP financial measures and other terms that may be used in today's discussion. We encourage you to refer to this information during our review -- during you review of our operating results and financial performance. Unless otherwise indicated, all per share results that we discuss this morning are based on the basic weighted average shares of common stock and Class A partnership units outstanding for the period.

I now would like to turn the call over to Dan DuPree. Dan?

Dan DuPree -- Chairman and Chief Executive Officer

Thanks, Jeff. The third quarter had a number of highlights, leading to what we believe is a solid quarter performance. During the quarter, we sold one multifamily community, Stone Rise in Philadelphia, for a GAAP gain on sale of $18.6 million. Subsequent to quarter-end, we also closed the sale of another multifamily community, Stoneridge Farms in Nashville, for a GAAP gain on sale of an additional $16.9 million.

On a non-GAAP basis, just sales price over purchase price of these two assets, we generated $25 million in net gain, pure profit. The sale of these two properties is consistent with our strategy of recycling capital out of our older assets into newer properties. The GAAP gains on sale we achieved in both properties, together in excess of $35.5 million, reflect our ability and our willingness to capture value at the top of the market. Combined IRR on these two assets was in excess of 22%.

These sales clearly impacted our balance sheet positively but had no impact on our FFO. What did affect FFO was a $3 million, or about $0.07 per share, loan loss allowance on accrued interest that we had booked under GAAP and which will be unable to be paid when the Irvine, California, project sells to a third party, which we expect to close in the next week or so. To be clear, over the term of this loan investment, not only was the principal of this loan or will the principle of this loan be repaid in full, but we will also receive over $20.1 million in interest yielding a 12.9% IRR on the investments, not a bad investment by any measure. Construction and inspection delays extended delivery by almost 18 months, which increased the cost of the project by over $10 million from its original underwriting.

With this FFO adjustment in mind and in anticipation of a strong fourth quarter, we are changing our previous year-end FFO guidance from $1.43 to $1.47 with a midpoint of $1.45 to $1.39 to $1.42 per share with a midpoint of $1.405. Midpoint to midpoint, our guidance adjustment is $0.045 per share. We are narrowing our guidance on total revenues for the year to $400 million to $415 million. During the third quarter this year, we continued our recent good work on multifamily same-store numbers.

Year to date, our total revenues are up 4% and our operating expenses are up a minuscule 0.8% due in large part of our tax appeal successes. Our year-to-date same-store NOI is up 6.5%. This is and will be and will continue to be an area of focus for us. In our real estate loan investment program, we generated -- generally receive an option to acquire the underlying asset on which we make a loan at a discount to the market value of the property at stabilization.

It is possible, however, that for a variety of reasons, including market cap rate compression, we may elect not to buy a property. If that occurs, we can still capture the value of the purchase option by terminating our purchase option with the developer in exchange for a cash payment equal to the approximate value of the discount. In the third quarter, we recognized $4.3 million from our five previous purchase option terminations. The balance of the proceeds from these purchase option terminations are being amortized and booked over the remaining term of each loan.

As we've noted before, the purchase option discounts we typically receive in connection with the origination of real estate loan investments are a meaningful and ongoing part of our business, and it is important that we are able to capture the value of these discounts whether or not they are exercised. Cap rates, particularly on newer Class A multifamily communities, have continued to compress even as interest rates have increased making the purchase of multifamily communities more difficult. Three years ago, for example, a typical deal, we would acquire a multifamily assets for cap rates between 5.7% and 6%. We then put debt on them at rates below 3.5%.

The same scenario today, however, the asset would sell for somewhere between 4.7% cap rate and 5% cap rate and 55% to 60% debt would cost around 4.5%, clearly, a decidedly different investment thesis. Our purchase option discounts nevertheless allow us to acquire some of these communities as we did in the third quarter with our Hidden River acquisition in Tampa that Jeff Sherman will talk about in a moment. Please remember that we are unique in the way we access capital and this impacts the way we do business. In addition to the sale of our publicly traded common stock, we also raised capital to invest through the sale of our Series A and Series M preferred stock into the independent broker-dealer and registered investment advisor channels.

We have been extraordinarily successful with this effort, raising between $35 million and $40 million each month. Having access to this source of capital allows us to make future commitments without concerns of capital availability from the more traditional public markets. We have an advantage investing this capital because we have the expertise in-house to diversify our investment into grocery-anchored retail, Class A office and student housing projects, where, presently, the investment metrics are more attractive. It is hard to imagine how we would be as successful for our shareholders as we have been if we could only invest in a single asset type where it is more difficult to buy that asset type accretively.

While our multifamily and student housing investments continue to make up the majority of our portfolio, it is an advantage for us to have the capabilities we have to invest and execute in these other two areas. Our business model is predicated on having the flexibility to invest in assets that contribute the most to stockholder total return. In a few moments, you will hear about several third-quarter investments across product lines that are outstanding examples of the value of this flexibility. With this, let me now turn the call over to Lenny to review our third-quarter results.

Lenny?

Lenny Silverstein -- President and Chief Operating Officer

Thanks, Dan. Overall, with the exception of the P&L impact of the Irvine, California, transaction that Dan just mentioned, we once again produced very good operating results for the third quarter. Revenues for the third quarter were $104.2 million, or over 39% greater than the revenues earned for the third quarter last year. Our FFO for the third quarter 2018 was approximately $11.5 million, or $0.28 per share, compared to approximately $12.3 million, or $0.36 per share, for the third quarter of 2017.

Our financial results have continued to allow us to pay a healthy increasing dividend to our common stockholders. As you may have read from our press release issued last Thursday, our board of directors increased our fourth-quarter common stock dividend to $0.26 per share payable to common stockholders of record at the close of business on December 14. With this fourth-quarter dividend increase, our total 2018 dividends will represent an 8.5% increase compared to the total dividends paid for 2017. In fact, since our first common stock dividend payment following our IPO in April 2011, we have now increased our dividend 14 times and produced an annualized dividend growth rate of 14.5%.

During the third quarter this year, we also issued an aggregate of approximately 358,000 shares of our common stock for approximately $4.6 million in connection with the exercise of warrants previously issued on under our Series A preferred stock and unit offering. Switching to other financial statement metrics, we continue to add quality assets to our portfolio in a meaningful way. For the third quarter 2018, our total assets net of depreciation were approximately $4.1 billion, or an increase of approximately $1.2 billion or 41.7% compared to the third quarter last year. This growth was driven primarily by the acquisition of 22 properties, net of the sale of two properties, since the third quarter last year.

In addition to increasing total assets, our cash flow from operations for the nine months ended September 30 of this year was approximately $112 million, which represents a huge 59% increase in cash flow compared to the nine months ended September 30 of last year. Although, as Dan noted, interest rates remain higher than this time last year, there have been no surprises. We have taken a cautious approach through our acquisition financing strategy, with approximately 90.4% of our permanent property-level mortgage debt having fixed interest rates or variable interest rates that are capped. In addition, as of the end of the third quarter, our leverage on our assets, based on the undepreciated book value, was 54.4%, which was basically the same as compared to the third quarter last year.

If, however, we measured leverage against the market value of our assets at today's cap rates instead of undepreciated book, our leverage ratio would be substantially lower. We will continue to closely monitor the relation between interest rates and cap rates in determining what we believe is the proper financing leverage in connection with our ongoing asset acquisition strategy. Jeff Sherman, who is responsible for all our multifamily efforts, including management, acquisitions, and real estate loan investments, will now review this division's performance for the third quarter. Jeff?

Jeff Sherman -- Director of Multifamily Investments

Thanks, Lenny. Let me start by reminding everyone of our overall multifamily strategy. Specifically, we remain focused on growing a portfolio of recently built, gated, heavily amenitized, and attractively appointed apartment homes in markets with strong job growth and more than 1 million people. We target markets primarily located in the mid-Atlantic, Southeast, and Texas.

We continue to see strong operating results for the multifamily portfolio. For the third quarter, our same-store set achieved year-over-year rental revenue and total revenue growth of 3.7% and 3.8%, respectively. These impressive results are further supported by same-store year-to-date total revenue growth of 4%. To reiterate a point made earlier, same-store net operating income for the third quarter increased 2.7% year over year, while it has increased 6.5% for the nine months ended September 30, 2018, compared to the same period in 2017.

In addition, our statewide portfolio achieved an average occupancy of 95.6%. Regarding our investment activity for the third quarter, we purchased one community in Tampa, sold one community in suburban Philadelphia, and originated a real estate loan investment for a new multifamily development in Fredericksburg, Virginia. The acquisition, named The Lodge at Hidden River, is a 300-unit Class A multifamily community. It is situated in a supply constrained submarket of northeast Tampa and stands apart from its competition with outstanding preservation of green space and superior product quality.

The Lodge will certainly be a great addition to our portfolio, and it epitomizes our investment thesis to acquire properties that either have an irreplaceable location, superior product quality, or other form of value proposition. As we noted earlier, in today's environment, finding assets above the lines of our investment criteria and are accretive over our projected hold period has become challenging in the face of compressing cap rates and rising interest rates. Nevertheless, there continues to be a significant amount of deal flow across the country and we continue to underwrite and pursue those opportunities that meet our criteria. The recent sale of Stone Rise and the acquisition of The Lodge at Hidden River in the third quarter lowers the average age of our multifamily portfolio to 5.3 years, which is the youngest in the public REIT industry.

If, however, you also factor in the sale of our Stoneridge community this quarter, our average age drops even further to approximately five years. Portfolio age is important because newer properties require less capital expenditures and lower maintenance costs and provide features that today's residents expect. Going forward, we'll continue to evaluate our portfolio on a quarterly basis and, when appropriate, purchase or divest assets in an effort to maximize returns to our stockholders. Turning to our real estate loan investment program, we closed on an aggregate loan investment of up to $12.3 million for the construction of a 240-unit Class A multifamily community located in the Washington, D.C., MSA of Fredericksburg, Virginia.

This community is part of Southpoint Landing, which is a 63-acre mixed-use project zoned for office, retail, and multifamily. With the addition of this loan, PAC's loan investment portfolio now consists of 21 projects totaling approximately 4,600 multifamily units and approximately 2,800 student housing beds and one retail center totaling approximately 195,000 square feet. From a total-dollar standpoint, as of September 30, our investment loan program had $392.2 million in outstanding loans and $515.5 million in aggregate loan commitments. The real estate loan investment program has always been an integral part of our business model from the very beginning.

It continues to provide us the pipeline of new Class A multifamily communities that we underwrite from the outset that are built in accordance with the design specs that we provide to the developer and that typically carry embedded value, which can be reorganized in a variety of ways. Let me now call on Paul Cullen, the head of Preferred Campus Communities, our student housing division. Paul?

Paul Cullen -- Chief Executive Officer of Preferred Campus Communities

Thanks, Jeff. Our student housing strategy is to bring a portfolio of best-in-class properties at Sherwood Universities that are located within walking distance to the center of the respective campus. The third quarter was a busy time, a successful move-in season across the student housing portfolio. Over a 23-day period, beginning late July through mid-August, we helped moved out all of our residents, completely turned all of our units and moved in a total of 5,208 beds.

Obviously, this is a huge undertaking for any operating platform but one our team handled tremendous well. Our student housing division also continues to see strong operating results with the stabilized properties performing in line with expectations year to date. Preferred Campus Communities, our student housing operating subsidiary, now owns seven properties in four states across seven different universities. Strong leasing activity for the current school year resulted in our stabilized June portfolio having an average physical occupancy of 96% as of September 30.

Our student housing management team is already refocusing its efforts on producing for 2019-2020 school year. We're holding various resident-appreciation events in an effort to build a resident renewal base for the next school year. Even though this school year has started, it' is important to be proactive for the next school year. Rental rates have been set for 2019-2020 school year, and we expect the team to deliver another strong lease up.

As mentioned on our last earnings call, the off-campus student housing sector is one in which we continue to see opportunity and believe the fundamentals will provide for consistent rent growth and steady occupancy metrics for the foreseeable future. Let me now call on Joel Murphy, the head of our New Market grocery-anchored retail division. Joel?

Joel Murphy -- President and Chief Executive Officer of New Market Properties

Thanks, Paul. We are also pleased to report another strong quarter of overall operating performance. We are continuing to execute our strategy to inquire -- acquire, invest in and operate grocery-anchored centers that fit our investment criteria in suburban submarkets from the Mid-Atlantic, the Southeast, and now through Texas. We target centers that have market-dominant grocery store anchors that maintain a No.

1 or No. 2 market share in that submarket and that have high and growing sales-volume stores in the particular center. As a result of this focused product-type strategy, we had zero exposure to the 2018 bankruptcy filings of Sears, which includes Kmart, Mattress Firm, and Toys "R" Us. Leasing space, renewing tenants, and keeping our tenants happy is a daily focus.

Our portfolio, which at the end of the third quarter totaled 44 grocery-anchored centers, was 94.6% leased, an increase of 20 basis points since the end of the second quarter and an increase of 40 basis points year to date. We have three centers in our portfolio that are in different stages of value-add phases or redevelopment, Champions Village in Houston, Independence Square in Dallas and Fairview Market in Greenville, South Carolina. In Fairview Market, we recently completed an important part of our redevelopment plan with the grand opening of Aldi in a new 22,000 square foot store. We completed this portion of the redevelopment faster than originally underwritten and well below budget on cost.

At the end of the third quarter, the core portfolio, excluding these three properties, was 96.7% leased, an increase of 10 basis points from the second quarter. We are also particularly pleased with the momentum of our lease renewals this past quarter, both anchors and in-line tenants. We continue to proactively manage our anchor lease expirations. All of our 2018 anchor renewals are now complete.

We also executed approximately 50,000 square feet of in-line tenant renewals for the quarter and we have approximately 35,000 square feet to remain to execute on through the balance of the year. Year to date, we have executed a total of 151,000 square feet of in-line tenant renewals so we expect the favorable momentum to continue. During the quarter, we acquired Brawley Commons, a 122,000-square-foot Publix-anchored shopping center in the Charlotte, North Carolina, MSA. Brawley Commons is our second asset in the Charlotte MSA and adds to the geographical diversity of our portfolio in a market that we like very much.

This is another excellent example of our focused strategy, anchored by a market-leading grocer, it has a high-sales-per-square-foot store and located in a solid Sunbelt submarket with excellent demographics. We executed on all cylinders in the third quarter. We leased vacant space. We keep our centers leased.

We renewed at higher rates. We managed our expenses and had very little bad debt expense, and we grew the portfolio. The combination of these positive trends allowed the New Market subsidiary to upstream outstanding results to PAC. As of today, we now own 44 grocery-anchored centers in seven Sunbelt states in 18 markets totaling approximately 4.6 million square feet with nearly 700 independent operating leases.

Twenty-three of these centers are anchored by Publix and 11 are anchored by Kroger or Harris Teeter banners. Both Publix and Kroger are being market share leaders and each of them generated approximately $2 billion in earnings in 2017. We remain active in the acquisitions marketplace. And while we are very focused on new opportunities, we are also remaining very diligent to stay inside our tight geographic and product-type strategy, while also being very disciplined about our due diligence and our pricing.

Now let me turn the call over to Boone DuPree, the head of our office division. Boone?

Boone DuPree -- Chief Executive Officer of Preferred Office Properties

Thank you, Joel. In the third quarter, we completed our acquisition of 150 Fayetteville, which is a 560,000-square-foot Class A office building in Raleigh, North Carolina's central business district. This is a deal we are particularly excited about. It gets us into a strategic market we've targeted and offers not only attributes of stability for PAC but also room to grow the upside.

There is some overdue repositioning and fundamentals tailwinds in a submarket with single-digit vacancy and strong demand growth. Subsequent to closing, we teamed up with top local developer King Realty to lease, manage and oversee repositioning efforts at the property. We are now well under way in design and preconstruction for a renovation that will include the building's lobby, plaza, and street-level curb appeal and eventually incorporate some new amenity retail into the first floor. We're confident this investment will pay off by driving property-level e-commerce.

Including in this recent acquisition, at quarter-end, the company's office portfolio stood at approximately 2.1 million square feet across six Class A assets. We were 93% leased with more than 7 1/2 years of weighted average remaining lease term. Our top five tenants, IHG, State Farm, USAA, Harley & Clarke, and CS Anderson, represented 51% of our portfolio's annual base rent and together have more than nine years of weighted average lease term remaining. Looking ahead, we will continue to focus on assembling a portfolio rent rule that features multiyear duration on the leases, high-quality credit, and industry diversification.

At the real estate level, our investment thesis centers on developing market strategies that extend beyond one-off transactions, with a focus, intentionally, on Atlanta, Charlotte, Raleigh, Dallas, Nashville, and Austin. Each of PAC's verticals has its own nuance. The office business, perhaps more than any other, is critically dependent upon local relationships for leasing success and sourcing opportunities. And we know this to be successful competing with larger, more established platforms, we have to formulate effective market entry and operation plans.

Each investment is considered within a strategy, and we expect that to become self-evident over time. With that, let me now turn the call back to Dan.

Dan DuPree -- Chairman and Chief Executive Officer

Thanks, Boone. Despite the ups and downs of the marketplace, our team has continued to do an excellent job building a carefully constructed portfolio, executing on our strategies and visions and delivering consistently strong financial results. We have a variety of solid investment strategies, which continue to allow us to be innovative, nimble and effective. Our investments in student housing, grocery-anchored shopping centers and office buildings have proven to complement our core focus on multifamily very well.

We continue to believe that all of these investments, together with the cash flow generated by our real estate loan investment program and the potential embedded value we've created through our discounted purchase options, place PAC in a sustainable position to continue to deliver consistent outsized results for our shareholders. With that, I'd like to thank you for joining us on our earnings call this morning, and I'd like to turn the call back to our operator to open the floor for any questions that you may have. Thank you.

Questions and Answers:

Operator

Thank you. We will now begin the question-and-answer session. [Operator instructions] OK. This concludes our question-and-answer session.

I would like to turn the conference back over to Dan DuPree, chairman and chief executive officer, for any closing remarks.

Dan DuPree -- Chairman and Chief Executive Officer

Again, thank you all for participating this morning. I really want to reiterate one key point. Clearly, with the $3 million loss that we're taking in our Fusion project, don't let that distort the balance of what we reported here this morning. We had a -- what we believe to be a very solid quarter.

Our metrics are up across the board. We recognized, on a GAAP basis, $35 million in gain. It's kind of frustrating sometimes to realize that we can show an absolute project -- absolute profit through the sale of assets, have that reflected on our balance sheet, but the headline isn't the $35 million gain. It's the $3 million hit.

This is the first hit we have taken on one of our real estate investment loans across the last seven years and probably won't be the last. It's one of the things that comes along with it. But I would remind you not to throw the baby out with the wash, numbers were really quite good. If you have any other questions or you'd like to discuss what we've gone over this morning, please give any of us a call, myself, John Isakson, who kept remarkably quiet on this call, Lenny, Joel, Paul, Boone, Jeff, we're -- we'd be happy to answer any questions you all might have.

Thank you again for participating.

Operator

[Operator signoff]

Duration: 31 minutes

Call Participants:

Jeff Sprain -- General Counsel

Dan DuPree -- Chairman and Chief Executive Officer

Lenny Silverstein -- President and Chief Operating Officer

Jeff Sherman -- Director of Multifamily Investments

Paul Cullen -- Chief Executive Officer of Preferred Campus Communities

Joel Murphy -- President and Chief Executive Officer of New Market Properties

Boone DuPree -- Chief Executive Officer of Preferred Office Properties

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