Dream Office REIT (TSX:D_u) (TSX: D.UN) has reported a resilient performance in the second quarter of 2024, despite facing headwinds in the Toronto office market. On August 12, 2024, CEO Michael Cooper and CFOs Gord Wadley and Jay Jiang provided insights into the company's financial and operational progress. The REIT has seen a 8.7% year-over-year increase in diluted funds from operations, reaching CAD0.76 per unit. Strong leasing activity was a highlight, with significant square footage leased and more in advanced negotiations. The company is navigating an evolving office space landscape, with strategic efforts to mitigate risks associated with rising interest rates and debt maturities.
Key Takeaways
- Dream Office REIT showcased a year-over-year increase in diluted funds from operations by 8.7%, reaching CAD0.76 per unit.
- The company has leased 360,000 square feet and has another 270,000 square feet in advanced negotiations.
- Net rents are 14% higher than expiries, with a weighted average lease term of 5.5 years.
- Efforts to proactively manage debt and reduce capital requirements are underway, in response to rising interest rates.
- The premier asset at 357 Bay, leased to WeWork, remains a confidence point for the company.
- Financial results also indicated a 1.2% increase in total comparative properties NOI and a decrease in net asset value per unit.
- Dream Office REIT is engaging in asset sales and has discussed the sale of one building and the potential sale of Dream Industrial units.
- Challenges include achieving net effective rents in the competitive leasing market and managing the impact of the Federal Government's lease expiry at 74 Victoria.
Company Outlook
- Dream Office REIT is focused on reducing leverage and derisking its business model.
- The company is considering asset sales to strengthen its financial position.
- Interest from large allocators of capital in the office sector is seen as a positive trend.
Bearish Highlights
- The company faces challenges with net effective rents and competition from new supply in the market.
- The Federal Government's lease expiry at 74 Victoria poses a potential impact on revenue.
- Rising interest rates are prompting proactive debt management strategies.
Bullish Highlights
- There is increased interest in property tours and a growing economy, indicating pent-up demand for office space.
- Conversion of office buildings to non-office uses is gaining momentum.
- The company is optimistic about achieving better deals on renewals in the next cycle.
Misses
- Lease termination income is expected to decline in Q3 due to its one-time nature.
- The company did not provide specific details on the rework of the WeWork deal or shareholder intentions.
Q&A Highlights
- Visibility on tenants' decisions regarding office space may take 12 to 18 months to stabilize.
- The company aims to reduce the debt-to-EBITDA ratio to around 11x within the next 12 to 18 months.
- Advanced negotiations for a renewal at 74 Victoria are ongoing, but details remain undisclosed.
- A larger expiry is anticipated at the end of 2025 in Kansas City, which is under discussion.
Dream Office REIT's earnings call revealed a company that is adapting to the shifting dynamics of the office market while maintaining a focus on financial health and strategic growth. With a solid leasing pipeline and proactive financial management, the REIT is positioning itself to navigate the challenges ahead.
InvestingPro Insights
As Dream Office REIT (TSX: D.UN) continues to adapt to the changing landscape of the office market, certain metrics and insights from InvestingPro can provide investors with a deeper understanding of the company's financial health and market position. Here are some key data points and tips to consider:
InvestingPro Data:
- The company's market capitalization stands at 242.83 million USD, reflecting its current market valuation.
- With a Price / Book ratio of just 0.28, the company is trading at a low multiple compared to the book value of its assets.
- Revenue growth has been impressive, with a 15.13% increase in the last twelve months as of Q2 2024, signaling a strong upward trend in the company's earnings capability.
InvestingPro Tips:
- Analysts predict that Dream Office REIT will experience net income growth this year, which could be a sign of the company's improving profitability and operational efficiency.
- The REIT has maintained dividend payments for 22 consecutive years, demonstrating a commitment to returning value to shareholders even amidst market fluctuations.
These insights suggest that Dream Office REIT is not only managing its current challenges but is also setting a foundation for future growth. For investors looking for more in-depth analysis, there are additional InvestingPro Tips available at https://www.investing.com/pro/DRETF, which can further guide investment decisions.
Full transcript - Dream Office Real Estate Investment Trust (OTC:DRETF) Q2 2024:
Operator: Welcome to the Dream Office REIT Q2 2024 Conference Call for Monday, August 12, 2024. During this call, management of Dream Office REIT may make statements containing forward-looking information within the meaning of applicable securities legislation. Forward-looking information is based on a number of assumptions and is subject to a number of risks and uncertainties, many of which are beyond Dream Office REIT's control that could cause actual results to differ materially from those that are disclosed in or implied by such forward-looking information. Additionally, the additional information about these assumptions and risks and uncertainties is contained in Dream Office REIT's filings with securities regulators, including its latest annual information form and MD&A. These filings are also available on Dream Office REIT's website at www.dreamofficereit.ca. [Operator Instructions] Your host for today will be Mr. Michael Cooper, Chair and CEO of Dream Office REIT. Mr. Cooper, please go ahead.
Michael Cooper: Thank you, operator and good morning, everybody. Today, I'm here with Gord Wadley and Jay Jiang, who will both speak about operations and finance. I just want to start by a couple of comments on what's happening in the office market, particularly in Toronto. Just in the last few weeks and conversations I've had with business leaders, one very large organization said that they re-did all their space after COVID and they did a hybrid. They can probably accommodate people 2, 2.5 days a week. And now they have people who want to come in 4 days a week. So they've got to re-figure out how to do their space. Meanwhile, traditionally in office leases from time to time, tenants they want right to terminate. And over the last couple of years, those termination offers have been exercised more frequently than they otherwise would have been. And then some tenants would try to sublet space, some of it successful, some will take it back. And we still have a lot of leases that haven't rolled over since 2020. So what I would say the fundamental issue we struggle with is our customers are trying to figure out how they use office space. We've got a lot more people coming back to the office. And I think that generally it looks quite positive but it's just a slow process to get to the point where people have decided how they're going to use office space, what their demand is and they can make decisions and we can make decisions. But overall, on a quarter-over-quarter basis, things have been going quite well. We're making a lot of progress on all fronts and we're quite pleased. And I expect that over the next 12 to 18 months, we'll start to get a little bit more clarity but that's just a general comment. Gord, do you want to give some specifics?
Gordon Wadley: Yes, definitely. Thanks very much, Michael. What I'd say is when you look across the industry at every asset class, nothing has been more polarizing I guess than the impact of value and negative sentiment around non-core markets and in particular, B and C Class office markets which make-up a large majority of the overall inventory in North America but also Toronto. I said essentially, none of us are immune to these headlines and hot takes. But at Dream Office, our team continues to work really hard and keep our buildings full with tenants that are generating good income, strong covenants and long walls. We often outperform the market and in the process we're doing some really good deals for the portfolio and ultimately the industry in Toronto as a whole. Supporting our results this quarter, we've seen some substantial growth year-over-year since 2021 on total square feet leased annually with last year being our strongest where we did approximately 100 deals for 775,000 square feet which said differently represented about 13% of our portfolio. I'm pleased to say that already for this year, we're on pace with already 60 deals for approximately 360,000 square feet. This has been a real key catalyst in Dream maintaining a market-leading current and committed occupancy versus our peers. We continue to be cautiously optimistic for the remainder of this year with another 14 high probability deals for an additional 270,000 feet that are either conditional or in advanced stages of negotiation and we still have 2 quarters to go. On a gross leasing perspective, we've been outpacing our annual average deal volume and absorption year-over-year. And I want to say, this is a testament to a slowly improving climate and hard work and dedication of our team as a whole. Our reputation and ability to manage couple with our well-located assets has helped us secure some of the best covenant tenants for arguably some of the biggest deals in a very, very competitive submarket. We've been able to secure our largest tenants for renewals right across the portfolio, including IO, BFL, DBRS and State Street (NYSE:STT) Bank. We've highlighted our largest expiry at 74 Victoria in previous calls and that transpires at Q4 of this year. We assumed the building would be coming back essentially vacant as of November 1 of this year. That would result in an NOI hit of about CAD11 million per annum. Our team is very pleased to say that we've conditionally secured over 1/3 of this expiring revenue well in advance of the termination date. And moreover, we're in very active conversations to add another 40,000 to 50,000 square feet in that building by the end of the year. This is all -- please keep in mind, this is all much earlier than we had forecasted for 74 Victoria. From an income perspective, we're seeing very healthy trends. Year-to-date on the 360,000 square feet of leasing signed, we saw net rents carrying a healthy spread of 14% higher than expiries with an average weighted average lease term of about 5.5 years. This is much higher than the market average. As mentioned over previous quarters, not much has changed in terms of net effective rents. NERs continue to be compressed given the challenges with inflation, rising broker fees, increased cost of materials and labor to build suites. Ultimately, net rents still have been quite resilient and I feel good about the trajectory of our in-place NOI. I feel that 2022 was the peak of the construction and supply impact costs. They had grown by almost 20% year-over-year. I remember Jay and I sitting down to talk about ways to mitigate the cost of construction, stay competitive in tendering but also get competitive advantage on our peers and generate some really important fee revenue. We started an in-house construction management and materials procurement team as a way to mitigate GC charges, self-perform fit-ups and of equal importance, be a trusted provider for our clients that's accountable and on-demand to deliver the space that they covet. As a result, last year, we generated approximately CAD2.4 million in construction fees and we continued that trend in 2024, all while performing work in creating beautiful environments for some of the most sophisticated clients in banking, government and professional services. Just for some quick context, our construction team has been actively working on marquee projects with Paramount Films, their national head office. We also completed this quarter the new ICICI Bank headquarters on Bay and have turned over the space for the very highly anticipated restaurant [ph] to put their finishing touches on what will be a spectacular opening later this year. Although we at Dream Office continue to see tempered improvements from an overall performance perspective, the Canadian office market, as Michael has mentioned in the past, can still be described as erratic. For example, while one performance metric sees improvements or an indication of stability, such as overall vacancy rates or absorption. And then you see in term, a bit of a leveling of cap rates, some improving interest rates and some renewed interest in buyers, you'll see another metric like the amount of new vacant space arriving, sublet space and pressure on any artistic effect. You often hear sublet space is being absorbed but then the same week, you'll hear about another large tenant adding sublet space to the supply. It honestly feels like a game of snakes and ladders but our team remains laser-focused on doing a good job with the assets we own and the variables in our control around leasing and property management. And I would say, our results this quarter illustrate those efforts right up until the end. Overall vacancy this quarter stabilized across all classes in Downtown Toronto at around 18%. This is a number not seen since the early '90s. It's buoyed largely by a very low vacancy rate in the Class A assets. Although the vacancy rates themselves did not see much movement quarter-over-quarter, our managed and REIT properties saw some positive absorption and in doing about 580 basis points better than the market with a current and committed occupancy of almost 88% in our Downtown assets. Many spectators on the sidelines for office have commented on concerns over the sublease market. Sublet space continued to decline as office users are beginning to make decisions to the return to office and/or rightsize their businesses. In Toronto, sublet space now represents approximately 6% of the existing inventory. Within Dream Office, sublet space only represents around 3% of our Toronto GLA. We're not too concerned about this overall exposure but are keeping a close eye on it. No one in the real estate market today is immune to the impact of rising interest rates. And it's become a more challenging lending environment today than 3 years ago. We were very -- we worked very well with our banking partners and are in lockstep with leasing strategy, operations and are executing as such. Since the historical low of 40 basis points in the mid-2020s, the 10-year GOC bond yield and cost of debt has risen by over 270 basis points. The last quarter, we've seen an easing in rate pressure. However, lenders are actively reviewing their office loan exposure and are becoming more selective based on properties' location, quality in addition to the covenant of the borrowers. They are evaluating tenant profiles with laser focus and leases carefully. Loans are sized more conservatively which Jay can speak about a little bit more. Tenants too are much more sophisticated in their demands and are acutely aware of their own balance sheets and liquidity position. Hence, many are trying to push traditional cost to the landlords on transactions to induce their tenancy which is having a real impact in a high interest environment. In light of these challenges, as Jay will further mention, we have proactively addressed nearly all of our near-term debt maturities, including our biggest at Adelaide Place. In the same vein, it's also very important to note that we completed all of our biggest capital, maintenance and base building projects and are forecasting much less capital required for maintenance and CapEx in the next 24 months, thus in turn, helping our annual cash flows, reducing our risk and protecting our balance sheet. It's always top of mind and we continue to improve and leverage our strong lender relationships to ensure the balance sheet is well protected through what we believe is a trough in the office lending market. I get asked all the time about 357 Bay. What I'll tell everybody on the call is WeWork has been a tenant in very good standing. They communicate very well with us. They never missed a rent payment and have brought in some great clients to our premier asset at 357 Bay. Coupled with all the beautiful renovations done to the building, we have a great deal of confidence and optimism. We worked very closely with them during their bankruptcy proceedings and came up with a fair solution that supports a good tenant, doesn't significantly impact our NOI long-term and ultimately protects the terminal value of one of our best and most in-demand assets. Despite some of the macro challenges in the sector, I really couldn't be more pleased with how the whole team has navigated through some evolving challenges to the industry. Their effort and dedication to not only our company but to our clients is what I'm most proud of. At the end of the day, everyone what I'd say, it's a combination of having irreplaceable assets coupled with very high quality, high character team of people. We have operated and leasing those buildings that gives me the greatest confidence closing out 2024. We're doing a lot of innovative deals that are making our assets better and we'll be in great shape as demand picks up and on future renewal cycles. As always, I always like to throw this out there but if at any time you'd like to tour or see first-hand the work that we've done or the work that we're doing, please reach out to me directly. I'm always really proud to showcase it and it would be a great excuse to pop into one of our many great restaurants. Thanks so much, everyone. And I'll pass you over to my friend, Jay.
Jay Jiang: Thank you, Gord. Good morning. I will provide a review of our financial results and also an update on how we are internally forecasting our business for the second half of 2024. We reported diluted funds from operations of CAD0.76 per unit, up 8.7% from CAD0.70 per unit in the second quarter of 2023 after adjusting for the 2-for-1 consolidation of units in Q1 of this year. We had approximately CAD0.04 per unit of lease termination income this quarter and also CAD0.04 per unit of short-term straight-line rent for 2 larger tenants that took possession of their space a few months early. That income will be fully reflected in our cash net operating income over the second half of 2024. Total comparative properties NOI increased by 1.2% compared to the same quarter last year comprised of 2.6% increase in Downtown Toronto, offset by a decrease of 2.7% in other markets. Our net asset value per unit was CAD64.82, down CAD1.10 or 1.7% from Q1 NAV of CAD65.92. The decrease includes CAD25 million attributed to fair value adjustments on investment properties. As part of our valuation process this quarter, we externally appraised 4 assets totaling CAD333 million or 14% of our portfolio. In February, we provided our annual guidance of CAD2.80 to CAD2.90 per unit of FFO post unit consolidation and flat-to-low single-digit comparable properties NOI. Based on the information and results since February, we are still targeting the midpoint range of our guidance for both FFO and CP NOI. The key variability to our forecast will be the maturity of the 206,000 square feet leased with the Federal Government at 74 Victoria on October 31, 2024. As Gord mentioned, we have received a renewal for 64,000 square feet with the existing Federal Government and we are currently in active discussions to lease another 50,000 square feet. With only the 64,000 square feet renewal and no other leasing, the in-place occupancy of the building will be approximately 55%. The temporary reduction in occupancy until we lease-up the building will result in annualized NOI impact of approximately CAD8 million or about CAD0.40. We are actively working on leasing strategies to mitigate this impact and look forward to reporting our progress next quarter. In addition, we have approximately 500 basis points of committed occupancy that will commence rent payments towards the end of this year. In aggregate, these leases will contribute approximately CAD7 million of higher comparative properties NOI in 2025 versus 2024 which covers much of the shortfall from the Federal Government's lease expiry at 74 Victoria. There is approximately 90,000 square feet of maturities, excluding 74 Victoria across our portfolio for the remainder of this year relative to the 271,000 square feet of leasing pipeline that Gord noted and we have 5 months this year to complete more leasing. Our expectation is to make reasonable progress on our leasing pipeline. And we think that 2025 total comparative properties NOI could be at or above 2024. Consistent with prior years, we will provide full financial guidance for 2025 on our Q4 conference call next February. We have made substantial progress on our mortgage refinancings this year. Out of the CAD73 million of mortgage maturities in 2024, we have closed on CAD56 million and are in discussions to address the remaining CAD17 million. We are also making good progress on our mortgage maturities in 2025, most notably, the CAD225 million mortgage at Adelaide Place. We believe we are close to receiving credit approval from the lenders and we'll look to complete the closing before the end of this year. With this mortgage addressed, we will have CAD141 million of mortgages remaining for next year, of which we have already received credit approval for CAD44 million. Our CAD375 million revolving credit facility also matures in September 2025 and we will look to start the renewal process starting this fall. Currently, we are seeing 5-year mortgage rates at GOC plus 250 basis points or an all-in rate of approximately 5.5%. Overall, the lenders have been supportive of Dream Office and we have benefited from Dream's overall relationship with the financial institutions. We will continue to take a cautious approach to refinancing our loans and so that we have better visibility on our liquidity over the next few years. Our current leverage is 51% and debt-to-EBITDA is 11.8x. We would like to reduce our leverage and continue to derisk our business in 2025. In July, we completed a sale of a small asset in Saskatchewan for CAD8.6 million. The cap rate for the asset was approximately 2.8% as the committed occupancy was only 53%. The proceeds were used to pay down our credit facility in Q3. We do not rely on dispositions in our forecast or guidance but we will use the proceeds to repay mortgages in our credit facility. We estimate that for every CAD50 million of assets we sell, we expect leverage to decline 100 basis points and debt-to-EBITDA by 0.1x. I'll now turn the call back to Michael.
Michael Cooper: Thanks, Jay. Thanks, Gord. I mean, fundamentally, what we're saying is in 2016, we had 172 assets. We decided to really focus on our best assets. We're down to 31 assets now. Those assets we took really good care of. We began upgrading them well before COVID. And most of the CapEx is done. The building is proven to be populated with our tenants. And for the most part, we're very pleased with our progress leasing. Our team has done a great job in a demanding field. And I think we're getting through this quite well and we're getting through with great buildings quite well. On the investment side, H&R sold their Corus (TSX:CJRb) building to George Brown College. We sold 720 Bay to a health group. So I think you're seeing buildings selling when there's a motivated buyer who probably has a different use. What I've been pleased with this more and more of large allocators of capital have been speaking to us about their interest in office. It's very preliminary but I think that when investors are looking at where the different sectors are office looks like it's been beaten up pretty bad and there should be opportunities there. So I think we're starting to get more people interested in office but not necessarily pulling the trigger. We've been working on a couple of things. We sold the arcade we had in Saskatoon. We're working on one other significant building. It's a slow process. We hope to be there by the end of the year. And we'll see if there's other assets that make sense for us to sell. But things have been going as good as we could have hoped for. We made a list of what we thought were the risk to the company at the end of 2023. That's something been a real focus for us. And one by one, we've been knocking off of those risks. There's been a few new ones but not much. And the company is in better shape now than it was before. At this point, we'd be happy to answer any of your questions Operator?
Operator: [Operator Instructions] Our first question comes from Mark Rothschild with Canaccord Genuity (TSX:CF).
Mark Rothschild: Maybe Michael, strategically, it sounds like the asset sales that you're pursuing are ongoing but maybe not with the sense of [indiscernible] maybe just takes time. Can you just comment a little bit on strategically if anything has changed and how you're viewing the asset sales? And maybe connected with that, is there anything else that you're considering or feel the need to increase liquidity in regards to maybe the Dream Industrial investment? Is that still something that you intend to own for an extended period of time into Office REIT?
Michael Cooper: Well, I think our liquidity level is pretty good right now and we've been prepared for things to be more difficult. So we're pleased with that. I think the sale of 1 or 2 buildings might be appropriate. And with the Dream Industrial units, they've been a great investment for us. They're obviously not office so that they're not our core strategy. If we need them or if we decide opportunistically to sell them, that's something we could consider. But we're not really considering that now nor do we feel we need to.
Mark Rothschild: Okay, great. And maybe for Gord, it sounds like there's a lot going on with the leasing and the face rates appear to be good. Can you just comment a little bit on the trends you're seeing on the net effective rents? If that's improving at all or if it's still really expensive just to get leasing done? And how you see that evolving over the next year?
Gordon Wadley: Yes. Good question, Mark. It's still really expensive to get leasing done I think right across the board. We're competing with a lot of different spaces that are fully improved. So for us, if we have base building space, it's table stakes to put in CAD70 a foot to CAD100 a foot to get it in a reasonably leasable condition to match our competitive set. So yes, I see NERs, at least for the next 18 to 24 months, being relatively challenged. But overall, I'm happy with how net rents are performing. And I'm happy with the pick-up of tours and the velocity of people that are coming through our buildings. So that's positive.
Michael Cooper: Yes. I do want to point out that since September 6 last year when we presented our model for Dream Office, we had said at the time that we believe that in 2024, 2025 and 2026 things would be pretty much the same as in 2023. So we're now 7 months into that plan and things are basically the same as before. So it is basically what we expected. We actually expect another 20, 30 months of this. So I'm glad it hasn't gotten worse. I think we've made improvements to our buildings. We've been pleased with our relationship with lenders and things we've been able to achieve. So I think we're doing pretty good compared to where we said we'd be.
Gordon Wadley: The only one quick observation I'd make for you Mark as well too is we're seeing finishing trades. We're seeing a lot more come to bid on jobs. And I think that's a result of there being a bit of a down cycle in development, not just residentially but commercially, obviously as well. So a lot of the finishing trades we're seeing instead of 1 or 2 come to bid on a job, we're seeing usually about 3 to 5. So that's been a positive sign for us.
Operator: And the next question comes from Sam Damiani with TD (TSX:TD) & Cowen.
Sam Damiani: I guess, first question just on dispositions. You talked about it a bit and you had a question from Mark there. But I mean, there was a couple of buildings listed for sale earlier this year. Just wondering, if you could provide an update on those specifically, if those are still intended to proceed or how that's going?
Michael Cooper: I know you think that's an easy question but the answer is hard. As I mentioned, we definitely have been making great progress in one but it's a slow process. On the other one, we actually don't have an update. One thing I had to mentioned is, I think that another source of capital for us, we have some buildings whose loans mature. And while everybody expects that there's going to be paydowns on loans, we have a few that are under leveraged and they'll be a great source of capital for the company. So that's another choice that we have to look at. But our liquidity is in pretty good shape right now, at least as good as we had expected.
Sam Damiani: Okay. And just on the leasing, the occupancy was kind of flat in the quarter on an in-place basis but there was some decreases in a few of the Bay Street type properties. I'm just wondering if there's trends specific to the Bay Street properties that are -- if they're at all different than the overall trends, Gord, you talked about?
Gordon Wadley: Yes. I think one of the biggest mitigating factors for the Bay Street properties and I'll be honest with you, first is just in the construction at the corner of Adelaide and Bay and on Richmond. It's been very difficult to get groups there to tour and it's been very punitive for brokers to bring them along. But that being said, we've seen it clean up a little bit over the course of the last 6 weeks, right at the intersection of Adelaide, right in front of First Canadian Place, Adelaide and Bay and we've started to see more tours. We had a good pick-up of tours at 330 and 80 Richmond especially.
Sam Damiani: That's good to hear. Last one for me. I mean, do you have an actual sort of CapEx budget for this year and next year that you'd be able to share?
Jay Jiang: Yes, sure. We'll talk through the pieces. So with leasing costs I think consistent with the guidance in February and what Gord talked about in his commentary is with the net effective rents. It really depends on the duration of the lease. So typically, we're budgeting about CAD10 per square feet per year. And it's a bit last -- if you do a 10-year lease, so you'd get to about CAD7.50. For maintenance capital, we've been really smart and only focusing on life safety and putting value in buildings where we can get a reasonable payback or lending value.
Michael Cooper: But that's because we've already improved the building as that's what's left over.
Jay Jiang: Yes. So on Phase 3, it will be very light because we planned the CAD50 million already. Otherwise, with respect to the reserves is about CAD1 to CAD2 per year per square foot.
Sam Damiani: Yes, that is very helpful.
Michael Cooper: I do want to pick-up on Gord's point which I hear from everybody I speak to which is it's hard for employees to get to work. That the traffic is a real problem. All the bike lanes that minimize cars is a problem. And I think that's something we got to work on as a community to help people get around. Any other questions?
Operator: And the next question comes from Sairam Srinivas with Cormark Securities.
Sairam Srinivas: Gord, this is only a question to you. Maybe a year ago we were talking about the number of stores going up but tenants essentially taking some time to actually sign those leases. When you look at the situation today, how does that compare in contrast a year ago? Are tenants being more willing to come to the table and actually execute or is it more the same?
Gordon Wadley: Good question. So we're starting to see more of these deals get executed. They're taking longer. We mentioned today that we've got at least 10 deals for about 270,000 square feet in the pipeline. These deals we've been working on for the better part of 6 to 8 months on some of them. I think everybody is just being prudent on what the responsibilities are going to be in terms of construction and costs. But yes, to your point, a lot of the deals that we've seen come to fruition this year were deals that we started last year. I wouldn't say, they're getting any faster to do in a competitive environment. There's a lot of leverage being set-up by brokers and other landlords. So we just have to be patient and navigate through them. And every time we have a window to close, just do everything we can to try and get these things done. But I don't foresee deals getting any quicker in the near-term. We just got to keep battling through each one as they come.
Sairam Srinivas: And maybe just looking at these deals that are being executed, like, let's say, 74 Victoria, when you look at the deals there, once signed and once the tenant takes an occupancy there, how long does it take before that shows up in the NOI? Is it still like 6 to 12 months over there?
Gordon Wadley: That's actually a good question. So one thing that we've been looking at instead of always putting capital in the deals is doing free rent, out-of-term fixturing. So that -- in that kind of case, we'll delay the occupancy date but give the tenant the access to the space in advance of the occupancy date. So they have out-of-term free rent but we start the term, say, for example, we do a 5-year deal, maybe we'll give them 5 months of fixturing period. It takes us a month to do the space then you effectively get 4 months out-of-term free rent and then their commencement date starts on the 5th year. So on bigger deals, you will see a bit of a lag from when the deal is signed to when the actual rent commencement date is. But a lot of the time that is out-of-term free fixturing and we make sure they get a full term to amortize the cost that we put in. Does that answer your question?
Sairam Srinivas: Yes, that definitely does. Maybe just switching to absorption in the market. Apart from obviously the subleases, another factor being on Toronto was the amount of supply that came into Downtown. When you look at the absorption of the new supply today, like do you see most of the spaces being actually absorbed or are they still in the market competing with you guys?
Gordon Wadley: They're still very much in the market competing with us.
Michael Cooper: A lot of the buildings have tremendous amount of pre-leasing but the amount that isn't is a competitor. What's the absorption been for the quarter or the year, that kind of stuff. How are we doing for the market.
Gordon Wadley: So it's actually -- the vacancy rate has been growing in the core. And one thing to look at and there's a lot of great publications and I don't want to name specifically but there has been some buildings, commercial buildings built on spec that unfortunately haven't had any absorption. So I think that's a real challenge and that's what we compete against on a daily basis on some of the new space. A lot of it's periphery to the core but there is still situations where there's vacancy on this space.
Sairam Srinivas: Right. And for my last question before turn it back, when you look at these spaces and all the competing spaces that came in, are they consent in terms of their net rents which means there may be a couple of years of concessions or roll offs and the average rent of the market would kind of go up? Would that be a situation we could see in the next couple of years?
Gordon Wadley: Yes, I think so. So some of the deals that you would have done now at lower NERs are marginally lower face rates. On the next renewal cycle, if it's 3 years, 5 years, 7 years or 10 years, you should very much see a pick-up on net rent but more importantly, on the renewals. You have to put -- you often put in less capital. So you see a benefit on both sides. So that's a good question. And I think on the next cycle, you'll see better deals, better net effectives and better rents.
Operator: And the next question comes from Matt Kornack with National Bank Financial.
Matt Kornack: Just quickly, Jay, I wanted to walk through kind of the bridge between Q1 and Q2 on NOI. I think most of it is either in straight-line rents or lease termination income. But if you could give us a sense as to how that straight-line rent, I think you mentioned that it will impact the second half of the year? But should we assume that the full kind of CAD1 million of straight-line rent converts to cash rent? And is that a run rate for the remainder of the year?
Jay Jiang: Sure. No problem. So to answer the first part of your question from Q1 to Q2, in addition to the noted straight-line rent and lease termination income, we were also a little bit higher about CAD350,000 on comparable properties NOI sequentially and that's just due to free rent burning off for tenants that have taken occupancy. Our property management and construction income was also higher by CAD150,000. And we did some work for tenants and we're paid a one-time income for that. On straight line, we had 2 tenants in Downtown Toronto that took occupancy a few months early this quarter, quarter being Q2. They commenced rent payment, I think one in July one in September. So these are very quick free rent period and that income will be reflected in the cash NOI in Q3. However, Gord mentioned ICICI Bank at 366 Bay. Their lease I think is in November but they actually finished the work early and they have taken occupancy and began operations this summer which is great. We will see some straight-line for that. So the simple answer to your question is, our straight-line will actually be around the same I think for Q3 and Q4 but it's puts and takes because we have 2 tenants burning off and then it will be replaced by 366 Bay.
Matt Kornack: Okay. So going into, I guess, Q3, the only variance would then be the lease termination which was one-time in nature. So maybe it's kind of why it goes down a little bit sequentially. Was there anything in recoveries? I also noticed that the margins were fairly high this quarter. It may just be typical seasonality.
Jay Jiang: That's a good cash. We're actually since January been working collaboratively with the property management accounting group to look for efficiencies with regards to our OpEx and that has created a gain in the NOI margin. So for example, we're looking at optimizing utilities, cleaning services that align with tenant hybrid working schedules. So for example, if they don't need to be in the space on Mondays or Friday, we can actually save quite a bit of money by optimizing electricity and cleaning. A couple of other things. We looked at suppliers for a lot of the supplies, cleaning materials and labor as well. So hopefully, that actually can flow through and becomes a normalized run rate but we're still sort of in the phase right now where we're trying to figure out we could save a bit more money.
Matt Kornack: Okay, fair enough. And then the last one for me on 74 Victoria. When you approach the leasing for that property, like obviously, there's some long-term optionality to potentially densifying the site. Are you taking that into account? And for the remaining 2/3 space, Gord, with those timelines that you've provided in terms of the gap between signing and commencing cash rents be similar for the tenants that you're looking for, for that space? And would you invest in that space against CapEx at this point given that the building may not exist in a decade?
Michael Cooper: Gord, can you answer those 7 questions?
Gordon Wadley: Yes, no problem. They're all good questions by the way. Yes. So in terms of investing capital, we would for the right deal in that building. It's a great location. We've actually had quite a few tours of people going in because it is a large block of space that's available. So on a case-by-case, I think a lot of people have to appreciate, in any single commercial lease, there's often a demo and relocation provision in these leases. So we try to structure our leases very much like the industry standard where it's down the road, there's flexibility. We work closely with the tenant to come up with optionality if we want to do something to the building. And we'll look at -- much like any space, we'll look at every deal on a case-by-case basis. If it requires capital, we'll do the due diligence to understand if it's something that's going to benefit us. If it doesn't require capital, maybe a low net rent and immediate occupancy, then we'll look at that on a case-by-case as well. So we try to do everything. We also have our CIB facility which we've talked about in the past. It's about CAD140 million Canadian infrastructure bank loan where we get a really low cost of capital to improve all of the base building in that building. And 74 Victoria is a building where we've done the studies on. We know what we need to do there and we've got this facility that we can lean on to do things cheap and then also to amortize those improvements to the tenants. I think that's the most important point, Matt, that we're prepared to put money into the space but we wouldn't expect to recover it after the existing tenant has gone and that goes to the potential redevelopment. But for the right tenant, for the right lease, we're happy to keep it as an office building in the meantime.
Operator: And the next question comes from Mario Saric with Scotiabank (TSX:BNS).
Mario Saric: Maybe a general question, Michael, on your comment that it still may take 12 to 18 months for visibility to kind of stabilize on what tenants are doing with their space and so on and so forth. It's been over 4 years since the start of the pandemic. So is the comment -- is it more so tenants having made decisions and now reconsidering those decisions in terms of how to optimize the space or is it simply like more tenants -- like most tenants still haven't figured out what they're doing?
Michael Cooper: It's absolutely everything. I'm not sure how your company is dealing with it. But everybody I know says their companies have had maybe 20 or 30 different policies in the last 4 years. So I think we are seeing people trying to figure out what the combination is that works best for them. I think what's been added a little bit recently is we're seeing that some buildings are doing -- some businesses are doing great and that may translate into more space. But people are getting more concerned about a slow economy. And instead of it being a discussion of remote work or these big ideas, it feels like the old days where the CFO is trying to figure out how to save money on office space. So when I say 12 to 18 months, I don't want to be held accountable, it could be longer. I doubt it would be shorter. But I do think that businesses are trying to figure out how they're going to use space. But overall, the economy is growing. Overall, I think the demand for space is picking up and I think there is pent-up demand. So as things settles out which is why I said 12 to 18 months, I think we'll have better insight. But your point about it's been since 2020 and is it that people haven't made decisions or they just thinking the reconsidering, this is really an unusual situation. I don't think this was the issue in retail 5 years ago. I mean, this is like nothing I've seen. But what I would say, what's amazing about it is, things are holding together pretty well. And there's been some big hits to the sector, let's say, in the stock market and there's been some loss of occupancy. But there's a lot of activity going on in all the buildings. We're starting to see some buildings getting converted, especially in Calgary but we're seeing more and more of it in Toronto. And it will fix itself. But until then, I'm pretty pleased with how it's holding together.
Mario Saric: Okay. And just on the building conversions, what's your sense in terms of the applicable inventory in Toronto that could be suitable for conversion?
Michael Cooper: So when people think about conversion, they're usually thinking about office to residential but it can be office to institutional and office to a whole bunch of other things. We are seeing that. We're seeing that like with 720 Bay, it becomes a healthcare building, with George Brown College taking over Corus building. As time goes by, that will become a school building. So don't underestimate the significance in terms of the conversion to non-office uses that are still commercial. On the residential conversion, it's used loosely. Sometimes when people say conversion, it means like conversion of the use which might include tearing down the building and building a new building. We're seeing that the City of Toronto on an ad hoc basis is reducing the requirement to replace office in some cases entirely. What we've seen is, they're also prepared to say, well, why don't you have the office over on one side so you can build a residential and the density has to be held for office but you don't have to build it. So it's starting to pick-up steam. I think last year there was 1 million square feet that was converted. I could see that going to 5 million relatively easily across the country. And I think I've said this before, I suspect that we'll be looking at not the net addition to supply but the net subtraction to supply over the next few years. So I think that will be a significant factor as we go forward.
Mario Saric: Got it. Okay. switching gears for my second question, just maybe for Jay. I think you mentioned that 14% of the portfolio was externally appraised during the quarter. In terms of the fair value change during the quarter, is it fair to say that it doesn't just apply to the 14% of the portfolio that was appraised but rather it was extrapolated throughout the entire portfolio?
Jay Jiang: Yes, you're right. We follow the external appraisal methodologies pretty closely. We also look for external data points. So all the brokerage research firms that released their cap rates, they were pretty flat this quarter. We make sure everything reconciled, because over the course of the year, we probably externally appraised 25% to 1/3 of the properties historically. And then we want to make sure that the methodologies are consistent. And of course, each quarter, the auditors review the methodologies and year-end there's a more fulsome process. But you're right, it's -- typically the methodologies are extrapolated.
Mario Saric: Okay. And then just one quick follow on. Jay, I think you mentioned that the sensitivity to debt-to-EBITDA 0.1, probably CAD50 million of sales, you're at CAD11.8 million. You've probably been asked this question before on prior calls in terms of what your targeted EBITDA that's a lot of asset sales to get down to kind of sub-10-ish type...
Jay Jiang: We want to grow the EBITDA. So that's on the numerator side. But if we can grow the EBITDA, get the leasing done, it's a lot more meaningful on the denominator.
Mario Saric: No, that makes sense. So is there a target EBITDA that you think you can get to by X date?
Jay Jiang: It's really hard to give a number but we're really focused on this metric. And if we can get it down closer to 11x within 12 to 18 months, I think that's the start.
Operator: And the next question comes from Lorne Kalmar with Desjardins.
Lorne Kalmar: Just on the 74 Victoria and not to beat a dead horse or anything, I think you mentioned there's 64,000 that's been renewed, correct?
Gordon Wadley: Yes, we're in advanced negotiations for it.
Lorne Kalmar: And I guess, so assuming this moves forward, there would be no downtime there. Can you maybe give us an idea of what sort of spreads you're kind of looking at on that?
Gordon Wadley: We don't want to disclose out of respect for the tenant right now. We're working through. I'd say, it's a market deal.
Michael Cooper: Yes. We're -- it's not done yet and we want to provide you guys with as much transparency as possible but we've got to take care of the business too.
Lorne Kalmar: Fair enough. Okay. And then on -- are there any other kind of material non-renewals that you guys are starting to work through now, so net new deals? Sorry, non-renewals, any non-renewals that you're looking to address in the not too distant future, maybe you're looking at 2025?
Gordon Wadley: Okay. So non-renewals, we usually classify as new deals on vacant space. We've got a pipeline in the pipeline of about 270,000 feet that we're working through now. I'd say, close to about 90,000 of that is net new. And towards the end of next year, we want to pick-up probably about another 114,000 square feet net new as well. And then Jay can give you a quick update on some larger expiries.
Jay Jiang: Yes. I think, Lorne, expiries are uncommitted in our MD&A disclosures. So actually, over the past 2 years, we had a lot of expiries. But over the course of next year, if you look at the disclosures, that number has come down quite a bit. The next largest expiry is actually at the end of 2025; that's our asset in Kansas City, and we're currently in discussions with them right now. So other than that, we already pre-leased IO at 438 University. So that was a large one and we don't have any larger exposures beyond that.
Lorne Kalmar: Perfect. And then, Gord, I think you gave -- you alluded in your prepared remarks, you might have done a little bit of a rework of the WeWork deal. Could you maybe give us a little bit of color on what you guys had to do to get that done?
Gordon Wadley: I mean, they were great to deal with and they were quite forthcoming and transparent throughout. So we provided a small or reasonable market adjustment to their net rent for a fixed period of time. And the future rents and the future steps were preserved. And we also work directly with them just to see what the pipeline was on occupancy for them and everything and they've got a great plan for the building and they've put in some great tenants. So we just did kind of, I'd say, a relatively near-term adjustment protecting our long-term value.
Operator: And the next question comes from Pammi Bir with RBC (TSX:RY) Capital Markets.
Pammi Bir: At 74 Victoria, I think you mentioned the 40,000 to 50,000 square feet of discussions with prospective tenants that's in the works. Can you maybe just expand on that? I'm just curious, what types of tenants that you're talking to? And any color would be helpful there.
Gordon Wadley: Yes. So there's a few different groups. So we've got a couple not-for-profits that are looking at various opportunities in the space. We've got a professional services firm that's looking at space. And also too, we own 30 Adelaide which is right next door. We have a lot of people asking us about availability in this space. This is a great well coveted building. So there's a lot of flexibility on kind of moving pieces throughout the portfolio and taking buildings where we have some vacancy and reallocating tenants from one building to another. And that's a real competitive advantage for us that not a lot of our peers have. And it really is a testament to the value of our portfolio. Having all these buildings so close together, I think it really helps us just plan our stacks and make sure we're forecasting the right way. So in closing, we've had about 4 groups take a pretty hard look at 74 Victoria and they range from not-for-profits right through to professional services.
Pammi Bir: And these would -- if these deals are successful, I mean, this is hopefully for some point, 2025 economic occupancy, fair to say?
Gordon Wadley: The back end of 2025. That's correct.
Pammi Bir: Back end. Okay. And just coming back to the comments earlier on the loan-to-value on some assets and maybe there some are perhaps have a lower ratio. On the refinancing to offset Adelaide Place, can you maybe share sort of what range of loan-to-value that maybe sits at? And are you anticipating any paydown on that property?
Jay Jiang: Simple answer is no pay down on the assets. We're refinancing for approximately the same amount of maturities. The LTVs are dictated by the lenders and they engage an external appraisal process for it. We're just in the final process for that and we expect the LTVs to be in the 50s.
Pammi Bir: Sorry, Jay, did you say 50s, 5-0?
Jay Jiang: Yes. Depending on the appraisal which they keep, we don't know but that's typically how they scale the loan.
Pammi Bir: Okay. And term-ish would be 5 years-ish or...
Jay Jiang: Yes, we're looking at 5 years.
Pammi Bir: Okay. And then just lastly, at 438 University, can you maybe just expand on maybe where that sale process sits? And I'm curious on any dispositions that you're looking at in the portfolio, would you be considering any VTBs?
Jay Jiang: I can answer the second part. I can't answer the first part. The discussions we're having are an all-cash deal with no structuring. But it's -- it would be uncomfortable for our counterparty to provide any more detail.
Operator: And the next question comes from Sumayya Syed with CIBC (TSX:CM).
Sumayya Syed: First question on the leasing costs in the quarter, they're about CAD1,670 a foot ahead of your last few quarters. Anything or any lease in particular that would have pushed that higher for this quarter?
Gordon Wadley: No, not in particular. It's just kind of an aggregate of deals put together and leasing up some space that was in raw condition which took a little bit more capital to move them through. The other thing I'd say, Sumayya which is interesting is broker fees even year-over-year are up about 20%. So it's the price to pay and to play. So we're seeing some increases there. But nothing tied to anything in particular.
Sumayya Syed: Okay. And then just on the refinancing side, you did the Calgary mortgage in the quarter, 6.65% [ph] rate. Is that fairly reflective of what you're seeing for rates generally? I guess, Jay, in your comments, you mentioned more along the range of 5.5%?
Jay Jiang: Yes. We closed the Calgary mortgage a couple of months ago. And the benchmark has been moving down a bit and we're just quoting rates in Downtown Toronto, if we were to do a mortgage today. I would say that Downtown Toronto also a different market than in Calgary. So it's a bit more competitive on the spreads. Every loan is a bit unique but most of the close that we've been getting are around the 5-year mark.
Sumayya Syed: Okay. Got it. And lastly, probably a question for Michael. You now have shareholder, holders that own more than 20% of the REIT. Just wondering, what's the dialogue like with them? And what you can share with us about their intentions?
Michael Cooper: The 20% holder runs Artis REIT (TSX:AX_u) and they have conference calls. I think you should ask them.
Sumayya Syed: Okay, got it. Thank you. I will turn it back.
Operator: [Operator Instructions]
Michael Cooper: Thank you, operator. Thank you everybody for your interest in the company. We look forward to follow -- any follow-ups, any tours on our next conference call. Thank you very much.
Operator: The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.
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