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NorthStar Realty Europe’s (NRE) CEO Mahbod Nia on Q2 2017 Results – Earnings Call Transcript

NorthStar Realty Europe Corp. (NYSE:NRE)

Q2 2017 Results Earnings Conference Call

August 08, 2017 09:00 AM ET

Executives

Trevor Ross – General Counsel and Secretary

Mahbod Nia – CEO and President

Keith Feldman – CFO

Analysts

Mitch Germain – JMP Securities

Jade Rahmani – KBW

Mike Bessell – Merrill Lynch

Operator

Hello, ladies and gentlemen, and welcome to the NorthStar Realty Europe Q2 Earnings Call. My name is Josh, and I shall be your coordinator for today’s event. [Operator Instructions]

I am now handing you over to your host, Trevor Ross, to begin today’s conference. Thank you.

Trevor Ross

Good morning, and welcome to NorthStar Realty Europe’s Second Quarter 2017 Earnings Conference Call. Before the call begins, I would like to remind everyone that certain statements made during the course of this call are not based on historical information and may constitute forward-looking statements. These statements are based on management’s current expectations and beliefs and are subject to a number of trends and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements. I refer you to the company’s filings made with the SEC for a more detailed discussion of the risks and factors that could cause actual results to differ materially from those expressed or implied in any forward-looking statements made today. The company undertakes no duty to update any forward-looking statements that may be made in the course of this call.

Furthermore, certain non-GAAP financial measures will be discussed on this conference call. Our presentation of this information is not intended to be considered in isolation or as a substitute for the financial information presented in accordance with GAAP. Reconciliations of these non-GAAP financial measures to the most comparable measures prepared in accordance with GAAP can be accessed through our filings with the SEC at www.sec.gov.

I will now turn the call over to our CEO, Mahbod Nia.

Mahbod Nia

Thank you, Trevor. And thank you, everyone for joining us today. In addition to Trevor, I’m joined by Keith Feldman, our CFO. NorthStar Realty Europe, or NRE, is a New York Stock Exchange-listed REIT focused on prime European office properties. We own 27 properties in key cities across five countries with a concentration in our core markets of Germany, the United Kingdom and France. Our objective is to create shareholder value by generating stable and recurring income for distribution to shareholders supplemented by capital growth over time. I’d like to begin the call with a few remarks regarding the macroeconomic environment and European commercial real estate market.

The European economy is in a gradual and sustained state of recovery for the past four years. GDP growth in the euro area remains buoyant and stood at 2.1% in the second quarter. The International Monetary Fund or IMF recently revised its 2017 euro area growth outlook up to 1.9%. Unemployment in the euro area fell to 9.1% in June its lowest level since February 2009. This stronger than anticipated economic recovery has resulted in the European Central Bank or ECB, recently signaling its intention to consider scaling back economic stimulus.

However, subdued inflation which stood at 1.3% in the year to July combined with the lack of real income growth and the disparity in the face of economic growth among the euro area member countries means that any tapering is likely to be gradual and subject to ongoing review.

The geopolitical uncertainty in the region appears to have receded for the time being with the outcome of recent elections in the Netherlands and France resulting in pro-EU candidates being elected and Angela Merkel seemingly on track for a fourth term as Chancellor of Germany.

Looking ahead, we remain confident in the strong overall macroeconomic fundamentals in our core markets as well as the high quality and diversity of our portfolio and its income profile.

In the UK, despite stronger than anticipated economic performance during 2016, the Bank of England recently revised its 2017 UK growth projection down by 0.2% to 1.7% citing uncertainty following last summer’s EU referendum. This uncertainty has a potential to negatively impact the investment as well as consumer demand, as the elevated inflation rates, primarily due to the weaker pound sterling, begins to erode real incomes. The outlook for the U.K. economy is likely to remain uncertain and dependent on the duration and perceived outcome of Brexit negotiations. However, we continue to have conviction over the longer-term prospects for the U.K. and perceive the current uncertainty as a potential catalyst for attractive investment opportunities in the future.

Turning to the real-estate market. European commercial real-estate investment volume totaled €74 billion in the second quarter of 2017 and €130 billion year-to-date, 13% above the first 6 months of 2016. The office sector represented approximately 33% of total second quarter investment volume. Property yields in most asset classes and markets were stable during the second quarter and continued to remain at a significant premium to sovereign yields. Driven by continued strong demand from foreign investors and a number of large transactions in the industrial segment, German transaction volume reached €26 billion in the first half of 2017, 41% about the same period last year and the highest midyear transaction volume since 2007. Total U.K. investment volume was £27 billion in the first 6 months of 2017, 1% about the same period last year, with London accounting for 50% of all transactions and Chinese- or Hong Kong-based investors being the dominant source of overseas capital inflows. U.K. yields remained broadly stable during the quarter. French investment volume stood at €7 billion in the first 6 months of 2017, 27% below the same period in 2016, primarily driven by scarcity of large transactions and uncertainty related to the general election in May. Occupational demand across major European office markets remains robust, with the strong take-up and decrease in vacancy rates witnessed across most major European cities. This trend is expected to continue through 2017, driven by improving economic fundamentals and a limited new supply pipeline.

Turning the discussion back to NRE. I’m pleased to announce strong earnings in real-estate operating results in what has been a highly active second quarter for the company. Our portfolio of 27 properties leased to blue chip and other high-quality tenants in key cities across Europe is valued at $2.1 billion based on the midyear independent valuation by Cushman & Wakefield. As of June 30, the portfolio had a combined lettable area of approximately 352,000 square meters, an average occupancy of 83% or 86%, including recently signed leases, and a remaining weighted average lease term of approximately 5.9 years or 6.5 years, including recently signed leases.

We are pleased to report that we executed a number of significant leasing transactions during the quarter we anticipate will result in a long-term value creations for NRE. Through active management of our properties, we successfully leased or renewed leases on over 10% of the portfolios’ overall rentable area during and subsequent to the second quarter. These included Deutsche Bundesbank, who has committed to a new 10-year lease in the Trianon Tower in Frankfurt, expanding to an additional 7,000 square meters, while simultaneously extending their existing leases by an additional 2 years. Deloitte, a major occupier of our Rotterdam asset, also committed to a 10-year lease extension for approximately 23,000 square meters of office space, demonstrating their strong commitment for the building, extending the assets weighted average lease term from 2.5 years to 6.6 years. We expect to begin realizing the benefit of these transactions in the upcoming quarters.

Our core portfolio has a value of approximately $1.9 billion based on the midyear independent valuation by Cushman & Wakefield and is comprised of 20 properties in key cities within Germany, the U.K. and France, representing 89% of the overall portfolio by value and generating approximately 85% of our total rental income. The core portfolio has a combined lettable area of approximately 233,000 square meters and remaining weighted average lease term of approximately 6.5 years as of June 30, 2017. The recently signed leases will increase the core portfolio pro forma occupancy to 96% and further strengthened its income profile.

During the second quarter, we completed a new investment and forged an important new relationship with China Resources Land, a leading Chinese property development firm, through the acquisition of 20 Gresham Street, 100% occupied Class A office building in London. NRE invested approximately $34 million by way of preferred equity with an expected yield of 8% with equity participation rights. Finally, we sold three further noncore properties during and subsequent to the second quarter, exiting Spain and further reducing our presence in the Netherlands.

With that, I’m pleased to announce that NRE delivered another quarter of solid operating results.

And will now hand it over to Keith Feldman, our CFO to further discuss the financial results.

Keith Feldman

Thank you, Mahbod and good morning, everyone. I’d like to begin by saying how delighted I am to be here for my first NRE’s quarterly conference call. Overall, I believe NRE is well positioned with a portfolio of high-quality office properties across the more stable and liquid markets in Europe. And I’m very much looking forward to being part of this company which I believe has tremendous potential.

Now I’d like to turn to our operating results. During the second quarter of 2017, NRE reported cash available for distribution or CAD of $11.7 million or $0.21 per share compared to CAD of $12 million or $0.22 per share for the first quarter of 2017. The slight decline in quarter-over-quarter CAD was primarily attributable to the timing of certain corporate-level expenses. As NRE continues to focus on the sale of nonstrategic assets, we’re exploring the potential for our operational efficiencies from a higher-quality portfolio across fewer jurisdictions in addition to more effectively leveraging the broader CLNS platform. During the second quarter of 2017, we reported net operating income or NOI of $25 million.

Looking at our same-store sequential quarter-over-quarter operating performance on an FX-adjusted basis, rental income was essentially flat and NOI increased by approximately $350,000 or 1.5%. The increase in NOI was primarily driven by additional income related to lease termination and other tenant-related fees. Looking at our same-store year-over-year quarterly performance, rental income was essentially flat but NOI decreased by approximately $250,000 or 1%. The decrease in NOI was primarily attributable to the timing of certain non recoverable property operating expenses.

I’d like to point out many of the leases signed during and subsequent to the second quarter of 2017 as Mahbod mentioned earlier, have not yet commenced and therefore, are not reflected in our second quarter rental income or NOI results. Our occupancy percentage was 83% as of June 30, 2017 compared to 86% occupancy pro forma for the recently signed leases.

Turning to our portfolio. In May, we made a $34 million preferred equity investment in 20 Gresham Street. In addition, we continue to make progress on rotating out of nonstrategic assets. Of the three properties that were held for sale as of March 31, 2017, two sold during the second quarter and the third sold in July, leaving seven noncore assets currently remaining. The sales of these three properties have turned approximately $14 million of equity to NRE. In addition, we reclassified one noncore property in the Netherlands with a $2 million carrying value that held for sale as of the second quarter of 2017.

With respect to portfolio valuation on a semiannual basis, in June and December of each year, we engaged Cushman & Wakefield to update the independent valuation for our real estate property portfolio. As of June 30, 2017, the market value of our own real-estate properties increased from $2 billion to $2.1 billion or $2.2 billion, including our preferred equity investment in 20 Gresham Street. After deducting debt financing and adjusting for cash and other balance sheet working capital items, EPRA NAV was $17.29 per share as of June 30, 2017, compared to $16.04 per share as of March 31, 2017. The quarter-over-quarter change in NAV was partially attributable to an increase in portfolio value of approximately $0.50 per share, with the remainder of the NAV increase attributable to the currency impact of a stronger euro and pound sterling.

Similar to my earlier comment about rental income NOI performance, many of the recent leasing achievements that we discussed today have not yet been fully reflected in our current portfolio valuation or reported NAV. As of June 30, 2017, our leverage based on portfolio — on our portfolio evaluation was 56%, down from 57% as of the end of the previous quarter.

Our weighted average cost of debt financing was 175 basis points over Euribor or GDP LIBOR, with no maturities prior to 2020. In addition, we continue to be proactively — proactively evaluate opportunities to extend these maturities and further reduced our cost of debt financing. In April 2017, we amended and restated our revolving credit facility with a commitment of $35 million with initial 2-year term and no borrowing days requirement. As of August 3, we had $90 million of total liquidity, including $63 million of unrestricted cash and $27 million of availability under our credit facility.

During the second quarter, we incurred approximately $5 million of non-recurring CapEx, predominantly related to a few core assets that are subject to ongoing value-enhancing projects. On August 2, NRE declared a cash dividend of $0.15 per share of common stock. This dividend is expected to be paid on August 18 to shareholders of record as of the close of business on August 14. As a reminder, our supplemental financial report is available on our website. This quarter we added additional granular level detail on our investment portfolio as well as operating performance that we believe will be helpful in evaluating our business.

Overall, we’re pleased with the company’s financial and operational performance during the second quarter and look forward to updating you further as the year progresses.

Operator, please open up the call for questions.

Question-and-Answer Session

Operator

Thank you very much. [Operator Instructions] So our first question comes from the line of Mitch Germain from JMP Securities. Mitch, please go ahead. Your line is now unmated.

Mitch Germain

Good morning. So tell me about the characteristics of the seven assets that you considered non-core? Is it location? Is it growth prospects? Is it capital requirement? I mean, what sits in the non-core bucket versus the core bucket?

Mahbod Nia

Hi, Mitch, it’s Mahbod here. It’s a good one. So early last year, we announced a change in strategy to focus the business on its major component, which at the time was very deliberately primarily offices in key cities in Germany, UK and France. At the time that was — we were 95% office and of that we were 75% in those markets. And so that was always very deliberate. And we made the decision to streamline the portfolio and focus on that largely because we couldn’t at that time and still [indiscernible] was expanding in some of these other markets where we held one or two assets. And so it really wasn’t economically viable for us to maintain a presence there. And there are also ancillary benefits from streamlining the business in terms of reduced leverage as you said half of that is lease premiums validating the NAV. And we anticipate some operational cost savings going forward as well.

So this is really consistent with that strategy. If you look at the portfolio — if you look at the business today, we were in nine countries. We’re now in five. We were at 52 properties. We’re now at 27. And in the noncore bucket, really the majority of the value there is in two assets. One of them is the Rotterdam asset that we spoke about a little bit earlier that we just — we gave — that a lease from a major tenant there for — and the other one is the logistics asset that we own in Paris and that, that — those two comprise substantially most of the value in that bucket.

Mitch Germain

Got you. And you had mentioned some uncertainty, I believe, was the UK region. I guess our conversations or research have indicated that really hasn’t caused any real pullback in investor demand for properties. It seems like a lot of people are trying to pitch a tent and find some opportunities in that market. Is that consistent with what you’re seeing? And, A and then B, how do you guys compete against a lot of that, let’s call opportunistic capital?

Mahbod Nia

Yes, very much so I think that’s true. So to some extent that’s probably currency driven with the pound being weak. But we’ve seen that particularly Asian capital and then especially Chinese capital and perhaps China — Mainland China and Hong Kong coming in the first half of this year in a pretty meaningful way. And there have been some notable transactions that you would have seen achieve greater than walkie-talkie get done at pretty premium valuation.

So I think it’s fair to say the investment market has held up very well. And actually, even the lettings market has held up pretty well so far as well. And my comment about uncertainty is really — was really in relation to the ongoing Brexit negotiations and what that ultimately may or may not mean for the city of London. And it is possible we see some softening at some point, but if we do, we actually think it could be a tremendous opportunity for us to be opportunistic. And how we do that? CBD and the way we’ve chosen to do it on the latest investment is by way of a preferred equity investment, but we’ll evaluate everything on the same merits.

Mitch Germain

Got you. So you’re having conversation with joint venture partners to kind of get a list of potential equity sources plan for this opportunity, is that the way to think about it?

Mahbod Nia

No. No, I think the way we think about the UK is we’ve got — most of the value of our portfolios in two fantastic assets, Portman Square and Condor House that we’d be happy to own for a very, very long time. We were very proactive in our approach to managing those assets. And so we in some cases leased up, in some cases regeared or extended the leases on those assets in — end of 2015, so roughly 6 months before the referendum. So we’ve 2 great assets, long income profile, about a 7-year WALT, great tenants. And so we’re very happy with what we have. To the extent we see opportunities down the road that we think make sense, we’ll find creative ways to take advantage of them. And we’re here to generate also for our shareholders. And if there’s nothing to do there, we will take advantage of it. But I wouldn’t say that there’s a specific JV partner and capital sitting waiting for something that may or may not happen because we haven’t yet seen that happen — seen softening in the market yet.

Mitch Germain

Got you. And then, last one from me. Obviously, Colony increased their ownership stake to around 9%. They’re managing or at least providing you guys some resources on the management side. Tell me about how you see that relationship evolving over time?

Mahbod Nia

Yes, I think, it’s a very positive step towards creating greater alignment between the manager and REIT and certainly signals an intention. NRE, I’ve said this before, is a high-priority vehicle and platform for Colony NorthStar. Richard has also reiterated that on CLNS’ conference calls and in meetings. So it’s a very — it’s a young but I believe will ultimately be a fruitful relationship whereby we are working together to find ways to unlock the value that we believe exists in this company.

Operator

Okay. Our next question comes from the line of Jade Rahmani from KBW. Jade, please go ahead. Your line is unmated.

Jade Rahmani

Thank you very much. Was just wondering if you could give some more color on the current investment environment in Europe and the U.K, in particular, in terms of transaction volumes, pricing? And also where you think investor interest is greatest? And maybe where you’re seeing interesting niches or opportunities?

Mahbod Nia

Hi, Jade, it’s Mahbod here. So — I mean, with regard to the U.K., as I mentioned, total transaction volume is roughly in line with the first 6 months of last year notwithstanding, but there was some subdued activity in the run-up to the referendum this time last year, but broadly stable. What we’re seeing in terms of investment mark, as I said, I think it’s really been business as usual. So seems to be a lot of capital that is still betting on London and betting on the U.K. and doesn’t look like that subsiding. And as I said, some of that is currency based, but also the economy has been performing very well, and the occupy market has been holding up too. With regard to opportunities outside of the U.K., we still — we think generally have to look to look hard for it, and the bar is pretty high. And we evaluate a lot but execute on 5 percentage of what we evaluate, but we do still see value in Germany. When you look at the — again, from — starting from the macro standpoint, Germany is doing incredibly well. We’re seeing inflation creep in, which has an impact on leases in a market which has predominantly index-linked leases and historically not a lot of rental inflation. We’re also — beyond that why we’re seeingthe demand and supply dynamics at a localized level very much in favor of landlords as well with very limited new supply coming online. And of course, with Germany being part of the euro area, there’s a little bit of an arbitrage there in terms of yields and financing costs which are probably artificially low by virtue of the fact that Germany is part of the euro area.

So, I think you got to look hard in Europe to find opportunities where we can leverage our platform to create value as opposed to necessarily buying buildings that are highly stabilized and top down in terms of value. But we still see value in that market.

Jade Rahmani

And where are you targeting acquisition cap rates?

Mahbod Nia

I mean, there’s not a specific target. Obviously, to the extent we invest those investments would need to be accretive for our shareholders and that means generate total returns at a net and going to be accretive going to be positive. So I wouldn’t say there is a specific target. And — but the discipline is, obviously, at an investment level, at an asset level, it’s got to be a cap rate that makes sense. And at a corporate level it also has to make sense when it comes to looking at accretion dilution and total return for shareholders.

Jade Rahmani

Can you give any color on what pro forma NAV would be for the post 2Q leasing and asset sales?

Keith Feldman

Yes. Jade, this is Keith. As we said this quarter, there was a $0.50 uplift from the prior time we updated the NAV. I think it’s tough to say exactly how much the NAV uplift will be from the additional leases. I mean they’re all clearly positive, increasing the tenant quality lease term and annual rent at the properties. But I think at this point it’s probably too soon for us to say exactly how much of an additional uplift we expect from those leases.

Mahbod Nia

Yes. And I’ll — this is an independent valuation and so the next one will be the year-end one. And so it’s very hard to put a number on that, Jade. And — but what you saw in the uplift this quarter was partly real value uplift, partly FX. But I think what we’re saying is that we anticipate everything else held constant that the real value uplift should be higher than what we witnessed this quarter based on the leasing activity.

Jade Rahmani

The assets in the noncore portfolio are those all being looked at for disposition?

Mahbod Nia

Yes. I mean, so they are held as noncore and the plan is to sell them. We’ve been careful not to commit to a specific time line and we’ll continue to do that. And some of these assets, as you know, we made a conscious decision to also what we felt as value that could — the value could be enhanced prior to their sale. And NorthStar, the Rotterdam asset is a good example of that, where we’ve just signed a lease extension — a 10 year lease extension with a tenant, with the largest tenant in that building taking the remaining lease from 2.5 years to 6.6 years. So — and I think — I described those assets as work in progress but are at different phases of the action plan that we have for them and — but the plan is to [indiscernible] at an estimated time.

Jade Rahmani

For the core portfolio, what do you anticipate for full year annual same-store rent growth and NOI growth?

Keith Feldman

Yes. Jade. So I if — we’re — I think in terms of the entire portfolio if you look at the leasing activities that we talked about today we do anticipate that, that increases NOI by approximately $2 million per year. Now just keep in mind that will take a couple of quarters to come into effect as the leases come in. And that’s same-store portfolio — that same-store performance for the entire portfolio that we have today including the noncore assets that we have today.

Mahbod Nia

And I think, Jade, just the other component to that is, again, just bear in mind that a pretty significant portion of the leases, certainly within France and Germany, not so much in the U.K. where the leases tend to be reversion REIT to market — upward only but reversion REIT to market. But in Germany and France, those leases are substantially index linked. So with inflation picking up in the euro area, that could also be a contributing factor going forward.

Jade Rahmani

And lastly, are there any plans to list on the London Stock Exchange?

Mahbod Nia

No, I mean — so we’ve looked at the listing and continue to look at alternatives for the listing. So I’d say, that’s a work in progress. And we’ve talked about it a few times before as well. And I don’t know necessarily that I’d say it’s London or it’s a dual listing or it’s a migration. But I think it’s fair to say that we’re reviewing all options and will continue to do so. And if there are structural enhancements like that, that we feel ultimately will create value for shareholders and it would be keen to pursue them.

Operator

Our next question comes from the line of Mike Bessell from Merrill Lynch. Mike, please go ahead. Your line is now unmated.

Mike Bessell

Hi, guys. Just a very quick one from me in terms of the transaction you’ve done at 20 Gresham Street and the structuring of that. To what extent do you feel that the structure of that was in some way, forgive me saying it, but forced by the pressure of funds looking at those sorts of London assets? And is there any thoughts to continuing to roll out similar transactions or even to reverse those sorts of structures onto the like of Condor House, Portman Square and some of your other existing assets?

Mahbod Nia

Yes. No, I don’t think the structure was forced on us in any way. I think it was actually the product of a very collaborative engagement with CR Land whereby we recognized their objectives and limitations and they recognize ours. And being a public company, having a certain earnings yields, not wishing to do dilutive deals, this was a deal — a structure that worked for both sides. So I think that was really a product of taking into consideration each side’s requirements. Whether it would be more of that going forward, it’s perfectly possible could be something like that. But — and by the way, I’m not necessarily referring to CR Land here but could be further joint ventures and partnerships. It could be on new asset. It could be on existing assets. Again, our goal is really to be open, alert, nimble in seeking opportunities that we feel create value for our shareholders, however that value may be created and however the transaction may subsequently be structured to create that value.

Operator

[Operator Instructions] Okay. So we have no further questions on the line. So I’ll hand back over to Mahbod to conclude today’s conference. Thank you.

Mahbod Nia

Well, thank you, everyone, for joining us today. And we look forward to updating you next quarter.

Operator

Okay. Thank you very much for joining today’s call. You may now replace your handsets.

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