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Edited Transcript of MR.UN.TO earnings conference call or presentation 1-Nov-19 3:00pm GMT

Q3 2019 Melcor Real Estate Investment Trust Earnings Call

Edmonton Nov 4, 2019 (Thomson StreetEvents) -- Edited Transcript of Melcor Real Estate Investment Trust earnings conference call or presentation Friday, November 1, 2019 at 3:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Brandon Park

Melcor Real Estate Investment Trust - Director of Asset Management

* Darin Anthony Rayburn

Melcor Real Estate Investment Trust - President, CEO & Trustee

* Naomi Marie Stefura

Melcor Real Estate Investment Trust - CFO & Corporate Secretary

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Conference Call Participants

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* Jenny Ma

BMO Capital Markets Equity Research - Analyst

* Matt Logan

RBC Capital Markets, Research Division - Senior Associate

* Sumayya Hussain

CIBC Capital Markets, Research Division - Associate

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Presentation

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Operator [1]

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Good morning, ladies and gentlemen. Welcome to the Melcor REIT Q3 conference call.

I would now like to turn the meeting over to Mr. Darin Rayburn, President and Chief Executive Officer of Melcor REIT. Please go ahead, Mr. Rayburn.

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Darin Anthony Rayburn, Melcor Real Estate Investment Trust - President, CEO & Trustee [2]

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Thank you, Laurie. Good morning, everyone. Thank you for joining our conference call and webcast this morning.

With me on today's call are Naomi Stefura, our Chief Financial Officer, who will run through financial highlights for the quarter. And Brandon Park, our Director of Asset Management, is also in the room and will speak to leasing activity.

Effective October 1, Andy Melton stepped away as CEO of the REIT, and I was appointed for my second go-round as Chief Executive Officer. I want to take this moment to personally thank Andy for stepping in and for taking charge, with the support of our team, 2 years ago. And I can tell you our whole team looks forward to continue working with Andy as he remains an active member of our Melcor REIT trustee board. I can also tell you I'm delighted to be officially back, although I've been here in the background for a while as a REIT trustee all along.

Now on to the business at hand. I'd like now to turn the call over to Naomi to walk you through some of the financial highlights of the quarter.

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Naomi Marie Stefura, Melcor Real Estate Investment Trust - CFO & Corporate Secretary [3]

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Thank you, Darin. Hello, everyone, and thank you for joining us today.

I'd like to remind you that the materials related to this call, including the MD&A and financial statements, are available on the Investor Relations section of our website at melcorreit.ca and also on sedar.com.

Before getting started, I have a few mandatory statements to make. First, certain statements made during this call may be forward looking. For a complete discussion of items that may cause actual results to differ, please refer to the business environment and risk section of our annual MD&A.

Second, we report our financial results in Canadian dollars and in accordance with IFRS. We supplement our financial reporting with nonstandard measures, including funds from operations, adjusted funds from operations, adjusted cash flow from operations and net operating income. We believe these measures are important in evaluating our performance but caution listeners that they may not be comparable to similar measures presented by other companies. These nonstandard measures are defined and reconciled in our MD&A.

I will now walk everyone through some of the financial highlights of our results for the third quarter and 9 months ended September 30, 2019.

Revenue was stable over Q3 2018 and Q2 2019. Net operating income, NOI, was up 6% in the quarter and 3% year-to-date due to property acquisitions. Same-asset NOI was up 3% over Q3 2018 across all asset classes and regions due to higher operating margins and stable same-asset occupancy. Q3 is the second consecutive quarter for same-asset NOI growth.

Net income in the current and comparative periods is significantly impacted by noncash fair value adjustments on investment properties due to changes in capitalization rates and NOI and Class B LP Units due to the changes in the REIT's unit price. Management believes funds from operations or FFO is a better reflection of our true operating performance.

FFO was $6.57 million or $0.23 per unit, up 5% from Q3 2018 due to higher NOI. AFFO was $4.86 million or $0.17 per unit, up 8% from Q3 2018. Year-to-date AFFO was $14.25 million or $0.51, down 1%. The year-to-date decrease was due to higher reserves for tenant incentives and leasing commissions on account of continued challenging market conditions.

We maintained distributions in July, August and September, for a quarterly payout ratio of 97% based on AFFO and 72% based on FFO. The REIT has maintained this distribution since its inception, paying steady distributions to our unitholders for 76 months.

At September 30, 2019, we had $1.42 million in cash and $13.1 million in additional capacity on our credit facility.

I'll now turn the call back to Darin.

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Darin Anthony Rayburn, Melcor Real Estate Investment Trust - President, CEO & Trustee [4]

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Thank you, Naomi. And congratulations not only on a good quarter but also on being named 1 of Edmonton's prestigious Top 40 Under 40 for 2019. This is a well-deserved recognition for Naomi, and we are incredibly proud and honored to have her as part of our Melcor REIT family.

As Naomi said, we are pleased to report to you our third quarter results. We achieved stable revenue once again and are seeing new stability and positive momentum of leasing activity. This led to an improved occupancy of 90% at the end of the quarter.

We believe that our unit price is not reflective of our current or future prospects, so we continued to be active with our buyback program in the quarter. In fact, since April 1, 2019, we've purchased and canceled over 53,000 REIT units. The normal course issuer bid is a part of our ongoing capital allocation strategy.

On October 10, we announced a potential acquisition, along with a convertible debenture to raise $40 million for the purchase and a $10 million private placement of Class B shares to Melcor Developments. This pending acquisition is part of our thoughtful, targeted strategy to find appropriate opportunities in our own backyard. Grande Prairie is a market that we've been looking to enter for an extended period of time. This acquisition will add 283,000 square feet to our portfolio's gross leasable area and increase our retail properties to 44% of that overall portfolio of gross leasable area. This acquisition will also be immediately accretive to our AFFO per unit.

As part of this transaction, Melcor Developments will be participating in a private placement of Class B units at a premium to the unit price in the Toronto Stock Exchange.

We received a question from an investor about Melcor Developments being able to buy units through a private placement while other unitholders were not given the same opportunity. I'd like to remind investors the following. Melcor Developments was granted a preemptive right by the REIT at IPO to maintain its pro rata ownership interest in the REIT. This was disclosed in the IPO prospectives and in our continuous disclosure since. Melcor Developments' continuing participation was always the plan and should be a surprise to no one.

Melcor Developments' current intention is to maintain its pro rata ownership interest at current levels, levels which have remained constant since our IPO. Melcor Developments didn't formally exercise its preemptive right and purchase convertible debentures but did so informally by agreeing to purchase Class B LP units at a premium to market at a future price after the Grande Prairie acquisition was announced. Management and the REIT trustees were cognizant of the impact on the debt-to-gross book value ratio had Melcor Developments taken convertible debentures. And management and trustee did not want to get that debt-to-GB be at a level which is, as stated, an internal ceiling.

So Melcor Developments took Class B Units instead at a negotiated premium that was reviewed, vetted and agreed to by a special committee of the independent REIT trustees of Melcor REIT through the established governance process.

This acquisition is an important purchase for our REIT. With its immediate accretion, it adds for a strong foundation as we continue our execution strategy. This also allows us to strengthen resiliency through these challenging economic times. Buying is key, but operating and leasing our existing portfolio is equally as important.

Brandon will now speak to our leasing momentum.

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Brandon Park, Melcor Real Estate Investment Trust - Director of Asset Management [5]

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Thank you, Darin.

We continued to execute on our proactive leasing strategy to both retain existing and attract new tenants. We completed lease renewals representing 124,211 square feet, including holdovers, for a retention rate of 80.3% at September 30, 2019. New leasing has been steady across the portfolio, with 63,730 square feet in new deals commencing to date in 2019 and an additional 48,000 square feet committed for the future occupancy.

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Darin Anthony Rayburn, Melcor Real Estate Investment Trust - President, CEO & Trustee [6]

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Thank you, Brandon.

I want to say a special thank you to our Melcor operations and administration teams for all your efforts on our behalf and on our unitholders'.

Over the past few years, we've continually adjusted to respond to market conditions while also focusing on operating efficiencies, asset enhancement and tenant retention. The future remains difficult to predict. However, the REIT remains well positioned to manage efficiently and build value for unitholders. Make no mistake, western Canada is open for business.

At this time, we'd like to open the phone lines and take your questions. Laurie, please open the lines.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And the first question is from Matt Logan from RBC Capital Markets.

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Matt Logan, RBC Capital Markets, Research Division - Senior Associate [2]

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Darin, you talked about looking to enter the Grande Prairie market for some time. Can you talk a little bit about the property itself and if you see any opportunity to add value through active management over the next few years?

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Darin Anthony Rayburn, Melcor Real Estate Investment Trust - President, CEO & Trustee [3]

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Sure. Thanks for the question, Matt. The property is 33 acres on the corner of 2 highways, where if you're in Grande Prairie it's what we call "on main and main," straight across the street from the Grande Prairie university college. It's also just down the street from the new $800 million hospital that's yet to be opened but plans to be open within the next 18 months. So we found a great opportunity at a great location with 283,000 square feet that's been virtually full for as long as we've been tracking and beyond that.

Is there opportunities to densify? Perhaps. I won't get too far into that because that sounds like a forward-looking statement, but as far as doing what Melcor does best, Matt, we've done this in Lethbridge. We do it in Airdrie. We've done it in Chestermere. We do it in Spruce Grove. These what are considered smaller communities have been the bread and butter for the Melcor REIT in our time as a REIT and for Melcor Developments in their time developing over the last 96 years. So you did a great job paraphrasing it. We absolutely plan to get boots on the ground, phase in the community, be a big part and generate what we can from this asset that we're quite excited about.

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Matt Logan, RBC Capital Markets, Research Division - Senior Associate [4]

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In terms of the cap rate, could you give us any color on how we should be thinking about that?

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Darin Anthony Rayburn, Melcor Real Estate Investment Trust - President, CEO & Trustee [5]

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The high-8% range, which is why I can confidently make the comment that it's immediately accretive moving forward. And we do see opportunities for some near-term revenue growth.

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Matt Logan, RBC Capital Markets, Research Division - Senior Associate [6]

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I appreciate the color. Maybe just changing gears a little bit. In terms of your balance sheet, can you tell us if you have any plans for future asset sales or capital recycling over the next year or 2? And maybe just where you're thinking about targeting leverage over the medium term.

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Darin Anthony Rayburn, Melcor Real Estate Investment Trust - President, CEO & Trustee [7]

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I'll take the first half of that question, Matt. Thanks. We're always looking at our capital allocation and recycling program. I can tell you right now we don't have any specific assets listed for sale, but part of us resizing and reallocating our percentage of GLA towards retail and away from the heavily weighted office percentage in the past is an indication of our strategy going forward. So again no promises, but we'd like to see that allocation.

When we IPO-ed, our office was 67% of our income. And we stated at the time we wanted office to be about 40%, so we're getting to that level. So beyond that, I think your question talked about any sort of capital recycling program for the next 2 years. We are deal junkies at heart, so we're always looking. Stay tuned.

Remember there is also the Melcor Developments pipeline of assets under construction that the REIT has an opportunity for a first right to purchase. And there are a few of those assets that will be potentially ready Q2 next year, so something else we're keeping our eye on. Your second question was about our leverage and balance sheet, and I think Naomi can give you some feedback on that.

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Naomi Marie Stefura, Melcor Real Estate Investment Trust - CFO & Corporate Secretary [8]

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Yes. Matt, I think that at this point after issuing this most recent convertible debenture and sort of pushing up our total debt-to-GBV with converts to 59%, that's probably at the peak of sort of where we would like to see that, so I think at this point we'll sort of focus on maintaining and/or reducing that leverage level.

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Matt Logan, RBC Capital Markets, Research Division - Senior Associate [9]

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Appreciate the commentary. And maybe one last question for me. Maybe if I look in your industrial portfolio, the business seems to be performing quite well at 7% in same-property NOI growth year-to-date. Can you give us a little bit of color on what you're seeing on the ground and how we should think about that area of your business going forward?

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Darin Anthony Rayburn, Melcor Real Estate Investment Trust - President, CEO & Trustee [10]

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Sure. I wish I could tell you that in Edmonton and Alberta right now industrial is booming, but I can tell you it's like everything else that's hanging in there. Our numbers may be business leading because industrial is such a small percentage of our portfolio. And we had a tenant with a rent step, but having said that, our industrial is holding in. We'd like to find more industrial. One of the challenges in the Edmonton market is you really have 2 classes of industrial. You have the old stuff with low ceilings, and you have all the new stuff that's been built by the funds over the last couple of years. So for us it's hard to find an accretive purchase for an industrial building that would make sense for the size of our REIT. Having said that, as you've seen, there's been a couple of large transactions of portfolio purchases in Alberta with funds from outside of Alberta. So word on the street is that there is still an opportunity to make money in industrial assets in Alberta.

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Operator [11]

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The next question is from Jenny Ma from BMO Capital Markets.

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Jenny Ma, BMO Capital Markets Equity Research - Analyst [12]

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Welcome back, Darin.

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Darin Anthony Rayburn, Melcor Real Estate Investment Trust - President, CEO & Trustee [13]

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Thank you.

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Jenny Ma, BMO Capital Markets Equity Research - Analyst [14]

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I wanted to follow on the question about the cap rate on the Grande Prairie asset. Now I know you guys know these smaller Alberta markets very well even if you're not necessarily in them from the REIT side but just wondering if that high-8% range is very particular to the Grande Prairie asset. Or do you think that's indicative of retail assets in some of the small Alberta markets? And what that informs as far as your future third-party acquisition opportunities are concerned.

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Darin Anthony Rayburn, Melcor Real Estate Investment Trust - President, CEO & Trustee [15]

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We are finding that's unique to this asset based on the size. So we've been tracking a number of what are typically smaller assets in the smaller communities. However, we have not been able to find cap rates in that range that make sense for us at this point, so I wouldn't say that, that is indicative of all retail projects in smaller Alberta communities. If it were, I'd be hoping to speak to you put more retail acquisitions in smaller communities, but who knows what the future brings? Did that answer your question, Jenny?

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Jenny Ma, BMO Capital Markets Equity Research - Analyst [16]

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Yes. That's helpful. And then this may be a question for Brandon. Just in the MD&A you talked -- there was a mention of some midterm lease amendments as far as the year-over-year changes. Are those amendments as -- are those amendments going the right way or the wrong way in that? Are they tenants leaving? Or are they extending? What kind of amendments are they?

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Darin Anthony Rayburn, Melcor Real Estate Investment Trust - President, CEO & Trustee [17]

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Jenny, I'll take that. It's a little bit of both, frankly. It's a bit of a mix. It's not material either way, but without a doubt, in good times and bad times, we have situations where sometimes tenants require rent breaks. So I'm -- I want to be really clear. This is not necessarily indicative of the market out here, but we've had a couple of smaller retail tenants who have required rent breaks. We've had other tenants that have done expansions where we've offered free rent sort of midterm to get expansion and extended terms. So there's not one material answer to that question. There's a whole bunch of little things at play.

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Jenny Ma, BMO Capital Markets Equity Research - Analyst [18]

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So net-net, would you say those amendments are modestly negative or positive?

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Darin Anthony Rayburn, Melcor Real Estate Investment Trust - President, CEO & Trustee [19]

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I will answer that question in 2 ways. On a portfolio basis, pretty much neutral, but if you break it down, I can tell you in Edmonton office, over the last quarter, I'd say net down, at least for now, although the down is not as much as down has been in the past. If you look at our BC and Saskatchewan portfolio, some of those results would be net up. So it sounds like I'm dodging your question, and Jenny, I promise you I'm not. There's just a whole bunch of little things coming into play.

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Jenny Ma, BMO Capital Markets Equity Research - Analyst [20]

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No, that makes sense. And it's not entirely surprising about the Edmonton office. And then congrats on the 3% same-store NOI growth. It looks like a good chunk of that came from the lower property tax and utilities, so my question is, is this a blip. And is the 3% something we can roll forward? Or is it really just a matter of timing that helped Q3 in particular, especially when you combine that with the RBC departure this quarter in Q4?

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Darin Anthony Rayburn, Melcor Real Estate Investment Trust - President, CEO & Trustee [21]

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Sure, yes. I mean I wish I could give you a forward statement saying we'll be up 3% every quarter. We just don't know, but I can tell you that, I mean part of it for sure is timing. But again, the other side of it is occupancy. Full buildings mean the landlord isn't funding the operating costs of the vacant space. And when -- Brandon talked about some of our leasing wins. We will see the benefit of those leasing wins once the tenants take occupancy in the first and second quarter of 2020. So looking forward, we see that there's a continued consistency with same-asset NOI.

If you break it down between asset class, you can see that office on itself is down 1%. With the Royal Bank leaving, that's going to take a bit of a hit, but again much of the activity we're seeing is also going to offset the Royal Bank leaving. If you look at it from a regional perspective, it's kind of flat across the board. It's kind of balanced. So I'm not sure I'd model 3% growth consistently going forward, but we would love to underpromise and overdeliver. So stay tuned.

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Operator [22]

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(Operator Instructions) The next question is from Sumayya Syed from CIBC.

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Sumayya Hussain, CIBC Capital Markets, Research Division - Associate [23]

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I just wanted to get some more of your thoughts on your revenue mix and the evolution. Obviously, the retail footprint has been growing. Where would you like to see that asset split finally settle?

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Darin Anthony Rayburn, Melcor Real Estate Investment Trust - President, CEO & Trustee [24]

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Our strategy 6 years ago was 40% office; 40% retail; and 20% other, which would be industrial and land lease communities. I know the world has changed in the last couple years. We're still moving towards that target. We don't want to get too heavily weighted in one asset class because, if you look at the foundation of the development company, how we survived 96 years is being conservative and balanced. So again we are not changing our initial target of the 40% office, 40% retail and 20% industrial/other. Ask me the same question next year, and you might get a bit of a different answer, but so far, we like the way we're going.

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Sumayya Hussain, CIBC Capital Markets, Research Division - Associate [25]

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Okay. I'll make a note of that. And then can you just speak to, I guess, the broader trend of repurposing some downtown office space and adding mixed use? Just what do you think about that strategy? Is it meaningful for the market? And is there any read-throughs to your office assets?

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Darin Anthony Rayburn, Melcor Real Estate Investment Trust - President, CEO & Trustee [26]

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Yes, I will make a general comment. No disrespect to Melcor REIT or other Edmonton developers, but Edmonton's issue isn't a supply issue when office. It's that we're underdemolished. We've got some older, inefficient, unoccupied buildings that are really skewing the numbers. Now what's positive is you're seeing some of these change. A building just down the street from our boardroom right now is being repurposed into a hotel. Building out the window to the west as I look is repurchased -- repurposed into some multifamily. There's another one being repurposed to student housing.

So my comment to you is, a lot of this repurposing, it had to happen, but the nice thing is it's taking some of the supply off the market. And it's easing up the pressure on landlords because, when tenants have many opportunities, especially in buildings that are virtually vacant, landlords at the time can be pretty aggressive on their rates. So don't misunderstand my -- it's tough to do office deals in Edmonton, as Brandon mentioned before. There is still momentum and there is still business to be had. There are pressure on rates, for sure, but as more of these inefficient, antiquated buildings come off the market, there are a fewer choices for tenants. The flip side too is some of the newer buildings that had vacancy like the EPCOR Tower -- BioWare just rented 3 floors in it. So you're seeing some of the really good space be chewed up.

And from our perspective, you asked what that does to the Melcor REIT. If you remember, we're not AAA class, but we're also not C class. We're kind of in that B+ to A-. It's how we've been successful the last 6 years. And that class is becoming important again because it's locationally based but it's not overpriced. So that's a long answer to your question. We're seeing some shifting, but make no mistake, there is still challenges in the Edmonton office market. And we're delighted to see some positive absorption, but we'd like to see absorption not just because old buildings got taken out. We'd like to see absorption because more people are moving downtown, and it's starting. Did that answer your question?

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Sumayya Hussain, CIBC Capital Markets, Research Division - Associate [27]

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Yes. It sounds like an incremental positive overall.

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Darin Anthony Rayburn, Melcor Real Estate Investment Trust - President, CEO & Trustee [28]

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Correct.

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Operator [29]

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There are no further questions registered at this time. I'd now like to turn the meeting back over to Mr. Rayburn.

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Darin Anthony Rayburn, Melcor Real Estate Investment Trust - President, CEO & Trustee [30]

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Thank you, everyone, once again for joining us today. We hope you're enjoying a pleasantful day and that your favorite team wins more than it loses.

Thanks, Laurie, for moderating the call. See you all next quarter.

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Operator [31]

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You're very welcome. Thank you all. The conference has now ended. Please disconnect your lines at this time, and we thank you for your participation.