Earnings Call Transcript - KW Q1 2021

Operator, Operator

Good day. And welcome to the Kennedy-Wilson First Quarter 2021 Earnings Conference Call and Webcast. All participants will be in listen-only mode. After today’s presentation, there will be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to Daven Bhavsar, Vice President of Investor Relations. Please go ahead.

Daven Bhavsar, Vice President of Investor Relations

Thank you and good morning. This is Daven Bhavsar, and joining us today are Bill McMorrow, Chairman and CEO of Kennedy-Wilson; Mary Ricks, President of Kennedy-Wilson; Matt Windisch, Executive Vice President, Kennedy-Wilson; and Justin Enbody, Chief Financial Officer, Kennedy-Wilson.

Bill McMorrow, Chairman and CEO

Thanks, Daven, and good morning, everybody, and thank you for joining us today. I’m pleased with the Q1 earnings that we reported yesterday. As the fundamentals in our markets continue to recover from the pandemic, the strong momentum we had into Q4 carried into an active start for the year. We anticipate that the global economy will continue to rebound and the strong institutional demand for well-located real estate assets bodes well for our existing portfolio and our strategic growth initiatives. And we have built an extremely robust investment and leasing pipeline that will drive growth for us for the balance of the year and beyond. Starting with our financial results in Q1. We had a GAAP loss per diluted share of $0.04, compared to a loss of $0.07 in Q1 of last year. Adjusted net income grew by 5% to $47 million. These results include the impact of a one-time $15 million loss on the early extinguishment of corporate debt in Q1 related to the refinance of our 2024 bonds, which will result in $10 million of annual interest savings. Excluding this one-time loss GAAP net income would have been $0.04 per diluted share and adjusted net income would have been $58 million. Finally, adjusted EBITDA grew by 14% to $128 million. Our stabilized portfolio at the end of the quarter equated to $389 million of estimated annual NOI. The operational performance across our largely suburban multifamily and office portfolio, which accounts for 82% of our estimated annual NOI, was strong as we continue to maintain high occupancy and once again collected 97% of our rents.

Mary Ricks, President

Thanks, Bill. In our multifamily portfolio, occupancy remained steady at 95% from year-end; suburban assets account for 90% of our multifamily NOI, and our average monthly rents stood at $1,675 per month. Our largest market rate multifamily region is in the Mountain States. The performance in this region continues to be very strong.

Bill McMorrow, Chairman and CEO

Thanks, Mary. I’d now like to discuss the progress we are making with our development and lease-up projects. Our development pipeline is building to, on average, a 6% yield on costs in markets where assets are trading at significantly lower cap rates.

Operator, Operator

The first question will be from Anthony Paolone of JPMorgan. Please go ahead.

Anthony Paolone, Analyst

Great. Thank you. We’ve heard a lot of anecdotes about where cap rates are for apartments across the country. But you all have a fairly unique footprint. Can you comment on where cap rates are in some of your Mountain States, perhaps Dublin and also for your more affordable product?

Bill McMorrow, Chairman and CEO

Yeah. Well, I think, Tony, as an overview, these low interest rates that you can finance have caused cap rates to decline. And also, as I think we all know, there are hundreds of billions of dollars of capital globally that are looking for real estate as an asset class, which has also had an effect as you can see from the sale that we did in Friars Bridge Court. I would say that we’re very fortunate in the sense that we got into most of the markets that we’re in today a long time ago, so we have very good footprints there. But it’s competitive on the buy side today, and our real strength, I think, on the buy side has been the relationships that we’ve created over these three decades that most of us have been together. We’re always trying to find that off-market opportunity. The decisions that we made as far as new construction really started almost seven years ago, and it takes a long time to fill the pipeline. We bought Clancy Quay in 2013, and there were only 420 units there, and now we’re going to have 865 units. In that case, we’re stabilizing Clancy at close to a 7% cap rate, brand new, and that property, although we have no plans to sell it, would sell at a cap rate today well below 4%. So the decisions we made have proven to be a great asset. Most of this construction we’re doing will come online before the end of 2023 and some into 2024. So while the market is competitive, we’re still finding opportunities on both the buy side and on the new construction side. We’re starting two new projects, one next to our project in Santa Rosa, called Santa Rosa Phase 2, which will have 300 units, and we just bought a property in Boise, Idaho called Jasper, which is next to land for another 240 units that we’re going to start on this summer. So, despite the market being competitive, we’re still finding opportunities that make sense for us, locking in spreads by using fixed-rate debt that generally has a 10-year term.

Anthony Paolone, Analyst

Got it. And are your investor partners adjusting down return expectations or adjusting to an environment where there’s an enormous amount of liquidity, or how does that conversation work with you as you’re raising capital?

Bill McMorrow, Chairman and CEO

Yeah. I mean, I started saying three to four years ago on these calls that the days of underwriting, when you’ve got basically zero cost of debt in certain parts of the world, the days of underwriting initial yields to 15% to 20% or 25% returns that we may have gotten eight or nine years ago was actually a fool’s game. So everybody has had to adjust their return expectations. But it’s broken down. We’re a value-add player, always trying to acquire things we can add value to, whether that’s through better management or new development. Partners particularly in the insurance industry have lowered their yield expectations to satisfy their own needs, which has allowed us to get into a space where we’re doing more core returns. So clearly, there’s a segment of the institutional investment world lowering their expectations to more core returns, seeking core risk-adjusted returns without going way out on a limb in terms of risks. At Kennedy-Wilson, we’ve got every flavor of capital, including that dedicated to core returns.

Mary Ricks, President

And I would also say, Tony, that our core plus vehicle in the industrial space in Europe is growing immensely. Our partners and ourselves understand that asset class and that band of returns sort of the 9 to 11 leverage. We might be going in at a 5, but we’re growing that to say a 6, and we’re seeing tremendous demand in all of our markets, and a lot of those fields we’re sourcing off-market. We have $300 million worth of new industrial assets throughout Europe that we’re evaluating, really excited about the growth in that platform.

Anthony Paolone, Analyst

Great. Thanks for all the context there.

Mary Ricks, President

Okay.

Operator, Operator

The next question is from Derek Johnston of Deutsche Bank.

Derek Johnston, Analyst

Hi. Good morning. KW expertise is distressed opportunities and specialist situations that really seem to have been elusive this cycle so far. There have been a lot of funds raised across the industry explicitly to target these scenarios. Has it gotten more competitive to source deals? If the government intervention has really eliminated a lot of distress this cycle, where do you go from here? Do you still expect to see some distress that just be a bit more delayed? Which of your core sectors stand out as likely having more opportunities, office, multifamily, or other banks?

Bill McMorrow, Chairman and CEO

Well, I think, there have only really been two sectors affected, the hotel and retail markets. Other than those two asset classes, there hasn’t been much distress. It depends on geographical location and what government restrictions came down regarding rent collection. The banking system is in the best condition I’ve ever seen; banks are well capitalized and working with borrowers. I don’t see near-term distress apart from those two asset classes I mentioned. Our real opportunity lies in the footprint we occupy within growth markets. We’re fortunate to be in the Western United States where job growth is driven largely by the tech sector and all its ancillary businesses. In Ireland and the UK, we’re very positive about the recovery. Thus, we're redeploying some of the capital from the Friars Bridge sale at attractive cap rates.

Derek Johnston, Analyst

It all makes a lot of sense, and it’s a good segue into my second question. You mentioned developments targeting a 6% yield. What level of compression due to highly elevated material costs and labor inflation are you underwriting? Is the impact around 100 basis points or 150 basis points in your opinion? Just trying to gauge possible multifamily development yield compression.

Bill McMorrow, Chairman and CEO

Very good question. Commodity prices are indeed increasing, but we’ve been lucky to have two highly capable teams running our construction. We always lock in our costs before beginning construction, leading to a high percentage of our projects already having fixed costs. Our costs for building in the Mountain States are lower than in California, where land costs per unit are higher. When I mention a 6% yield, that’s just a target. Clancy, the largest multifamily project in Ireland, is stabilizing at a 7%. We start with a conservative number we know we can achieve, and market conditions may allow us to outperform expectations.

Mary Ricks, President

We’re seeing that actually. Clancy III is currently 70% leased, and we are doing seven units a week ahead of budget. Just as Bill mentioned, these are target numbers, but given the supply/demand dynamics, I believe people are willing to pay for the product we offer, including amenities.

Bill McMorrow, Chairman and CEO

To give you an example with Clara in Boise, we leased 67 units in one month ahead of our initial underwriting expectations. Clara is a highly amenitized project, with first-class clubhouse, fitness centers, pools. We have tried to create properties with exceptional amenities, and our management teams have performed excellently.

Mary Ricks, President

Asset management is what is providing our value-add returns. We’re not seeing distress in our markets, and while we’re not making money from discounted purchases, we’re adding value to properties and growing income, potentially yielding 40% IRR.

Derek Johnston, Analyst

Great. Thank you, Bill and Mary.

Mary Ricks, President

Thank you.

Operator, Operator

The next question is from Sheila McGrath of Evercore ISI.

Sheila McGrath, Analyst

Good morning. Your Mountain State multifamily has outperformed significantly, while California is more challenged. Once you re-stabilize the California multifamily, would you consider reducing your exposure and reallocating capital to the Mountain States?

Bill McMorrow, Chairman and CEO

That’s a very good question, Sheila. I think California will make a comeback; it always has and will do so again. The jobs base in California remains strong. The biggest issues have been the complex overlay of rules regarding rent collections across various jurisdictions. We made the decision to diversify away from California around 15 years ago. This has served us well, particularly in markets like Seattle and Salt Lake City, where we now have significant positions. While we continue to look for opportunities in California, most assets we’ve purchased have been in funds run by Mary.

Mary Ricks, President

We’re focusing on California markets surrounding tech-centric areas. We're excited about life sciences as well; we just acquired an asset in Fremont with a promising tenant looking to go public. While we remain selective about our California acquisitions, we see positive stories within that sector.

Matt Windisch, Executive Vice President

As of today, roughly 20% of our NOI is in California, down from over 50% five to six years ago. In terms of our development pipeline, it’s roughly 10% in California, and pro forma we expect to be down to 15%. We strongly believe in these markets but have been redeploying capital into the Pacific Northwest and the Mountain States over the past decade.

Bill McMorrow, Chairman and CEO

The decisions to diversify were made a decade or more ago. They were separate from political changes in California or the pandemic. It has proved beneficial to have geographic diversity during the crisis we faced due to the pandemic. There are still attractive opportunities in various markets within the Western United States, which we will continue to explore.

Sheila McGrath, Analyst

That’s helpful. Regarding your industrial ventures, you’ve doubled your portfolio size there. Can you talk about your thoughts on this segment and whether any of your U.S. funds are investing in industrial properties? Additionally, how did you source such volume in Europe, given the high demand?

Mary Ricks, President

We’ve had deep relationships in the industrial space since we began in Europe; it’s grown significantly. Our focus has been on last-mile, well-connected assets with established distribution locations. Much of what we are acquiring is off-market with quick execution rates, leading to major growth in logistics. In Q1, the U.K. saw 9 million square feet of take-up. We are seeing strong demand in logistics distribution.

Sheila McGrath, Analyst

Last question, when is the Shelbourne opening, and was it fully shut for the first quarter?

Mary Ricks, President

I love that you asked about the Shelbourne. Yes, it was closed for the entire first quarter. We’re focusing on the Irish traveler for staycations and have secured 11% of total room nights for 2021 at pre-COVID rates. We expect the reopening to focus on staycations, and as Ireland and Europe open up, we anticipate a rise in international travelers.

Sheila McGrath, Analyst

Thank you.

Mary Ricks, President

Thank you.

Operator, Operator

The next question is from Jamie Feldman of Bank of America Merrill Lynch.

Jamie Feldman, Analyst

Thank you. I apologize if this has been addressed; I got cut off for a little bit. Just to take a step back, leasing is picking up as we’re seeing headlines about returns to office. I want to get your views on what will be different going forward, specifically in the U.S.?

Bill McMorrow, Chairman and CEO

As far as office use, my belief is that remote working will not be sustainable long-term. The missed connections and interactions essential for business success cannot be replicated remotely. Our company plans to fully reopen offices in June. While I believe the office market will not disappear, certain office types will perform better than others, particularly suburban, low-rise buildings. There are certainly evolving trends, with younger and older demographics preferring more affordable markets with lower tax bases and higher quality living conditions. Our markets are likely to continue growing in the long term.

Jamie Feldman, Analyst

That's helpful. Regarding the potential repeal of a 1031, how might that impact real estate in your business?

Bill McMorrow, Chairman and CEO

There’s ongoing debate around the tax bill that encompasses the 1031 exchange, which has been in existence since 1920. Although there’s much discussion, I don’t know what the outcome will ultimately be. While we’re cognizant of this change, the volume of capital eager to invest in real estate will likely counter any impact from the potential change in 1031.

Jamie Feldman, Analyst

Thank you. I appreciate your insights.

Operator, Operator

This concludes our question-and-answer session. I would now like to turn it back over to Bill McMorrow for any closing remarks.

Bill McMorrow, Chairman and CEO

Well, listen, as I said at the beginning of my prepared remarks, we appreciate the interest and the support that we get from all of you. Any follow-up questions you may have, Mary, myself, Daven, Matt, Justin, or any of us are here to continue the dialogue. So, have a great day and thank you for your time today.

Operator, Operator

Thank you. The conference is now concluded. Thank you all for attending today’s presentation. You may now disconnect your lines. Have a great day.