Dream Office Real Estate Investment Trust (DUN) Earnings Call Transcript

Good morning, ladies and gentlemen, and welcome to the Dream Office REIT Third Quarter 2026 Conference Call for Friday, November 6, 2026. 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. 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.

Thank you very much, and welcome, everybody, to our third quarter conference call. I'm here today with Derrick, Kingsley and Jay, who will speak in that order. Just before I turn it over to them, I would say that the last 5 quarters have been really good for the office market in Canada, especially in Toronto. We've been seeing significant leasing volume, reduction of sublease space, reduction of vacancy, increase of occupancy. And it looks good. Obviously, it started with the highest -- most expensive buildings, and it is working its way down. We're pretty pleased with the progress we've had throughout this period. Each lease is still a lot of work. It's not like falling off a log, but it's generally been in one direction, which is positive. I think we're starting to get more momentum in Adelaide Place almost full, 30 Adelaide is in great shape. I mean most of our buildings are great. And the ones that are a little bit behind are catching up. So we're feeling quite positive. The punch to the gut was finding out that ILAC had ceased operations, even the senior management didn't know about it. We had worked with them on a lot of things. We had no expectation. Like we knew that because of the business they were in, it was slower, but we've been working with them last 2 or 3 years. And we helped facilitate some sublease of their space, but we were quite shocked. And the guys will talk about it. But other than that, we're very pleased with how things have been going, and I think the teams are doing a great job making progress across the board. With that, Derrick, do you want to start?

Sure. Thank you, Michael, and good morning. The Dream Office sector experienced positive momentum in Q3 2026. National vacancy decreased by 40 basis points quarter-over-quarter to 16.7%. Of note, Downtown Toronto vacancy decreased by 90 basis points to 13.1% and experienced 709,000 square feet of positive absorption over this period. In addition, national sublease space fell 1.3 million square feet, representing the largest quarterly drop since 2005. This space currently sits below 9 million square feet, marking the first time since Q2 2020 and is down approximately 50% from its peak. In Q3 2026, Dream Office completed 43,000 square feet of new leases and 49,000 square feet of renewals. Toronto committed occupancy was 9% at the end of the quarter and was flat compared with Q2 2026. Other markets committed occupancy was 74.9%, representing an increase of 300 basis points quarter-over-quarter. The increase was due to new leasing representing 140 basis points of the increase and the reclassification of Sussex Center into a joint venture, representing 160 basis points. Jay will speak on the reclass later in the call. On September 18, International Language Academy of Canada, or ILAC, filed for bankruptcy and ceased operations. ILAC previously occupied 132,000 square feet across our Toronto portfolio. The leases were displayed in October. At 655 Bay Street, we have backfilled 53,000 square feet, immediately offsetting approximately 40% of the total vacated area by ILAC. Kingsley will provide additional color on ILAC as well as our progress on backfilling the space later on the call. At 606-4th Street in Calgary, our conversion from office to residential remains on track. The old office windows, building envelope and facade have been removed and replaced with a new energy-efficient window wall system. Interior electrical, mechanical, plumbing and finishing work is progressing as planned. Project time lines and costs remain in line with expectations. All major construction packages have been tendered, which enhances the predictability of project costs. First occupancy is targeted for Q3 2027. For the quarter, comparative properties NOI increased by 4.5% year-over-year to $24.4 million. The increase was due largely to new leasing in Toronto as well as higher step-ups in rents in other markets. For Toronto, comparative property NOI increased by 4.1% year-over-year to $20.3 million. Through Q3 2026, we were trending ahead of our prior committed and in-place occupancy guidance. However, as a result of the ILAC departure, which occurred post quarter end, we are updating our year-end Toronto committed occupancy target to 85% to 87% and our in-place occupancy target to 82% to 84%. These revised targets reflect the impact of ILAC's departure, partially offset by tenants taking occupancy under contracted leases. Higher NOI from other properties in the portfolio in the fourth quarter is expected to mitigate the net impact of ILAC's departure. As a result, we are maintaining our 2026 comparative properties NOI growth targets of 3% to 5% for Downtown Toronto and 1% to 3% for the total portfolio. Overall, Q3 2026 was a strong operational quarter. While we are disappointed by ILAC's departure, we are pleased to have converted a sizable footprint of the former subtenants occupancy to a head lease. We remain confident in our ability to re-lease the remaining space and recover income over time. I'll now turn the call over to Kingsley for more color on our leasing progress and what we're seeing on the ground.

Thanks a lot, Derrick, and good morning, everyone. Q3 was another positive leasing quarter for Dream Office. Tenant retention in Toronto was strong at 71%. And with our new leasing, we maintained committed occupancy at 90%. In-place occupancy also continued to climb, increasing 30 basis points from last quarter to 83.5%. Occupancy growth in Toronto has been strong. Since the start of the year, committed occupancy is up 260 basis points and in-place occupancy is up 410 basis points. Importantly, we've maintained strong deal economics alongside that growth and performance continues to improve. Year-to-date, Toronto NERs averaged $22.56 per square foot, which is 11% above our 2025 average. We're also converting more of our committed leases into rent-paying tenants. With leases starting throughout the year, the gap between committed and in-place occupancy has narrowed from 8% at the start of the year to 6.5% today. We expect it to tighten further, landing between 3% and 3.5% by year-end. As Derrick introduced, we did face a setback in Q3 with ILAC announcing bankruptcy, and I'd like to address that now. On our last call, we set a committed occupancy target in the high 80s for Toronto and an in-place target in the mid-80s. Before ILAC's announcement, we were on track to exceed both of those. However, at the start of October, ILAC ceased operations and has since disclaimed its lease. As this occurred after quarter end, it's not reflected in our Q3 occupancy. ILAC occupied 132,000 square feet across 2 buildings, 81,000 at 655 Bay and 51,000 at 425 Bloor. The team has moved quickly to limit the impact. This week, we signed a 53,000 square foot lease with a subtenant that already operates in the space. We achieved a low $20 NER on the deal, recovering about 40% of the space that ILAC vacated within 3 weeks of them leaving. Net of that lease, approximately 80,000 square feet came back to us that was not in our plan. That represents about 2.7% of occupancy and about $4.3 million of annual gross rent beginning in Q4 of 2026. As Derrick noted, we are lowering our year-end committed occupancy target to 85% to 87%. However, the impact on the in-place occupancy is smaller. We've adjusted that target to 82% to 84%, supported by leases at 74 Victoria and 30 Adelaide that commenced earlier than planned. Our CP NOI growth in Toronto is also unchanged at 3% to 5%. Outperformance earlier in the year from higher revenue share income and lower OpEx more than offsets the ILAC impact on our full year NOI. We have a clear path to hit our new occupancy targets, and we've already hit our renewal goals for the year. To reach our committed occupancy, we need about 17,000 square feet of additional leasing on vacant space. That's concentrated at Adelaide Place with about 15,000 square feet and on Bay Street with about 2,000 square feet. All of those deals are in advanced negotiation. Adelaide Place continues to perform very well. It's 97.5% committed. Deal costs are stabilizing and NERs are up approximately 5% year-over-year. In our Class B assets, costs remain elevated and rents have been relatively flat, but demand is there. Committed occupancy on Bay Street has improved to about 85% this quarter. That's up nearly 10% since the start of 2025. Our priorities for the portfolio are backfilling the remaining ILAC space and leasing up 74 Victoria. Both sites have been active with tour velocity. We know where our opportunities in the portfolio are, and we're focused on capturing them. And with that, I'd like to hand -- thank the team for their continued hard work, and I'll turn it over to Jay to walk through the financials.

Thank you, Kingsley. Good morning, everyone. I will walk through our third quarter financial results and provide an update on our outlook for the balance of 2026. For Q3, we reported diluted funds from operations of $0.62 per unit. This compares to $0.65 per unit last quarter and $0.60 per unit in the third quarter of 2025. Year-over-year, the $0.02 increase reflects $0.10 of higher straight-line rent, $0.05 of higher comparative NOI and $0.02 of lower G&A. That was partially offset by $0.10 of lost income from assets sold over the past year to reduce debt and improve our liquidity and $0.03 of lower nonrecurring lease termination income. Relative to last quarter, the $0.03 decline was primarily attributed to the percentage rent arrangement for certain tenants that was recognized and collected in the second quarter of each year. Comparative properties NOI was up 4.5% year-over-year and 4.1% in Downtown Toronto as leases we signed over the past 18 months turn into cash rent. At the same time, straight-line rent remained strong at $2.1 million this quarter as several larger tenants took possession of their space to start fixturing. Straight-line rent continues to be a good leading indicator of income and value growth. As those leases reach rent commencement, straight-line rent comes down and cash NOI goes up, and we expect to see this trend continue in Q4 and into 2027. Concurrent with the growing our occupancy and NOI, we have made progress reducing operating expenses and managing our buildings more efficiently. Most of our operating expenses are recoverable, so our tenants share in those savings. However, we will need to cover the operating cost on any space that is vacant, so those savings directly improve our NOI. Lower operating costs also let us recover more of the capital we've invested in common areas, washrooms and amenities. The tenant pays the same additional rent and gets a better building, and we recover more of our capital investment. You will be able to see this in our margins. Excluding bad debt provision, our NOI margin this quarter was about 55%, up roughly 130 basis points from the same quarter last year. Turning to our outlook. As Kingsley mentioned, temporary revenue exposure of ILAC is approximately $4.3 million per year or just over $0.05 per unit of FFO starting in Q4. Despite the decline, we are still maintaining our 2026 FFO guidance of $2.35 to $2.40 per unit as we have benefited year-to-date through our operating cost savings, accretive asset sale of 212 King and higher straight-line rent. We're at $1.83 through 9 months, so we are currently on track to deliver the high end of our guidance. Both 655 Bay and 425 Bloor have a long track record of leasing well and the capital we put into those premises stays with the buildings. We expect to replace that income, and we'll know more over the next few months. We look forward to giving everyone a more fulsome picture in February when we provide our 2027 guidance. On the balance sheet, liquidity remains strong and the secured lending market has been improving for good quality office buildings. We ended the quarter with about $102 million of cash and undrawn revolver capacity. During the quarter, we refinanced our last remaining 2026 maturity, upsizing a mortgage in Calgary from $8 million to $11 million for a 5-year term. We have already started to make progress on our 2027 maturities with about $200 million across our 4 mortgages remaining at our share, and we're already in discussions with our lenders for some of those renewals. Our net asset value per unit was $48.64, down $0.59 or 1.2% from last quarter. The decline was mainly driven by $24 million of fair value losses, which includes a valuation adjustment to reflect the ILAC insolvency at 425 Bloor and 655 Bay. As we re-lease the space, we expect the value of those 2 assets to recover. In other markets, we recorded a $4.4 million fair value loss on an office property in Calgary, reflecting appraisal cap rate of 10.25%. As a result, our weighted average cap rate in other markets is now over 9%, which is more conservative than it has been in the past. Overall, our NAV reflects a weighted average cap rate of 6.3% on the total portfolio, including 6.1% in Downtown Toronto. Partly offsetting the fair value loss on income portfolio, our interest rate swaps gained about $7.9 million or $0.42 per unit due to an increase in benchmark yields in the quarter. These swaps reduced our variable interest rate exposure as a percentage of our debt stack to 11.4% and also helps to mitigate the impact of increasing interest rates. Lastly, a note on Sussex Center. Starting the summer, we began the process to reorganize our 49.9% interest in Sussex from a direct co-ownership into a limited partnership to align with the other JV ownership structures that we have. Our economic interest hasn't changed, but Sussex is now equity accounted, which means it is no longer included in our reported occupancy, debt or assets. For full transparency, we laid out the impact in our press release and MD&A. On our financial metrics, it has reduced our level of debt by about 120 basis points to 53.3% and our net debt to EBITDA by about 0.6x to 10.9x. It also added about 1.6% to our other markets committed occupancy. On a like-for-like basis, debt-to-EBITDA was flat to last quarter and leverage would have increased 30 basis points. There was no change to the interest coverage ratio as a result of the reorganization. To wrap up, Q3 operating and financial performance was solid and in line with our expectations. The leasing we've done is turning into cash income. We're running our buildings more efficiently, and our balance sheet remains in good shape. ILAC is expected to be a temporary setback, which we intend to address promptly, and our focus remains on improving occupancy, income and value. We look forward to updating you on our progress in future quarters. And now I'll turn it back to Michael.

Thank you, Derrick, Kingsley and Jay. At this point, we'll be happy to answer any questions you might have.

[Operator Instructions] Our first question will come from the line of Sairam Srinivas with ATB Cormark Capital Markets.

Congrats on a good quarter outside of the ILAC development. Just looking at the impact of ILAC on 2027. While the guidance hasn't changed as much for 2026, how should we be thinking about building that into our 2027 numbers?

This is Jay. Thanks for the question. It's a fair one. So the simple way to think about it right now is at our AGM in May, we gave guidance to 2028 about $3 a share, which would imply that next year, the midpoint is about $2.65. We quantified the impact of ILAC simply, which is about $0.22. But -- So that's a starting point. One thing to note that, that is a full annualized impact. And as we re-lease the space, the numbers will recover. The other thing is because we have more space to lease now, there's more opportunities to recover that income.

And Jay -- Yes, sorry, Michael, go on.

No, I do want to make sure that helps. What Jay is saying is on its own, ILAC is $0.22 annualized. And since we have more space, we expect that whether it's the ILAC space or some other space, we should lease more space than we would otherwise plan for. For the fourth quarter, we'll have more information in February to provide a little bit more information. But generally, we're just saying with more space, we should lease a little bit more, so it should be less than $0.22. We don't know how much, and we're working hard on it now. We may have actual leases or certainly a sense of the flow of tenancies.

Yes. No, that makes a lot of sense, Michael. But maybe just comparing the rents you've been getting, when you look at the subleases and 655 Bay and you compare it to the head lease, how would you say the net rent differential has been there?

So are you talking about the sublease that we just did, Sai, at 655?

Yes.

Yes. The rent that we're going to be collecting from the tenant is the same as what we were getting from ILAC on that individual space.

And just to be clear, Sai. In addition to the space that they were using, they took on just under another 10,000 feet. And that space we had to provide a cash inducement for. And I would say this as well, we had a very narrow window to make sure we've tied in a 50,000 square foot tenant. We're very glad that we did. I think they wanted to be there. And the terms are probably fair, but I mean, we -- it was very important for us to secure that tenant.

Yes, I totally agree, Michael. I mean, in the current situation, it's definitely a positive development as far as that lease is concerned. Maybe then shifting to the commented occupancy numbers. Just looking at Downtown Toronto, it's been consistent at 90%. And when you look at the assets that have opportunities ahead, there are basically about 5 of them, 74 Victoria leading it. When you think about leasing efforts from here on to push from that 90% level committed, do you think the cadence of leasing slows on as it becomes more challenging? Or is it essentially more a play of incentives coming in and a longer duration of leasing going there?

I would actually almost say the opposite side, like -- so obviously, you know we've done very well at Adelaide Place and at our A-class assets. They're essentially full. The trickle-down effect to the lower class assets is definitely real. I think I mentioned at the start of 2025, Bay Street was about 70% occupied. Now we're at 85% occupancy. So as those A class assets has filled up, we've really been benefiting at the other assets. I look at 74 Victoria, we toured more than 100,000 square feet at 74 Victoria over the last 2 years. Touring has been very strong. So we feel good about getting those assets leased and the space shows very well.

Our next question will come from the line of Sam Damiani with TD Cowen.

I'll just echo the congratulations on the good quarter outside of ILAC and also securing that subtenant as a direct tenant. So good to see that happen quickly. Maybe just to drill into the Sussex Center change. So that restructuring, does it affect the nonrecourse nature of the mortgage? Does it in any way limit the REIT's exposure to that asset versus what...

It has no effect on the relationship between Dream Office REIT and the lender.

Okay. And then that mortgage comes up next year, I think, is that right? And what are the plans on that?

Next August, we're working with the lender. We've had a tour with them, but I don't think we'd be talking any specifics for quite some time. One of the lenders we have a great relationship with. And we're quite curious to see what they say, but we've got a plan for the asset, and that's why we had a tour in August. And do you want Kingsley to explain what we've been doing with the leasing there?

Yes. We've built out a lot of really nice space at Sussex, Sam. So we've done a couple of model suites. We've improved some other suites that already had good bones to them. So that represents about 50,000 square feet of space that we've improved at Sussex Center. It's in really good shape. The touring on it has been good, and it's led to a number of deals that we've gotten this year. Like whether they sign on that individual space, it's a showcase for the asset that markets very well, and it's really been helping the leasing efforts out there.

So the idea is to try to spur on more leasing in Sussex to be in better shape for the renewal.

Makes sense. Okay. And then with it now being in equity accounted, like were the operations and interest costs in the third quarter fully in equity accounted?

Yes. So it was actually signed at the end of the quarter. So the operations is still in NOI and interest expense. So going forward, I think what you'll see is the NOI on the top line will come down, but so will the interest expense, and it will be in the line called net income from JVs.

Okay. Got it. And then, you referenced those 2028 targets from the AGM. I mean, I know you don't have to update that and maybe it's too early, but any thoughts on that just given the ILAC development there?

Yes, it's a fair question, Sam. I think our goal is still the same. So at the AGM, we said that if the business gets to 90% in-place occupancy in Toronto, we could achieve the $3 FFO and also get to the 10.5 debt to EBITDA. Those targets are still within range. ILAC's income is a delay. We will recover it. And by middle of next year, I suspect we'll be able to give a better indication on the timing, but the -- we feel confident we can get back to that number.

Okay. Great. Lastly for me, just on the transaction market in Downtown Toronto. Would you say there's been a noticeable change in discussions or indications...

Are you talking about leasing or investment?

Trend? No, investment. Yes, just investment. Just it's been a very volatile industry environment, et cetera. But yes, just curious if things have evolved since August.