Brandywine Realty Trust (BDN) 2010 Q2 法說會逐字稿

At this time I would like to welcome everyone to the Brandywine Realty Trust second quarter earnings conference call. (Operator instructions). Thank you. I would now like to turn the conference over to Gerry Sweeney, President and CEO of Brandywine Reality Trust.

Good morning everyone and thank you all for joining us for our second quarter 2010 earnings call. Participating on today's call with me are Gabe Mainardi, our Vice President and Chief Accounting Officer, George Johnstone our senior vice president of operations, Tom Wirth our executive vice president of portfolio management and investments and Howard Sipzner our executive vice president and chief financial officer.

Prior to beginning, I'd just to remind everyone that certain information discussed during our call may constitute forward-looking statements within the meaning of the Federal Securities law. Although we believe the estimates reflected in these statements are based on reasonable assumptions we cannot give assurance that the anticipated results will be achieved. For further information on factors that could impact our anticipated results, please reference our press release as well as our most recent annual and quarterly reports filed with the SEC.

Before addressing our performance for the quarter, just a quick observation on the economy. Clearly the economic environment is less bullish than it was during our first quarter call. Macro data remains mixed and the economy seems to be operating without a sense of conviction on the timing or pace of recovery. And while that data can certainly not be ignored, we have not yet seen either directly or indirectly any real hesitation or lack of forward planning on the part of our tenant base. In fact so much to the contrary, a number of our tenants are already looking forward to 2011 and 2012 on their space requirements.

An increasing number of tenants are evaluating build to suit opportunities and while I believe most of those will stay on the drawing board, quote, unquote, they do reflect, I think, a more positive bias by some major users. This impact as we talked on previous calls however, remains somewhat mitigated by continued downsizing by some users that still need to align their office needs to their current business plans. The offsetting of those two factors will result in a market environment that will continue to favor tenants, but all in all however, we remain optimistic with a small out on the recovery we are seeing in our primary markets. Even when looking at our markets most impacted by weaker demand like in New Jersey, leasing activity during the quarter remained encouraging.

In terms of looking at the second quarter, we continue solid execution of our 2010 business plan, including strong leasing performance. As you look at the quarter and the remainder of the year, several overall comments. Headline leasing news for us was 1.1 million square feet of leasing activity during the quarter. A strong and steady new deal pipeline of 2.4 million square feet. 548,000 square feet of executed forward new leasing transactions. And over half a million square feet of leases in negotiations. From our standpoint all very strong metrics.

Overall leasing velocity continued to be in line with our expectations and we do expect fundamentals to continue firming. Some markets are recovering faster than others. These conditions are factored into our business plan and reflect our view on the market bottoming with rental rate stability in some markets and continued downward trends in several others. Near term pressure on operating trends however, will persist. Our mark to market on rents remain negative. Both in line with our expectations.

Our NOI margins remain stable and we have executed approximately 91% of our annual 2010 speck revenue target. Our tenant retention rate for the second quarter was 66%, excluding early terminations and 56.5% with early terminations included. Capital costs for the quarter were 15.4% of gross revenues for new leasing activity and 9.1% of gross revenue for renewals. Again all in line with our expectations and reflect of what we see as continued stability in the cost involved in leasing transactions. Traffic through our portfolio was down slightly from Q1 but up 11% year over year.

Our strongest performing markets in terms of activity and rental rates remain Philadelphia CBD, Radner Plymouth meeting in new town square sub marks in suburban Philadelphia, the Toll Road Carter in DC, and Austin and Richmond. As outlined on our last call our 2010 operating and business plan assumptions are, first our major objective for the year is to simply lease office space. As evidenced by our strong pipeline we have an active engaged leasing program underway for every one of our properties and are aggressively pursuing all deals.

We understand the leasing realities in this type of market and have tailored marketing plans for each under leased asset to insure that we accelerate absorption to the extent that we can. Our original business plan contemplated a 46% tenant retention rate. Based on results thus far, we believe our actual retention rate will approach 55%. Core portfolio occupancy which is our same store plus our recently completed five developments, was 86.4%. That level is down 80 basis points from last quarter's 87.2%, or down by about 211,000 square feet. Contributing to this decline was 150,000 square feet of early terminations including 70,000 square feet of bankruptcy and lease defaults, and we also had a 77,000 square foot tenant who moved out when they purchased a vacant building.

For the fourth consecutive quarter though, tenant expansions exceeded contractions, and as I mentioned on the last call, we expect our occupancy levels to drop to the 85% range later in the year primarily due to several known tenant departures out pacing new lease commencements. In September we will commence occupancy and NOI on our IRS Philadelphia campus that we've also referred to as the Post Office project. This event will trigger funding of the $256.5 million forward financing. That loan as you recall fully amortizes over the 20 year GSA lease and has a stated interest rate of 5.93% with an effective rate of 6.8%. The development yield on this project's net cost increase slightly to 8.9% based upon among other things our anticipated $13.5 million of cost savings.

After factoring in our management fee income, our return on net costs which is the $342 million total cost, less our tax credit funding, will be 9.2%, so up slightly from our original projections a number of years ago. Upon completion, the GSA will become our single largest tenant comprising 7.2% of our annual base rents and our percentage of NOI contribution from Philadelphia CBD will rise from 13.4% to just shy of 19%. Taking a look at the investment environment, we continue to see high quality office properties located in CBD or town centers coming to the market primarily in the metro DC area. These assets are receiving strong interest and in some cases trading at pricing levels achieved during the high point of the investment cycle a number of years ago. Demand for these core assets is driven by ample equity availability and a very favorable lending environment for high quality, well located, well leased assets in desirable sub markets. We do expect that trend to continue.

While I mentioned the majority of asset sales have occurred in metro DC, some high quality assets are now coming to market in both Richmond and Austin. Philadelphia, on the other hand, continues to have a lack of available product on the market, but we anticipate that more investment offerings will be coming to the market as the year progresses. In assessing our investment plan, the balance we're trying to strike is to execute on value added transactions at price points that ensure significant upside for our company. Clearly in our primary targeted market of metro DC, we are at a period of hyper investment activity and cap rate compression with properties trading at significant pricing premiums and in some cases well over replacement cost with minimal gross prospects given our perspective on near term rental rates.

Given this aggressive pricing climate, our view on near term rents and our cost of capital, our focus is really spent on transactions that require capital stack reconfigurations, high quality, under leased assets we can acquire well below replacement cost or other value added or partnership type situations. We are currently working on several opportunities to buy vacancies, very good risk adjusted pricing at an all investment base well below replacement cost where we can reposition the asset for significant growth as market conditions continue to firm. As noted previously, the execution of any of these opportunities will be part of our balance sheet strengthening program. We've already taken significant dilution through equity rates last year, so the plan remains to manage further dilution through funding any acquisition activity through stock issuance. And while we have no acquisition opportunities built into our 2010 plan, we are becoming increasingly optimistic that we will be able to execute on a transaction or two sometime this year.

That being said, most of our investment focused energies right now is on evaluating some of our own properties for entry into the market for sale or joint venture by the end of the year. Our overall goal remains to remove non-core, slower growth properties, via either outright sale or joint venture over the next several years. With the investment market recovery, we believe that we will begin to see an increased level of investment activity in the Philadelphia metro are as 2010 progresses. We fully expect that with pricing becoming increasingly dear in New York City and Washington, D.C. capital will begin as it historically has to migrate towards high quality office assets in key markets like Philadelphia.

Our objective is to make sure we are in a position to take advantage of those opportunities. Our 2010 business plan contemplates an additional $69 million of sales. We currently have about $20 million in property in due diligence and contract negotiations at an average cap rate of just below 8%. As I stated before we are fully committed to moving up the investment grade ratings curve one notch. We anticipate achieving that through a combination of NOI growth, occupancy improvement, disposing of slower growth assets, and funding any acquisitions on an equity basis. The combination of these tactics will achieve our overall de-leveraging objective.

Earlier this year, and along those lines, we initiated our continuous equity offering program. That plan is designed to remove our debt to GAB towards our 40% target range to position us for the ratings upgrade and create financial capacity for new investments. Year to date we have raised $40.9 million by issuing 3.3 million shares. During the second quarter, we issued 2.2 million shares, realizing $24.8 million in net proceeds, and we have about 11.7 million shares remaining under this program.

During the second quarter we purchased $19.3 million of our 2010-2011 notes and 2012 on secured notes, generating a slight loss in the early extinguishment of debt. With the debt markets continuing to firm, that buy back volume will continue to diminish, and our business plan does not contemplate any further purchases, but we'll continue to track those markets carefully and remain opportunistic. Howard will walk through a more detailed capital plan but suffice it to say we are in excellent shape. Our business plan does not contemplate any new financing activity, other than utilizing the pending cash sources like the $206 million net recovery on the IRS mortgage funding, the CIM $40 million loan repayment which is imminent, the historic tax credit funding and our remaining credit facility capacity to pay off our $197 million of 2010 bonds in December and our $42 million secured mortgage on Plymouth meeting executive campus.

Subsequent to year end we executed an eight month extension option on our $183 million term loan, which pushes that maturity out to 2011 and we have an additional option available at our discretion. We are still projecting a 2010 year end line of credit balance of less than $120 million. Finally, as noted in our press release, we revised the bottom end of our 2010 FFO guidance upward to a range of $1.30 to $1.34, versus the prior range of $1.27 to $1.34. Based on the mid point of our new 2010 guidance our FFO payout ratio is 45.5% and our CAD payout ratio for the quarter was 65.2%.

We continue to expect to generate free cash flow this year of between $30 million and $40 million. And the upward revision to our guidance has been driven by better retention rates than we originally expected, being slightly ahead of plan on SPEC leasing, good expense control, which has resulted in stable and aligned margins and a lower interest rate environment then originally forecast back in October 2009. With that overview, Howard will now review our second quarter results.

Thank you, GERRY. As noted we are performing very much on track with our overall business plan and the financial results I will discuss will reinforce that. Our FFO or Funds From Operation available to common shares in units in the second quarter totaled $46.6 million. That translated to FFO per diluted share of $0.34 which beat the analyst's consensus of $0.33 by a penny. It's a very high quality FFO figure as we reflect on it in that second quarter termination revenue, other income, management fees, interest income, JV income and net debt activity totaled $6.8 million on a gross basis or $5.3 million on a net basis at the lower end of our annual guidance range for these components.

A few observations on our 2010 second quarter performance. Cash rental revenue of $110.4 million was down $600,000 sequentially and about $3.5 million versus a year ago after adjusting for the effects of de-consolidating three joint ventures effective January 1st, 2010. Straight line rent was up $300,000 versus a year ago, but down $400,000 sequentially versus Q1 and generally in range with expectations. Recovery of $17.7 million and our recovery ratio of 33.8% were in line with recent quarters, although down from Q1 2010, when we had a significant impact to cost, recoveries and the recovery ratio from snow removal charges. None of those right now, of course.

In the second quarter we had net bad debt expense of $400,000 versus $1.3 million in Q1 2010. In line with expectations and reflecting various write offs, recoveries, and adjustments to reserves. The net effect in the second quarter was about a $50,000 dollar decrease in our overall reserve balance. Interest expense of $31.2 million decreased sequentially by $300,000 and by $3.7 million year-over-year due to lower debt balances from our liability management and debt reduction program. Interest expense in Q2 includes $420,000 of non-cash APB 141 costs related to our remaining exchangeable notes. G&A at $6.6 million was somewhat elevated above our expected $5.75 million to $6 million run rate do to a variety of minor items. We incurred $445,000 of losses on $19.3 million of aggregate debt repurchases.

Lastly, deferred financing cost the client $860,000 reflecting prior period accelerations of deferred amounts as a result of debt repurchase activities. This figure will rise at the end of the third quarter and in Q4 and beyond as we begin to account for the new post office and garage loans. On a same store basis, cash rents were down $2.6 million, reflecting lower occupancies and lower rent levels. Non-cash rent items increased $270,000 as we provided greater levels of free rent and new leases. Reimbursements increased by $913,000, reflecting better lease structures including more triple net leases. Termination fees and other items increased by $428,000, as we saw increased levels of early move outs and associated termination payments.

Property operating expenses and real estate taxes were essentially flat versus a year ago, and our recovery ratio for the same store portfolio improved to 32.9% from 31.2% despite lower occupancies. As a result for the quarter, same store NOI declined 1.9% of the GAAP basis and 2.3% on the cash basis, both excluding termination fees and other income items and largely as a result of lower occupancy in the same store portfolio. For the second quarter our cash available for distribution after all adjustments totaled $0.23 per share and provided a 65.2% coverage ratio on the second quarter dividend.

Our overall ratios and margins were very solid with EBITDA coverage at 2.5 interest, 2.3 debt service and 2.2 fixed charges. And again, despite our occupancy levels we're seeing very high margins of almost 61% on NOI, about 34% on recovery and 62.4% on EBITDA which makes us very comfortable looking ahead as occupancies improve. 2010 guidance, as Gerry mentioned, we are raising the bottom end of our range due to performance and tightening in our business plan. This is our third consecutive quarterly increase from what was originally $1.23 to $1.34 and is now $1.30 to $1.34. This accommodates quarterly FFO to be in the range of $0.31 to $0.33 in the third and fourth quarters of 2010. Our key assumptions include the following, a decline of 4% to 5% of GAAP same store NOI for the full year excluding termination and other revenue and a decline of 5% to 6% for cash same store NOI on the same parameters.

We continue to see rents trending down, although as Gerry noted the results have been mixed. Cap mark to market should be down between 3% and 5% and cash mark to market should be down between 7% and 9%. Each of these assumptions is unchanged from last quarter except the GAAP mark to market which is 100 basis points tighter or better. In terms of leasing we expect to do 2010 aggregate leasing of about 3 million square feet in our speculative revenue program to produce $28.9 million of revenue, of which we are 91% done on the revenue side.

Our speculative revenue production is up about $1.5 million from our prior 2010 estimates reflecting better renewal activity as well as the overall pipeline. We see $25 million or $30 million of gross all other income items or $20 million to $25 million net after management expenses. Our G&A should run in the $5.75 million to $6 million level. Our total interest expense for the year should come in between $130 million and a $135 million. The next two quarters will begin to rise, especially in the fourth quarter as we draw down the post office and garage financing and we eliminate capitalized interest on that project as well.

We're currently not anticipating any additional issuance under our he continuous equity program and as a result of all of these activities we'll also see cash available for distribution in the $0.85 to $0.95 range, reflecting about $20 million of additional capital expenditures for leasing activities this year. As Gerry noted, our plan should produce between $30 million and $40 million of free cash flow. Our capital plan is actually very simple and very straightforward for the balance of 2010 we see total capital needs the balance of the year from July one of about $387 million. That translates to about $98 million of investment activity. $53 million to complete the post office and garage. An additional $20 million or $10 million a quarter our revenue maintaining CapEx, and $25 million for remaining redevelopment outlays, lease up or recently completed projects and other revenue creating capital expenditures.

On the debt side we see $245 million of debt repayments. As Gerry noted, that include $197 million for the 2010 note and the aggregate of $48 million for repayment of the Plymouth meeting mortgage as well as principal amortization. And we have extended our bank term loan to June 29, 2011, taking that out of the 2010 plan. We'll pay approximately $44 million of aggregate dividends and as previously all in cash. To raise this $387 million we're projecting the following, about $80 million of cash flow from operations for the rest of 2010, we'll realize the remaining $3 million of historic tax credit financing proceeds.

As noted in our press release, we received $27.4 million as the next to last installment in June of 2010 towards and ultimate total of a little bit over $64 million. We expect the $256.5 million post office and garage loan to have funded by the end of the third quarter. We have the $40 million CIM note repayment scheduled for August 2. We may in fact get it a few days early so that is counted as an incoming fund and we're looking at additional sales of $69 million over the balance of the year.

As a result of these activities, we could pay off as much as $60 million of our credit facility, and bring its balance down to as low as $100 million certainly within the $120 million level Gerry outlined. Credit activity or account receivables was very much as expected in the second quarter. Our total reserves at June 30th were $15.6 million which reflected $4.4 million on $24 million of operating and other receivables and $11.2 million on $99.3 million of straight line rent receivables. The $24 million of other receivables is a bit elevated because it includes $7 million of receivables attributed to our advanced payments on the post office project which presumably do not need reserves from the government.

Total reserves are comparable to last figures quarter as I outlined and generally reflect good credit conditions. On the balance sheet we came in at 45% debt to gross real estate cost, continuing our track record of bringing that figure down towards a 40% goal. As I look back, that's our best debt to GAV ratio in almost five years. We continue to have very low secured debt creating a very high quality unencumbered pool and are among the lowest in the space in terms of reliance or floating rate debt.

Lastly, our $600 million-dollar credit line was $160 million drawn on June 30th, providing ample liquidity for our future needs. On the credit side, we're 100% compliant on all our credit facility and indenture covenants. And now I'll turn it back to Gerry for additional comments.

Thank you very much Howard. To wrap up our prepared comments, even with our positive buy for the outline during the call, we are fully cognizant that the market will continue to present operating challenges for the balance of the year and possibly into 2011. We understand that, we've made good progress, but also recognize we still have more to do and we are very much focused on getting it all done. So even with what we anticipate to be continuing tepid tenant demand, we believe that our capital position, the quality of our inventory availability, our strong sub market positions, provide a clear competitive advantage for us, and we think that's evident by our year to date leasing velocity and the strong pipeline of forward activity we have in place.

We certainly anticipate continuing to use our entire operating teams including our leasing professionals and our capital flexibility to ensure that we maximize all of those advantages and achieve all of our 2010 business objectives. With that, we would be delighted to open up the floor to questions. We would ask in the limit of time you limit yourself to one question and a follow up. Thank you very much.

(Operator Instructions). Your first question comes from Anthony Paolone of JP Morgan.

Thanks. Good morning. Gerry can you give us any more detail on the leasing traffic you have seen in the last couple of months? You mentioned it had slowed from the first quarter and just give us a little more color on tenant behavior and what you think is happening there?

Sure. I'll make some overview comments, and George, maybe you can pick up with some of the sub market information. First of all, we're heading into the summer months, which typically tend to be slower decision periods for tenants, but I think across most of our markets we continue to see pretty good traffic, and frankly even more importantly that 2.4 million square foot pipeline has remained pretty constant the last couple of quarters with some good forward leasing activity. What we're hearing from our tenants range, there are some large users out there, no question, Tony, as I touched on. We think they are still undergoing a process of rationizing their space requirements. A lot of these companies clearly grew an awful lot over the last decade and I think they're resetting their business plans and as part of that reassessing there overall office requirements.

We're also seeing on a more positive front for a lot of the mid-size companies and some of our larger users a complete reshifting back to looking at what they need to do to continue growing their business. Some companies are hiring again, recent survey that we did of our Pennsylvania tenant showed that almost 20% of those tenants were in the process of rehiring. Some of that rehiring will go to fill empty cubicles that are in place because tenants laid off. That's actually a very good positive sign. We do know a number of our tenants are still a bit hesitant to make big decisions until they can kind of fully quantify the effect of a lot of this new regulatory environment relative to the healthcare, financial regulation, et cetera. But generally we're seeing that people feel as if things are continuing to move in the right direction. George, maybe you can outline what we've seen in some of the sub markets.

Market and region specific, traffic was up 21% quarter over quarter in metro DC and 56 Market and region specific, traffic was up 21% quarter over quarter in metro DC and 56% year over year. Inspections were up 100% in Richmond and 189% year-over-year. We did see declines in Pennsylvania and New Jersey, and again I think some of that is associated with getting into the summer months, and some of it is the amount of activity that we actually got executed in New Jersey during the second quarter. I think we're in the cycle or wave of inspections turniing into proposals turning into executed deals.

My follow up is on capital allocation, you guys traded a bit lower multiple than your peers, your capital costs were a little higher, as you look out at investment opportunities, what kind of return hurdles do you think you need to kind of justify putting money to work versus continual de-levering.

We really do view that certainly as we talked to a number of investors, the relative level of leverage we have versus some of our peers remains a bit of an equity blocker for us. We are very much driven to bring our debt to EBITDA down to our core peer group level, all consistent with that plan of getting that investment grade upgrade. So as we look at in terms of the bigger picture, we certainly recognize that the ways to do that are increasing our occupancy which we think we're on track to do. Disposing of some slower growth, non-core assets which is a plan we've been executing and anticipate executing going forward. The real next step is how we either issue equity is de-lever or identify aquisistion opportunities that we think will present a good capital growth story for the company as markets continue to recover.

As we've looked at the investment landscape, and Tom certainly I'd like you to jump in and make some observations, we have seen that given our cost of capital, our perspective on where New York term rent growth is, and possibly some reversionary value calculations, we find ourselves being priced out of some of the markets we had targeted earlier this year, primarily metro DC to make acquisitions because the point of entry pricing is well below our cost capital, but more importantly, Tony, when we look at how that property will perform given our expectation of growth rates on an unleverred IRR basis, we don't view those returns coming up to what we consider cost of capital to be. On those transactions we tended to take a pass, but are very much focused on those acquisition opportunities where we think that we can add some value and create some good growth rates on the acquisition going forward. Tom, maybe just shed some color on what we are seeing in some of the other markets.

Hi Tony. When we look at the ohter markets we have been looking at transactions in Washington, primarily because that's where most of the activity's been. We also have seen some activity in Richmond and Philadelphia, and we have been actively bidding on a number of select transactions that we see, over a million square feet, but those properties when we take a look at how they're being bought, the final numbers are they're close to $400 a foot, cap rates, you know, below seven, and we've looked at some assets inside the district, some older assets that went for over $600 a foot, cap rate of 5.6. And we did not feel there was a lot of growth. We've looked at assets inside the beltway, B assets, $300 a foot, and the rents were already getting 90% of their highs in the past couple of years, and at Richmond we've looked at some downtown assets and again, cap rates and replacement costs are challenging and rents above market based on where those markets are so we're not seeing unleverred returns even on what we think are somewhat conservative cap rates that were in the market to buy those.

Great. Thanks. Good Color.

Your next question comes from the line of Jordan Sadler with KeyBanc Capital .

I would like to follow up on the investment activity side of things. I understand a bit more clearly what you are looking to buy. Maybe you could just outline what you would sell if it would be the opposite, if those would be fully stabilized and would those be in some of the weaker markets that you're currently in or would it be a function of amount of properties available for sale versus demand? I mean how are you framing it?

Jordan, I think when we look at the properties that we're targeting right now, a lot of the things we are looking at are off-market. I think they are still going to be in the CBD's, although we do assess and underwrite them, most of the stuff we are looking at is CBD and our core markets. We don't want, as we said, any more problem childs, any more hard leasing that has to be done. We're still in a defense position. So the things we are looking at are CBD. They are value added. They will have vacancy there will be a component there that we feel will help our growth. So those assets are going to be, you know, maybe lower yielding and have a vacancy but we expect they're in our core market, more CBD oriented and we'll be able to lease them up over time and show some very good returns.

Jordan, I think you're also alluding to what we're looking to sell?

Yeah, yeah, yeah.

We go through a pretty rigorous review every quarter based upon our forecast on what we think relative returns are for every piece of property in the company. Again, our bias right now is to, through that ranking process, look to dispose of properties that are either non-core markets for us or even if they're in core markets are ones that are relatively underperforming the rest of our portfolio. Now, by extension a number of those assets we're looking to move or explore to move are in some of the non-core Philadelphia, metro Philadelphia, suburban marketplaces.

There are also markets frankly that have not seen the line of investment activity as of yet where a real return of large institutional investors. So most of those transactions that we're feeding into the market right now tend to be one off deals ranging in size from $2 million to $10 million. That will be targeted toward private equity investors, smaller private development companies that have access to some capital both on the debt and the equity front. I think we're probably still at least a couple quarters away from being be able to look at any larger scale transactions in some of the suburban Philadelphia central southern New Jersey marketplaces.

What about something that might be a little more core or stabilized like a Sierra, where there may be better institutional demand that might drive attractive pricing? What sort of decision matrix relates to something like that?

That's a very good point. I think as we talked on some previous calls, when we look at a Sierra center, that's certainly a property we targeted to try to get a joint venture done a couple of years ago, with the collapse of the debt markets and it's corresponding impact on equity pricing, we were not able to get that executed. Certainly as we're tracking trophy quality CBD asset pricing in the district inside the beltway markets, even New York City to some degree, and seeing what that bid pool looks like we're certainly keeping our ear to the street on what type of demand might be coming from that bid list on high quality buildings outside of those two core markets. So the evaluation process is pretty simple on that project. We know what it's generated from a cash flow standpoint, we know what its growth expectations are. We remain incredibly optimistic on the future of University City in Philadelphia but we also anticipate that at the appropriate time we will be able to persuade a joint venture partner of those same characteristics. And get what we think will be an exceptionally good price on the assett.

Lastly a clarification, Howard, I think maybe Gerry said the expected return on Post Office will be 9.2%, that's cost less of tax credit. Is that the right number? Is that an unleveraged cash going in yield?

Yes, that's basically the NOI from the property plus the management fee as the numerator. The demoninator being the $342 million of cost less the historic tax credit and new market tax credit funding that we've received.

Okay, thank you.

You're welcome.

Your next question comes from the line of Michael Bilerman with Citigroup.

Hi thanks. It's Josh Attie here with Michael. You mentioned in the past you could lose up to a 1000 basis points of occupancy in New Jersey in the second half of the year. Could you talk a little bit about the pipeline to fill some of that space and what the recent activity has been?

Sure. George, as we put in our press release we signed 345,000 square feet worth of deals in New Jersey during the second quarter. The pipeline of new deal today stands at 408,000 square feet with another 304,000 square feet of renewal pipeline. Again, the average tenant size is kind of in that 7,000 to 10,000 square foot range. There are some large users in the market that we are talking with to backfill some of the vacant space we're going to take back in Mt. Laurel later this summer. Traffic was down for the quarter but leasing volume from the deals executed in a pipeline perspective is actually picking up.

Is the guy to assume that that is space that is leased or is a guy to assume that it's vacant.

It assumes that some of it is leased and as we talked previously we're expecting that year end occupancy levels in New Jersey are in the 73% range.

Okay. I'm sorry, I know you mentioned this earlier. What was the effective gap rate on the IRS debt that's going to come on your balance sheet?

6.8%.

Okay, thank you.

Your next question comes from the line of Dave Rogers with RBC Capital Market.

Good morning. Thank you. With respect to your discussions earlier in the year with capital partners you had started the year with the assumption that maybe you would find some partners to raise some joint venture money and do some acquisitions. And now it seems like the return expectations at least between you and other buyers is different, at least in terms of the growth rate. Was that same scenario true with the discussions you had and that's what is leading you to be more of a seller in the back half of the year, or is it a shift in capital in the markets? If you can give a little more color on some of those early discussions.

Dave, great question for clarification. We didn't real touch on it in our prepared comments. We are still actively engaged with a number of private capital co-investment potential partners. Clearly when we look at our direct costs to capital versus a levered rate of return we might get on a co-investment opportunity is very different. We would still like to have a higher percentage of our NOI over time coming in from the metro DC area. We're just recognizing that given how cap rates have become compressed over the last couple of quarters versus what we were thinking in the fourth quarter of last year, it's just not a very attractive landscape for us to pursue an acquisition on a wholly owned basis and finance that on an equity basis given where we're trading. I don't think that diminishes our appetite to try and get some transactions done, but recognizing that to effectively execute those at a pricing return level to us that makes sense that needs to be done in a joint venture format. Certainly Tom, George and the rest of the investment team, Howard and myself are engaged in a number of discussions with traditional real estate investors, pension funds, pension fund advisors, some European capital funds as well as some soveriegn wealth funds looking at the metro DC and particularly the district on some potential transactions that would have a different levered capital stack that we would anticipate having on an on balance sheet transaction.

Any of those discussions not yet I guess progressing outside of DC metro within your footprint?

I think the appetite is clearly much more in the metro DC area. I think we're beginning to see some early indications that capital is refocusing back on the key markets like metropolitan Philadelphia given some of the pricing that's happening in those core markets. As I say, I do think that's probably a couple of quarters away. Certainly as we evaluate what assets we have that we currently own that we would like to explore a joint venture with, we are having some of those discussions now in terms of identifying the right pool of assets that some of these investors might find attractive as an entry point into the greater Philadelphia area.

What's the right spread today for a comparable acquisition with value add to value add or core to core between those types of markets, between whether you go to DC to New Jersey or DC to Philadelphia. How does that spread come in this your underwriting here in the last 6 to 9 months?

Historically the spread between kind of a New York and a metro DC compared to Philadelphia has been between 100 to 200 basis points, obviously depending on the sub market, the product quality, size, etcetera. In as much as there really have not been, Dave, a lot of transactions in the greater Philadelphia area this year, it's hard to really benchmark what that spread is. We've seen cap rates as Tom alluded to on some of the transactions we've reviewed in the metro DC area in the mid five to low sixes. That implies we could get back to sub eight cap rates on suburban Philadelphia assets. We're not seeing any evidence of that as of yet. Our hope is as the year progresses there will be more offerings that come out in this marketplace and we'll get a better benchmark to quantify what that current spread is.

Good. Thank you. To follow up on a different topic. The speck revenue target you guys are pretty close to your full year expectaions. I imagine you're getting a little late in the year to hit the rest of that expectation. Two things, one is the retention ratio higher kind of offsetting what might be a modest shortfall in the speck, and second, George if you could provide some color on, versus your speck expectation, how did you perform on absorption versus what they rent?

Sure. I mean, we are seeing and continue to see a little bit of a shift from assumed vacates and subsequent new leases to some of the existing tenants staying. We are still projecting a 55% retention rate. On the speck revenue we did raise the target based on leasing we already achieved in a pipeline of deals that we still feel good about so we've increased the target to $28.8 million and we're 91% achieved on that. We've got about $2.5 million of speck revenue to go on .5 million square feet of deals, but again, I think we feel good about where those deals projected to occur and the pipeline that supports those.

Thank you.

The next question come from the line of Brendan Maiorana with Wells Fargo.

Good morning. To follow up on Dave's last question, if I look at your year end occupancy targets, which I think in the prior call are 85% to 86% you've got 86.4% occupancy. Today it seems like probably the renewal rate for the back half of the year is probably around 50%. You've got 425,000 that's leasing that's already done that's going to come on line in the back half of the year, and then you've got the post office asset that's going to come online. All that would seem like it would get you to 86% or maybe even a little bit higher without getting any additional speck revenue. Is there something that we're missing or are your occupancy targets by year end moved up a little bit from where they were.

We're still in that 85% range. We do have in addition to some of our contractual 2010 leases that will expire and vacate, we do have a few tenants that we have programmed that have a subsequent to 2010 expiration that may be giving us back some space early. Some through a blend and extend program where we are going to retain the tenant but they're going to downsize and give us a longer term. We've got some additional early terminations kind of baked into the plan.

Maybe for George or for Gerry, the commentary earlier that contractions are probably still outstripping expansions a little bit, at what point do you think that your occupancy levels on kind of a same property basis just stop going down, should that start to happen in the beginning of 2011 or do you think it's more likely to be later in the year?

No. We're hoping that our occupancy levels will trough by the end of this year and start to move back in a positive direction in 2011. In looking from where we are today through December, some of the big occupancy declines we have we've known about and as George touched on really a big piece of that is by one large tenant who is leaving two of our better buildings in southern New Jersey to buy their own building. Then I think when you try and reconcile the NOI, or the earnings impact to the occupancy number, you have to be very mindful of the timing of whatever those vacations may be. Certainly a tenant that would leave us in December may have a very minor revenue impact but we pick that up as an occupancy decline in our year end numbers.

I think we spend an awful lot of times with the managing directers and the leasing teams and go through a detailed quarterly reforecasting process and George stays in very close touch on leasing transactions with our team. I think while the overall commentary is positive, underlying that are some areas where we know we have areas to improve such as New Jersey. We have been running that operation at 73% lease is clearly an historic low for us. We think that's been the combination of tenant cutbacks, generally weak demand, and then a number of our key tenants either consolidating back into their own facilities or buying their own facilities, we think that wave is behind us. More importantly when our leasing came into that marketplace, we assessed the quality of the pipeline we certainly do expect to turn that market as well as a number of other markets in a positive direction as the year progresses.

Just quickly to follow up, for some of the early terminations should we expect so see some lease term fees pick up in the back half?

Yes. Obviously, there would be a termination fee associated with any space that we're going to take back before the scheduled expiration.

Great. Thank you.

Your next question comes from the line of Mitch Germain with JMP Securities.

Good morning, guys. Most of my questions have been answered. I guess the only thing I'm looking for is leasing spreads in the Jersey region are they similar to your portfolio or possibly a bit lower?

Lower. For the second quarter are GAAP spreads on new leases were down 6%, renewals were the same, first quarter spreads in Jersey were down almost 12% on new deals and down 130 basis points on renewals.

Thank you.

Your next question comes from the line of Aaron [Avlaskin] with Stifel Nicolaus .

Hello, good morning. Quick question on when is the rent actually suppose to begin on the IRS asset both in terms of GAAP and cash?

We're assuming around September 1. And GAAP and cash are the same on this project because it's a flat lease.

Okay, very good. Where did you guys actually save the $13.5 million against the budget on that asset? You know what actually came in better than your expectation?

It's variety of things. An element of hard cost savings there, when you undertake a project of any significant size like this, particularly when it involves a renovation, you build in a fair amount of contingencies to cover unplanned items. There are some soft cost savings that we incurred that came in below budget, so pretty much across the board. No one large element that was a major driver of that versus the GMP that we executed when we undertook the project in construction.

Thank you very much. Congratulations.

You are welcome.

Your next question comes from the line of Dan Donlan with Janney Montgomery Scott .

Good morning. Just a question on the NIO margins Gerry, you guys mentioned that you use more triple net leases going forward. Could you maybe talk about what you are looking at for the margins maybe in 2011 into 2012 if you can actually see some occupancy increases from here?

Yes, Dan it's Howard, I'll jump in first and George will probably elaborate. I think it's noteworthy to look back overall several quarters, even several years, we're tracking consistenty at around the 60% NOI margin and around 32%, 33% recovery ratio, and that's with occupancy down right now 500 or 600 basis points or more. If and when that occupancy turns, I don't think we're going to see an increase in operating expenses, we're spending what we're spending Real estate taxes are subject to market values but if those leases are on a gross basis, obviously we'll pick up the expenses.

If they have a base year, we'll get whatever escalation there is above that and since a portion of our leases and particularly in markets like New Jersey, parts of Pennsylvania, and Austin are triple net, there will be a recovery of expenses that in effect we've already been incurring, so it will all be bottom line effects. I think those margins could go nicely higher. It ultimately depends on the lease structure, but there are several hundred basis points on each to get to levels that the company has never been at. And the reason we've been able to do that is because our expense contro over the last couple of years has been very, very focused as you can well imagine. George, can you jump in.

Yes. Metro DC and Richmond are really non-triple net lease structure regions at this point. All the new leases in New Jersey, Delaware, Pennsylvania, are converting to go triple net or have converted to triple net and we try to convert every renewal as well. I would expect that margin to continue go up. The one thing that can skew it sometimes quarter to quarter is that bad debt runs through the operating expense line which isn't a pass through item to the tenants. So that sometimes can have an impact on how that margin looks or recovery percentage looks quarter to quarter.

Just a follow-up on the dividend. Given your low payout, just curious how you look at that going forward because you talking about more investment activities. Do you want to use more of your capital now for investment or is there an opportunity down the line to start to bump up your payout.

The policy of the board is still to match our dividend with taxable income. Taxable income to a great degree is a function of how much revenue we generate which is a function of our occupancy levels and rent. To the extent that we're successful in moving our occupancy levels up, generating higher taxable income and higher expectations we'll relook at the dividend. Certainly we're in a very, very good position here with a very, very well covered CAD payout ratio with our existing dividend.

It's good to be sitting in a position where we're going to be generating, even at these low occupancy levels, $30 million to $40 million cash flow. Given where our stock is trading right now and our relative dividend return, we certainly don't feel under any pressure to increase the dividend to try to make it more attractive to investors. I think our major objective is to execute a business plan that creates the revenue that generates a higher multiple. That we reward the shareholders from that standpoint. We like having a very well covered dividend.

We had that for a number of years, and as the market turned add few years ago, we wound up being upside down on the CAD payout ratio. We don't think that's av ery wise way to run a business, particularly in this uncertain environment. So I would not anticipate any changes the board would make to our dividend this year. When we certainly look at our 2011 business plan and roll it out to the marketplace in our third quarter call and the board reviews that business plan in detail, most of our taxable income. We'll make a decision at that point and risk assess our projections and expectations versus where we think the markets are.

Okay, thank you.

If you would like to ask a question, please press "*" 1 on your telephone key pad. Your next question comes from John Stewart with Green Street Advisors.

Thank you. Howard, you said the IRS building is a flat lease. Do we take that to mean there are no rent lumps over the 20 years?

That's correct.

George, can you maybe shed some light for us on the big occupancy declines in Plymouth meeting and the DRA JV.

Sure. In Plymouth meeting which is really a combination of both the Plymouth meeting and the Blue Bell sub markets we had really three transactions kind of drive the decline there. A.I.G. had a contractual right in their lease to give us back a floor which was 36,000 square feet and they had exercised that. Which generated the termination fee and that occupancy decline event happened in the second quarter. That was in 401 Plymouth road and Plymouth meeting. We have several prospects looking at that space and some additional space that we're currently negotiating with.

The others were in Blue Bell where one was a renewal with an associated contraction, and then the other was a tenant that moved back to corporate-owned facilities so we had a 56,000 square foot decline in the Blue Bell sub market, a 20,000 square foot net decline with some additonal leasing to offset the A.I.G. give back in Plymouth meeting and we've got pre-leasing in both those markets of about 40,000 square feet. So we went from 88.6% down to 81.4%. We have pre-leasing in place that gets us back to 85% with a pipeline that should get us back to close to a 90% occupancy level there.

And the DRA JV?

I'll have to follow up with you after the call on DRA.

No problem. Howard, could you please explain the hold back on the line of crediters as it relates to the tax credits and also maybe help us understand what happened with the swap on the term loan? I know you renewed it but it looks like the rate went from LIBOR plus 80 to 5.6%. It's hard to imagine what that swap would have looked like during the last 90 days.

Good questions. We can clarify both. On the hold back, the agreement in place with our financial partner on the post office projects, for every $1.00 they advance we set aside or carve out $1.50 or 150% of availability on the credit facility. It's really an insurance policy so to speak on their part that the project gets finished on time. So as we reached a little over $60 million at the end of the second quarter with the latest funding, that holdback or unavailability in the credit facility by contractual agreement would then reach $92 million. Once the project is accepted by the IRS and our permanent financing is in place, that hold back goes away, so we expect that to happen before the end of the third quarter.

Got it. The term loan?

With respect to the term loan that no change in the swaps that are in place. But from a presentation purpose to make sure that all of our weighted averages effective rates track correctly, we stopped just categorizing that as the LIBOR plus 80 which it is, but instead put the full swap in place and that's the 5.54% that you see. That reflects swaps that were done back primarily late 2007 when that loan was originated to turn it into a more fixed rate obligation. Those swaps for the most part burn off by October of this year, and then for the rest of that term, unless we do otherwise, that will be a pure floating rate obligation.

Got it. That's helpful. Thank you. Lastly, it looked like there were buildings taken out of service that are under demolition. Can you give us some color there?

Yeah. This is Gabe. Those are a couple projects that we took them out of service and are classifying them as land inventory now. No current development plans. There's a couple of ideas in places, but the projects have undergone interior demolition and the structures will come down so we just made an assessment that they have no remaining useful life and they're now part of our land inventory.

Okay, thank you.

At this time there are no further questions. Gentlemen, do you have any closed remarks?

Nothing. Just to thank everyone for taking the time to listen to our call and we look forward to updating you on our business plan during the next quarterly call. Thank you very much.

Thank you. This concludes today's conference call. You may now disconnect.