Brandywine Realty Trust (BDN) 2010 Q3 法說會逐字稿

Good morning. My name is [Latange] and I will be your conference operator today. At this time I would like to welcome everyone to the Brandywine Realty Trust third quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator instructions).

Thank you. I would now like to turn the conference over to Jerry Sweeney, President and CEO of Brandywine Realty Trust. Please go ahead, sir.

[Latange], thank you very much. Good morning, everyone, and thank you for joining us for our third quarter 2010 earnings conference 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 like to remind everyone that certain information discussed during our call may constitute forward-looking statements within the meaning of 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 quarterly performance, just a quick observation on the overall state of the real estate markets and the economy. On the last call, we talked about the recovery we are seeing in our primary markets. We continue to believe that the market has bottomed and that the recovery is still under way. As we've seen with broader economic indicators, however, this recovery, while we anticipate it to be steady, will be slow from a real estate standpoint. Even though there are an increasing number of tenants already looking at their 2011 and 2012 space requirements, as evidenced by some of our traffic and pipeline activity, that positive continues to be offset by tenant downsizing and space give-backs. These two factors combine to create a market that, while positively biased, is one that will have very competitive conditions persisting well into 2011.

In this type of climate, given very little new incremental demand, we will generate leasing activity primarily by increasing our market share and as such, upward pricing pressure will be minimal and will remain so until our markets return to normal levels of absorption and reduce the vacancy rates below their current low to mid-teen averages.

So with that overall comment, and looking at the third quarter, we continue good execution of our 2010 business plan, including strong leasing performance. As you look at the quarter and the remainder of the year, several points to note -- first, the headline news for the quarter for us was 1.4 million square feet of leasing activity during the quarter, a new deal pipeline of 3 million square feet, 414,000 square feet of executed forward new leasing transactions and 518,000 square feet of leases in negotiations, all strong indicators.

Overall velocity was in line with our expectations, but even with these strong leasing metrics, we continue to face space consolidations by a number of larger tenants that has impacted both our 2010 and will impact our 2011 business plans.

From an operating metrics standpoint, our business plan always anticipated that the third quarter would be challenging, so we did see continued pressure on our operating trends during the quarter. Our mark-to-market on rents remained negative. Same-store NOI declined, both in line with expectations. Our NOI margins, however, remained stable and we will -- and we project we will exceed our 2010 spec revenue target by $3 million or 11%. Our tenant retention rate for the third quarter was 68.3%, excluding early terminations, and 63.3% with early terminations.

Traffic through the portfolio was up 4% from the second quarter and up 14% year-over-year. Our strongest performing markets in terms of both activity and rental rates remain Philadelphia CBD, the Radnor, Plymouth Meeting, Newtown Square sub-markets in suburban Philadelphia, the Toll Road Corridor in Metropolitan DC and our operations in Richmond.

As outlined on our last call, our 2010 operating business plan assumptions are -- they originally contemplated a 46% retention rate. Based on results thus far, we anticipate we will have an actual retention rate that will approach 60%.

Our core portfolio occupancy for the quarter at the end of the quarter was 84.9%. This occupancy level is down 150 basis points from last quarter's 86.4, primarily due to 1717 Arch, or as we now know it, Three Logan, being 67% leased, which added about 90 basis points of vacancy, with the balance of the decline due to several large known moves of our tenants back to corporately-owned facilities, notably ARI in southern New Jersey that moved out of 158,000 square feet, and Verizon and Vanguard who vacated square feet in our Pennsylvania operations, as well as about 33,000 square feet of bankruptcies and lease defaults during the quarter.

During the third quarter, we did deliver the IRS Philadelphia Campus which is 100% leased to the IRS and the Cira South Garage which is 93.2% leased. The GSA is now our largest single tenant comprising 6.4% of our annual base rents.

During the quarter, we acquired the leasehold interest in 1717 Arch, as I mentioned, also known as Three Logan, a 1,029,000-square foot, 53-story trophy-class office tower located in the Philadelphia CBD. We acquired it from an affiliate of the Blackstone Group. The property was acquired for $129 million or $125 per square foot. We funded that through a combination of $51 million -- $51.2 million in cash and 7.1 million operating partnership units. That partnership is subject -- or that property is subject to a long-term ground lease which is prepaid through 2023 that can be extended through 2092, and is subject to a fair market value purchase option.

Also during the quarter, we announced a $25 million preferred equity investment in the Commerce Square, Philadelphia's CBC twin 41-story office tower complex owned by the Thomas Properties Group. It aggregates 1.9 million square feet. Brandywine will be a 25% limited partner in that transaction, with a 9.25% cumulative preferred return. That transaction is waiting approval by the property's lenders and is slated to close within the next 60 days.

Brandywine now owns 4.7 million square feet of office space in the Philadelphia CBD, including One and Two Logan Square, which are together 97% leased, as well as Cira Center, which is 100% leased, and the IRS Campus, which is 97% leased, as well as two development sites at Cira South in University City. Including the Thomas Properties JV, Brandywine now owns about 51% of the Philadelphia trophy CBD market. Based on this recent activity, our percentage of NOI contribution from Philadelphia CBD rose from 12.9% to 18% and based on this increase, we are showing Philadelphia CBD in our Supplemental as a standalone reporting segment, with the Pennsylvania reporting segment now being comprised entirely of suburban properties.

On the investment front, efforts are focused on marketing non-core properties for sale or joint venture over the next several years. We fully expect that with pricing becoming increasingly dear in New York City and Washington, DC, capital will begin to migrate towards high-quality office assets in key markets like Philadelphia. As such, as 2011 progresses, we expect to see an increased level of investment activity in the Philadelphia metropolitan area, as well as in Richmond and Austin.

We closed $18.4 million of sales year-to-date and have another 34.4 million under contract or in contract negotiations at a cap rate of about 7.5%. This amount, if closed, will bring us to $53 million of sales for the year versus our original forecast of $80 million.

We remain fully committed to moving up the investment-grade ratings curve one notch. This is a multiple-year plan that we will achieve through a combination of NOI growth, occupancy improvement, disposing of slower growth assets and funding any future acquisitions on an equity basis. Through our continuous equity offering program, year-to-date, we raised $70.8 million of net proceeds by issuing 5.7 million shares and during the third quarter, we issued 2 million shares, realizing $25 million of net proceeds.

As noted in our press release, we raised the bottom end of our 2010 guidance upward to a range of $1.32 to $1.34 versus the prior range of $1.30 to $1.34. Based on the midpoint of our new 2010 FFO guidance, our FFO payout ratio was 45.3%. Our CAD payout ratio for the quarter was 68.3% and we continue to expect to generate free cash flow this year between 30 and $40 million. This is the fourth time this year that we raised the bottom end of our guidance. As with previous quarters, this upward revision is primarily driven by better retention rates than we originally expected, being ahead of plan on spec leasing, due to expense control programs that have resulted in stable aniline margins and a lower interest rate environment than we originally forecast back in October of 2009.

As we did also indicate in our press release, we announced our 2011 guidance was a range of $1.24 to $1.34 per share, creating a midpoint of $1.29 which is below consensus estimates. At the midpoint of our guidance, we are projecting an FFO payout ratio of 46.5%, a CAD payout ratio of 75% and again, anticipate generating between 30 to $40 million of free cash flow. This guidance is fairly consistent with our original 2010 guidance of $1.23 to $1.34 per share.

As with last year, the guidance was conservatively developed and is really driven by the following macro assumptions. As I touched on earlier, we do believe the market has bottomed, but we do expect the recovery to continue at a steady, but a very slow pace. That assumption is based on prevailing economic data points that we're all familiar with and also reflects activity that we're seeing in our markets. While we're seeing increasing levels of activity in almost every market, velocity still does remain well below historical levels.

Also, despite having an excellent 2010 leasing activity level, we are still in an environment where net absorption in most of our markets is still below long-term averages and large tenants are still rationalizing their space requirements. As such, our 2011 business plan projects spec revenue levels that are 18% below what we expect to achieve in 2010.

During the past year, another key assumption in our business plan is that we issued the equivalent of 12.8 million shares of stock or 10% of our equity base, which while accelerating our deleveraging plan, has also created between $0.06 to $0.12 of dilution, depending on the assumptions of how we apply those proceeds, and the impact of those share issuances is fully reflected in our 2011 guidance range.

By year end -- by 2010 year end, our portfolio will have had negative absorption of approximately 854,000 square feet or about a 330-basis point decline of occupancy. More importantly, the majority of that negative absorption is occurring during the second half of 2010, so it has a big carry-forward impact into 2011.

We also have several known moveouts in early 2011, particularly in our Metro DC operation which creates some additional near-term occupancy pressure in the early part of next year. We are projecting flat to 100-basis point improvement in year-end 2011 occupancy levels, but with occupancy dipping in the first half of the year.

For 2011, we estimate we'll achieve approximately 3 million square feet of leasing activity versus the 3.2 million square feet projected for this year and to provide a frame of reference, our current leasing pipeline stands at 3 million square feet. So we're confident of meeting our targeted leasing objectives that are incorporated into our business plan.

We did continue with last year's approach in compiling our 55% projected tenant retention rate where we basically assume that any tenant that we don't know for sure is staying leaves upon expiration.

On the capital-raising front, we've assumed $80 million in sales for 2011 occurring mostly in the second half of the year. We have not assumed any additional acquisition activity or any further equity issuances. We have provided for a $300 million 10-year unsecured note issuance in the fourth quarter of 2011 and we also plan on keeping our line of credit balance in line with our previous forecast with an average of one-third or less funded and a year-end 2011 balance well below $100 million.

While George and Howard will go into more detail, our objective in presenting guidance this year for 2011 was to continue to recognize the reality of the current markets. Fundamentals have clearly bottomed. However, 2011 will not be a year of quick recovery, and as such from our standpoint, both prudence and caution, coupled with a very aggressive leasing strategy, is really the order of the day. This guidance provides a solid platform from which we can, market conditions permitting, improve on during the course of the year, similar to the execution of our 2010 business plan.

At this point, I'd like to turn the presentation over to George Johnstone, who will review the key revenue drivers and operating assumptions behind our guidance. George will then turn it over to Howard for a financial review of our -- of the quarter, the balance of 2010 and 2011 guidance. George?

Thank you, Jerry. From an overall standpoint, given the current state of the real estate markets and the lack of visibility on demand drivers, we took a very cautious view of forward leasing activity. As such, our 2011 business plan is primarily based on conversations with existing tenants in our existing pipeline of activity.

Our 2011 guidance contemplates a decline in same-store NOI of 5 to 7%. As mentioned today and on prior calls, moveouts by six large tenants, aggregating 600,000 square feet, predominantly in the second half of 2010 and the first quarter of 2011, account for 58% of this decline. These moveouts include ARI and Virtua Health in New Jersey, both 2010 moveouts, Verizon and Vanguard in the Pennsylvania suburbs, again, 2010 moveouts, and Computer Associates and Verizon in Dulles Corner, first quarter of 2011 moveouts.

In addition, $6 million of termination fees in 2010 have been reduced to a $3 million run rate for the 2011 plan which accounts for another 18% of the decline. So these six tenants and reduced termination fees account for 76% of the total same-store NOI decline.

In general, our leasing plan for 2011 assumes 2.9 million square feet of speculative leasing consisting of 1.8 million square feet of new leases and 1.1 million square feet of renewals. This is about 90% of the 3.2 million square feet we expect to achieve in 2011. This activity, when combined with forward leasing already executed and anticipated contractions, will produce a flat to 100-basis point increase in year-over-year occupancy. Revenue produced in this leasing plan totals $25 million which is approximately 82% of the $30 million of speculative revenue generated in 2010.

Our anticipated mark-to-market on GAAP rents is a 5 to 7% decline. Occupancy is expected to drop by the second quarter due to large moveouts and excessive speculative new leasing. Our northern Virginia portfolio is impacted the most, where we expect over 600,000 square feet of tenant contractions during the year. The majority of these contractions are occurring in our Dulles Toll Road properties.

As we assess the speculative revenue plan for 2011, on new leases there's an active pipeline of prospects -- 500,000 square feet of leases under negotiation, 2.6 million square feet of prospects are in receipt of a proposal and 1.4 million square feet of current space inspections.

Relative to renewals -- as Jerry mentioned, we have assumed tenants that we don't know who are staying will vacate the portfolio upon lease expiration, thus leading to our planned 55% retention rate.

In regards to concessions and capital, we have assumed, based on recent trends, that the request for free rent will continue to be a preferred concession by our tenants. The 2011 plan assumes 60% of these transactions will have a free rent component. This is up from 42% in 2010.

Tenant improvement costs are estimated to exceed historical levels caused by longer lease terms on average and a few 10-year deals in our Metro DC region.

Now I'll turn it over to Howard for the financial review.

Thanks, George, and thanks, Jerry. In the third quarter, FFO available to common shares and units totaled $45.6 million or $0.32 on a fully diluted basis per share and that met analyst consensus. It's a high quality FFO figure and that third quarter termination revenue, other income, management fees, interest income, JV income and debt losses totaled $6.2 million gross or $4.7 million net, and are at the lower end of our guidance range for these other revenue components. Our payout ratio in the third quarter is 46.9% on the $0.15 dividend paid in July 2010.

A few observations on the third quarter performance -- cash rents of 112.4 million was up $2 million sequentially versus Q2 2010, but down a million versus Q3 2009 when that year-ago period is adjusted for the effects of deconsolidating three JVs effective January 1, 2010. Straight-line rent of 3.8 million was up 1.1 million versus Q3 2009 and 1.3 million sequentially versus Q2 2010, echoing George's comments on increased free rent concessions.

Recovery income of 20.2 million, our recovery ratio of 35.6% reflected typical expense and recovery conditions.

Property operating expenses increased $3.8 million and real estate taxes increased 700,000 sequentially with much of that attributable to the new assets that came online in the third quarter.

Interest expense of 34.5 million increased sequentially by 3.3 million and by 3 million year-over-year as we absorbed the expense of the Post Office and Garage permanent loan. Interest expense in Q3 includes $340,000 of non-cash APB 14-1 costs related to our remaining exchangeable notes and also reflects reduced capitalized interest versus the prior quarter.

G&A of 5.75 million was in line with our expectations and deferred financing costs declined to $827,000 reflecting prior period accelerations of deferred amounts as a result of debt repurchase activities offset by the commencement of amortization on the Post Office and Garage loan costs.

So in sum, Q3 2010 reflects a partial period for both the Post Office Garage asset, as well as for 1717 Arch or Three Logan. Together they account for 4.6 million of rental revenue, 1.2 million of recoveries, 2.2 million of property expenses, 320,000 of one-time transaction expenses in G&A, 2.1 million of interest expense and about 110,000 of deferred financing cost.

In the third quarter, we had net bad debt expense of $560,000 in line with expectations and reflecting various write-offs, recoveries and adjustments to reserves. The net effect in the third quarter was about a $270,000 increase in our overall reserve balance versus a quarter ago.

And lastly, we incurred minimal or $64,000 of losses on 1.7 million of debt repurchases.

For the quarter, same-store NOI declined 6% on a GAAP basis and 7% on a cash basis, both excluding termination fees and other income items and largely as a result of lower occupancy in the same-store portfolio.

Our margins were very solid, as were our coverage ratios, despite our higher vacancy levels and are equal to, or above, recent levels.

We did tighten the range on 2010 guidance to $1.32 to $1.34 and to echo what Jerry said, seeing many of our assumptions coming in nicely as the year winds down and having very few surprises in the overall operating environment.

Just to highlight a couple of items -- our speculative revenue for the -- is up $1.4 million from the July 2010 figure and is up almost $3 million from our initial 2010 guidance. This is a key contributor to our guidance increase.

For the year, we see between 25 and $30 million of gross other income items or 20 to $25 million net and that's in line with prior expectations and we see our G&A coming in consistently for the balance of this year.

Our total interest expense for 2010 will be in the 131 to $133 million level with next quarter's expense, or the current quarter, consistent with this quarter's due to the full impact of the Post Office and Garage financing, the elimination of virtually all of our capitalized interest, offset by a mortgage payoff on October 1 and the burn-off of various underlying LIBOR swaps. We don't anticipate any additional issuance in our numbers for the continuous equity program beyond what's already been done year-to-date.

For the 2010 capital plan, looking at the balance of this year, we'll have total capital needs of about $330 million. This will include 40 million of investment activity between finishing up the Post Office and Garage, revenue-maintaining cap ex, other capital and the initial funding on the Commerce JV. We'll also need $247 million for debt repayments, including the 2010 note, a few million dollars of quarter-to-date repurchases and $46 million for the mortgages with the large one already behind us.

As noted in the press release, we've also extended our $183 million bank term loan that was due earlier this month and now runs to June 29, 2011, contemporaneous with our credit facility. We see $20 million of negative working capital changes, primarily due to Q4 interest payments that'll need to be funded in cash, and $23 million of aggregate dividends, again now behind us, in the month of October.

To raise this 330 million, we're projecting the following. We'll use the $104 million that we have of cash on hand at September 30, $5 million raised during October from the continuous equity program, about $50 million of cash flow from operations for the rest of 2010, $34 million of projected remaining sales activity in 2010, bringing our total for the year to 52 million. And we'll borrow 137 million or so on the credit facility, bringing us to a year-end balance of 159 million, ending the year pretty much as planned earlier.

Just to elaborate on a couple of points of 2011 guidance, between Jerry and George, they went through many of the portfolio metrics. I'll point out one item and that is on the gross other income items, termination fees, other revenues, management revenue, etc., we're down a little bit in our projections from 2010, seeing those numbers on a gross basis of 20 to 25 million and on a net basis of 15 to 20. So that's down anywhere from 5 to maybe $7 million below our 2010 figure.

GA should run consistent with 2010 at 5.34, the 6 million a quarter. Interest expense should be consistent with the full year 2010 figure, between 130 and 133. We do include in earnings and FFO a net historic tax credit financing impact of $0.07 per share. This will hit the income statement in Q3 2011 and will show up as about $0.08 of additional revenue on a newly created line item, and will also reflect an extra $0.01 or so of interest expense in that period. This is essentially non-cash and will be excluded in our CAD calculation. It reflects 20% of the net proceeds to be realized in connection the historic tax credit financing that we'll recognize pro rata over the next five years beginning in 2011.

We do have $80 million of sales activity programmed for 2011 at up to a 10% cap rate. It's weighted toward the middle to back end of the year and we see it having an impact on a gross basis on NOI and FFO of about $3.2 million. We don't have any additional equity issuance programmed into our numbers for 2011, nor do we anticipate doing any market financing until the end of the year.

So in short, we see our plan producing between $1.24 to $1.34 of FFO and between $0.75 and $0.85 of CAD, and as Jerry mentioned, producing between 30 and $40 million of free cash flow.

Very quickly on the 2011 capital plan, it's a much lighter year in the aggregate than 2010. We see about 113 million of aggregate investment activity, including any remaining finish-up on the Post Office and Garage for final items, $50 million of revenue-maintaining cap ex, $40 million for remaining redevelopment outlays, lease-up of recently completed or purchased properties, and the middle piece, or about $15 million, of the Commerce JV funding.

We have $240 million of debt repayments programmed for 2011. These include 70 million for the 2011 exchangeables that we believe will be put to us in October, $128 million for mortgages, and we've made a conservative assumption that we'll refinance -- that we'll have to pay back, rather, 42 million of JV debt. We plan to extend our $183 million bank term loan and the $600 million LOC during the early part of 2011 to a final maturity of June 29, 2012. And lastly, maintaining the same current dividend level as a good assumption, we will pay in the aggregate about $93 million of dividends all in cash.

To raise this $446 million, we're projecting about 170 million of cash flow from operations. We will receive funding of the remaining -- the final HTC installment in early 2011, about $3 million, bringing the total gross inflow to about 64 million, the 80 million of sales, and a $300 million year-end unsecured note issuance resulting in $107 million paydown on our credit facility and a year-end balance of about $52 million.

That wraps up the capital plan. I'll touch very briefly on account receivables. Total reserves at 9-30-2010 were 15.7 million, 4.4 million on 24.5 million of operating and other receivables or about 18% and 11.3 million on 102.1 million of straight-line rent receivables or about 11%. These reserves are in line with prior quarters and reflect expected credit activity.

And lastly on the balance sheet and credit metrics, we achieved our lowest debt to gross real estate costs of 44.2% in well over five years. We have a very good balance between secured and unsecured debt, maintaining a very high unencumbered pool and we're 100% compliant on all of our credit facility and indentured covenants.

And with that, I'll turn it back to Jerry.

Great. Thank you, Howard. Thank you, George. To wrap up the prepared comments, clearly the market will continue to present operating challenges for both the balance in the year and into 2011. We're in good shape as we close the books on 2010 in the next 60 days in terms of accomplishing our key business plan objectives.

Looking at next year, the opportunity implicit in our 2010 -- 2011 guidance is that our best growth strategy is to simply lease up our existing vacancy. We're fully focused on that and believe that our liquidity, inventory quality and strong market position provide a clear competitive advantage for us, as evidenced by our year-to-date leasing velocity and strong pipeline. We plan to continue to execute a very aggressive leasing approach to ensure that we maximize that advantage and achieve our 2010 and forward-looking 2011 objectives.

With that, we'd be delighted to open the floor up for questions. We would ask that in the interests of time, you limit yourself to one question and a follow-up. Thank you.

(Operator Instructions). Your first question comes from the line of Michael Bilerman with Citi.

Yes, just on guidance, just for 2010 first was -- I guess the other income, all those various line items, Howard, it seems that for the fourth quarter, you got 5, 10 million baked in there. You've done about 15 year-to-date net and you said 20 to 25 for the year. What would take you from -- I guess the 5 is sort of the normal that you've been earning each quarter. What sort of takes you up to 10 million?

I don't think we'll come in at the high end of that range, Michael. We'll be towards the bottom of that range.

Okay. And then I guess moving forward to 2011, and you gave off a lot of details, but if I just step back from it and say you're running about $0.32 a quarter, right? So about $1.28 plus the $0.07 non-cash from the tax credit gets you to about $1.35, right? And your guidance is $1.24 to $1.34 now. I think I heard you said the occupancy is going to dip in the first quarter. I don't know how much, but 100 basis points is only like a penny a share, so that can't really drive it that much. But what's really depressing next year's FFO, relative to the pieces? I know that other income you said was going to go down to 15 to 20, but if you're probably going to come in, it sounds like more like towards 20 than 20 to 25. So that's not a big, big driver. What's really getting it down for next year?

Yes, Michael, this is Howard. I think there are three factors. I think there's a little bit of downdraft in terms of the overall operations, but the reality is when you combine the same-store declines with the new revenue pickups from the Post Office, the Garage operations, as well as Three Logan, those tend to offset each other. So we'll be -- they'll plus or minus right around neutral in the overall level of NOI. So the factors that are pushing down guidance are really threefold -- number one, the full share load of the incremental shares in 2011 versus '10 --

But that's already in -- but I'm already taking that, but my starting point is the fourth quarter at $0.30, even with --

Fair enough.

Right, so all that should already be in there.

So if we look at $0.32 as a run rate and we ignore the HTC, so we're at $1.28, to pick up on your comments, versus maybe a midpoint on the guidance of $1.22, I think the two things we can point to are incremental sales activity in both the fourth quarter and 2011 being worth probably on a property weighted basis, between 3 and $4 million net or $0.02 to $0.03. And then I think the other is a much more conservative posture on other income items. If those come in between 5 to $10 million light, that's worth another $0.04, $0.05. I think between those two components, you pretty much solve for the delta in the FFO guidance.

What I'll point out is in 2010, we took a fair amount of early termination, as you'll see that in the leasing stats and you'll see that in the termination revenue. And at this point of the year, we're not programming to do anywhere near that level of activity and that, plus other factors, are leading to a lower other income item, and I think those two do solve the puzzle.

Thank you.

Your next question comes from the line of Jamie Feldman with Bank of American Merrill Lynch.

Thank you. Jerry, something to follow-up on your comment where you said you think institutional capital will start to move out or will find New York and Washington too expensive and start to move into markets like Philadelphia and Austin. Can you give some indication of what you've seen along those lines so far? And then also kind of help us think about your move -- your adding to your CBD Philly portfolio and whether that's more of a cap-rate story or an improving fundamental story.

Happy to. And Tom, I'll turn it over to you maybe to talk -- give some observations on what we're seeing in the investment market. What we've started to see, even in the last quarter, is a lot more reverse inquiries relative to properties in the Greater Philadelphia area, which we were not seeing.

Now, if you go back to our -- we initially thought 2010 would play out, is we assumed there would be a higher level of investment philosophy in Philadelphia by the end of 2010, and I think we were tracking along those lines until kind of the spring when the economy started to move sideways. And I think what we really saw was a real push of money to stay in the gateway markets and essentially, bidding up a lot of properties, buying growth bonds with a high level of security and the liquidity in those markets -- the two markets being New York and Washington.

And I think that put a bit of a damper on what we were hoping to see this year, which I mentioned, is more of an accelerated investment base and more investment activity in Philadelphia. I think with pricing continuing to get increasingly dear on that, and Tom gave you some illustrations, we do think that the folks that are getting priced out of that market will start to turn their attention to some of these other very buyable, but compared to New York and Washington, tier-two type of markets. And we think that will come both from domestic institutions, as well as foreign capital and we're beginning to see the beginning of that now.

Relative to the view on CBD's buildup, we think that it is a value play, as we talked about when we announced the Three Logan transaction. Our appetite for properties in the CBD of Philadelphia is limited to really the trophy class which has been fairly economically resilient from an occupancy standpoint through many up and down cycles. We do think that there's some good dynamics taking place long-term in Philadelphia that will create a good upward movement in rents. We've been seeing that already in both One and Two Logan with our early renewals on Cira. Certainly, can [talk] in more detail at One-Three Logan later, but Tom, why don't you share some observation on what we're seeing on the investment market?

Hi, good morning. When you look at the investment market, we are still seeing the CBD of Washington be very competitive and we're seeing trades still occurring 400, 600 a foot on some of the properties. They're core-core plus, with the trophy class still going well up above replacement costs, but we are starting to see some activity, some trades that are occurring in the Beltway and even out into some of the areas along the Toll Road. So we are seeing some more properties come to market that [are] those core transactions that are commanding the high pricing and we're still seeing some deep pools of investors on those properties.

So we would expect that as we now start to see some of that pricing improving along the Beltway, that you'll start to see it occurring in some of the other markets. We have not seen a lot of product coming to market, but we have had some reverse inquiries about investments in Austin and in Philadelphia. So there is some interest coming that way, but again, not a lot of trades to benchmark where those should be.

And Jerry, I guess going back to CBD Philadelphia, I mean, you're actually seeing an increase in the level of interest or you're just getting calls?

Well, we're getting calls from --

And do you think we're closer to seeing -- (inaudible) my question -- do you think you're closer to seeing non-local market participants go after buildings there?

Absolutely. I think we're much closer where we are today versus where we were six months ago, and again, I think part of that is being driven by people getting a better flavor for what rental fundamentals will be in the area, with the market kind of bottom, even though of course that recovery will be slow, but I think it's also being driven by the price compression you've seen in those two gateway markets -- no question.

Okay. Thank you.

You're welcome.

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

Thanks, good morning.

Good morning.

First question, I think, maybe George, you can provide some additional color surrounding the detail you gave on the leases or space that's under negotiation versus prospects versus, I think, inspection. Can you maybe give us a -- the historical number in terms of percent hit rate related to those three categories?

Sure. I mean, I think our average conversion of deals that we issue proposals on runs anywhere from kind of the mid-to-high 20s to the mid-to-high 30s and on inspections, it's probably 10 percentage points beyond that. So as we've talked on prior calls, I mean, we kind of track every prospect through the pipeline on kind of a nine-stage category and as they move up that pipeline, clearly, we see a better conversion rate. Those that are in negotiation, it's typically north of a 90% conversion. Rare is it that we get kind of to a draft lease or we're actually negotiating the lease that the deal turns sideways on us.

Prospects could be 20 or 30; inspections could be 30 to 40?

Right.

Is that --

Yes, I think that's kind of the range that we've seen over the last couple of years.

Okay. And then as it relates to 1717 Arch and CBD Philly, maybe Jerry or Tom, if you could walk through sort of how the investment opportunity is shaping up? I know we're two months into the deal for you guys or so, but -- almost three already -- but any early read on sort of activity (inaudible) better in the market and sort of asking rates would be helpful.

Certainly. I think we continue to be very pleased with the level of activity we're seeing. I think the market opportunity we saw on that transaction was that because of the master lease structure that was in place on that building for a number of years that was scheduled to mature -- or to expire in 2012, that property had effectively been out of the tenant market for a number of years. Certainly we assume -- and I think that assumption is bearing some fruit -- is that once the high-quality building like Three Logan came onto the market and had to go to the lease space on market conditions, we'd be able to generate a lot of activity, and that's exactly what's happened.

We've had about 25 inspections thus far with over a million square feet of aggregate activity. We have, I think, six pretty good proposals outstanding on the vacant space. Remember that the top half of that building is fully leased to sub-tenants on leases that mature in midyear 2012 that are paying an average rate of about $22 a foot. The bottom half of that building is where really the vacancy is, absent the 125,000 square foot lease that we signed with Verizon.

So activity level has been very good. There are a number of larger tenants in the market we are working with, but certainly there's no guarantee that any or all of them get across the finish line, but we certainly are being very aggressive. The rental rates that we pro-forma'd are very much in line with the proposals and discussions we're having with tenants and their advisors. On the upper bank of the building, again there's about 55 tenants up there, about 550,000 square feet. We are in discussions with about 30% of that square footage already on early renewals, basically blends and extends, all along economic terms that are at or slightly better than our pro forma.

We've also been able to realize some nice expense savings relative to electricity. We saved about $420,000 versus our underwriting, janitorial, about $500,000. We've been able to improve the parking NOI a little bit and have seen good activity, as I mentioned, to the vacant space.

So the focus for 2011 is really to convert some of the activity, get as much as traffic as we can through the door, do early renewals, particularly on the lower bank of the upper bank and lock some of those away, and hopefully get one of the large deals across the table for occupancy, either later in '11 or more likely, early 2012.

So while nothing's been done and certainly the market is fraught with uncertainty, I think we are pleased with the activity, the economics being discussed and the reaction of the sub-tenant base in terms of their desire to stay in the building.

There just is a clarification. There was a little bit of a delta between what you disclosed. I think it was [53]% occupancy when you announced the deal and then it's up. It's 66.5. Is that just a clerical difference of some sort or did you actually do some leasing?

No. I think that I have to go back and check, but the occupancy level hasn't changed in the 90 days we've owned the property. We'll take a look at that for you.

Okay. Thanks.

Your next question comes from the line of John Guinee with Stifel.

Oh, okay, thank you. A bunch of little [nits and nats]. First, I might have got the math wrong, Howard, but I think you said $93 million worth of dividends in '11 and I think that's the weighted average share count for your guidance is in the mid-140s, the quick math translates to a $0.63 dividend. Is that correct or incorrect?

That would be incorrect because you're including the units from the Three Logan transaction in full and those, if you recall, do not get a distribution until the one-year anniversary of the transaction. So we did not assume in those figures, or in the projected payout ratio, a change in our dividend level.

Got you, okay. How many square feet of buildings did you demolish recently and did you have to take an impairment charge when you knocked those down?

You guys check on this (inaudible). No, actually we were carrying those at what we thought were essentially land bases.

Yes, the square footage -- we don't even show the square footage anymore. I mean, in the aggregate, they're now about eight acres of land area.

Right, yes. It was approximately 100,000 square feet, each building about 50.

Right.

Okay. And then how's the accounting going to work for Three Logan, 1717? Are you -- do you have that 100% in service for the entire time or are you taking it out of service in 2011 or 2012?

Yes. No, that'll be a core operating property, not a same-store property. There will be no capitalized interest on any component of the base building. As we do larger or any TI jobs consistent with our practice, any open jobs for tenant work will get capitalized interest treatment for the duration of that job, three, six, whatever many months.

And then last, what's the earliest -- maybe Tom, what's the earliest timing in terms of either you or Thomas Properties exercising the buy-sell on the One and Two Commerce Square?

Well, the buy-sell that we have in place is for us is in 2016. There's no restriction on them trying to sell the property ahead of time before that, but ours is 2016.

Do you have a right of first refusal or just mark-to-market if they decided to sell it before then?

It's a mark-to-market.

Got you. All right. Thank you.

Your next question comes from the line of Rich Anderson with BMO Capital Markets.

Thanks. The debt offering that you're assuming in 4Q of 2011, does that presume that you get upgraded by then?

No, we don't believe the upgrade is likely in that timeframe unless there's a dramatic improvement in sort of the overall economic conditions. And we've projected that at a rate currently wide of market, but it doesn't have any real impact on 2011 numbers one way or the other, as we expect it to come towards the latter part of the quarter.

Okay. And then the follow-up question is on the dividend policy. You're being conservative in your outlook for 2011 as you were in 2010 on FFO. Can the same be said about dividend growth for 2011?

Well, the board has the policy of matching taxable income with dividend. Certainly we are well covered today and like being in the position of generating the level of free cash flow we are as a company. My expectation of it if the board gets more visibility on both the economic climate improving generally, our portfolio performing in line or ahead of expectations with a good, positive bias towards the intermediate term, they'll take a look at what the dividend wants to be.

I mean, right now, we have a dividend that's one of the best in the REIT sector. It's very well covered, both from an FFO and CAD standpoint. So certainly the expectation would be that as the portfolio grows off of its trough low-to-mid 80s occupancy level, and we generate more NOI, that will hopefully generate more taxable income and that will create some upward bias on the dividend.

Okay. And could you just reiterate for me -- sorry -- the free cash flow 2010 versus 2011 that you're presuming?

We're actually presuming about the same levels year-over-year.

So is it 50 million or so?

It was 30 to 40.

30 to 40, okay. Thank you.

You're welcome.

Your next question comes from the line of Brendan Maiorana with Wells Fargo Securities.

Thanks, good morning.

Good morning.

So I just wanted a clarification on the occupancy numbers, the flat to 100-basis point increase kind of average. Is that a year-over-year expectation or is that from the current level of -- call it roughly 5%?

We're expecting to end the year around 85% and our expectations will end 2011 there or slightly up with a potential dip down to -- what, George?

83% in the second quarter.

Okay. 83% in Q2 and then you build it back up?

Right.

Okay. And then the retention expectations and the 55% and you guys have a good deal for the tenants that you've talked to thus far, of the 45% that's in expectations that are not expected to renew, what's the level of discussion that you've held with those tenants to suggest that you're not including them as likely to renew? Is that something that you're confident in? You've had significant discussions or is that just something you don't have any indication from them?

Well, I mean, we've had discussions with just about every tenant, but those that could not give us a good sign in a positive direction, we kind of took the conservative approach and wrote them out of the plan. I think as we look at -- I think there's probably a 10-percentage point upside to the 55% if we can kind of convert everybody in that unknown category, but we do have several tenants -- more than several -- that have definitively told us they're moving out. And that's the lion's share of the 45% not renewing.

But the 55% you're highly confident in and then if things work out well, you could --

Yes.

-- possibly move that up [10]? Okay. And then just lastly, sales -- I think you have 14 million slated for discontinued ops, that Austin property, but I think Howard, if I heard you correctly, the expectations for Q4 are 34 million of dispositions. What's the additional 20 and how confident are you of getting that done?

We have several other properties in advance discussions, did not meet the criteria of held for sale, and candidly, to be conservative, from a revenue perspective, we assumed those sales would close. Other than that 20, we don't have any near-term sales, so the balance of our sales activity is more mid-2011 to the latter part of the year in terms of timing. So we'll have to just watch and see if that 20 happens, but we have assumed for the time being that it will happen.

Okay, great. Thank you.

Your next question comes from the line of John Stewart with Green Street Advisors.

Thank you. Howard, just following up on the disposition activity for next year, what is the projected cap rate?

In the modeling, we've assumed up to a 10% cap rate. It's kind of got a 40% calendar year weighting on the 80 million, so that, I mean, mathematically is about 3.2 million of gross NOI. We just wanted to thank you for getting up early this morning and joining us on the call.

That's all right. Thank you. And how about -- likewise, sticking with the guidance, how about same-store NOI and the mark-to-market on a cash basis for next year?

Same-store NOI, between cash and GAAP, they're not going to be terribly different based on our forward modeling, so the 5 to 7% range covers them, and probably a 5 to 10% range covers GAAP, but it's typically been better, as well as cash. Rental rates unfortunately are still down.

Okay. And George, can you give us any color on the known moveouts in DC?

Yes. I mean, we've got several -- well, two that are going to happen in January. One is Computer Associates who currently occupies 230,000 square feet with us. They are going to renew, but only in 67,000 square feet. And then the other one occurring in January is with Verizon currently in 180,000 square feet and they're going to give us back half of the square footage and extend the other half for 10 years. So, I mean, some of the other ones that we have are just again some more of the larger tenants who are moving back to corporate-owned facilities, who are kind of just right-sizing their space based on utilization.

Okay. Thank you.

Your next question comes from the line of Anthony Paolone with JPMorgan.

Thanks. Yes, Jerry, you mentioned at occupancies of these levels, there's not a lot of pricing power and you still have rent roll downs in the portfolio. So I'm just wondering, can you give us a sense as to what the recovery in your markets needs to look like, so that if we roll forward a couple of years, we're still not looking at same-store comps being negative?

Yes, a great question, Tony. Look, I think it's hard for us to really project with certainty what we see happening over the next couple of years in terms of total velocity. What we have done though -- if you take a look at all of our core markets, the interesting thing, it really is a bifurcation of the market. So for example, when we refer to the Crescent markets in Philadelphia, suburbs or Radnor, Plymouth Meeting, Conshohocken, those sub-markets for the class of inventory is -- vacancy rates are well below 10%. We are seeing very good activity and the ability to frankly move rents up.

Our properties in CBD Philadelphia fit in that same category and there's a few other spot markets around the Company where we're actually having some fairly good leasing velocity, generally in those sub-markets, along with some positive absorption, albeit at levels well below long-term averages. Other markets, particularly as we look at our portfolio in southern and central New Jersey and Wilmington, so I guess it's about 13 or 14% of our rents, the vacancy rates there are at such a level -- they're in the 16 to 19% range. That's up about 300 to 400 basis points from where they were in year-end 2007, and those markets, for the most part, are still having negative absorption in 2010 where they've historically been positive.

So I think those markets will be slower to recover. I think the challenge we have in our portfolio is to really identify those areas where we can execute leasing activity on an accelerated basis and then be as aggressive as we need to be in some of those markets where we think it's going to be a slower [slide], but certainly I think we're encouraged with what we're seeing in some of our core markets. Very mindful of how slow it will be in the recovery into southern New Jersey or central Jersey or suburban Wilmington, southern 202.

But also when we take a look at our 2011 vacancy profile, while it's a bit disappointing to have the level of contractions that we're going to see in our Metro DC, the Toll Road Corridor, that is also a market where we're getting back very good space, either with good toll road signage or extraordinarily good physical [plant] and quality, with a good leasing team in place. And that is a market that can absorb space fairly quickly. In fact, that market will wind up having positive absorption this year. At least year-to-date, it's positive, but that level will be down well off of the 3.2 million square feet of absorption that market saw in 2007.

So I think we feel very good about both a mark-to-market uptick and a recovery at a faster pace in our northern Virginia portfolio. I think we'll continue to see good traction through our Crescent markets in the Pennsylvania suburbs in the Philadelphia CBD, and I think we're prepared for and have reflected in our business plan, a slower recovery in the other sub-markets where we have product.

Okay. Thank you.

(Operator Instructions). Your next question comes from the line of Dave Rogers with RBC Capital.

Hey, good morning. Jerry, with respect to the tenants looking for space in the Philadelphia CBD, a number might be looking for build-to-suits or have the option to have a building built for them. So can you kind of talk about replacement costs in that market relative to your acquisition? If you did that earlier, I apologize. We were having some audio difficulties.

And then on the flip side of that argument, if you look at Metro DC, where obviously the capital flows have been strong and assets are for sale maybe above historical replacement costs, does anything in that Metro DC market, on the flip side to Philadelphia, suggest that maybe you should be a seller today if assets are trading maybe above where they should be? Any color would be appreciated. Thanks.

Dave, very good questions. On the first part, as we talked about -- when we announced the Three Logan transaction, certainly reinforced by our working in this market on different build-to-suit proposals, we anticipate that replacement costs for a high-quality building in Philadelphia is about $400 a square foot. Our purchase price here on Three Logan was $125 a square foot. We anticipate it will be around in -- or fully around 170 a foot before land, so when we talk about a fully loaded land value, we're probably in about 50%, or slightly below, from a replacement cost standpoint.

And frankly, while a number of tenants look at build-to-suits in this market, we frankly think the gap up in rents that's required today is probably in the final analysis a prohibitive jump for a number of companies looking at that. So while they may want emotionally to be in a brand new building that's built for them, I think pragmatically, when they assess their various options, they migrate back towards the existing stock.

The second question relative to Metro DC, it's certainly a topic that we have given a lot of thought to and have had a number of discussions on. Clearly, if we are being priced out of that market from a buying standpoint, and have certainly seen an amazing recovery of values in those markets, it certainly is something that -- in selling some of our properties, it's certainly something that we're evaluating. And I think our preferred method to do that would be to form a joint venture with -- some of these institutions are looking for a very solid operator and those institutions may have not had the ability to co-invest with us on future acquisition activity. But that is certainly something that's on Tom and his team's agenda and they're spending time working through.

In those discussions, either Tom or Jerry, how far along are you at this point? Is that contemplated in your '11 guidance or could that be added to the terms of asset sales?

Yes, we're -- we've got various stages of discussions taking place and they accelerate, they decelerate; they're on one day and on hold the next day, but to go the core of your question on 2011 guidance, we've not reflected in our 2011 guidance anything relative to new acquisition activity, the formation of joint ventures on existing portfolio properties, or any related equity issuances there too. It's a very benign investment program that we've built into our 2011 forecast. In fact, the only thing we really have built into our forecast for '11 is Howard and Tom had touched on the -- some sales in the $80 million range and kind of staging in the latter part of the year.

Okay. Thank you.

You're welcome.

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

The only closing remark is thank you all very much for your participation on the call today and we look forward to updating you on our forthcoming activities on our next call in the first quarter. Thank you very much.

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