Brandywine Realty Trust (BDN) 2011 Q2 法說會逐字稿

Good morning, my name is Latanji, and I will be your conference operator today. At this time, I would like to welcome everyone to the Brandywine Realty Trust Second 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) I would now like to turn the conference over to Mr. Gerry Sweeney, President and CEO of Brandywine Realty Trust. Please go ahead, sir.

Latanji, thank you very much. Good morning, everyone, and thank you for participating in our Second Quarter 2011 Earnings Call. On today's call with me are Gabe Mainardi, our Vice President and Chief Accounting Officer; George Johnstone, Senior Vice President of Operations; Howard Sipzner, our Executive Vice President and Chief Financial Officer; and Tom Wirth, our Executive Vice President of Portfolio Management and Investments.

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 the Federal Securities Law. Although we believe the estimates reflected in these statements are based on reasonable assumptions, we cannot give assurances that the anticipated results will be achieved.

For further information on factors that could impact our anticipated results, please reference our press releases as well as our most recent annual and quarterly reports filed with the SEC.

Moving into the presentation, our actual results are progressing well ahead of our 2011 business plan, and we are very pleased to report solid progress during the second quarter. Market conditions range from stable to improving, and we continue to see strong tenant activity levels.

Certainly, the return of strong real estate fundamentals generally is subject to macroeconomic events such as the federal deficit, the divide on public policy, which appears to be ongoing, state and municipal budgetary constraints, and private sector employment growth.

Essentially, however, we continue to see a steady recovery. This recovery, coupled with our tactic of aggressively pursuing occupancy has created a solid platform for Brandywine to exceed our original 2011 business forecast.

We will continue this market-driven leasing strategy, and this approach will vary by sub-market. In some, we have been pushing rents and in others we will continue to buy occupancy. In those weaker sub-markets, we will continue this aggressive approach until those markets return to historic activity levels. We also continue to see a flight up the quality curve that has greatly benefited our portfolio.

Some observations on our second quarter leasing, balance sheet management and investment efforts -- attacking leasing first. On the leasing front, we posted another very strong quarter. There is no single bigger contributor to our growth profile than simply leasing up our existing space. As evidenced by our second quarter results, we are making strong progress, and leasing production remains our primary focus.

We had our third consecutive quarter of leasing activity in excess of 1 million square feet. Additionally, our 65% tenant retention rate for the quarter was significantly ahead of plan, and as a result we are projecting a 2011 retention rate of 60% versus 55% in our original plan.

The strength of this leasing production has resulted in the following positive adjustments to our key metrics. We are increasing our projected 2011 core occupancy percentage at year-end to be 86.6%, a 90 basis-point improvement over our projection last quarter, and 100 basis-point improvement over our year-end 2011 levels.

We have moved our speculative revenue target up 6.2% to $34.4 million, and we are 94% executed on that plan component. Our same-store has improved from our original forecast and from last quarter. We are now projecting a same-store GAAP NOI decline of 3% to 4% versus our originally forecasted 4% to 6% and a cash-based decline of 4.5% to 5.5% versus 5% to 7% previously forecasted.

Capital costs are up quarter-over-quarter. George will outline the detail in a few minutes, but note that we had accelerated leasing activity, and while doing so have increased the average length of our lease by about 20%. We are up to 5.4 years on average versus our 2011 business plan. More importantly, we're up 35% from the 4.0 year average lease term that we experienced in 2010.

For leases commencing in Q2, the average lease term was 6.5 years. Additionally, as George will outline, the size of our four leasing commencements has necessitated the early paying of commissions on leases that will not commence for a number of quarters.

We continue to make progress on managing rental rate declines even as we are aggressively pursuing tenants. Our GAAP rental rate decline has remained at 1.5% to 3%, which is in line with last quarter but a significant improvement over earlier projections. On a cash basis, we continue to anticipate a range of between 6% to 8%, which has tightened a bit from last quarter, and the upper limit is down from the 10% we originally forecast.

Increasing market share remains a major objective, and on that front the plan also continues to progress well. By way of example, in Southern New Jersey, we experienced a 51% increase in activity, Q2 over Q1, but, more importantly, our leasing teams did 36% of all the deals in the marketplace compared to our 19% ownership stake.

In the Pennsylvania suburbs, we had similar results where we captured 58% of the market share for leasing activity versus a 14% ownership stake. So the overriding goal remains to seal deals, be aggressive where we need to be, and execute as many transactions as we can.

We are currently 88.7% leased, which is significantly ahead of our target. We are maintaining about a 200 basis point spread in our leased versus occupied percentage. Our 2011 business plan anticipates that we will hold this 88% to 89% leasing level through year-end.

So, all in all, a nicely improving picture on the leasing front, and we are seeing solid rental rate growth in several of our markets. We also made good progress on expense control and improved our operating margins to the best level in the last six quarters.

As a result of our leasing success and expense management programs, we have increased our FFO guidance range for the year to $1.32 to $1.36 a share. This is an improvement over our previous range of $1.27 to $1.32 per share. Given a high level of plan execution, we believe this range is readily achievable.

Looking at our balance sheet, an investment grade rating coupled with continued leverage reduction and maturity management programs remain key objectives. As you know, we recently completed a $325 million bond transaction. During the quarter, we used those net proceeds primarily to reduce our 331 line of credit balance from $197 million to $42 million and pay off $115 million in various secured mortgages on several of our properties.

These payoffs were part of our longstanding plan to reduce property level debt to provide us more investment flexibility and to increase the strength and financial metrics of our unencumbered pool. We also used excess liquidity during the quarter to repurchase $21.5 million of our 2012 notes and $1.4 million of our 2015 notes via open market transactions.

We continue to monitor the debt markets with an eye towards reassessing them as the need arises. Our primary attention, however, is on our investment program, which has the potential to generate additional liquidity and reduce our need to re-access the debt market near term.

We are also engaged with the bank market as we assess the process and timing of redoing our line of credit and our $183 million term loan, both of which mature in mid-2012. That market has continued to improve, particularly relative to spreads, cap rates, and related covenants.

Looking at investments, we had a quiet quarter but a lot of work is in process. Our 2011 business plan contemplates $80 million of dispositions weighted towards the second half of the year. As such, year-to-date, we have only sold one property, Three Greentree Center, a 13% occupied 70,000 square foot building in Marlton, New Jersey, for gross proceeds of slightly less than $6 million and realized a $3.8 million gain on the sale.

Looking at the balance of 2011, we would expect the following -- we are in the market with a variety of properties undertaking price discovery to meet and possibly exceed our $80 million disposition target. The properties on the market range from single assets to small portfolios. They are assets that we have deemed to be noncore from either a locational, future NOI growth or capital consumption standpoint. We expect to provide more visibility on these efforts on our third quarter call. The properties currently being targeted for sale, are primarily in New Jersey, Pennsylvania, and Virginia.

We have also made good progress in our joint venture effort on several properties in Northern Virginia. That offering memorandum was circulated during the second quarter. We have already received solid indications of interest and are in discussions with several institutional partners. We expect to advance those discussions over the next 60 days. As previously outlined, this venture will consist of us contributing several assets, receiving a forward equity commitment from our venture partner that would enable us to form a discrete co-investment vehicle targeting assets inside the Beltway.

The total value of the initial property contribution could be between $150 million to $175 million with a potential for an equity commitment between $75 million and $100 million. We expect to report an attractive cap rate of price per square foot and a Brandywine ownership stake between 25% and 50%.

Overall, we are pleased with the response and look forward to providing more clarity on our next call. This venture, if it proceeds, would expect to close by year-end and is not factored into our 2011 business plan as we anticipate the effect on 2000 earnings to be minimal.

As we all well know, the investment market remains bifurcated. We are beginning to see some select opportunities in some markets outside of DC that, based on yield, value-added characteristics and price per square foot may present interesting opportunities for Brandywine. While we do not have any additional acquisitions built into our 2011 plan, we do continue to seek and underwrite quality value-added additions to our portfolio. Those investments, if they occur, would be financed primarily through either redeployment of sale proceeds or an equity basis to further improve our balance sheet metrics.

At this point, I'll turn the presentation over to George. He will provide color on our second quarter operational performance. George will then turn it over to Howard for a financial review of the second quarter. George?

Thank you, Gerry. Leasing activity for the quarter was strong with positive net absorption of 138,000 square feet and continued progress on the business plan. During the quarter, we commenced 1.1 million square feet of leases including 614,000 square feet of new leases and tenant expansions. We had 120,000 square feet of contractions by tenants who did renew a portion of their space, 58,000 square feet of which related to computer associates in our Northern Virginia portfolio as discussed on previous calls.

An additional 230,000 square feet of tenancy simply vacated at the end of their lease term due to office closures and company downsizings, relocations to other sub-markets, and a few who purchased their own buildings.

In terms of early terminations for the quarter, 80,000 square feet were negotiated to accommodate existing tenant expansion, the remaining 45,000 square feet were the result of bankruptcies and evictions.

Traffic for the quarter was up 9.4% over last year with all but Metro DC and California posting increased levels of inspections. Despite inspections being down over last quarter, the pipeline remains strong at 3.7 million square feet -- 3.2 million of new deals, and 528,000 square feet of renewal deals. We currently have 521,000 square feet of deals and lease negotiations with the balance all entertaining proposals.

In order to achieve the open leasing assumptions in our plan, for new leases, we need to convert 12% of today's active pipeline. Our conversion rate during the first half of 2011 was 39%. So we are very confident of achieving our revised forecast.

Several of our core markets continue to perform well, and we are seeing the ability to push rents and lease term. To illustrate, Conshohocken is 100% leased and GAAP rents on leases commencing in 2011 are up 8.4%. Radner is now 97% leased with GAAP rent growth of 6.3%. Philadelphia CBD is now 94.9% leased with GAAP rent growth of 4.9%.

For the balance of 2011, we expect the Pennsylvania suburbs, Philadelphia CBD, Richmond and Austin will continue to perform well. We face challenges in both our New Jersey operations and Dulles Toll Road Corridor until the market recovery is complete. But we are pleased with the levels of activity in both of these markets.

Our regional teams remained focused on operating expense control. While snow removal accounts for a majority of the decline in operating expenses from first quarter, our energy procurement and conservation efforts along with aggressively rebidding service contracts has contributed to improving our operating margin.

Lastly, a comment on capital expenditures. We report capital costs for CAD in the quarter in which they are paid, which is not necessarily the quarter in which the lease commences. As we continue to achieve higher levels of forward leasing, you can expect this mismatching of capital and lease commencements to continue.

This quarter we had $22.5 million of revenue-maintaining capital, which was clearly one of our highest to date. To illustrate, the $22.5 million we reported this quarter included $8.6 million of capital on leases that commenced prior to the second quarter, $8.5 million of capital on leases that commenced in the second quarter, and $5.4 million of capital associated with leases that will commence in subsequent quarters.

This completes the operational overview, and I will now turn it over to Howard for a financial review.

George, Gerry, thank you. For the second quarter of 2011, we reported FFO available to common shares and units of $47.5 million. At $0.32 per diluted share, we exceeded analyst consensus by $0.01 per share. It's once again a high-quality FFO figure in that second quarter termination revenue, other income, management fees, interest income, and JV income totaled just $6.8 million gross, or $5.3 million after management expenses in line with our 2011 guidance range for these items.

The FFO payout ratio in the second quarter of 2011 came in at 46.9% on the $0.15 dividend we paid in April 2011.

A few observations on the components of our second quarter performance. Cash rent of $114.3 million was up $5.4 million versus second quarter of 2010. Straight line rent of $4.7 million was up $2.2 million versus second quarter 2010, and is flat sequentially versus the first quarter of 2011. The quarter-over-quarter increases are primarily attributable to the post office and garage completions and the Three Logan acquisition in the third quarter of 2010 as well as the Overlook acquisition in the first quarter of 2011.

Recovery income of $19 million, and our recovery ratio of 34.4% reflected typical expense and expense recovery conditions and are in line with our expectations. Property operating expenses were down $5.4 million sequentially, due to snow costs in Q1 2011, as George mentioned, while real estate taxes were flat sequentially.

Interest expense of $34.7 million increased $2.3 million sequentially due to the closing of our $325 million unsecured issuance on April 5th and lower floating rate balances in the current quarter. G&A at $5.9 million was in line with our expectations for this item.

In the second quarter of 2011, we had net bad debt expense of $322,000, in line with expectations and reflecting a combination of writeoffs, recoveries, and adjustments to reserves. The net effect in the second quarter was about $135,000 decrease in our overall reserve balance.

For the quarter, same-store NOI declined 4.7% on a GAAP basis, and 6.9% on a cash basis, both excluding termination fees and other income items and in line with our expectations.

EBITDA coverage ratios are solid and consistent at 2.4 times interest, 2.2 times debt service, and 2.1 times fixed charge coverages. And the emphasis on these is an important part of our ratings upgrade strategy. Our margins are very strong and are above recent levels despite the vacancy levels at 61.1% for NOI, the 34.4% for recoveries, and 62% on our EBITDA margin.

As a result, and as Gerry outlined, we are increasing our previously issued 2011 guidance of $1.27 to $1.34 per share by $0.035 at the midpoint to now be in a range of $1.32 to $1.36. With our $0.65 per share six-month result, this translates to a quarterly rate of $0.30 to $0.32 for the balance of the year once you exclude the $0.08 of gross historic tax credit, transaction impact we'll recognize in the third quarter.

Portfolio metrics and assumptions, as George and Gerry both noted, are equivalent or better than we've previously guided to on a combination of cash and GAAP rental rents, year-end occupancy, retention and overall leasing. And these are a factor in our guidance upgrade.

We are continuing to project $20 million to $25 million of gross other income items or about $13 million to $18 million net resulting in, again, a very high-quality FFO for 2011. These figures, at the midpoint, are about $0.05 per share, or $6.8 million below the figures we reported for these items in 2010. We are continuing to expect G&A at about $6 million per quarter.

Interest expense for the year should come in between $133 million and $136 million, down from the prior figure of $136 million to $140 million due to accelerated loan repayments during and just after Q2 2011. Please note that we will accelerate an expense about $800,000 of deferred costs in the third quarter due to the One Logan Square mortgage loan repayment, and this is, of course, included in our guidance.

We see about $75 million of additional 2011 sales activity at up to a 10% cap rate, but it will be weighted heavily towards year-end for an expected gross NOI reduction of only about $1.8 million in the balance of this year.

As I mentioned earlier, the historic tax credit impact should appear to be about $0.08 per share on a gross basis in the third quarter of 2011. For the full year, this is offset by about $0.01 of interest expense that's been running through our interest expense line item and has been phasing in quarterly for the past six months and will continue to do so. The revenue component is essentially noncash and will be excluded for our CAD calculation. It reflects the annual impact of 20% of the proceeds realized in connection with the historic tax credit financing, and this will be recognized in the third quarter of each of the next five years -- 2011 through 2015. We are not assuming any additional issuance under our continuous equity program, and no additional unsecured note buyback activity. And we're running our modeling at 147 million shares for FFO in 2011 versus 139 million in 2010.

The overall impact of higher capital expenditures both on a current and forward basis is reducing our estimate for CAD per diluted share to be between $0.58 and $0.64 for the year, reflecting approximately $20 million of revenue-maintaining capital expenditures per quarter for the balance of the year.

Our 2011 capital plan for the balance of the year is actually quite simple and easy to achieve. We have total capital needs of $279 million over the last six months of 2011 including the $60 million we used earlier this month for the One Logan Square payoff. This comprises $71 million of investment activity, about up to $44 million of revenue-maintaining CapEx, $21 million for other capital expenditures, and $6 million of a potential investment in our commerce JV.

We see $160 million of debt repayments, $60 million we already disbursed for One Logan, $60 million for an expected early redemption of our remaining exchangeable notes, and $40 million for assorted mortgage repayments and amortization, and we expect to pay at current levels $48 million of aggregate dividends on our common and preferred shares.

To raise this $279 million, we are projecting the following -- $85 million to $90 million of cash flow before financings and investments, $2 million of remaining HDC proceeds bringing the ultimate funding to $64 million, the $75 million of additional sales, and $113 million of borrowing under our unsecured credit facility with a projected year-end balance of about $155 million.

On accounts receivables, our total reserves at June 30, 2011, were $15.1 million, $3.5 million on $17.7 million of operating or other receivables or about a 20% coverage ratio, and $11.6 million on $114.8 million of straight line rent receivables -- about a 10% ratio. Neither of these categories experienced any particular changes in this quarter.

Our balance sheet and credit metrics remain extremely strong. We have 57.7% debt to total market cap, and a 44.9% debt to gross real estate cost. Most importantly, the various financings and repayments we undertook in the second and now third quarter continue to improve our balance sheet from an unsecured basis. Our secured debt is only 10.7% of total gross assets, and our floating rate debt is just 14.7% of our debt.

Our leverage levels are in line with recent quarters, and our mix of secured, unsecured, and floating fixed reflects our commitment to overall credit quality and an improved rating. Our $600 million line was $42 million drawn on June 30, 2011. Following the July 11th prepayment of the One Logan loan and other assorted activity, our credit facility balance now stands at $113 million with close to $500 million of availability.

We are 100% compliant in all our credit facilities and indenture covenants and are extremely pleased with the second quarter performance. Now back to Gerry for some additional comments.

Great. Thank you very much, Howard, and thank you, George. The second quarter was a very good one for us. We exceeded our leasing targets, posted over 1 million square feet of leasing activity for the third quarter in a row, lengthened our lease terms, reduced the negative spreads in our mark-to-market and same-store forecast, and produced good expense management.

Moving our year-end targeted occupancy level up 90 basis points reflects our high level of production. That stat, combined with our continued strong pipeline, as George outlined, clearly indicates that we are well on the path to continued occupancy improvement.

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

(Operator Instructions) Jordan Sadler, KeyBanc Capital.

I wanted to get a little bit of clarification on the leasing guidance update. The incremental $2 million spec revenue, which is up from last quarter's guidance is now 94% complete. So I'm just curious -- based on your historical hit ratio of -- or close ratio of 39% in the pipeline, which is materially better than you're projecting for the back half, are you still being pretty conservative here on the spec revenue? And if you were to hit the 39% close ratio on that pipeline that you've got under negotiations, what would the spec revenue number be then?

George, why don't you take that?

Yes, sure. I don't think that we're conservative at this point. A couple of observations -- one, the window of contribution towards 2011 is closing. So, one, we would have to get that pipeline converted, negotiate a lease, build out the space. So we're really looking at, for the most part, a fourth quarter and potentially a late fourth quarter commencement to drive that spec target up even further.

The $2 million that we increased it this most recent re-forecast, most of that revenue will be recognized over the second half of the year.

Okay, that's helpful. And then just as a follow-up, you disclosed that there's 731,000 feet of executed leases that are scheduled to commence. Can you give us a little bit of color on the timing and maybe the average rent on that pipeline?

I think our most recent press release addressed some of that, and that we had 97,000 square feet of new deals commencing after 2011. Not included in that press release but in our subsequent press release was the 146,000 square feet with Janney. But the Janney lease is in the 731 of forward leasing at the end of this quarter.

We've got 197,000 square feet commencing in the third quarter, 284,000 square feet of new deals commencing in the fourth quarter.

(cross talk)

Yes, I don't have the average rental rates, but I think, as we outlined in some of our sub-markets and even with the trends we saw in the second quarter, we are seeing that -- on our new leases, we are starting to see a positive mark-to-market on the GAAP rent.

My last one is just on the Janney deal closing. Where are we relative to original underwriting on Three Logan, Gerry? And maybe can you just talk about the prospects?

Jordan, we're in very good shape relative to the original underwriting. We have, right now, after the Janney lease execution, roughly, 200,000 square feet of current vacancy. We have about 1 million-plus square feet of active prospects for that. About 800,000 of that million is larger users with the balance being small users that range in size from 5,000 to 25,000 square feet.

So we're in very good shape from that standpoint. We also, as you know, there's a component of that building that has leases -- is in there on leases that expire midyear 2012, and that's about another 250,000 square feet or so. So a lot of that leasing pipeline is also directed towards that forward roll. The leases that we've executed and the leases that we are in discussions with all have economics that are very much in line with our original pro forma.

Jamie Feldman, Bank of America.

I was hoping you could talk -- it sounds like you're pretty comfortable with the way the back half of 2011 is going to shape up. Can you talk a little bit about your expirations in 2012 and where you think there's risk? And then along those lines, if you could talk about your different regions. What's the different sentiment given everything we're seeing on the economic side?

Sure. We've not provided 2012 guidance, and we don't expect to do so until later this year. But we are at the early stages of our 2012 budget and re-forecasting process, so we are in the middle of trying to ascertain the renewal probabilities of tenants who are up for 2012 renewals. So that process is still underway. We can certainly provide better clarity on that later in the year.

In terms of overall sentiment, I think we're seeing that sentiment reflected in some of the numbers that George had outlined earlier. Generally, the sentiment, apparent that we're absent the dialog on the federal deficit of the last couple of weeks has generally progressed to be more positive. But the pipeline of deals has remained very encouraging. We're at 3.7 million square feet. Our [error] expectations of tenants -- the square feet that comprise that pipeline is real. Tenants looking for requirements not just price-checking for stay puts as it was some time ago.

So both the velocity and the intent of a lot of that tenant activity is biased towards moving up the quality curve and seeking to go longer in terms of the length of leases. So a fairly good prescription, we think, for the next couple of quarters in meeting our upward leasing trajectory and continuing to improve our occupancies.

We have a number of tenants who are clearly up in 2012. Again, the focus right now is for us to really ascertain what their probability of renewal is. Some we know are going to stay, some we know are going to leave. The vast majority are still in the middle of not having provided us with any clear clarity. And, as a consequence, we really can't provide a lot of detail on that.

Thanks. If I could ask another way, if you think about Northern Virginia versus Philadelphia versus Texas, which do you feel you are most concerned about what's happening in the government, and which have the best job growth prospects? It sounds like everyone is trading up, but I'm trying to get a sense of which have real long-term demand growth prospects here.

Well, I think the sentiment that we're seeing does vary by those regions. Look, Philadelphia suburbs particularly are crescent markets, as we call them -- continue to perform very well. Sentiment is very positive. That's reflected in the high levels of absorption as well as the upward pressure on rents.

Philadelphia CBD in the trophy class inventory we're in, we believe continues to have a very positive bias. We've been very pleased with the level of activity generally in the Austin, Texas, market, and the ability of our team to maintain very high levels of occupancy and upward rental pressure.

Richmond has performed well and in line with our plan this year. Things have slowed there a bit, but we continue to be very much on track for our 2011 business plan. Circling in on the metro DC, activity levels are down quarter-over-quarter. There is clearly a pause in that marketplace by both federal agencies but, more importantly, private sector employers who rely on the government in terms of committing to large blocks of space. And we would expect that that situation would stay in place until there's a lot more clarity on the federal spending programs.

We were very pleased to announce the other day a major lease that moves in a very seamless space with a vacancy we knew we had coming up in 2012. So our team continues to do a very good job down there. The pipeline, while not as robust as some of our other markets, certainly has some large users in that queue, and if we're successful in negotiating transaction with them could change the profile and the trajectory of our occupancy ramp up in that market considerably.

Okay. And then when you talk to your tenants in the DC area, are they concerned that leases will get signed or are they just concerned that it's going to be on hold for a while? There's a real concern about downsizing actually making the demand go away?

It depends on what the headline in the paper is that day. But I think the reality is there is the primary sentiment we're having reported back to us is that it's on hold. The demand will remain there. The demand may be more muted than original expectations based upon how this federal spending program works its way through the system. But that is a market that has historically generated fairly decent job growth in a broad base. So, long term, we believe the prospects for that market are solid. But it would be unrealistic for us to be overly aggressive in assuming accelerated absorption there until there is a lot clearer picture on the federal spending programs.

Brendan Maiorana, Wells Fargo Securities.

A question on the leasing strategy -- is the -- I guess I'll just put it in the term of buying occupancy, which you guys are doing in moving the occupancy up pretty nicely, but the CapEx costs are relatively high. Is that driven more by your portfolio level occupancy or is that something where if your markets start to firm up a little bit, you'll back off, kind of being aggressive in terms of getting those tenants in? And if it is more portfolio-driven specific to Brandywine, what kind of level do you think you need to get to before you may be a little bit less aggressive on the concession levels?

A very good question. I think the overall strategy has always been driven by your latter point of emphasis, which is it's very much focused on how we're reading the markets. And the best examples we have in our portfolio is what we've seen, frankly, with our sub-market concentrations in New Town Square, Radner, Conshohocken, Plymouth, to some degree, where those markets were, 18 months ago, kind of where New Jersey and Delaware and a couple of other sub-markets are today, where we were very aggressive in attracting absorption to the portfolio, paid for it, but the market tightened up significantly, so now we are in a position of dramatically exceeding our occupancy standards in those markets.

New Jersey, Delaware may be slower to recover, but I think, as we're reading the tea leaves there, the overall objective tactically is to gather a significant amount of market share in a market where we own about 20% of the inventory. So the mantra to our leasing team is to generate tremendous activity, both directly and through the brokerage community, fully vet every prospect, analyze each deal as economics both from an absolute and from a relative standpoint, and then to the extent we think it's a fair transaction, move forward and absorb that occupancy. Cover our [sunk] cost, minimize our capital cost to the extent we can, and lengthen our lease terms. And we are fully confident that every market we're in, that as the suburban market recovers to where it was a number of years ago, we will return to a 70% to 80% average annual retention rate. So, certainly, we have a high degree of expectation, and some of those tenants we're bringing to the portfolio today we'll be able to retain when their leases come up for renewal.

Thanks, that's helpful. And then just in terms of the net investment activity, or the disposition source of new investments -- if you sell $80 million of noncore assets, and then it sounds like proceeds from the JV could be, I guess, around $120 million or so, you're selling 75% of that, where do you think you reinvest that? Is this just a paydown of debt or are there investment opportunities that are available?

I think it would be a combination of both, Brendan. And it's to be determined based upon the velocity of those dollars we get in the door. As Tom can touch on, we continue to look at a variety of good quality acquisitions. And we certainly want to continue that effort. But we also very much have priority focus on continuing to improve the balance sheet as well.

So I think with those two possible uses of proceeds, we'll make a game-time decision based upon the timing and the size of the proceeds we actually realize. One of the interesting things about our investment efforts now, as we touched on, we're very much doing a lot of price discovery across the board to try and find what the depth of the investment market is right now in some of our sub-markets.

And just a follow-up quickly -- has there been any movement on the land parcel that you guys have at 20th and Market downtown? Because you did mention that you're seeing pretty good activity in the CBD market in Philly. Any potential that you guys could do something there?

There's certainly a lot of potential on what we can do there. We are undergoing right now the planning process for mixed-use development; talking to a variety of other development companies and financing sources to pull together an overall development program that we would anticipate starting the formal approval process on that site sometime in early 2012.

Dave Rodgers, RBC Capital Markets.

Good morning, Gerry, Howard. A question on, I guess, your decision to raise the guidance perhaps relative to taking down leverage a little bit more during the second half of the year. Can you just give us some thoughts around, maybe, I guess, the hinge points to your decision-making around that? And I guess if timing is the big answer for the second half of this year, maybe what we can think about as key points for moving into next year from a de-leveraging versus earnings performance perspective.

Well, Dave, good morning, it's Howard. The guidance increase really flows almost directly from a combination of our performance on the plan, some slightly higher retention, a little bit more lease activity coupled with the net result of all the balance sheet transactions and aggressively paying down debt where we could.

But, having said that, I will point out that that paydown of debt is not a leverage reduction, it's really just a substitution of one type of debt for another. So what we've found out is we were able to put the $325 million that we raised early to work ultimately in a better way than we might have initially expected. We paid off a number of mortgages, brought down some forward maturities and, in general, just put the balance sheet in better shape.

On a go-forward basis, to the extent some of the disposition activity and the JV activity that Tom is involved in produces call it a "surplus of proceeds." To address the earlier question, we would then have the opportunity to look at those dollars and say do we use the proceeds to bring down overall leverage levels? Is that the best use of capital? Or do we have investment opportunities that would, in effect, be more accretive than eliminating that debt. No way to know that at this point, but that would be the decision process we'd go through.

It's really part of a matrix you look at in terms of a key driver in our overall leverage program is obviously to generate more EBITDA, as that's the most powerful driver in terms of improving all of our financial metrics. We overlay that strategy with the points Howard touched on, which is really a point in time evaluation of the best use of proceeds. The overall objective of this company, as we talked about, is to put ourselves in a position for that investment ratings upgrade. So we understand that's going to involve operating performance improvement, effective capital deployment and recycling, as well as overall leverage reduction.

John Guinee, Stifel.

Hi, guys, nice quarter. Congratulations. Drill down a little bit, Gerry or George. Basically you've got a 25 million square foot portfolio. You have 3 million square feet that comes with lease expiry every year. At a 60% tenant retention you get 1.8 million you can renew, which means you lease about 1.2 million square feet every year new to break even on occupancy. And then you take it one step further, each occupancy point is about 250,000 square feet for you guys.

So to get from, say, 86% to 92% occupancy is a gain of about 1.5 million square feet above the annual 1.2 million square feet of new leasing. Is this a one-year process or a three-year process or a five-year process to get up to stabilization?

John, it's a great question. We're focused on making that timeframe as compressed as possible. And, look, this portfolio always ran in that 92% to 94% range. Clearly, it's been subject the last few years to a much higher level of tenant vacations and downsizings. As we've talked on previous calls, we think the vast bulk of that is behind us.

Our pipeline is returning to historically high levels of activity, primarily for new leasing activity. And that our conversion rate on that pipeline has improved over where it historically has been, as George touched on, just shy of 40%.

It's a very hard question to answer. I will tell you, it won't be a year, and we're determined not to make it five years. So given the three options, without the absence of making a formal forecast, it probably would be three years. But the reality is that we are exercising every effort we can in the company to both absorb space and dovetail that leasing campaign with our investment program to move from the portfolio assets that we believe will not be effective rent contributors from either an NOI or a capital consumption standpoint.

John, it's Howard. I just want to add one point on that -- if you look at page 29 of our supplemental package, you'll see that you may have overstated the 3 million square feet per year. First of all, it tends to be lower in some years, and maybe, more importantly, we've done a lot of blending and extending the past couple of years to take down those forward maturities and put away longer-term occupancy.

So when you go through the math, as I'm sure you'll do, you'll see we don't need quite that $1.2 million to stay even, and it will be less, number one. And, number two, with an expected higher retention rate, it will be that much less even more. So the numbers are going to start working more in our favor just on an overall basis as we move forward.

Thanks, Howard. And we'd also handicap where we have that vacancy. So if you take a look at the big blocks of vacancy we have in our company right now, Three Logan remains a nice piece of upside for us, as we execute some of these additional leases. We have been occupancy-impacted in DC, but, as you well know, that's a marketplace that has the ability to absorb a lot of space in a fairly short period of time. We think we have good inventory to present to the marketplace.

And in New Jersey, we're going to rely on the higher-end quality of our portfolio versus a competitive set to get that portfolio back to its historic 93% to 95% leasing levels.

Michael Bilerman, Citi.

Hi, thanks, it's Josh Attie with Michael. In any of your markets, are you seeing positive absorption on a marketwide basis? And can you talk about how rent economics on a marketwide basis are trending?

Yes, we're certainly seeing decent levels of activity. On an absorption basis, we are seeing positive absorption that we've seen in the CBD Philadelphia, in Richmond, in the PA suburbs, in Austin where we've also seen some positive absorption. Now, all those absorption numbers, though, Josh, are well below the 10-year historical average.

Richmond, Q2, there was about 40,000 square feet of absorption versus an historic 10-year average of about 167,000 square feet. So the absorption numbers are kind of working their way back, and that's certainly a real benchmark that we look at in terms of our ability to move rents. In terms of our ability to absorb space, we are very keen on the activity levels that we see in the various markets. And those numbers continue to be fairly good with very few exceptions.

Certainly, the activity levels in the metro DC market in the second quarter were down. But we also saw nice numbers of activity in the PA suburbs, CBD Philadelphia, Richmond, and, frankly, in several of the New Jersey markets as well.

And are rent economics starting to improve in those markets that are seeing positive absorption?

I don't think there's any question. I think, as George touched on, and maybe, George, you can amplify. We're seeing good rental rate increases on a GAAP basis and, in some cases, on a cash basis in some of those key sub-markets. I think George outlined several of them, but we probably have 10 or 15 other sub-markets that we're getting positive GAAP rents.

Now, we still have probably 15 where we're not getting positive GAAP rents. But that's certainly something that -- we're seeing that list of positive GAAP rent and sub-markets grow quarter-over-quarter, which is a good sign.

Right. Just for the second quarter we saw GAAP rent growth on new deals in our Pennsylvania suburbs of 7.5%; in metro DC, 11.8%; and on the new deals we commenced in New Jersey/Delaware for the quarter, we saw rent growth of 2.4%.

Thanks. And just one more question -- on external growth, can you just talk about what you're seeing in terms of acquisition and development opportunities so that as some of this cash comes back to you through asset sales in the DC joint venture, we could think about what the prospects are for putting that capital to work through investment as opposed to just debt re-paydown?

Sure, Tom?

Yes, talking about the investment activity, we have been seeing increases in some of our markets -- Austin, Washington, and Philadelphia. And in terms of what we're looking at -- the pricing in DC continues to be tight; still a deep pool of investors looking at assets inside the Beltway, the District. And even outside the Beltway on some occasions. And we still see prices being tight. We are, though, seeing maybe, because of the GSA maybe taking less space in the government point of view, you may see slower projections on rent growth when people are taking a look at investments in those markets. But other than a slower rent projection growth, where there are some people that were projecting spikes, that may be tempered a bit. And I think the mortgage market, relative to some of those investments is about the same as it's been -- very strong.

When it comes to looking at Austin, for example, we think that that market is showing some pickup. There's been a few transactions occurring in the Southwest and in the Northwest of some well-located assets. And we think there's a few more portfolios coming out on the market there.

In terms of what we're looking at, we have about 4 million square feet in our pipeline that we're looking at. About half of it is off-market transactions. And then as it relates to the joint venture, to the extent we have that done, and we have a forward equity commitment, we'll try to deploy that money in our targeted markets primarily inside the Beltway for Washington.

Rich Anderson, BMO Capital Markets.

The question is on the guidance of FFO going up a bit. But what does that say about -- if you were to issue guidance on an AFFO basis? Would that have been flat or down considering the use of CapEx to buy occupancy?

Well, Rich, it's Howard. Unfortunately, we did bring that down a little bit because the capital spend is higher. Now, as George alluded, some of that is forward-based. We're at one of the highest forward leasing spreads we've been in a long time -- close to 300 basis points. The brokerage commissions and some of the early spend of those end up showing up in our financial reporting before the actual leases commence.

So I think what you can expect to see over the next couple of quarters, as we continue to aggressively lease, is a little bit of an elevation in the capital we spend. But the expectation is, certainly, with longer leases that we're going to level that off and bring it back down. That, coupled with higher overall retention, which will be a natural byproduct of a stronger market, should create a lot of acceleration in our CAD or AFFO in -- call it 6, 12, 18 months, but a little bit far out to really know for sure. But that's the longer-term expectation of how it will play out.

Fair enough. And then just the follow-up question is on disposition. I guess kind of a twofold question on that. First of all, the $80 million -- to the extent you're able to do more than $80 million, do you anticipate that will have any impact on your guidance, or do you think it will be late in the year, so no real impact?

And the second is, the target for sale -- New Jersey, PA and Virginia. When I think of you guys, I'm kind of waiting for is for you to get back to your sweet spot and what you're really good at and that's the mid-Atlantic and really focusing on that. I'm curious as to why you don't have California and Austin included in that list of targeted markets for sale?

Let me take each question in order. Certainly, to the extent that we would have a disposition execution level that was greater than the $80 million, we do believe the timing of that would be so late in the year that the impact on 2011 numbers would be minimal. So I think that's pretty clear from just a timing standpoint.

On the broader question you touched on, I think, without being overly specific, we are undertaking -- and we've used the term "price discovery" twice now. We are undertaking price discovery on a whole variety of assets through the portfolio. And our expectation is that in the next 30 to 60 days, we'll be getting some feedback on a variety of properties, both single assets and small portfolios. We'll be able to make a determination on the optimal time to sell.

And certainly the California markets, as you touched on, are not viewed to be long term for us. We've talked about it on previous calls. So we continue to very actively monitor that marketplace from an investment standpoint to identify the right time for us to implement our program.

John Stewart, Green Street Advisors.

Gerry, I wonder if you can address, particularly given the slower rent projections that you mentioned investors are underwriting in DC. I know that you have said that you expect pricing to be tight and attractive, but are you seeing -- has it been impacted by the [pause] that you've described in DC, in terms of what you expect to realize on a JV?

Hi, John. No, I think that the pricing that we were expecting -- or circling -- is where we expect it to be. I was basically just referring to -- I think that as we talk to brokers and we see investments, I think that people may start to take a -- I think there were some -- if you look at a lot of the reports and where we thought underwriting was relative to some pricing, you heard a lot of talk about rent growth of 6%, 7%, 8% over the next several years and a lot of that being generated by demand both on the private and government side. And what we're just hearing a little bit more of besides not just this week but in the past month has been with the idea of the government maybe not taking as much space -- not shrinking but taking less. And, therefore, those growth rates that people are using to value some of the assets and get to the returns they're expecting, may be muted but still grow.

Can you put some brackets around what pricing you think you might achieve?

Actually, at this point, we're going to just give you the dollar range and hopefully being able to just talk about particular cap rates and prices per square foot on the next call.

Okay. Gerry, I wanted to get your -- I guess, take, first of all, in terms of whether there is a market for vacancy? I presume that where you are "buying" occupancy, you're really referencing some of the weaker markets where presumably you have noncore assets held for sale, and I wonder whether you're better off just taking the pain today and selling vacancy rather than trying to put in the capital and sell a leased up asset?

Look, John, I think the sale transaction I referenced earlier in the call is a perfect reflection of how we view it. That was an asset in Southern New Jersey, about 70,000 square feet. It was about 14% leased. When we did our sitting around the roundtable talking about the absorption pace, the effective rents, we'd realize the capital costs, we made a determination that it was better for us to sell that property in its vacant condition because the net present value of that sale from our standpoint, we ran a number of different financial scenarios, was better than the lease up and hold strategy. So that is an approach we are taking on every single asset we review as part of our portfolio management program.

Last year we did sell a number of significant under-leased properties. You know, frankly, for prices per square foot that (inaudible) were optimal, but they represented the best financial decision for the Company. So I would certainly expect, with this wave of assets that we're currently testing the market on, as well as any subsequent waves, we continue to follow that same discipline.

What would the total dollar volume be of everything that you're testing the market on?

We haven't disclosed that.

I realize that it's not all likely to hit, but just in broad brush terms.

Yes, broad brush terms -- I'll broad brush it really well. It's greater than the $80 million target we have in our plan.

Okay, lastly, for Howard -- Howard, you had referenced the rating agency upgrade strategy, and I wondered if you could share with us what specifically the agencies have communicated they are looking for from you and when you expect to get there?

Well, I think, number one, they never specifically communicate what the goal is, so it remains a bit elusive. But from conversations we continue to have and, more importantly, monitoring the peer group, what we think will do it for us is mostly on the debt-to-EBITDA side. And that gets improved primarily by lease up, improving EBITDA, but also at the margin if there is some excess sales activity, it could chip into the debt side of it.

So that becomes, really, a natural evolution of executing the business plan. In addition, I think it follows in suit from that would be somewhat better but not a great deal better coverage ratios than we have. I think our coverage ratios right now are probably between bottom investment grade, BBBs and mid-BBBs, or BAA3 and BAA2. So I think as we do that lease up, that's going to improve well through where we need to be. And that assumes that rates stay, plus or minus, 100 basis points around where they are. And we've been pleasantly surprised that where we've been able to execute fixed-rate financings thus far.

And your timeframe for best guess when you get there?

It becomes really an answer when we think we're going to hit those higher occupancy levels. I think we're encouraged by the turn in this current quarter. We still see some ups and downs over the next couple of quarters. But the strength of the forward plan, the strength of the regional teams, suggest that we could have some pretty good results going into 2012. And then begin to accelerate those conversations toward the end of next year.

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

Just to thank everyone for their participation, and we look forward to updating you on our next quarterly call. Thank you very much.

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