City Office REIT Inc (CIO) 2014 Q3 法說會逐字稿

Good afternoon and welcome to the City Office REIT third-quarter Inc. (sic) conference call. (Operator Instructions). Please note that this event is being recorded. I would now like to turn the conference over to Tony Maretic. Please go ahead.

Good morning. Before we begin I would like to direct you to our website at cityofficereit.com where you can download our third-quarter earnings press release and a supplemental information package.

Certain statements made today that are not in the present tense or that discuss the Company's expectations are forward-looking statements within the meaning of the federal security laws. Although the Company believes that these expectations reflected in such forward-looking statements are based upon reasonable assumptions, we can give no assurance that these expectations will be achieved.

Please see the forward-looking statements disclaimer in our third-quarter earnings press release for factors that could cause material differences between forward-looking statements and actual results. The earnings release and supplemental package both include a reconciliation of non-GAAP measures that will be discussed today to their most directly comparable GAAP financial measures. I will now turn the meeting over to Jamie Farrar our CEO.

Good morning and welcome to City Office REIT's third-quarter 2014 earnings call. With me today is Tony Maretic, our Chief Financial Officer, and Greg Tylee, our President and Chief Operating Officer.

For those of you who are joining for the first time I'd like to begin with a short overview of City Office and our strategy before we discuss the specifics of our third-quarter results.

City Office invests in high quality office properties in markets with strong economic fundamentals. We are focused on cities and properties in the south and west that are typically overlooked by larger public REITs and many institutional investors. Our objective is to provide our investors with stable and predictable cash flow growth as well as long-term capital appreciation.

Today we own eight office complexes comprising 20 buildings and 2.2 million square feet of net rentable area. Our properties are well located in highly desirable submarkets leased to a high percentage of credit tenants and are in good condition having underwent substantial capital improvements and are operated by leading local managers.

City Office's strategy is to concentrate on well located Class A and B buildings in both the downtown and select suburban locations that are amenity rich and transit oriented. Our focus is on properties with a high percentage of credit tenants and a stable rent roll. Our typical acquisition price is between $20 million and $50 million which we believe is a less competitive segment of the market and below the radar of many institutions.

In terms of financial metrics, our acquisitions typically are in the range of a 7% to 9% capitalization rate with upside as rental rates grow. Also they are generally acquired at a material discount to the property's replacement cost.

Since our IPO we've been focused on executing our business plan. We have closed two acquisitions in great locations totaling $54 million at just under an 8% average capitalization rate. We expect to close on an additional asset later this month which I will discuss in a moment.

Our properties are performing well. In place and committed occupancy has increased from 91.3% at December 31, 2013 to 93.1% at September 30, 2014. With our new acquisitions and higher occupancy levels our annualized base rent has increased by almost 25% since the end of 2013. Given our strong performance we initiated a dividend of $0.94 per share on an annualized basis paid quarterly.

In the coming quarters we intend to continue to create value for our stockholders by concentrating our efforts on leasing remaining vacancy, extending lease terms and sourcing and completing accretive acquisitions.

Before Tony takes us through our financial results I'd like to provide you with an update on a couple of our markets where we have some leasing expirations occurring at the end of 2015. Then I will focus on our portfolio performance, our acquisition program and capital market strategy.

A significant portion of our December 2015 lease expirations are in Portland and Boise, which are markets that are exhibiting very strong underlying fundamentals. Specifically at the end of the third quarter vacancy in the downtown and Southeast Boise submarket was 8.9%, a significant drop from 9.4% at the end of June. This resulted in approximately 186,000 square feet of net absorption year to date. Average lease rates are estimated to be $18 in the downtown submarket, which has steadily increased since bottoming at $15.50 in 2010.

In Portland technology jobs continue to be a major driver for employment growth and they recently achieved a 12-year high of 61,000 jobs in that sector. Overall direct vacancy in the market has declined to 11.8% from a high of approximately 15.5% in 2009. Rental rates have continued to rise and ended the quarter at $22.61, the 11th consecutive quarter of positive growth.

Similarly Denver, one of our largest markets, continues to have exceptional performance. The third quarter of 2014 was Metro Denver's 12th consecutive quarter of rental rate appreciation to $22.71 gross. Denver's construction pipeline remains constrained and demand for quality space will continue to push lease rates.

Moving to our portfolio, the first thing I would like to discuss in detail is our overall leasing results during the quarter. Slides 17 to 19 of the supplemental accounting package provide significant detail. Overall given our high levels of occupancy results have not materially changed during the quarter. Our committed and occupied lease ratio remained unchanged at 93.1% at September 30. This statistic includes our in-place tenants as well as those leases signed where the tenant has not yet moved in.

As outlined on slide 18, we completed approximately 26,000 square feet of new leases during the third quarter at an average GAAP rate of $21.17 and a 7.5 year weighted average lease term. In total we now have 32,000 square feet of committed leases where the tenant has not yet occupied. The base rent associated with these leases is $20.14.

Also during the quarter we renewed approximately 9,500 square feet of existing tenants at an average GAAP rent of $20.54 versus the expiring rates of $17.43.

Finally, approximately 24,800 square feet of space vacated during the quarter. These leases had an average rent of $16.47. Approximately one-quarter of this amount related to our Cherry Creek property.

During the quarter we terminated a lease with one tenant representing approximately 6,700 square feet in order to do a long-term lease with the state of Colorado that will commence in January at a higher rate. A $69,000 termination expense was paid to the vacating tenant and included in our Q3 operating results. This was offset by a $140,000 termination fee received in the quarter relating to a tenant at the Washington Group Plaza property.

Moving to acquisitions, slide 5 of our supplementary package contains an overview of the Lake Vista Pointe acquisition which we completed during the third quarter. We discussed this acquisition in detail on our last conference call.

Going forward our current pipeline of acquisition opportunities is over $200 million. These transactions are located within our target markets and are generally in the sweet spot in terms of deal size, quality of location and acquisition metrics. We are at various stages of diligence on properties in our pipeline and we continue to see particularly interesting transactions in our Texas markets, Florida, Denver and Phoenix.

I'm pleased to report that earlier this week we secured one of these deals, the Florida Research Park property, and we are in the process of closing it over the next few days. We've summarized this transaction on page 6 of the supplemental package.

Overall we are confident that this acquisition is a good fit with our strategy. The real estate is well located in Orlando, Florida, one of our key target markets. Within Orlando there are a few key submarkets that we've been focused on. One of them is the Central Florida Research Park which is one of the largest research parks in the country. This park has a high concentration of industry and jobs and houses thousands of employees and a variety of Fortune 500 tenants.

The Central Florida Research Park also has the benefit of being located adjacent to the University of Central Florida. UCF is the second-largest university in the country by enrollment at over 60,000 students. This large educated population at UCF is an ideal draw for the various corporate users concentrated in the Research Park. We believe this favorably positions the real estate over the long-term.

The Florida Research Park property is a well-built 124,500 square foot Class A property. It was constructed in 1999 with high end finishings and amenities. Also it possesses one of the highest parking ratios in the submarket at 7.1 per thousand square feet, positioning it as a top contender for high density tenants.

It is a very technologically equipped building with an on-site data center and backup generators capable of running the entire building function 24/7. These attributes make the property a premium offering within the market. The purchase dynamic was quite interesting and will allow us to acquire the property at an attractive valuation.

The building itself was designed to be multi-tenanted, but it was leased on a long-term basis entirely to one tenant. However, over the course of the lease term, this tenant's requirements changed. Today the tenant still houses a number of mission-critical divisions and fully utilizes the top half of the property, but they've freed up the first floor and subleased half of it to another strong corporation.

This has resulted in a strong and profitable tenant leasing the entire building until December 2021. However, approximately one-quarter of the building has been subleased to another strong tenant and the remaining quarter of the building is available for future sublease. This situation provides us with favorable lease terms over the next seven years but also gives us the potential to create incremental value by signing direct leases.

Given the attributes of the building and its prime location we're confident that we can create additional value from this situation over the next seven years. The total purchase price is $26.5 million which represents an approximately 9% capitalization rate on the first year's net operating income. We intend to close the purchase with a $17 million mortgage with a 10-year fixed interest rate in the range of 4.4%.

We've been watching this particular submarket for some time with our local operator Tower Realty Partners. Tower is one of the largest owners of commercial real estate in the Central Florida Research Park and provided us a distinct advantage. Furthermore, Tower previously owned this particular building prior to selling it in 2008, which gave us significant insight.

I would now like to discuss our capital market strategy. We will close the Florida Research Park property acquisition with a mortgage and a revolving line. Future acquisitions will be completed through other potential sources of capital, including a potential equity raise, issuing OP units to sellers or structuring transactions with a JV partner.

In order to have flexibility to consider all of these options a number of weeks ago we filed a registration statement that positions us to raise equity at the appropriate time. However we remain very sensitive about our stock price when contemplating the issuance of equity as management and the Board own close to 20% of City Office.

We intend to position ourselves to keep every option available to us to support our future growth with the goal of creating significant long-term value for our stockholders. I'll now turn the call over to Tony Maretic, or Chief Financial Officer, to discuss our financial results.

Thank you, Jamie. As mentioned earlier, we completed our IPO in April of this past year. Given the complexity and timing of our formation transaction there are a number of adjustments that are needed to normalize our second- and third-quarter results. In our supplemental package we have provided additional details to create a more meaningful representation.

On page 11 you will find a reconciliation of core FFO and AFFO. While the formation transaction complicates our first two quarters' results somewhat, you will see that the impact has gone down as the pre-rent TIs, LCs and CapEx associated with deals struck prior to our IPO burn off or are funded.

Before I go through the details of our financial statements I would like to comment on how our financial statements reflect our joint venture properties and the liability associated with Second City's earn out at Central Fairwinds.

Three of our properties are owned through JVs with the local property managers. All of the JV results are 100% consolidated with a corresponding deduction below the net loss on the income statement and below the stockholders' equity on the balance sheet entitled non-controlling interest in properties.

Our calculation of FFO, core FFO and AFFO all make adjustments to account for our partner's interest. We have included our NOI and EBITDA at our pro rata share in our supplemental package.

On our balance sheet we have a liability of $8 million, which is our estimated valuation of the potential earn out associated with the Central Fairwinds property in Orlando and an increase of almost $1 million over the prior quarter.

This earn out structure was used at the IPO to bridge the valuation gap as the Central Fairwinds property was approximately 60% leased at the time of the IPO. As such a structure was developed that would pay the contributor of the property if the occupancy and cash flow increased in the future.

It is important to remember any payout under the earn out will only be realized if the property's occupancy increases and its baseline NOI increases by more than 2% annually compounded, excluding the earn out NOI. Furthermore the earn out, which is paid in stock, is subject to a claw back.

As the valuation of this earn out changes over time the impact will flow through our income statement. In the current quarter the value increased by $942,000 which you can see on the income statement as a change in fair value. This increase is due to the increased leasing activity at the property as the in place and committed occupancy has increased to 76%. The change in fair value will be offset in the coming quarters as the tenants associated with this leasing take possession and begin paying rent.

Moving to our reported FFO, we completed the third quarter with a core FFO of $3.2 million or $0.27 per share. Our core FFO adjusts NAREIT-defined FFO for acquisition fees and expenses, loss on the early extinguishment of predecessor debt, change in the fair value of the earn out and the amortization of stock-based compensation.

Our third-quarter AFFO is $3.1 million, or $0.26 per share. Similar to the core FFO normalization adjustments there are a few items relating to AFFO. At the time of the IPO our predecessor, the Second City Group who contributed the initial properties, pre-funded certain TIs, LCs, unpaid capital expenditures and the free rent associated with specific leases that were signed prior to the date of the IPO. We have adjusted for these onetime amounts in calculating our AFFO for the quarter.

As an example, $274,000 of free rent was paid by the predecessor in the third quarter to offset certain free rent periods contained in several of our leases, a decrease from the $401,000 in the second quarter. The last of the free rent associated with these leases will burn off in the fourth quarter as the tenants will commence paying us directly.

In addition, we have deducted cash reimbursements from the predecessor for certain abnormal tenant improvement and leasing costs that were associated with the stabilization of certain properties prior to our IPO, but were subsequently paid by the successor. We do not believe these amounts to be reflective of ongoing expenditures and they were paid for by the Second City Group. Having said that, we expect there will be a larger gap between core FFO and AFFO going forward than in our first two quarters as a public Company.

I would like to also highlight that a supplementary package also includes the Lake Vista property for a partial quarter as the acquisition closed on July 18. The core does not include any financial impact from the Florida Research Park acquisition as it is scheduled to close next week and be reflected in our results going forward.

We have included a slide in the package to show the impact of this acquisition on some of our key metrics. Page 16 of the package shows a pro forma impact of the acquisition. As you can see, the acquisition can be funded from our existing capital structure.

We will still have significant dry powder from a third-quarter ending cash balance of $8.9 million and on a pro forma basis approximately $13 million authorized but undrawn on our line of credit after the acquisition. Additionally, we have $13.2 million of restricted cash which is available to fund future TIs, LCs and capital projects.

Our total debt at September 30 was $179.6 million, or $172.3 million when deducting the non-controlling interest share of certain debts. Our net debt to EBITDA after normalizing the impact of the lake Vista acquisition for the entire year was 7.8 times.

Our conservative strategy of building a stable portfolio with predictable growing cash flows extends to our capital structure. Over 95% of our debt is fixed-rate with a weighted average interest rate of 4.2% and our debt has a weighted average maturity of 5.8 years.

Lastly, we'd like to provide some guidance on our general and administrative expense expectations going forward. G&A costs in Q3 were $407,000. $407,000 is in line with our expectations for a normalized G&A rate per quarter based on the existing capital structure for each of the first, second and third quarters.

For the fourth quarter of each year we would expect that number to be approximately $120,000 higher due to the additional costs associated with that time period which includes the cost of the year-end audit. In sum, we would expect our annual G&A cost to be just under $1.8 million.

That concludes our prepared remarks and we are now happy to open the line for any questions. Operator?

(Operator Instructions). Craig Kucera, Wunderlich Securities.

Thanks and good morning, guys. I appreciate the color on the acquisition. But can we go through that again? I didn't get all the detail between what was being sublet and the opportunity to lease up. Can you go through that again as far as the single tenant having a certain amount and just some color on that again?

Yes, sure, Craig. So the acquisition the property is 124,500 square feet, so the second floor is fully leased until December 2021. The second floor effectively is being fully utilized by a number of key divisions. On the first floor, if we were to split the remaining half of it approximately, has already been subleased to another very strong tenant and roughly half of the first floor is available for sublease.

So just round numbers, approximately 30,000 feet has been sublet and approximately 30,000 feet is available. Now, the entire property and all of our dealings with the primary tenant over the lease term.

Got it. So does that mean that the initial 9 cap, is that based on effectively the asset being three quarters occupied so there's upside or is it that you could possibly get some incremental income by it being subleased but not necessarily 25% or 33% more?

The cap rate is based on the cash flow from the property and, since we've leased 100% of it to the primary tenant, it's based on that. So our strategy is to -- it was designed initially to be multi-tenanted.

Our strategy over the next seven years of term would be to look at subleasing it and turning those into direct leases with the tenant and potentially trying to realize some value by possibly letting the tenant off the lease early upon us having a direct deal where you potentially could have that tenant, the primary one fund the cost of re-tenanting the building. But from our standpoint until December 2021 we've got a strong tenant who fully leases the entire building.

I see. Okay, I appreciate that. And with your -- when we look at your tenant improvements and leasing commissions going forward, they were a little lighter this quarter. And I appreciated the detail, but going forward should we think of that as a percentage of NOI? Or how should we think about that going into fourth quarter and on a go-forward basis if you could give us some color?

Sure. Just roughly, I mean it depends on the tenant and the space and timing. If you look at a very long term basis, approximately 11.5% of NOI relates to TIs and leasing commissions and approximately 2.5% for CapEx. So as a combined reserve roughly 14% is what we've looked at and internally look at long-term. Now that can swing a little bit. Generally we look at five-year renewals and terms. If we have a much longer term often that percentage can be a little bit higher, but you're getting a longer-term lease.

Got it. And so, when I think about fourth quarter and maybe first quarter do we see any sort of catch up or are things -- do you anticipate any pickup in that or is 11.5% a pretty good number as in line with long-term?

Yes, I mean for the fourth quarter we should just keep in mind look at the lease expirations, because obviously that has a big impact and you'll see that there's only 12,000 square feet of lease expirations occurring in the fourth quarter. So I would expect that for the fourth quarter the number would still remain below that percentage and probably as well for Q1.

Okay. And then I'll go back to the -- and I've just got a couple more on the acquisition. What were the lease escalators on the acquisition in Orlando? And can you give us a sense of what replacement cost was as a percentage of the acquisition price?

Sure. So generally in that market, similar to a lot of our markets, the annual bumps in the leases are between 2% to 3%. And so this particular lease is within that range at the higher end and that's consistent with market.

The replacement cost -- again, this is a very well constructed building, huge parking ratio. There actually is some surplus land if we ever needed to expand parking or consider some alternatives. We haven't underwritten any value for that, but replacement cost is in the $240 a foot range versus our acquisition price of $213.

Okay, great. I'll go back in the queue. I appreciate it.

Wilkes Graham, Compass Point.

Hi, good morning. Just a couple of quick questions. Can you give any -- similar to the CapEx detail you gave Craig, can you give any -- and I apologize if you already did this -- but any sort of guidance for how straight-line is going to go going forward? I suspect it's going to come down, but can you comment at all on how that's going to look?

Hi, Wilkes. It's Tony here. Yes, you are right. We will expect the straight-line rent adjustment to start to be decreasing over the terms. As far as exact guidance we can't provide any at this time.

Okay. And then am I right that the Plaza 25 asset does not currently have debt against it?

Correct. So the Plaza 25 property we acquired with all cash right after the IPO and we put that property of against our line of credit. So it effectively helped increase our authorized line of credit with KeyBanc to $30 million.

And do you plan to eventually get a mortgage on that asset?

In the short-term we don't. We like the secured credit facility, it gives us some flexibility. And at this point I think we'll be keeping it in a line for the short-term.

Okay, that's it for me. Thanks a lot.

Doug Christopher, Crowell, Weedon.

Hi, thank you. Thanks for taking my question. Just to go back to the beginning of the call, you were talking about the end of 2015 leases. You're saying that just the fundamentals in those markets have greatly improved. Is that correct?

That's correct. I'd say across the board in all the markets we're in we're seeing vacancy shrinking. And correspondingly, like we would expect, when the market's tighter rates start to move up. And I'd say that's consistent in pretty much every market we're in.

The one laggard has been Orlando where vacancy is remaining about the same as it has been. Rates have been pretty much flat, although over the last number of quarters it has started to move in a positive direction. So we think that's one that we will see significant declining in the vacancy rate and ideally a bigger pickup in the rental rates going forward.

Thank you. And I have one more question just on the balance sheet. You guys are living within your means, you are making strong fundamentally sound acquisitions. Where would you like to see the debt to assets or the debt to the real estate go in the future debt to EBITDA?

That's a great question. So our long-term goal is to have in the range of 50% net debt to enterprise value. Now given our size acquisitions can make that number swing around a little bit. In the near-term we're comfortable operating at the higher end of the 50% range with us having secured long-term fixed-rate debt, so we have our capital structure in very good order.

Thank you very much. Good job.

Thank you. So at this time it appears we have no additional questions so I'll wrap up. Since completing our IPO in April --.

One moment, I do apologize. One moment. We do have a follow-up question from Craig Kucera of Wunderlich Securities. Please go ahead.

Sorry to cut you off, Jamie.

No problem.

One final question. And maybe I missed this, but the Orlando asset, as far as how that rents for that existing tenant is relative to market, can you give us a sense is it at market, is it maybe above market? Where do you see that relative to market?

Sure, that's a good question, Craig. So the lease was done in the beginning of the recession in 2008, late 2008. This is a property that given its size and layout, high parking ratio, being attached right to UCF -- it's one that can be marketed on a national basis and ultimately that's how Tower who previously owned it secured Kaplan.

So rates were negotiated 2008 with the escalators that I mentioned earlier. Today it's pretty hard to benchmark a property of this size in that market as to where it relates to market rates, but our view is being conservative it's a few dollars above current market rates. With that caveat that it is difficult to estimate, but all in all it's pretty close to where the current rates are.

Got it. And that's not going to roll over anyway for another seven years, correct?

That's correct.

Okay, great. Thanks a lot.

Steve Manaker, Oppenheimer.

Thank you, good morning. I just wanted to get a sense of the acquisition pipeline that you're seeing right now. Has there been any change in velocity or pricing due to the fallout from ARCP and the other [NIC source] entities?

We haven't seen that yet, Steve. If you look at our pipeline, generally we'll have somewhere between six and eight deals. So right now there are seven that are kind of the top prospects. It takes quite a while to build this pipeline and work through the process, so that may change over the next coming months.

But right now our pipeline is similar to where it has been. It's about $230 million, that represents about 1.1 million square feet. So on an average transaction size it's right in our sweet spot, just over $30 million. Cap rates are still in the 7% to 9% range and I should include our pipeline right now does still have our Florida Research Park property in it since we haven't acquired the property yet.

If you look at our pipeline as well, virtually all, with the exception of the Florida Research Park, our existing multi-tenanted buildings and velocity I think is similar to what we've seen in the past.

Given how markets continue to improve there is more competition. I would say in the range that we're buying 20 to 50 we are still competing with local and regional buyers. So we haven't really seen much of a change. But at the larger side of the transactions, $50 million plus, especially when you get up closer to $100 million, there absolutely is bigger competition than what there was previously.

Thank you.

And this concludes our question-and-answer session. I would like to turn the conference back over to Jamie Farrar for any closing remarks.

Thanks, Ed. So since completing our IPO in April we've been focused on executing against our business plan. In this regard we've made great strides. We remain focused on increasing occupancy further as well as extending lease terms.

We completed the Lake Vista Pointe acquisition. We are in the final stages of completing the Florida Research Park property acquisition. And we've continued to refine our acquisition pipeline to support our future growth.

We remain optimistic about our markets and their prospects, as well as our position and ability to create value for our stockholders. Thanks again for joining today and we look forward to communicating our future progress with you.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.