City Office REIT Inc (CIO) 2015 Q2 法說會逐字稿

Good morning and welcome to the City Office REIT Inc. second quarter 2015 earnings conference call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (Operator Instructions). As a reminder, this conference call is being recorded. (Operator Instructions).

It is now my pleasure to introduce you to Tony Maretic, the Company's Chief Financial Officer, Treasurer and Corporate Secretary. Thank you, Mr. Maretic, you may begin.

Good morning. Before we begin, I would like to direct you to our website at CityOfficeREIT.com where you can download our second quarter earnings press release and the supplemental information package. Certain statements made today that discuss the Company's expectations or are not based on historical fact may constitute forward-looking statements within the meaning of the federal securities 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 second quarter earnings press release and the Company's filings with the SEC for factors that could cause material differences between forward-looking statements and actual results. The Company undertakes no duty to update any forward-looking statements that may be made in the course of this call. The earnings release and supplemental package both include reconciliation of non-GAAP measures that will be discussed today to their most directly comparable GAAP financial measures.

I will review our financial results after Jamie Farrar, our Chief Executive Officer, discusses some of the quarter's operational highlights. I will now turn the meeting over to Jamie.

Good morning. I'm pleased to report substantial positive results for the second quarter. Our markets have continued to perform well and we are seeing strengthening in rental rates, increased leasing opportunities and tighter landlord incentives. We are capitalizing on this environment, making significant progress on a number of our stated objectives, including completing 380,000 square feet of new and renewal leases. This helped to drive our in-place and committed occupancy to over 95%, the fifth consecutive quarter of higher reported results.

In addition to strong operating performance, we closed on two attractive opportunities representing over $60 million of purchases. Of particular importance is the high-quality nature of these properties, which we believe will position them for long-term cash flow growth. Both the Superior Pointe and the DTC Crossroads acquisitions are Class A properties located in thriving Denver submarkets. Each possesses a combination of solid tenancy, attractive purchase price metrics and we expect them to deliver steady cash flow growth over time.

Our momentum carried over to the third quarter and we announced this morning that Granite 190 is under contract in Dallas, Texas. Granite 190 is a 307,000 square foot Class A multitenant property that we will acquire for $54.4 million before closing costs or $177 per square foot and it's currently 97% leased. Consistent with our prior acquisitions, it has a great location in the growing Richardson-Plano submarket with highway frontage on President George Bush Turnpike. Granite 190 is a two-building property that was built in 2001 and 2008 and its design, construction quality and amenities make it a leading building in the submarket. The purchase price is anticipated to generate a full-year cash net operating income yield of approximately 7.5% after adding back some remaining free rent credits that are being funded by the seller. We anticipate closing in late August with a long-term fixed rate mortgage. Upon completion of this purchase, our total acquisitions during 2015 will have increased to $125.7 million. This is on track with our prior guidance of at least $150 million to $200 million annually.

Moving to our operating performance, we have concluded the quarter with impressive results. Specifically, we executed 380,000 square feet of leasing transactions during the second quarter. We have converted two of our arguably highest risks across our portfolio into exceptional long-term leases with very strong covenants. One of these leases replaced an existing large tenant in Boise that had a lease expiration on December 31 of this year. As recently reported, we executed a 10-year deal for the space with St. Luke's Health System, the largest employer of Boise.

Further, we completed an early renewal in Allentown with Dun & Bradstreet on a 10-year lease time as well. During this renewal, we also substituted the subsidiary tenant with its very strong parent, the Dun & Bradstreet Corporation. Securing this long-term lease with an investment-grade tenant has substantially increased the value of this asset and has opened the door to various attractive alternatives. These include maintaining it as a long-term low-risk hold, a potential sale, refinancing or recapitalization. We will conclude an extensive review of our options during the upcoming quarter.

While we believe that these two leasing transactions have been transformative at the respective properties, our operating performance has been impressive across our entire portfolio. For example, our 241,000 square foot city center property in the Tampa market achieved a 100% occupancy level at June 30. We don't anticipate that it will remain fully occupied over the long term but it's a remarkable achievement for a diversified multitenanted property. As another example, the Central Fairwinds building in downtown Orlando achieved a committed and in-place occupancy of 87.5% at June 30. This was up from 72% a year ago.

We continue to be focused on our last remaining major lease expiration in 2015. As previously reported, we have a known vacate on December 31 of this year at our AmberGlen property in Portland for approximately 65,000 square feet. We do not give the space back until the end of the year but we have recently entered into a letter of intent with a credit tenant to take approximately half of the building on a 10-year term. While there can be no certainty that we will conclude a lease on acceptable terms, we are pleased with the high level of interest at this property.

Our leasing success during the quarter naturally leads us to paying out commissions and commit to tenant improvements over the coming months. During the quarter, we paid $3.2 million in total capital expenditures. The vast majority of this relates to our new lease with St. Luke's and the Dun & Bradstreet renewal. It is important to remember that these two leases represent approximately 12% of our total square footage at a weighted average lease term of over 10 years and do not represent our typical leases. While they require significant capital to complete, there were less capital-intensive options that we could have pursued. However, based on our analysis we believe that both transactions created significant value for shareholders at the asset and portfolio level. Tony will provide more detail on how these TI and leasing commissions will impact the reported numbers in the coming quarters.

Overall, the combination of the operating environment as well as our portfolio's strong results have led us to increase our projected net operating income guidance for calendar 2015. Tony will discuss further in a minute but these results are a testament to the strength of sourcing great real estate in vibrant submarkets and managing it for long-term cash flow growth.

I will now turn the call over to Tony Maretic to discuss our financial results.

On a GAAP basis, our net operating income was $7.5 million this quarter versus $7.1 million in the first quarter. Half of the $360,000 increase is attributable to the additional NOI contributed by the Superior Pointe acquisition late in the quarter and having a full quarter of operations for Logan Tower. The remaining increase was due to improved operating performance from the properties that we owned at December 31. These properties are tracking slightly ahead of budget, partly due to lower operating expenses and marginal improvements in occupancy. As a result of this and the increased occupancy expected in the third and fourth quarter, we are increasing our 2015 NOI outlook range to a range of $28.0 million to $28.4 million on a GAAP basis and $28.7 million to $29.1 million on a cash basis. Obviously we are extremely pleased with the operating performance from our portfolio.

Our G&A continues to track our budgets, with a small variation in this quarter due to the timing of expenses related to our annual meeting which occurred in Q2. We reported core FFO of $4.2 million or $0.27 per share. Our core FFO adjusted NAREIT defined FFO for acquisition fees and expenses, change in fair value of the earnout and the amortization of stock-based compensation. Our core FFO is tracking our budget and we ended the quarter $150,000 higher than Q1 on a sequential basis as the increase in NOI was offset by the increase in the aforementioned G&A and the slight increase in interest expense as a result of the acquisitions in the quarter. Our second-quarter AFFO is $3.3 million or $0.21 per share. This was essentially flat with the prior quarter, as the increase in FFO was offset by the leasing commission for the D&B lease and the increased reoccurring CapEx due to the chiller replacement at Central Fairwinds which was discussed on our last call. Adding back the recent commissions for the D&B lease results in a normalized AFFO of $4.1 million or $0.26 per fully diluted share.

As Jamie mentioned, our leasing activity during the quarter required substantial capital improvements on our part. Our leasing activity in capital expenditures are clearly laid out on pages 17 and 19 of the supplemental package. Consistent with our definition of AFFO, the nature of the major repositioning of Plaza 1 and industry practice for first-generation leases, the capital costs for the St. Luke's repositioning will not flow through AFFO but instead are disclosed on page 19 under nonreoccurring capital expenditures.

As a result of our leasing success during the quarter, we increased the earnout liability at Central Fairwinds. As you may recall, as part of the IPO formation transactions, the Central Fairwinds property in downtown Orlando included a future earnout liability linked to achieving leasing and cash flow milestones. As a result of the faster-than-anticipated leasing results, the Company increased the expected value of the earnout liability by $600,000 to $8.6 million at June 30. Also during the quarter, the 70% occupancy threshold was achieved and $3.2 million of earnout consideration will be paid in common stock and operating partnership units during the third quarter of 2015. These awards are subject to a clawback if any of the new tenants move out or if the property fails to achieve an annual 2% NOI growth rate excluding the impact of the rent from the new tenants.

Subsequent to the end of the second quarter, we expanded and extended the revolving credit facility to $75 million with an initial rate of LIBOR plus 2.25%, representing a 50 basis point reduction. We also put 10-year long-term financing on our Plaza 25 property at a fixed rate of 4.1%. From a liquidity standpoint, we had cash of about $11.3 million at June 30 and approximately $40 million remaining undrawn and authorized under our current $75 million credit facility, which provides us ample liquidity to fund our acquisition strategy. Additionally, we have $10.1 million of restricted cash that is available to fund future TIs, LCs and capital projects.

Our total debt at June 30 was $241.1 million or $233.8 million when deducting the noncontrolling interest share of certain debts. Our net debt to enterprise value was 54%, based on our share price at June 30. Using our internal estimate of asset value, based on acquisition price and the contribution at the IPO, our net debt to asset value remains below 50%. Our conservative strategy to build a stable portfolio with predictable growing cash flows extends to our capital structure. The majority of our debt is fixed rate, with a weighted average interest rate of 4.0% and a weighted average maturity of 5.6 years.

That concludes our prepared remarks and we will open up the line for any questions. Operator?

Thank you. We will now begin the question-and-answer session. (Operator Instructions). Rob Stevenson, Janney Capital.

Is there any additional earnouts available in Central Fairwinds or does this quarter sort of max it out?

With respect to the earnout payment, the total liability we've recorded is $8.6 million. We're paying out $3.2 million this quarter. The $8.6 million is an estimate and it's just important to recognize that the earnout will only be paid if the future lease-up occurs and the NOI increases at the property level. Currently we've estimated that the $8.6 million is based on us achieving occupancy of 89%. So in theory, it could edge a little bit higher than the $8.6 million or it could come down if we don't actually ever achieve that level.

Okay. And then, Jamie, you talked about the 2015 lease expirations. When you're looking at 2016 in terms of major expirations there in conversations, can you give us a little flavor of what's going on there?

Sure. So with respect to 2016, the big one was just done with Dun & Bradstreet so beyond that, if you look at our rent roll, the next largest would be Fairwinds Credit Union and that rolls mid-2016 and is about 40,000 feet. So that one they still have a fair bit of time on. It's one of their key banking branches and their corporate headquarters. They've got terrific space, arguably some of the best signage in the city. So we are confident in renewing them but it's still early days. Beyond that, it starts to get fairly small and diversified.

Okay. And then, just lastly, can you tell me a little bit about once you close the Dallas acquisition, what you have in terms of financing liquidity to be able to execute additional acquisitions? I mean, obviously you can issue more stock but down at $11.90 today it's well below NAV, etc. Can you just talk a little bit about that?

Sure. So as we announced at June 30 we had about $11 million in cash. We have $40 million authorized and undrawn under our expanded facility. So in terms of liquidity, we are sort of in a good position to finance the acquisitions.

Our intention with the Granite acquisition is that we're likely to put maybe slightly higher loan-to-value on that property. We're looking at about a 75% loan-to-value and it will be priced in somewhere right around 4.5% to 4.6%. So that would put us in a position to actually do one more acquisition within our target size and range if we wanted to.

Just in terms of our metrics, from a net debt to asset value test, obviously given our stock price, which you mentioned, on a net debt to enterprise value we are showing that we are already [above] 50% but when we look at it from a net debt to asset value and asset value we define as being the purchase price of what we paid for the assets, what we've [been to] the assets at the IPO, we're still below 50%. With the Granite acquisition we'll be right on that 50% level and we've said in the past that that's our target range in the short term and we could tick a little bit higher. So I think we still have -- in short, we have the ability to close on Granite and potentially do one more acquisition if there is a very attractive opportunity out there.

I think, just to kind of elaborate on that a bit further, I guess our belief is our shares are mispriced based on where we believe the value of our real estate is in the private markets. So we are looking at a number of alternatives in that respect. Very near term, as Tony mentioned, having slightly higher property level debt, using our corporate facility to grow a little bit further but once we hit that point, the real focus is going to be on NOI growth, executing at the property level. There's quite a bit of capital out in the markets, in the private markets, and there are opportunities there. We've had a number of dialogues in that regard. So we do believe and are confident that without raising equity at this price, which we are very much against, we've got the ability to grow outside of just internal growth.

Okay. And then, just lastly, in terms of the opportunity, beyond the Dallas acquisition, how significant are opportunities of assets that you would buy that would be acceptable returns, acceptable quality, etc. out there in your core markets these days, that if you had currency that was $13, $13.50, $14 stock price that you'd be pulling the trigger on? How big is that pipeline and what has it been whittled down to, given the financial constraints right now?

As far as kind of how we're looking at our pipeline, we're being really cautious right now to not get too far ahead of ourselves, but also keep that pipeline in check so that we know we can execute on it. So with Granite, we'll have closed about $125 million to date this year. Our markets are still performing really well. In particular, we're focused on Dallas, Tampa, Orlando, Phoenix. We also have a few transactions we're working on in Seattle right now so those are the top of the list of where we're spending the time, Houston being at the absolute bottom, just given the unknown impact on tenants in that particular marketplace.

Pipeline -- it's at various stages. Top of the pipeline in those markets is well over $200 million and if you include [shadow], where transactions we know are available, it's a multiple of that.

So there are the opportunities for sure for us to grow. One transaction in particular we are working on right now that's at an advanced stage; it's in the Tampa market. We're comfortable we can complete it with our own resources, as Tony indicated, at leverage levels that we're comfortable with and it fits perfectly with our overall strategy, a stable predictable cash flow, great tenancy, high-quality newer construction, attractive metrics. So that would be at the very top of our pipeline and beyond that we are slowing down but keeping it warm, based on raising additional capital in some form outside of a stock price issuance at today's level.

Okay. Thanks, guys. Appreciate it.

Craig Kucera, Wunderlich Securities.

Good morning, guys. I'm sorry, I hopped on the call late so I might have missed this. But with the earnout, is there -- I know you mentioned you're paying out $3.2 million this quarter and (inaudible) stock. Will that be struck at the IPO price or is that that sort of a volume-weighted current price?

It's the latter. So it's based on a 20-day volume-weighted price and the final price is actually $12.31.

Okay, got it. And then, with the new acquisition you announced this morning, can you give us a little bit more color on maybe the largest tenant or types of tenants and maybe how you see the rent there relative to market and maybe just a little bit of detail? I apologize if you already gave some of this.

We haven't disclosed the tenants yet. So we'll provide some data once we've closed, which is what we typically do. But when you look at the tendency, very strong investment-grade tenants. It's very complementary to our overall lease maturity profile so it fits nicely, diversifies. We see upside in the rents over time as well.

And do you see as far as rent escalators, any ballpark figure?

Yes, it would be standard. The leases are all a little bit different but generally this market is in the 2% to 3% range annually.

Got it. Okay, great, thanks.

Wilkes Graham, Compass Point.

Good morning. On the earnout, just one last question on that. The $3.2 million that is going to get paid out in stock in the third quarter, is that going to be sort of a one-time charge in the quarter or is it going to get amortized over a certain period?

It will be a one-time charge so what you'll see is right now we have a liability on our balance sheet of $8.6 million and what you'll see is you'll just see a reduction of that liability from $8.6 million by the $3.2 million.

Okay. Two other questions. On the CapEx, obviously the CapEx was affected by the additional leasing you did during the quarter. Can you sort of talk about what a more normalized level of CapEx is or is there a way we can think about that?

Yes, I think the guidance we've been giving, Wilkes, since the IPO which I don't think has changed at all in terms of total CapEx, as a percentage of NOI we've guided to 14% but 11.5% for TIs and LCs and about 2.5% for CapEx. That would be sort of a more normalized level. Obviously this quarter, with two very large leases which represented 12% of our portfolio, it skewed things, but that would be a more normal normalized level.

Okay. Then just last -- as you talked about how it doesn't make sense to raise capital down at these levels, I'm curious -- good to know that you've got runway for one more asset if you were to lever up Granite a bit. But I'm curious if you have any non-core assets that you might be interested in selling to free up additional equity and potentially show a signal to the market of what the market cap rates are for your assets.

I think that's a great point, Wilkes. We mentioned on the call the Corporate Parkway asset that we now have over 11 years of term left on. When you step back and look at it, it went from one of our biggest risks to an incredible low-risk asset. So as far as positioning that, it's a great asset, good condition, good office park. It's a key location for Dun & Bradstreet globally so triple net lease market is extremely strong right now. This is an ideal property so we have engaged in initial exploration of alternatives for that one and it would be at a materially lower cap rate than where our overall portfolio is trading.

Great, thank you.

Barry Oxford, D.A. Davidson.

Hi, guys. Thanks so much. When I think about the downtime leasing in the Boise asset and the $1.2 million, should I divide that 600 by the quarters? How is that going to work as far as -- will that cash flow start picking up July 1?

Yes, that's exactly right. we are estimating six months of downtime for the repositioning for the moveout of AECOM in the St. Luke's so July 1 is our estimate of when they'll be in and paying rent.

Great. Thanks, guys. The rest of my questions have been answered.

Thank you. (Operator Instructions). There are no more questions at the present time so I would like to turn our call back over to Mr. Farrar for any closing comments.

Thanks for joining today. We are really pleased overall with our performance during the quarter and we are confident we can continue to execute well against our plan in the coming quarters.

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