City Office REIT Inc (CIO) 2015 Q4 法說會逐字稿

Good morning and welcome to the City Office REIT, Incorporated fourth-quarter and full-year ended 2015 earnings conference call. At this time, all participants are in 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 fourth-quarter earnings press release and the supplemental information package.

Certain statements made today that discuss the Company's beliefs or expectations or that 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 statement disclaimer in our fourth-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 financial 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.

Thanks for joining today. I would like to start by saying that we are very pleased with the Company's performance for both the fourth quarter and our full fiscal year. We've delivered impressive growth and our net operating income as well as our per share, core FFO and AFFO. These accomplishments are particularly impressive given the choppy capital markets during 2015 which were dominated by concerns related to economic and financial conditions throughout Europe and China, falling commodity prices, rising interest rates and a slowing economy. Notwithstanding the negative capital markets, our focus was concentrated on providing cash flow growth and sourcing attractive property acquisitions.

Our targeted cities continued to experience improving demand for space, rising market rents and higher occupancy. These positive trends support our confidence that selecting high-growth markets and buying well located real estate with strong tenants and low in place rents will continue to create value for our investors.

The success of this strategy has been reflected in our results. Our fourth quarter was our strongest quarter yet and we continue to achieve both higher portfolio net operating income as well as rising per-share cash flow metrics. For example, our portfolio's fourth-quarter net operating income increased to $10.9 million from $6.4 million for the fourth quarter last year. This increase was primarily attributed to acquisitions, higher rental rates and improved occupancy. Same-store net operating income increased an impressive 12.7% over the fourth quarter last year reflecting the value creation from our existing portfolio.

Core FFO was $0.37 per share in the fourth quarter, a 42% increase over the same period last year. Similarly, AFFO was $0.28 per share, a 22% increase over the fourth quarter last year.

While any dividends we declare are at the discretion of our Board, we remain confident that our $0.235 per share quarterly dividend remains well covered. We expect that our coverage levels will continue to grow over the long term as we benefit from contracted escalating rents as well as our below-market in-place rents.

Moving to leasing activity, 2015 was an exceptional year for us. In total, we completed a remarkable 565,000 square feet of new and renewal leases and ended the quarter at a healthy 94.8% occupancy level. These leases included 10-year deals with the Dun & Bradstreet Corporation, St. Luke's Regional Medical Center, and Kaiser Foundation Health Plan.

However, while these leases have created substantial, long-term value for us, there is an upfront investment that will occur during the first two quarters of 2016. During this time, our FFO, core FFO and AFFO will temporarily operate at lower levels until later in the year when these tenants take occupancy and rent commences. Tony will reflect on this in a few minutes so you can clearly understand the impact in 2016 and where these levels will stabilize by the end of the year.

On our last earnings call, we indicated that we had engaged CBRE to explore opportunities and commence marketing of our Corporate Parkway property in Allentown, Pennsylvania. During the quarter, we signed a non-binding contract to sell the property. While the transaction could close as early as the second quarter of 2016, numerous conditions and uncertainties remain and there can be no assurance that the transaction will close.

In terms of issuing equity, the question that we are frequently asked, we continue to believe that over the long term growing our shareholder base, improving our liquidity and buying additional high-quality real estate will benefit the Company.

However, capital markets have been extremely volatile and our share price has been trading at a steep discount. Given these factors, we remain focused on finding opportunities to create value internally. This was a major focus for us during 2015 and I think the pace of improvements in our quarterly per share results really demonstrate success.

For your own reference, we posted on our website an updated investor presentation and it provides a great summary of the quarter-by-quarter trends across a number of important metrics.

Finally, before I hand the call over to Tony, I would like to touch upon the recent changes in our management structure. On February 1, we completed the previously announced internalization of our management team which is viewed as a best practice by many REIT investors. The feedback received from shareholders has been overwhelmingly favorable and we are confident that it has positioned us positively as we build the Company.

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

As Jamie mentioned earlier, on a GAAP basis, our net operating income continues to grow and reach its highest level in the fourth quarter at $10.9 million. This represents a $1.8 million increase over the $9.1 million achieved in Q3. $1.2 million of the increase is attributable to the acquisitions of 190 Office Center and Intellicenter, which were both acquired late in Q3 on September 3.

$600,000 of the increase was attributable to our existing portfolio of which $385,000 related to an unspent lease incentive and a lease departure payment for leases which expired on December 31. This represents a same-store sales quarter-over-quarter NOI increase of 8.6% and a healthy 3% when excluding the one-time unspent lease incentive and departure payment.

We reported core FFO of $5.9 million or $0.37 per share. Our core FFO adjusts NAREIT defined FFO for acquisition fees and expenses, change in the fair value of the earnout, cost of the internalization and the amortization of stock-based compensation. Our core FFO ended the year ahead of our budget and we ended the quarter $0.8 million higher than Q3 on a sequential basis as the increase in NOI was offset by the increase in interest expense as a result of the aforementioned acquisitions.

Added back to core FFO are some costs associated with the internalization. You will see this line item described as external advisor acquisition. These costs are comprised primarily of the legal and other advisor costs incurred to year-end. We do expect approximately $100,000 will be expensed in Q1 of 2016 related to the work completed as of the closing date of February 1.

Our fourth-quarter AFFO is $4.5 million or $0.28 per share. AFFO similarly benefited from a full quarter of these acquisitions and improvements in same-store NOI.

Our leasing activity and capital expenditures are clearly laid out on pages 15 and 17 of the supplemental package. Consistent with our definition of AFFO, we have excluded some first-generation leasing costs and the capital costs planned at acquisition for the most recently completed acquisitions.

We have also excluded those costs associated with the major repositioning of Plaza 1 at Washington Group Plaza as we did in the prior quarter. Further details are disclosed on page 17 under nonrecurring 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 earn out liability linked to achieving leasing and cash flow milestones. As a result of the (inaudible) leasing results, the company increased the expected value of the earn out liability by $200,000 to $5.7 million at December 31.

Also during the quarter, the NOI threshold associated with 80% occupancy was achieved and $3.8 million of burnout consideration will be paid in common stock and operating partnership units during the first quarter of 2016. These awards are subject to claw back 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.

From a liquidity standpoint, we had cash of about $8.1 million at December 31 and approximately $25 million remaining undrawn and authorized under our current $75 million credit facility. Additionally, we had $15.2 million of restricted cash that is available to fund future TIs, LCs and capital projects.

Our total debt at December 31 was $344.7 million or $337.5 million when deducting the noncontrolling interest share of certain debts. Our net debt to enterprise value was 63% based on our share price at December 31.

Lastly, we would like to provide some guidance for 2016. Prior to providing that guidance, we would like to remind everyone of the downtime associated with retenanting two material leases at Washington Group Plaza and AmberGlen. We previously announced that we secured a replacement tenant for AECOM, whose lease expired on December 31, 2015. St. Luke's Hospital Administration premises are currently being built out with a scheduled Q3 delivery and no revenue will be received on the approximately 147,000 square until that time.

Similarly, Cascade Microtech also vacated their space on December 31, 2015. And Kaiser Foundation Health Plans approximately 33,000 square feet space is also currently being built out with a scheduled Q2 delivery. As a result of these moveouts, our 2016 first-quarter property GAAP NOI will dip and is expected to come in the range of $9.6 million to $9.8 million.

Q2 will see a further slight dip before building back up beginning in Q3 and then by Q4 reach the normalized level achieved in the fourth quarter of 2015. That translates into a full-year guidance of property level GAAP NOI between $40 million and $41 million. This guidance was determined based on incorporating the full-year results for all 14 properties owned at January 1, 2016, does not include any acquisitions or divestitures. And is based on an assumption of weighted average shares outstanding of $16.4 million to $16.6 million during 2016.

On a core FFO basis, we are providing guidance in the range of $1.19 to $1.25 per share for the year inclusive of the lower results from the first half of the year. Further details on how we arrived at that outlook including a more complete discussion of our assumptions can be found in our press release.

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

(Operator Instructions). Rob Stevenson, Janney.

Jamie, I appreciate that it still in flux and hasn't closed and anything yet, but can you just talk a little bit about any of the parameters around the Dun & Bradstreet building and where -- did things come in as you had expected etc.? Anything positively or negatively surprise you during that process?

Sure, thanks for the question, Rob. So if you recall, we launched our process back in the fall and I'd say November, December, January were pretty choppy times and also not only in the capital markets, lenders generally widened their spreads a fair bit over that period of time. So that has hurt buyers underwriting a bit. I think the question was asked on our last call if the broker opinions were in the range of I think 6 to 6.5 cap and we acknowledged at the time that that was in the ballpark. So with the weaker capital markets, generally, cap rates have weakened somewhat, meaning they are a bit higher but they are not tremendously different, Rob.

So our expectation today is if it closes, it has a number of conditions remaining, it is likely to occur in the second quarter and not tremendously different as far as our expectations from where we were last time.

Okay. And then how active are you guys -- I mean given your capital stance and your desire not to issue a common equity on here, how active have you guys been over the last four or five months in underwriting potential acquisitions and how robust is that market today?

Yes, we've been pretty active as far as underwriting and I would say values have come down a little bit over the last quarter from the fall. So we continue to be active. We closed last year about $172 million of acquisitions which was right in the midpoint of our guidance of $150 million to $200 million. So there still are attractive acquisition opportunities out there. And I guess our view is if capital markets improve, we still think we can execute in that range of what we said we would do last year.

There are deals out there but we are being cautious because we don't want to get ahead of ourselves and put ourselves in a box where we either flake out on a deal and don't close or we are put in a position where we have to issue equity.

Okay, thanks guys.

Craig Kucera, Wunderlich.

I wanted to revisit your straight-line rent for this year and more particularly going forward. If you go back to the first half of 2015, I think the total was maybe 100,000 and is it fair to say that excluding the rent abatements that you discussed in your press release that fourth-quarter run rate or looking forward to 2017 that something in the $600,000 to $1 million range is correct or would it be lower than that?

I think your assessment is pretty good. We have these one-time amounts that are flowing to 2016. If you exclude those numbers, the range you gave is exactly right. A lot of it is actually coming from the recent acquisitions. Intellicenter in particular is a good portion of that number and that's the difference why you are seeing a difference in run rate now versus nearly zero at this same time last year.

Got it. So if you guys were to complete the Dun & Bradstreet sale then it would not materially impact the run rate straight-line?

Yes, so the material -- good question. You have the one-time impact of the free rent period that burns off in early Q3. So depending on when the sale hits, it could have an impact on that quarter. But if you are looking further out, it doesn't have as much of a material impact.

Got it. And you spoke to this, and we've been hearing this across the board, the choppiness of the debt markets and what's going on there. You do have a term loan maturing in September. Have you begun exploring refinancing that and what kind of quotes do you are looking at or at or is there any potential to maybe extend that loan?

So very good question. The terms of that loan are such that if we are successful in executing on a sale, the proceeds would be used first to pay down that debt and so depending on the results of the Corporate Parkway transaction, that would be the first option.

Other than that if you look at our balance sheet, you will see that we still have pretty substantial cash, we have substantial room still in our line of credit and so there is an ability just to pay down the facility through existing sources and the term loan is actually with KeyBank who is also our lender on the line of credit. So we have some options in that respect as well.

Okay. I want to talk about your same-store NOI which is very, very strong year-over-year and even from third quarter. I may have missed this but recognizing that you picked up some occupancy and income at Central Fairwinds, were there any notable expense items that were lower than where they were in the third and second quarter or was it just purely the pickup in Central Fairwinds?

Good question. So in Q4, you do have the impact of the one-time items that are impacting results in Q4. In our press release, we referred to the $385,000 one-time amount that was a combination of a termination payment and an unused lease incentive amount. So if you deduct that amount out, that's a part of it. There isn't really anything too significant. What I can tell you, Craig, is at year-end, we do do CAM reconciliations and sometimes there's a little bit of an anomaly in Q4 that may have slightly impacted it but it's not significant.

Got it. I've got one more and I'll hop back in the queue. Just going back to your guidance for next year, excluding the down time for the two assets where you've got people picking up occupancy midyear, I think you've got about 7% of your space rolling over. Most of those are smaller leases. Do you anticipate any material down time and kind of what are your thoughts on how rent escalators are looking for next year, maybe some of your expense assumptions if you could share that?

Sure, I'll hit the first part, Craig, as far as leasing assumptions. The largest single role we have in 2016 is with Fairwinds Credit Union. Subsequent to quarter end, we did do a one-year extension at a very attractive rate, $33.50 gross with no TI associated with it. The terms of the lease included basically an extension option for another nine years at market rates which are today in the range of $24 plus marking to market the signage.

So the tenant has until later in 2016 to exercise that extension right. So we'll have better visibility later in the year but that's a first major roll has been taken care of. The balance, they are all pretty small and there will be some standard turnover but for the most part we don't expect much.

Your second part of the question was in terms of rent escalations, you mean they are still averaging within our portfolio about 2.5%.

Okay, great. Thanks, guys.

Amit Nihalani, Oppenheimer.

Are you guys seeing any changes in competition for the assets you are underwriting?

I wouldn't say there's been much of a change. I think with the capital markets in the fall, I think that's caused some buyers to pull out. We have heard of a number of larger institutions that have put acquisitions on hold. So I think that will translate probably to some better buying opportunities today. I can't say definitively we've seen that yet just because of the time it takes to move through the process of buying assets and reporting. So we will have better visibility but I'd say it's better now than it was probably in the last half of last year.

Got it. And looking into 2016, would you guys be open to do more dispositions.

We generally try to keep an open mind about the values of our properties and if we think any particular submarket is really well positioned for a sale, we certainly aren't averse to that. With not busy on the acquisition front, we are constantly exploring things like that, expense savings etc. So today our only asset for sale is Corporate Parkway but I'd say we've got an open mind if think there's a good opportunity.

Got it, thanks.

(Operator Instructions). Ken Billingsley, Compass Point.

I appreciate the guidance on NOI and I just want to confirm the way you have laid out the quarters. I believe you said -- was that the second quarter NOI would actually be coming down slightly from the $9.6 million to $9.8 million in the first quarter? Is that correct?

That's exactly right. You will see a further dip in Q2 before it starts to build back up in Q3 and then further into Q4.

And will that -- from an AFFO standpoint in the first two quarters, does it likely push AFFO below the dividend at least for those first two quarters before ramping back up?

Yes, I think that's a fair assessment. Q1 and Q2, it's a pretty substantial loss of income. You have the straight-line rent impact which gets backed out for AFFO so we do see us not covering the dividend on an AFFO basis for Q1 and Q2.

Okay. And then on the lease incentive and lease departure, it was about $0.02, $0.025 in the quarter. Is that something that should be built in the models or is that a nonrecurring one-time event and that was a sizable amount that we should be excluding from our rent numbers?

It is the latter, Ken. They do happen on occasion but these two particular ones are really related to departures of tenants and they are one-time in nature.

Okay would that be -- $0.02, $0.025, is that the proper amount it would be on a per-share basis for the quarter?

Yes, you mean $385,000 divided by our $16.2 million shares, closer to $0.02, yes.

Okay, there's no offset though anywhere else. That's a (inaudible).

There isn't an offset, correct.

And my last question, you said on page 3 of the press release that you'd reduced your normalized full-year 2016 guidance. I just don't recall, what was the original guidance that you were giving?

I can't recall -- where are you referencing. I'm just looking at page 3 where you are making that comment.

Page 3, it's under material considerations, after you give the full-year 2016 guidance -- material considerations, it's in the first sentence. It says the downtime associated with retenanting to material properties has reduced our normalized full-year 2016 guidance. Maybe you're just talking about that property specifically. I didn't know if you were --

Yes, I don't think the intention was for us was referring to prior guidance. I think what we are just trying to highlight is these are two signed leases, they are known vacates. We previously mentioned them on previous calls and we are just highlighting the fact of the impact it has on Q1 and Q2. It's a bit of an anomaly, that's all we were trying to highlight.

Great, I appreciate you clearing that up. Thank you for taking my questions.

As there no additional questions, we will terminate the call at this time. Thank you for joining today.