City Office REIT Inc (CIO) 2016 Q4 法說會逐字稿

Good morning, and welcome to the City Office REIT, Inc. fourth-quarter 2016 earnings conference call.

(Operator Instructions)

As a reminder, this conference call is being recorded.

(Operator Instructions)

It is now my pleasure to introduce to you 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'd 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. 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.

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 statements 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.

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. Before we focus on the results of this quarter, I want to take a moment to draw your attention to some of the progress we've made over the last year. 2016 was an exceptional year in terms of acquisition volume, and in December we surpassed $500 million in real estate investments since our IPO.

In achieving this milestone, we've maintained a disciplined return profile for our investments and have continued to focus on our non-gateway target markets in the Southern and Western US. We recognize that growing our Company is only valuable insofar as we are able to make high-quality investments and create value at the property level.

Our two dispositions to date, one of which is under contract and will be discussed later, are expected to generate in excess of $55 million of gains. This was made possible by completing significant leasing transactions, building upgrades, and implementing operational improvements that allowed us to position these properties at a premium valuation.

Importantly, we've coupled our growth and value creation at property level with the implementation of corporate best practices in line with what we believe to be in the best interest of our shareholders. In 2016 we internalized management, strengthened our balance sheet, and materially reduced our overall leverage.

Relating to corporate initiatives, we are excited to welcome John Sweet to our Board as an Independent Director effective as of March 1. Most recently John founded Physicians Realty Trust, a leading public healthcare REIT, and served as its Chief Investment Officer from its IPO through his retirement from the company in the end of 2016.

During his tenure, Physicians Realty grew from $125 million in real estate investments to approximately $3 billion. John is highly regarded by his peers and brings over 40 years of experience in finance, real estate and public companies. We believe he will be a strong asset to City Office.

We also recently announced that Sam Belzberg has chosen to step down from our Board of Directors. Since our IPO Sam has contributed greatly to our success, and we sincerely thank him for his service. With these changes the Board now consists of seven Directors, six of whom are independent.

During 2016 with the support of our shareholders and our improved access to capital we were able to more than double our equity market capitalization. This significantly increased the liquidity of our common stock. Furthermore, this expansion of our investor base has positioned City Office to potentially achieve other important milestones in 2017, including the potential addition to the RMZ index and surpassing $1 billion in total real estate assets.

With that, I'd like to now turn to operations and portfolio performance for the fourth quarter. Our total leasing activity for the quarter was 177,000 square feet, comprised of 166,000 square feet of renewal leases and 11,000 square feet of new leases.

Our weighted average portfolio occupancy at December 31 was a healthy 91%, and approximately 54% of our base rental revenue from our properties was derived from tenants that are federal or state government agencies or investment-grade tenants or their subsidiaries. The most significant leasing transaction in the fourth quarter was an early renewal with a 37,000 square foot tenant at our Cherry Creek property in Denver. The tenant agreed to a five-year renewal at a rate 12% higher than the existing rate and with $0.50 annual rental rate bumps. The lease will commence on July 1, 2017.

Furthermore, subsequent to the end of the quarter we secured a couple of significant early renewals which will result in stronger cash flow over the next few years. Specifically, we concluded an early lease extension with Microsoft at our DTC Crossroads property in Denver and extended their lease term from 2019 until 2025.

In addition, we've concluded a renewal with ProBuild Holdings also at our DTC Crossroads property. This renewal was discussed on our last conference call and the final terms are similar to what we anticipated at that time.

ProBuild's current lease expires in November 2017 and we completed a 51,000 square foot extension. 34,000 square feet of this was extended on a five-year term and approximately 17,000 square feet was extended on a two-year term beyond 2017. As we expected we will be getting back approximately 42,000 square feet, a very marketable space in the fourth quarter.

On our last call we also discussed plans to reposition Plaza 25 in Denver to improve leasing prospects following two negotiated early terminations. We've commenced the implementation of a $2.5 million plan to renovate the property and create more attractive spec suites and amenities. With these improvements, the property will be positioned to participate in the sub-market's recent positive net absorption and increasing rental rates.

Relating to the leasing developments we are experiencing good leasing momentum at our Central Fairwinds property in downtown Orlando, and we expect occupancy will soon exceed 90%. At the time of our IPO occupancy was below 60%, and as you may recall, as part of the IPO formation transactions there was a future earn-out liability linked to achieving certain leasing and cash flow milestones.

As a result of the leasing activity, the Company, led by its independent Board members, negotiated an early termination of the earn-out agreement. As part of that agreement a $2.4 million cash settlement was paid subsequent to quarter end which releases the Company from any future obligations under the previous arrangement. We believe this transaction is a positive development for shareholders as it removes uncertainty around the timing and amount of future payments which could have been materially higher given the strong leasing prospects.

Moving to our investment activity. We acquired over $180 million in real estate in the fourth quarter and have continued momentum into 2017. In November we acquired Park Tower in Tampa, Florida. The purchase price was $79.8 million, exclusive of closing costs and future renovation capital, representing a 7.1% cap rate. We are finalizing our renovation plans with renowned architect Gensler. We are very pleased with the results of our planning, and believe that we will create value by positioning the asset as a modernized and premier downtown Tampa property, as we've done with several other repositionings in Florida.

Also in November we acquired 5090 North 40th Street in Phoenix, Arizona. The purchase price was $42.6 million, exclusive of closing costs, representing a 7.1% cap rate. Having undergone a recent renovation, the property is in great shape providing the opportunity to lease up the remaining smaller available suites.

In mid-December we acquired SanTan Corporate Center, a two-building office complex well located in Phoenix's technology-driven Chandler sub-market. The purchase price was $58.5 million, exclusive of closing costs, representing a 7.7% cap rate. SanTan is 55% leased to credit tenants, and we expect to realize strong cash flow with limited near-term lease roll.

In January subsequent to quarter end, we acquired 2525 McKinnon in the highly desirable uptown sub-market of Dallas, Texas. The property is surrounded by some of the highest-quality office, hotel, high-rise residential and retail properties in the State of Texas and was acquired for $46.8 million, exclusive of closing costs and future renovation capital, representing a 6.1% cap rate. In-place rent at the property are approximately 35% below market, and we expect to increase cash flow as we roll rents up to market in conjunction with our planned upgrades to the property.

On the disposition front, on our last earnings call we disclosed that we've entered into a contract to sell our Washington Group Plaza property in Boise, Idaho for $86.5 million to St. Luke's. At the time, St. Luke's was conducting their property level due diligence.

We are pleased to report that St. Luke's has completed their due diligence and made a $5 million nonrefundable deposit. Closing is scheduled to occur in April 2018, in conjunction with the maturity of the property's mortgage. However, either party has the right to accelerate closing by providing at least 120 days advance notice and paying the mortgage prepayment penalties.

Turning to our acquisition pipeline. We currently have over $400 million in attractive opportunities within our target markets that meet our preliminary investment criteria. We continue to be very positive about the real estate fundamentals across our markets, and believe that we can intelligently expand our portfolio with additional great properties.

Our best estimation around timing is that we will invest our remaining dry powder in the second and third quarters. That concludes my remarks, and I'll turn the call over to Tony to discuss our financial results.

Thanks, Jamie. On a GAAP basis our net operating income in the fourth quarter was $12.8 million. This represents a $1.4 million increase over the $11.4 million achieved in the third quarter.

The increase was primarily as a result of the acquisition activity. As Jamie discussed, we acquired Park Tower, 5090 North 40th Street and SanTan all in the fourth quarter.

On a cash same-store basis our net operating income increased by 5.1% over the same quarter in the prior year. We've added a new schedule to our supplemental accounting package which provides further detail on our same-store results to demonstrate the performance of our stabilized properties.

Another change I wanted to briefly mention, beginning in Q4 we have combined general and administrative expenses with our stock-based compensation expense. Stock-based compensation expense is a non-cash item that we previously disclosed on a separate line item on our income statement and which is excluded from our definition of core FFO. We have combined the stock-based compensation figures within general and administrative expenses on our income statement beginning this quarter to better conform with industry practice and SEC rules, but we continue to add it back to our definition of core FFO.

We reported core FFO of $5.6 million, or $0.23 per share. Our core FFO adjusts may redefine FFO for acquisition costs, change in the fair value of the earn-out and the amortization of stock-based compensation.

Our core FFO ended the quarter $1 million lower than the Q3, primarily due to the $1.8 million in preferred stock distributions related to the preferred stock offering which closed in early October. This was offset by the increased NOI from the acquisition activity later in the quarter. We expect the preferred offering to be accretive to core FFO on a run rate basis.

As a result of our leasing momentum both during the quarter and subsequent to quarter end, which Jamie described, we increased the earn-out liability at Central Fairwinds by $500,000 to $2.4 million, which represents a full and final settlement. Our fourth-quarter AFFO was $4.2 million, or $0.17 per share.

AFFO was negatively affected by unusually large charge for leasing commissions totaling $1.0 million paid in the quarter. Half of the total related to the Fairwinds Credit Union 10-year extension. The majority of the commission was due upon the expiry of the termination option in early October.

Our leasing activity and capital expenditures are clearly laid out on pages 20 and 22 of the supplemental package. Consistent with our definition of AFFO, we have excluded some first-generation leasing costs and the repositioning activities which have begun at Plaza 25. Further details are disclosed on page 22 under nonrecurring capital expenditures.

From a liquidity standpoint, we closed on a $71.3 million common stock offering subsequent to our quarter end. At December 31, prior to that closing we had cash of about $13.7 million and approximately $15.9 million in restricted cash.

During the quarter we also expanded the authorized borrowing capacity under the secured credit facility from $75 million at September 30, to $100 million. Our total debt net of deferred financing costs at December 31, was $370.1 million, or $361.6 million when deducting the non-controlling interest share of certain indebtedness. Our net debt to enterprise value was 44.7% based on our closing common stock price at December 31 as compared to 63% as of December 31, 2015.

Lastly, we have provided full-year 2017 guidance. We have assumed in addition to the $46.8 million acquisition of 2525 McKinnon completed in Q1, we expect to close an additional $165 million to $185 million of properties in 2017 with all of the acquisitions occurring in Q2 and Q3.

Based on this assumption we are estimating core FFO between $1.03 to $1.09 per share for the full year ending December 31, 2017. Our assumptions assume no dispositions take place during this year, including Washington Group Plaza which is under contract for sale in 2018.

This includes an increase in cash NOI from our same-store properties in the 4% to 6% range. The actual timing of our acquisitions will impact our guidance estimates, but assuming these acquisitions close and once we are fully deployed we are anticipating fourth-quarter 2017 run rate core FFO in the range of approximately $0.29 to $0.31 per share.

Further details in how we arrived at our guidance including a more complete discussion of our assumptions can be found in our press release and the supplemental information package. That concludes our prepared remarks, and I will open the line up for questions. Operator?

(Operator Instructions)

Vincent Chao, Deutsche Bank.

Hey, guys. A big picture question. You mentioned the $400 million pipeline that you're looking at for acquisitions. Curious if you can comment on post-election, and so far this year what if any impact it's had on the markets that you are looking at in terms of the investment markets?

Sure. Thanks for the question, Vin. As a general comment, if you look at our past we are most excited to be buying when there is some dislocation in the market. And in the fall in the fourth quarter there were a lot of concerns both over rising interest rates as well as the election uncertainty. Another factor was potential carried interest tax law changes, which really spurred some private equity people to want to sell.

We saw a great buying dynamic in the fourth quarter which allowed us to close, as we said, over $180 million of properties and what we think were very attractive prices. That momentum continued early in the first quarter with our closing of the uptown Dallas transaction for $47 million, which again another solid buy.

I'd say with the market improving as much as it did and the change in expectations around job creation, early in 2017 we did see a lot more buyers actively pursuing properties in our markets, and we actually opted to bow out of a few transactions we were working on as the pricing started to move to levels that were above where we were comfortable. The irony is, in some of these cases we think the chosen buyers were groups that didn't actually have all their own funds to buy it, which start to look for capital while they were doing due diligence.

Our preference in that situation is to step aside, watch the transaction, see what happens and often some of our best buys are when a seller struggles to close a sale. As of right now, I'd say it was a bit of a slower start in 2017.

We have built up of a fairly deep pipeline of over $400 million. We do have a number of pretty solid prospects in that. Guidance, again Tony gave the midpoint's about $175 million of additional properties, and we are very comfortable that we can close that between the second and third quarter based on what we are seeing.

Got it. Thanks for that color. I guess it sounds like cap rates may have risen a little bit in the fourth quarter and then have come back in, in the early part of 2017. Is that a fair characterization?

That's fair. We are still in the 7% to 8% range. I'd say we are trending towards the lower end of that range, but still have a good pipeline in that range.

Okay. Okay, and then a question on guidance. Thanks for the additional same-store disclosure this quarter. It looks like about 65%, 66% of the portfolio is captured by same-store as of the fourth quarter.

I was just curious, is the same-store pool set now for the rest of the year or is there going to be changes over the course of the year? Is today's same-store pool the same as what the 4% to 6% is based on?

That's a fair comment. What you will see in 2017 is we're going to be providing information on a quarterly basis. The acquisitions that occurred in 2016 will start to hit your Q3 and Q4 numbers.

The only other adjustment is from the prior year Washington Group Plaza was treated as a repositioning when we were totally remodeling one of the buildings. It was held out as repositioning in Q1 and Q2. If we still owned the building, Washington Group Plaza in Q3 and Q4, that will also come into the numbers.

Got it. Okay. I'll jump back in the queue. Thanks.

Sure.

Craig Kucera, Wunderlich.

Good morning, guys. Going to your guidance, can you talk about what you are thinking as far as new leasing, and embedded in that is there a pick-up in occupancy, or how should we consider that?

Yes. Good morning Craig, it's Tony here. Generally if you look at occupancy we are projecting essentially flat occupancy in our number. The pick-up is going to come from the lease renewals and the step-up in rents, and hence the same-store guidance we gave in the range of 4% to 6%.

Got it. I do appreciate the additional disclosure this quarter. Can you comment on where leasing spreads were this quarter relative to prior rents, and where you see your overall current rents relative to market?

Sure. In terms of leasing spreads in Q4, relatively small sample size in the numbers. 166,000 square feet in renewals. The spreads on that were kind of in the same range as our same-store projections in the high end of that, so they were kind of in the 6% range. In terms of the second part of your question was -- remind me, Craig?

Where you see your current rent in the portfolio relative to where market rents is? Are we 5% below or some range below or at market, I guess?

Yes, consistent is what we said. It's very similar to what we've guided before, approximately 5% that translates into just over [$1] below market.

Got it. That's it for me. I'll jump back in the queue. Thank you.

Thanks, Craig.

(Operator Instructions)

Rob Stevenson, Janney.

Good morning, guys. Jamie, you talked earlier in the call about space coming back to you in Denver in the fourth quarter. When you take a look at the roughly 400,000 [square feet] of lease expirations in 2017 as a whole, what are you guys expecting to have to re-tenant versus the percentage of that that's likely to renew?

Sure. Thanks, Rob. First off there's about 43,000 [square feet] of that has been net leased in Park Tower and our expectation is we will get that back in May. If that happens we get $2 million of cash coming back, which is close to $50 a foot for re-tenanting it. That's our best expectation today.

Based on remaining leases it's around 320,000 feet so far we've either renewed or in advanced discussions of lease renewal for about 140,000 feet of that in 2017. In addition we are far along or have renewed another 50,000 [feet] relating to 2018. So we are seeing very good leasing activity.

Just commenting on rates, renewal rates very healthy. They are in the guidance that we gave about a 4% to 6% pick-up, so nice price pick-up there.

In terms of getting some space back, we mentioned on the call, the 42,000 feet at DTC Crossroads which we get at the back at the end of November. General Dynamics we are going to get back later this month at our FRP Collection as they did not renew a contract. We've got some good leads there, that's about 34,000 feet.

Portland, we are going to get back about 19,000 feet from Delta Products on December 31. But aside from that, we are in very good shape. Our own internal numbers when we are looking at renewals this year we are going to be in the 65%-plus range on renewals, which is skewed a little lower than normal because of the ProBuild space we're getting back.

Okay. Then, of the whatever you'd like to call them, the sort of sub-optimally leased assets, the stuff that's low 80%s or below. Where are you seeing the most leasing interest and traction of those properties, like Plaza 25, is it Washington Group Plaza, et cetera? Any of that stuff -- obviously Washington Group Plaza is going to St. Luke's, of the other sort of low 80%s assets, anything where it sticks out from a demand perspective to share?

Basically the biggest focus right now, as we said on the call, is Plaza 25. And that's going to tick down a little bit lower in the low 50% range with the move-outs that we already announced and received the termination income for.

We are in the process, we said, of doing a major repositioning there. I think that's going to make a huge difference in being able to lease that up over the balance of the year and into next year. That's where our main focus is, Rob, and I think with our plans we have in place we are well positioned to do that.

Superior Point is one as well that we are focused on, good space there. We are hoping to push that up closer to the 90% range by the end of the year.

Okay. Then just last one for Tony. Where's the big probability for deltas in the $1.03 to the $1.09 guidance? In other words, if you guys came in a couple of pennies below the low end or a couple pennies above the high end, what's the things in the guidance that really would -- that you think at this point would drive coming in -- outside that range?

Yes. Sure, Rob. I think the biggest driver is the timing of our acquisitions. We've assumed that they begin early Q2 and are completed by the middle of Q3 so that we are fully deployed. That's the biggest driver. If we can accelerate those acquisitions we can push above the range, and if they are delayed that will put them to the bottom of the range.

Okay, Perfect, guys. I appreciate it.

Thanks, Rob.

Vincent Chao, Deutsche Bank.

Hey, guys. Just a quick follow-up (technical difficulties) reconcile some stuff here. In the press release you guys talk about 144,000 square feet of leases signed that will or have commenced subsequent to year end. I'm just trying to reconcile that with the disclosure in the sup, which comes out to maybe 12,000 square feet of signed but not commenced? Page 20 (inaudible).

The stat we are giving in the press release consists of both either signed or commenced. In terms to reconcile the two numbers, I think the 143,000 square feet, put a little note at the bottom of the table that shows what's been -- what commenced in Q1. It's really a combination of the numbers of both, and I'm happy to give you those numbers.

Maybe it's more of an offline question. That's fine. I'll follow-up with you later on that. Okay. In terms of some of the acquisitions on 2525 McKinnon, for instance, it says excluding cost and future reno capital. How much renovation do you expect to put into that asset? Then I think same question for one of the other buildings here as well, Park Tower.

Park Tower, it's a pretty major renovation we are planning on doing. We are working with Gensler as far as both a lobby, some exterior work. So when we bought that, in factored in about an $8 million budget, which we think will have a significant impact in moving rents.

It's really quite a dramatic improvement, repositioning it. That is underway as far as planning. That's our best estimate today.

2525, it's a much smaller number. We've got internally around $400,000 to $500,000 earmarked for that. We haven't finalized plans there so it could come in a little below or a little above, but that's our expectation.

Okay, and do you think that $8 million will be spent this year or is that over more than just 2017?

That's probably 2017 and it'll slip into 2018 as well.

Okay. Great. Thank you.

(Operator Instructions)

Ladies and gentlemen, this concludes our question-and-answer session. I would like to turn the call back over to Mr. Farrar to conclude.

Thank you. Overall we are pleased with our progress last year and believe that we are well positioned to create value for our investors in 2017. Thanks for joining us today, and we look forward to discussing our progress in the coming quarters.

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