City Office REIT Inc (CIO) 2018 Q1 法說會逐字稿

Good morning, and welcome to the City Office REIT, Inc. First Quarter 2018 Earnings Conference Call. (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 first quarter earnings press release and a 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 to 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 first 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 obligation 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'll now turn the call over to Jamie.

Good morning. Early April marked the fourth anniversary of our initial public offering. We wanted to take a moment to track the progress of our company since that time before we discuss this quarter's results.

We launched City Office with a handful of great properties in 6 markets, which we thought had outsized growth potential. Over the past 4 years, we have exited approximately 1/3 of those properties and generated over $70 million in gains from an initial portfolio of about $300 million. The remaining properties in that initial portfolio have seen in-place annualized base rent increase by 23% in 4 years.

We believe this speaks to the strength of the markets we have selected and our success in negotiating favorable lease terms through active asset management.

Meanwhile, our external growth strategy centered on expanding our portfolio through acquisitions in our existing markets and adding high-potential new markets. We have now acquired over $1 billion in assets, including the addition of Dallas, Phoenix and San Diego as new markets, while exiting Allentown and Boise, which were previously our 2 smallest markets. These quality acquisitions and strategic dispositions have vastly increased our geographic diversification and tenant mix, and wholly aligned our footprint within our high-growth markets in the Southern and Western United States.

We've also focused on corporate governance and made improvements to our company's structure. We internalized management in 2016 and have undertaken additional initiatives, which further align our interests with those of shareholders. We have deleveraged our balance sheet and executed on a fixed-rate debt strategy, locking in long-term attractive rates.

Through capital raises and an expanding shareholder base, we've also improved the liquidity of our common shares. With all these initiatives, the company is well-positioned to grow efficiently and flexibly and benefit from increasing economies of scale. We are grateful for the support from our shareholders along the way, and we believe our strategy and execution will continue to generate attractive long-term returns.

With that, I'll turn it to the topics of our operations and acquisitions. We are pleased to report that our first quarter results tracked our expectations.

Starting with our operations, on our last call, we stated that one of our key focuses for 2018 is leasing up vacancy within our portfolio. During the quarter, we executed 130,000 square feet of new and renewal leases. Despite the moveout of a 44,000 square foot tenant at our Sorrento Mesa property, which was expected at acquisition, our occupancy increased 60 basis points quarter-over-quarter to 88.3%. We have a number of highly desirable blocks of space at a handful of our properties and have implemented renovation programs that will position these properties to maximize rents and absorption.

We continue to target 90% to 93% occupancy through these efforts. One case study for this is Park Tower in Tampa, where our major renovation and construction is tracking on schedule for substantial completion during the third quarter.

During the first quarter, we executed 7 new leases for a total of 26,000 square feet, bringing in-place and committed occupancy to 89.2%. The comprehensive upgrade and repositioning of the property has allowed us to execute those leases at rents approximately 20% higher than in-place rents at the time of acquisition in November 2016. Given our success to date, we are in the process of launching another floor of specs weeks, and we anticipate eclipsing 90% occupancy ahead of schedule.

On the acquisition front, we ended the quarter with ample dry powder to pursue our growth strategy. Subsequent to quarter-end, we acquired PIMA Center, a 272,000 square foot 2-building complex located in the desirable Scottsdale submarket of Phoenix. We're excited to add Scottsdale to our portfolio, a submarket known for its desirable amenity base, highly developed workforce, executive housing options and the largest concentration of Class A office space in the region.

The asset itself is well located in central Scottsdale, with premium frontage along the Loop 101 freeway, offering outstanding visibility feasibility and direct freeway access.

The Class A finishes, large functional floor plates and above average parking ratio have attracted a high credit tenant mix with the 3 largest tenants rated A- or better by S&P. The property was 99% leased at close, and it's situated on a favorable ground lease with over 70 years of remaining term.

The pool of potential buyers for the property was thin due to the protracted marketing process, asset size below $100 million, and the ground lease, despite the 70 years of remaining term. These favorable dynamics helped produce an attractive 8.3% year 1 cash cap rate.

To review our expectations for future acquisitions, we previously provided guidance of total property acquisitions between $210 million and $240 million in 2018. After the $56.5 million acquisition of PIMA Center, we're targeting another $155 million to $185 million in acquisitions. And based on our current pipeline, we continue to expect to deploy that capital by the end of the third quarter.

Our pipeline remains healthy and currently consists of over $700 million of properties.

With that, 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 first quarter was $19.9 million. This represents $0.6 million increase over the $19.3 million achieved in the fourth quarter of 2017. The increase was a result of a combination of a couple of offsetting factors, NOI increased due to the impact of a full quarter of income from the Papago Tech acquisition and a further increase in termination fee income received at our Sorrento Mesa property. These increases were offset by the disposition of our Washington Group Plaza property at the beginning of March 2018, which resulted in a $47 million gain.

We reported core FFO of $10.3 million or $0.28 per share. Our core FFO ended the quarter $0.7 million higher than the Q4 2017, primarily due to the same reason I described earlier.

Included in our core FFO, we recognized $0.9 million of a $1.6 million termination fee related to a tenant at our Sorrento Mesa property that departed in February. We recognized the other portion back in Q4 of 2017. The $1.6 million payment represented 77% of the tenant's base rent and estimated reimbursement obligation through its lease expiration in March 2020. We underwrote this departure at the time of acquisition.

Our continued expectation is that NOI and FFO will be lower in the second quarter due to the disposition of WGP and the reduction in termination fee income just discussed, which together contributed $1.8 million of NOI in Q1. This decrease will be partially offset with NOI from the acquisition of PIMA Center, which occurred at the beginning of Q2. We expect NOI to resume increasing in the third and fourth quarters as the impact of the anticipated acquisition, which Jamie described, come online later in the year.

Our first quarter AFFO was $6.7 million or $0.18 per share, as several planned value-enhancing capital and leasing costs were incurred during the quarter, which had been previously disclosed and which we expect to continue into the next quarter.

Due to the relative size of our portfolio and the impact of significant leasing in any 1 quarter, our AFFO numbers will continue to move around some from quarter-to-quarter. As far as our expectations for the remainder of 2018, we continue to track our previously issued guidance, and we believe the assumptions underlying our guidance remain intact at this time.

Our leasing activity and capital expenditures are provided on Pages 17 and 19 of the supplemental package. Consistent with our definition of AFFO, we have excluded some first-generation leasing costs and the repositioning activities at Plaza 25, Park Tower and FRP Ingenuity Drive. Further details are disclosed on Page 19, under nonrecurring capital expenditures.

Our same store cash NOI decreased 1.4% for the quarter. Despite a 2.7% decrease in average same store occupancy as compared to the same quarter in the prior year, revenue actually increased due to our rent escalators and renewals occurring at higher rates.

However, this was offset by some expense inflation and the timing of certain other expenses. We continue to expect that same store cash NOI will turn positive by the fourth quarter of 2018 due to the impact of expected normalized occupancy levels, rent escalators and below market rent rollers.

We believe our strategy over the past 4 years to lock in long-term fixed-rate debt has been prudent. At March 31, fixed-rate debt represented 100% of our total debt, with a weighted average interest rate of 4.2% and a weighted average maturity of 6.8 years.

During the quarter, the company replaced its secured credit facility with a new unsecured credit facility. The new facility was undrawn at quarter-end and is authorized for up to $250 million, $100 million increase over our old facility.

Furthermore, it reduces our borrowing costs through lower spreads and will provide us with ample dry powder to execute on our acquisition program for the remainder of the year. Our total debt net of deferred financing cost at March 31 was $421.8 million, our net debt-to-enterprise value was 42.9%.

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

(Operator Instructions) And your first question will be from Rob Stevenson of Janney.

Jamie, you were saying that you had dry powder. What are you looking at now? You have enough capacity right now to close on this additional $150 million plus of acquisitions that you're expecting through the remainder of the year without raising additional equity, either common or preferred?

That's correct, Rob. So if you look at our pipeline right now, so north of $700 million. We've got opportunities across many of our existing markets, a few potential new markets that we've discussed in the past. We've got a lot of irons in the fire right now, so I think we're feeling very good about our pipeline, and we're excited about a number of opportunities that we're seeing. There does continue to be significant private capital in the market. So the success on closing them, we'll find out here over the next little while, but we're feeling very good about our position.

Okay. And then the 91,000 square feet of leases signed in the quarter that will commence after March 31, how far out does that go? And if I'm doing my math right, that looks like it adds close to 200 basis points of occupancy to the March 31 portfolio?

Yes. So Rob, it's Tony here. It's going to add 140 basis points to the portfolio, that's contracted, and most of that will start hitting in the second and third quarters.

Okay. And then these occupancy gains, are they -- are these leases in same store assets predominantly or predominantly in some of the recent acquisition portfolio? Because just curious as to how we should be thinking about same store occupancy over the remainder of the year, given your comments on same store NOI?

Yes, it's a bit of a split. Park Tower is where we've seen a lot of the activity, Rob. So I would say that you'll see a good chunk of it there. And in terms of our same store, this leasing activity that we've discussed will help us kind of turn positive later in the year.

Okay, And then, Tony, you said that the same store expense increase was timing related and that, that goes away in the back half of the year, but it's going to be with you for the next couple of quarters in terms of elevated expense growth?

It's a little bit of a combination of factors included in the expenses as we've had some higher property taxes. Property taxes typically lag 2 years after acquisition, when the taxing authorities have a chance to update their values based on the sales. And so, that -- some of that is permanent, but some of that I do expect to timing. So there's a little bit of both going on there.

Okay, but the revenue should be positively impacted by occupancy gains, and then whatever you wind up doing on rental rate is the wildcard there?

Exactly right.

Okay. And then any new incremental known moveouts in the remainder of '18 or '19 at this point from a tenant perspective?

Yes, if you look at the balance of 2018, the largest role we have is VICAL, which is a tenant of ours at Sorrento Mesa property in San Diego. They fully occupy the 68,000 square-foot building. When we acquired the property, we actually expected them to vacate, their lease ends at December 31, 2018. But we already have strong interest in the space, we're in discussions with a few prospective tenants, who actually just want to step right into their completely built-out space. So that is the largest role we have in 2018.

The next question will be from Craig Kucera of B. Riley FBR.

Wanted to circle back to the PIMA Center, just kind of your expectations for financing there and maybe what quotes you're currently seeing that you might be doing there.

Yes. Hey, it's Tony here, Craig. In terms of financing, this is an asset that we're planning to add to the line of credit, so we just completed the unsecured line of credit. And so we did go out and get some quotes on that. And what we're finding is, despite -- and again, I was looking at quotes on long-term fixed-rate at the property-level debt. And so we've seen that move, but when we kind of did a preliminary discussion with some of the brokers, we're still seeing rates kind of in the mid-4s, 4.5%, a little bit above that. But still a lot of lenders want to put out money, and spreads are tightening despite the ten-year really moving.

Got it. I would like to talk about your TIs. The table on Page 17, when I looked at that, trend is sort of tenant improvements on new leasing and renewables kind of from this year versus a year ago, it looks like your new lease TIs have maybe tripled on a per square foot basis and your renewals are up 50%. Is this -- does that table include your first generation TIs? Or is this really sort of an apples-to-apples basis? And that being said, is it mix related? Is it that St. Petersburg tenants are requiring more TIs? Or is it really just across-the-board you're finding you have to spend more to get new tenants and keep the ones you have.

It's a good question. I think there are few questions there. First one is, this does include all of the leasings, so it hasn't been kind of reduced by first generation. This is a complete total of all the leasing totals. The sample size here, I would point out, is relatively small, there's not a ton of leasing. So I'm not sure this is necessarily indicative of major changes. I think speaking to it just more generally, certainly, we're seeing some growth on costs for TI buildouts, but I wouldn't just consider it tripling, in fact. And so this is just a factor of a couple of spaces that may have been first gen, like you pointed out, at Park tower, but generally, we're seeing some inflation in TI costs, but nothing that dramatic.

Just to add to that, Craig. One of the renewals here is a tenant that had a very substantial increase in rate, which we were able to keep. But there was a bit of an elevated TI in order for them to fix up their space. So that was more than offset by the pickup in rate.

(Operator Instructions) The next questions will come from Barry Oxford of D.A. Davidson.

2 questions. Jamie, when it comes to the acquisition pipeline, could you give us a little color maybe how far you are down the line with maybe some of the properties that you're looking or the final negotiations on LOIs? And then maybe talk broadly, not specifically, about 1 property, but maybe broadly about the cap rates we might be seeing from this acquisition pipeline.

Sure. So first part of the question, as far as the number we quoted, $700 million, north of $400 million of that we've traded LOIs, we're in late stage in a process. So there's a few other groups still at the table like ourselves. So we've done full underwrites, full teams have toured the property, we've had our engineers through. So we're very advanced as far as our knowledge base and desire to own it, and we understand in many of those cases the submarkets very well. So I think we're well positioned there, Barry. It needs to kind of conclude a process here, which I think, depending on the particular deal, some of them will be over the next few weeks, some a little bit longer. But we're pretty far along. In terms of cap rates, when we did our initial forecast, it was generally year 1 cash NOI between 7% and 7.5% is what we kind of modeled internally. The Scottsdale deal was just above an 8%. I'd say the 7% to 7.5% is pretty good. In some cases, it may be a little higher, in some cases, a little lower. And if it's a little lower, typically, there's longer leases in place, a lot of capital has been spent. So over the next 10 years, we expect much lower both TIs or capital that has to go into the building. So from a math standpoint on numbers and dividend coverage in growth, we still feel very comfortable about that.

Okay, great. And then, Tony, just a quick question for you. This straight-line rent kind of popped up. How should we think about this straight-line rent number moving into the second, third and fourth quarters here?

Yes, so it's moved up a little bit, and it's really the result of some of the acquisitions we did, Barry. If you look back at the last press release, we provided guidance for straight-line rent, which a little bit higher than it was last year, but we're still tracking that range.

As there are no additional questions, I will turn the call back to Mr. Farrar to conclude.

Thanks for joining everybody, today. We appreciate everyone's time and look forward to discussing our continued progress with you. Have a great day.

Thank you, sir. Ladies and gentlemen, the conference has concluded. Thank you for attending today's presentation. You may now disconnect your lines.