City Office REIT Inc (CIO) 2018 Q2 法說會逐字稿

Good day, and welcome to the City Office REIT, Inc. Second Quarter 2018 Earnings Conference Call and Webcast. (Operator Instructions) As a reminder, this conference call is being recorded. (Operator Instructions)

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

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. 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 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 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 will now turn the call over to Jamie.

Good morning. As we caressed the midpoint of 2018, I would like to take this opportunity to review our progress year-to-date and to highlight our areas of focus for the balance of the year.

At the beginning of the year, we laid out a roadmap to growth and our run rate earnings that focused on leasing high-quality blocks of vacant space and continuing to expand our footprint through acquisitions and strong growth submarkets.

Additionally, we are focused on our balance sheet, and judiciously, locking down our debt cost on a long-term basis, while working towards a well-covered dividend.

The takeaway message, as we stand today, is that we are tracking well towards these goals. Overall, I am pleased with our financial and operating results, which are demonstrative of our strategic acquisitions, leasing activities and portfolio operations. Tony will provide more detail on our results in his remarks.

On the leasing front, we have executed 136,000 square feet of new leases in the first half of this year and ended the quarter at 89.6% occupancy. However, when including signed leases that commence in future quarters, we are currently at 91%.

I'd like to speak to a few recent leasing highlights, including Park Tower in Tampa and our 5090 property in Phoenix. Despite Park Tower's major renovations being underway, we have signed 10 new leases year-to-date for 35,000 square feet at rental rates that exceed our in-place rents when we bought it by approximately 20%. With these leases in place and committed occupancy has reached the 90% milestone, and we look forward to driving this number even higher. At 5090, we leased 13,000 square feet through 4 leases during the quarter and the property is now 94% occupied to high-quality tenants, including in-place and committed leases.

We continue to believe that our remaining larger blocks of space are positioned well to attract quality long-term tenants. The largest blocks of space are at our DTC Crossroads and Plaza 25 properties in Denver, our Sorrento Mesa property in San Diego and our FRP Collection property in Orlando.

Over the next 5 months, we're focused on driving further occupancy gains and monetizing the value inherent in our vacancies.

Next, I'd like to provide you an update on our $175 million San Diego portfolio acquisition that we completed last September. When we acquired the 10-building portfolio, 7 of the buildings were stabilized core assets, which have performed well. We plan to further enhance these buildings through capital improvement projects, including modern fitness facilities, upgraded lobbies and central outdoor amenities among other improvements that will drive leasing. Out of the 10 building that we acquired, we categorized 3 as having a value-add component, such as vacancy or a major tenant that would likely depart in the near term. A major focus during our first 9 months of ownership has been to take steps to derisk these properties and unlock incremental value.

Late last year, we achieved the first phase of this objective when we negotiated an early lease termination with a full building tenant that we knew was likely to cease operations at the 10398 building. This transaction generated $1.6 million of termination income, split between the fourth quarter last year and the first quarter of this year. However, what this really accomplished was capturing 77% of the base rent and estimated operating costs for the remainder of the tenant's lease through March 2020. By completing this buyout, we're able to take early possession of the building and have since completed our reconditioning work to position it for releasing.

Recapturing this space coincides with the commencement of our planned, central outdoor amenity for the Sorrento Mesa campus, which will differentiate our buildings within their competitive set. And finally, getting the 10398 building back early positions us for additional upside by applying current building measurement standards in determining the rentable square footage. Securing a replacement tenant will allow us to increase the net rentable area by approximately 15,000 square feet and meaningfully enhance the property's cash flow.

The second value-add property was the 10390 building, which had a tenant that planned to vacate when its lease expires at the end of this year. We believe that leasing prospects for this building would be strong with limited blocks of quality, available space for a life sciences tenant in the Sorrento Mesa submarket.

I'm pleased to report that subsequent to the end of the second quarter, we executed a new replacement lease on attractive terms for the full building, totaling 68,536 square feet. The execution of the lease successfully stabilizes the building with a well-securitized lease to a life sciences company that desired to take the space with limited tenant modifications. The new 5-year lease is expected to commence on January 1, 2019, immediately following the lease expiration of the existing tenant.

The third value-add building in the portfolio, the 10455 building, continues to be 46% occupied. We're exploring a number of alternatives to unlock value, and we'll provide further updates in future quarters as we advance our plans.

Turning to acquisitions. We have acquired $167 million of properties year-to-date, inclusive of the previously announced Pima Center and 2 new properties, Circle Point and The Quad. We're very excited about the prospects for these 2 new properties, which we recently closed in July. Both of these complexes epitomize the quality of assets and submarkets that we've targeted.

Circle Point is a 2-building Class A office campus, comprised of 272,000 square feet. It's located in the 36 corridor submarket of Northwest Denver, which spans the area between Denver and Boulder along Route 36. This area is known for its high quality of life, attractive housing options, well-educated employment base and technology-related industries. Within this submarket, Circle Point has an identity as one of the most visible and accessible Class A buildings. Located within 2 miles of over 30 shops, restaurants, hotel and entertainment options, Circle Point also boasts its own amenities with an on-site cafe and direct access to a well-landscaped 2-acre park. The recent lease-up of 130,000 square feet over the last 12 months is indicative that the mountain views, contemporary finishes and prominent submarket location make the asset highly desirable from a leasing perspective. We acquired the complex for a purchase price of $59.8 million at a 6.8% Year 1 capitalization rate. It has a 7-year average remaining lease term and is 93% occupied by a desirable and stable tenant mix.

The Quad is a 163,000 square foot, 14-building Class A campus in Scottsdale, Arizona, that we acquired for $51 million at a 7.1% Year 1 capitalization rate. It is a unique, creative campus-style project and its recent $20-plus-million renovation won it the 2018 NAIOP Redevelopment Project of the Year award. The property features an on-site restaurant, conference and amenity center, outdoor recreational spaces and a fitness center. With a full amenity package, excellent location in Scottsdale and state-of-the-art tenant build-outs, the project has seen outstanding demand from creative and tech-oriented tenants. Virtually, all of the project has been leased up over the last 24 months, bringing occupancy today to 97% with limited capital requirements going forward.

On a blended basis, the weighted average Year 1 capitalization rate of Pima Center, The Quad and Circle Point is approximately 7.4%, which we believe is an indicator that we will continue to have success in finding well-located and desirable real estate within our targeted markets that possess attractive return profiles.

With that, we still have an attractive acquisition pipeline. We've closed approximately 75% of the midpoint of our acquisition guidance for the year, leaving approximately $58 million remaining at the midpoint. We continue to have an active pipeline of over $500 million of opportunities, and our goal is to deploy the balance of our capital by the end of the third quarter or shortly thereafter. With our actual results in the first half of the year and expectations for operations and acquisitions during the second half of the year, we are pleased to increase our 2018 Core FFO guidance and reaffirm our occupancy guidance.

In summary, our goal for the second half of the year is to do more of the same. Continue to source quality acquisitions, execute on value-enhancing programs and drive occupancy and same-store results through the lease-up of our vacant space.

With that, I'll turn the call over to Tony, to discuss our financial results and the details of our updated guidance

Thanks, Jamie. On a GAAP basis, our net operating income in the second quarter was $18.5 million. This represents a $1.4 million decrease over the $19.9 million achieved in the first quarter. The decrease from the prior quarter was primarily attributable to the reduction in termination fee income from our Sorrento Mesa property, which Jamie just described; and the sale of our Washington Group Plaza property, which sold in March. These decreases were offset by the income from the Pima Center property, which was acquired in April.

We reported Core FFO of $9.3 million or $0.26 per share, which was $1 million lower than first quarter and was similarly impacted by the sale of WGP and a reduction in termination fee income.

Our second quarter AFFO was $7.1 million or $0.19 per share. Our AFFO in 2018 continues to be affected by several planned, value-enhancing capital and leasing costs, which have been incurred during the first 2 quarters. Of the $4.1 million in value-enhancing expenditures that we've previously estimated for the first 3 quarters of the year, approximately $1 million remains to be spent. These remaining costs are primarily related to our DTC Crossroads property, common area upgrades and amenity additions, which have been pushed out due to an extended permitting process and value engineering. We expect these remaining costs to be spent evenly in the third and fourth quarter.

Due to the relative size of our portfolio and the impact of significant leasing in any one 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 and material considerations underlying our guidance remains intact at this time. We raised and tightened our full year 2018 Core FFO guidance from $1.08 to $1.13 per diluted common share to $1.10 to $1.14 per diluted common share as our year-to-date acquisition volume and timing have slightly surpassed our budget expectations. We've maintained our fourth quarter Core FFO guidance of $0.31 to $0.34 per share, which continues to assume that we are able to fully deploy the remainder of our acquisition capital prior to the start of the fourth quarter. Our leasing activity and capital expenditures are provided on Pages 19 and 21 of the supplemental package.

Consistent with our definition of AFFO, we have excluded some first-generation leasing costs and the repositioning activities at several of our properties, the largest of which continues to relate to the Park Tower repositioning. Further details are disclosed on Page 21, under non-reoccurring capital expenditures.

Our same-store cash NOI decreased 3.1% for the quarter, despite a 2.4% decrease in average same-store occupancy as compared to the same quarter in the prior year, same-store GAAP NOI actually increased 3.2%. The difference in calculation using the 2 methods can be primarily attributed to approximately $400,000 of free rent credits at our Superior Pointe property in Denver. Occupancy at that property increased from 87% to 92% due to an expansion, a renewal and a new tenant. This occupancy increase helped drive GAAP NOI higher, but had little impact on cash NOI due to the initial free rent periods associated with these leases. Rent escalators and renewals occurring at higher rents across our portfolio are also driving this GAAP NOI growth.

We continue to expect occupancy to tick higher through the balance of the year and finish the year within our previously issued guidance of 90% to 93%. However, we expect same-store cash NOI to remain negative through the fourth quarter of 2018 before turning positive in the new year.

The addition of the Sorrento Mesa property to the same-store pool in Q4 will be a drag on same-store results in that quarter due to that ROCA tenant vacate earlier this year, which will result in a reduced occupancy year-over-year as well as continuing free rent periods associated with lease-up across the portfolio, which will also impact same-store cash NOI results.

Moving on to our balance sheet. Our total debt, net of deferred financing costs at June 30, was $479.6 million. Our net debt to enterprise value was 44.4%. We believe our balance sheet strategy over the past 4 years to lock in long-term fixed-rate debt has been prudent. At June 30, fixed-rate debt represented 88% of our total debt with a weighted average interest rate of 4.1% and a weighted average maturity of 6.2 years. We have also rate locked on property-level financing on the 2 acquisitions, which closed subsequent to quarter end. 10-year property financing for Circle Point and The Quad have been fixed at 4.49% and 4.20%, respectively, and we expect to close those loans later this month. We closed both transactions on our unsecured line of credit subsequent to quarter-end, and we'll use the financings to repay borrowings under that line.

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

(Operator Instructions) The first question we have will come from Craig Kucera of B. Riley FBR.

Wanted to start up talking about some of your leasing activity during this quarter. I think your new and renewal leases averaged both around $28 per square foot. And Tony, you mentioned that it was up across-the-board, but do you have a sense of what that -- what those rents were relative to prior rents on a percentage basis or dollar basis, whatever is easier?

Craig, so the average for the leasing spread was approximately 3% in the quarter. And it was slightly lower than -- otherwise because we actually had 1 renewal at a slightly lower rate, and it's partly due to the fact that they received no TI allowance whereas before they had a TI allowance. So -- but it averaged out to 3% this quarter.

Got it. And it looks like a lot of the activity was concentrated in Park Tower and at -- and 5090. But I guess for the remainder of the activity, was it pretty broad-based? Or were there any markets or specific assets where you saw a nice pickup in leasing?

Yes. The biggest change we had in the quarter was at Superior Pointe, I talked about a little bit, that pushed that occupancy from 87% to 92%, but the rest was pretty evenly spread out.

Okay. And as far as your occupancy guidance for the year, was that inclusive of the drag from Sorrento Mesa or was that occupancy guidance based on the same-store pool sort of at the start of 2018?

So the short answer is yes, it does include Sorrento Mesa. It was based on our December 31 portfolio, which did include the San Diego properties and excluded WGP, which was held for sale. So we're working off of our December 31 portfolio. That was 88.5% occupied at the time, and we're tracking nicely to get into our range of 90% to 93%.

Got it. Can you give us some additional color on the tenancy at the Circle Point building? I know you've had some occupancy challenges in Denver, and it looks about 9% as rolling next year. Can you tell us who that tenant is? Or the type of tenant? And any additional color on the tenants in the building?

Craig, it's Jamie. So generally, when you look at that building, the weighted average lease term remaining is about 7 years, and we haven't disclosed who the tenants are but the majority are very high credit. Some of the technology, pharmaceutical, aerospace. So really solid tenant mix. And those have very long-term leases, going out to 2031 in some cases. So the near term, we're not as concerned about. It's just great long-term leases in place.

Next, we have Bill Crow of Raymond James.

I think I'll pick up where Craig left off on Circle Point. Just looking online, it looks like there's maybe another 1 million square feet of entitlements for office out in that -- as part of the same development. Do you know what the plans are for construction there?

Most of the park is expected to ultimately be developed for multifamily. So there has been some multifamily construction. But that's the bulk of what our expectations are.

So no more office within that area?

It's possible, but I think the latest thinking from the owners of the land is, it's probably highest value as multifamily.

Okay. Great. And then getting back to leasing the economics. The lease that you talked about, I think you said you signed it after the quarter in Sorrento Mesa to back to [vacancy]. Could you, specifically on that lease talk about how the starting rents compare to the -- any expiring rents on the former tenant?

Sure. So the building we talked about are currently paying $36 triple net. That was one -- it's very specialized life science space. We took a very pretty conservative approach when we bought the portfolio as far as what our underwriting expectations were. And so signing a lease with a low TI and no downtime starting Jan 1 is a home run. The rents start at $37.80, so that's about a 15% pickup over the expiring rents that have 3% bumps. There is about 3 months of free rent spread across the first 6 months of the lease.

Okay. That's good. And then finally for me. Just kind of reiterate your thoughts on the balance sheet. We tend to think in terms of net debt to EBITDA, and I was just -- after you finish your current year acquisition target, where does that leave you as far as dry powder goes going forward?

Yes. Bill, it's Tony here. So on a net debt to EBITDA, June 30, we're just at exactly 7.0%. Once we deploy, get to the midpoint of the guidance that we provided, that number will push into the mid-7s, call it, 7.5%. And on a net debt to enterprise value, we're at about 44% today, and we'll approach 50%.

So 7.5%, seems like it would be pretty well maxed out. Is that a fair way to think about it?

Yes. When you say maxed out, I mean, that's where we've set as the target for once we're fully deployed. Once we do capital raises and if and when we do capital raises in the past, what we've said is we intend to put leverage on at 40% to 45%, just so that over time, we kind of walk that number down, walk down both the net debt to enterprise value and that net debt to EBITDA. We like to ideally see it 7% and below, but it's going to take us a little bit of time to get there once we're fully deployed.

And next, we have Michael Carroll of RBC Capital Markets.

I was just wondering if you guys could just provide any update on the plan with Plaza 25. I know you guys said someday, you're considering selling this property, and I was wondering if that was still in the works.

So we actually have been ready to go to launch our renovation program for some time. We did have a few purchase inquiries earlier in the year, and we decided to run a bit of process and kind of compare the 2 alternatives of putting the capital in to repositioning it, or potentially selling. So we're still engaged in that exploratory process. We think it will be properly wrapped up one way or the other during this quarter. So we'll look to provide more guidance on our next call.

Okay. Great. Secondly, I was wondering if you guys could provide some more color on the Circle Point deal. The cap rate seem to come in below your target range. So I was wondering if there's anything unique about the asset.

Yes. The location -- and Boulder has just been a phenomenal market. So when you look at that particular area, it's pretty much right dead center between Downtown and Boulder. So it's very easy for companies to draw the tech talent that's up in Boulder as well as people from the Downtown. So we've just seen a huge trend of companies moving to that particular area. Rents are about 10% below market. The suites have all but built out to extremely high standards with great credit tenants, and we've got solid weighted average lease term remaining of about 7 years. So all-in-all, if you look at the attributes of the asset, the retail base all around it, the great housing options, we just think it's really well-positioned long term. So we like that. It is a little lower than our general target. However, if you look at a blended acquisitions to date, we're at about 7.4%. So we're trending right in the middle of where we said we would.

Next, Rob Stevenson of Janney.

Tony, given your comments surrounding leasing and CapEx, et cetera, is it still the supposition that you guys -- with the $0.31 to $0.34 fourth quarter guidance are going to get to the -- at or above the $0.235 dividend coverage in the fourth quarter of this year?

Rob, good question. Just to answer, our guidance is predicated really on 2 main assumptions. One, being that we fully deploy our remaining capital to the midpoint of our guidance range, prior to the start of the fourth quarter. And that will get us to that $0.31 to $0.34 you mentioned. And two, just given the relative size of our portfolio that we don't have any unusually large TI or CapEx expenditures in the fourth quarter. But if you just do the math on $0.31, $0.34 and you take our average TI capital that we have historically, which is about 10% to 11%, the result is dividend coverage. I mentioned earlier in my prepared remarks that we do have $1 million of value-enhancing capital that have yet to be spent this year, that could elevate our historical CapEx number and potentially quick slide into Q4. But saying all that, nonetheless, once the acquisitions are completed and those spikes in capital pass were back to normalized dividend coverage.

And what is the sort of remaining dry powder that you guys have to invest into acquisitions?

So roughly to hit the midpoint, Rob, it's about $60 million.

Of incremental investment?

Of acquisitions. Dollars.

Correct.

Okay. And then, what are you guys thinking about beyond that? I mean, given where the stock price is, are you guys contemplating dispositions to turn into other assets? Do you guys sit in a hold if you're still looking at 12-something-dollar stock price? How are you guys thinking about that these days in terms of where you go from here after this next $60 million is deployed?

Yes. It's a good question. So focus for us right now, primarily, is on closing the deals in capital that we have. Putting that money to work. Driving occupancy. We are exploring a couple of potential sales, earlier stage. We mentioned Plaza 25 is one. The one particular building with low occupancy in San Diego is another one we're exploring. We've had some inquiries around our lands. So there's a number of alternatives there that we're weighing. And we'll see how acquisition pipeline and operations come together over the next little while and make a call at that point.

Okay. And then just last one for me. What drove the sort of shorter term on the renewals during the quarter? It was only like 2.6 years. Was that one lease in particular? Was that a -- several sort of 1-year lease extensions or something like that? What brought that down from your sort of normal levels?

Yes. So in Florida, we have a couple of properties that have short-term, 1-year renewals that is driving down the average. We have 1 tenant, who's been a tenant in our Central Fairwinds building as long as we've owned the property, that does 1-year renewals that drags down the results. And then we have a couple of government tenants in our Florida Research Park Collection building. They're also on -- they're basically automatic 1-year renewals.

And next, we have Barry Oxford of D.A. Davidson.

To build on Rob's question, Jamie or Tony, would you guys look from a capital structure if the stock price isn't where you want it to be to use preferred from that type of standpoint, as far as continuing to build your equity?

Maybe I'll start with answering the question, Barry. I think the short answer is, yes, potentially, we have, we believe, a little bit of room in our capital stack to add additional preferreds. We do have an ATM program in place that we've yet to really utilize, but potentially, that ATM could be used for both the common and the preferred. On the preferred side, generally the volume is relatively low on trading. So the ability to issue the ATM may not be that significant. But certainly, ultimately, whenever we're thinking about raising money, we have to kind of look at where our pipeline is, and would these transactions be accretive to AFFO. So all those options are under consideration.

And just to kind of go a little further. So the options we kick around internally is, we're looking at where various prices are of stock. I mean, for us, it's the common, there's preferred. We've looked at some JVs in the past, selling assets, which I just mentioned. We do have 1 transaction we're talking about that could be an OP unit. So there's a number of different alternatives that we can consider.

Jamie, are you looking seriously at joint ventures or nothing in discussions at this point?

It's been more with a few different groups that have assets that we've had a few preliminary discussions. Nothing advanced on the JV side today.

(Operator Instructions) Our next question will come from Merrill Ross of Boenning.

Looking at Circle Point and Quad, it's very difficult to see that there's any value-add component, but I just wanted to be sure I wasn't missing something and that these were bought more for their long-term potential that you referenced rather than any value-add component.

Yes. There really isn't a major value-add component to either. I think what we see is great submarkets that are going to continue to perform well. There's a mark-to-market on the rents. So at Circle Point, they're about 10% below market. The Quad's a similar number. We think market rental rates for both of those are going to continue to grow at healthy numbers. So when we have renewals, we're looking for no above average step-up in long-term growth.

Well, at this time it appears that we have no further questions. I'll go ahead and hand the conference back over to Mr. Jamie Farrar for any closing remarks. Sir?

We want to thank everybody for joining today and wish you all an enjoyable rest of your summer. Goodbye.

All right. Thank you, sir, and also to the rest of the management team for your time. Again, the conference call has now concluded. At this time, you may disconnect your lines. Thank you. Take care and have a great day, everyone.