Equity Commonwealth (EQC) 2010 Q3 法說會逐字稿

Ladies and gentlemen, good afternoon. Thank you for standing by, and welcome to the CommonWealth REIT third quarter conference call. At this time, all lines are in a listen-only mode. There will be an opportunity for your questions, and instructions will be given at that time. (Operator Instructions). As a reminder, this conference is being recorded.

At this time, I would like to turn the conference over to our host, Vice President Investor Relations, Mr. Tim Bonang. Please go ahead.

Thank you, Tom. Joining me on today's call are Adam Portnoy, Managing Trustee, and John Popeo, Chief Financial Officer. The agenda for today's call includes a presentation by management, followed by a question and answer session. I would also note that the recording and retransmission of today's conference call is strictly prohibited without prior written consent of CommonWealth REIT.

Before we begin today's call, I would like to read our Safe Harbor statement. Today's conference call contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, and federal securities laws. These forward-looking statements are based on CommonWealth's present beliefs and expectations as of today, November 3, 2010. The Company undertakes no obligation to revise or publicly release the results of any revisions to the forward-looking statements made in today's conference call, other than through filings with the Securities and Exchange Commission, or SEC, regarding this reporting period.

In addition, this call may contain non-GAAP numbers including funds from operations, or FFO, and cash available for distribution, or CAD. A reconciliation of FFO and CAD to net income is available in our supplemental package found in the Investor Relations section of the Company's website.

Actual results may differ materially from those projected in any forward-looking statements. Additional information concerning factors that could cause those differences is contained in our Form 10-Q, which we expect to file shortly with the SEC, and in our Q3 supplemental operating and financial data package found on our website at www.CWHReit.com. Investors are cautioned not to place undue reliance on any forward-looking statements.

And now I would like to turn the call over to Adam Portnoy.

Thank you, Tim, and good afternoon, everyone, and thank you for joining us on today's call. For the third quarter 2010, we are reporting fully diluted FFO of $0.92 per share, compared to $1.06 per share during the same period last year. The decline in FFO per share primarily reflects the issuance of 8.6 million new common shares in March 2010.

During the third quarter, we also generated CAD of $0.73 per share, which is 3% greater than the $0.71 per share generated during the same period last year. The increase in CAD per share primarily reflects lower expenditures for tenant improvements and leasing commissions in the current period. Our CAD dividend payout ratio remains very strong at 67%, and we generated an annualized $60 million of free cash flow during the current quarter.

As of September 30, our occupancy rate was 86.4%, which is 40 basis points higher than the 86% we reported at the end of the second quarter. During the quarter, we signed leases for two million square feet. 64% of our third quarter leasing activity were renewals, and 36% were new leases. Leasing activity this quarter resulted in a 3% roll-up in rents, and $13.04 per square foot in capital commitments. The average lease term was 5.8 years, and the average capital commitment per lease year was $2.25.

Generally speaking, leasing market conditions for our portfolio have stabilized across the country. In most markets, conditions are not getting any worse, but they're also not getting any better, either. As a result, we're generally operating in a weak market for landlords. However, development activity across the US has slowed considerably. And this bodes well for incumbent landlords such as ourselves in the future, because when the economy does start to improve, we should benefit from the lack of competing new product available for tenants.

As a result of the current market conditions, year-over-year same-store consolidated NOI for the third quarter declined by 4.9%. As many of you may know, we operate in over 60 markets in 33 states and Washington, DC. And 43% of our NOI comes from suburban office properties, and 34% comes from CBD office properties, and 23% comes from industrial and other properties.

Because of the size and the diversity of our portfolio, our leasing results tend to track closely to national office trends. Generally speaking, our CBD office properties are performing better than our suburban office properties, and our Oahu industrial properties are performing better than our industrial properties located in other markets. Our better performing major markets are Philadelphia, Pennsylvania, Oahu, Hawaii, Washington, DC, and Denver, Colorado.

As of September 30, we have 8.9 million square feet scheduled to expire by the end of 2011. On average, the leases scheduled to expire through the end of 2011 have in-place rents that are 5% to 10% above market. As a result, we expect that same-store NOI may decline further for the next few quarters, or until the economy begins to show sustainable growth, and employers start hiring again.

Even though we have been operating in a difficult leasing environment, during the last couple of years, we have taken advantage of the market to upgrade our portfolio with first-class property acquisitions at fantastic valuations. Since July 1, we have acquired 26 properties for $374 million, and the going in cap rate for these acquisitions range from 8.6% to 11.4%. We've also sold 13 properties for $200 million, and recognized gains of $27.4 million.

As of today, we also have a portfolio of seven properties located in Birmingham, Alabama, with about 900,000 square feet under agreement to purchase. This portfolio is 96% leased to 40 tenants for a weighted average lease term of 4.5 years. We expect to acquire this portfolio during the fourth quarter of 2010. However, this acquisition is subject to customary closing conditions, and no assurance can be given that this acquisition will be consummated in that time period, or at all.

In summary, although CommonWealth is facing a difficult business environment for office landlords, we are taking advantage of the current market to significantly improve our portfolio by acquiring high-grade properties at low prices.

I will now turn the call over to John Popeo, our CFO.

Thank you, Adam. Looking first to the income statement, rental income increased by 6%, while operating expenses increased by 7%. The year-over-year quarterly change in rental income and operating expenses reflects increases in NOI from properties acquired since June 2009, offset by the $5.5 million decline in same-store NOI in 15 properties sold to GOV between June and September 2010. The 10.9% increase in general and administrative expenses reflects property acquisitions and sales activities, and additional legal fees and expenses related to litigation in Hawaii.

Current quarter EBITDA increased by 2%, reflecting property acquisitions, offset by the decline in current quarter same-store NOI, and property sales in 2009 and 2010. Interest expense increased by 7%, reflecting the issuance of $125 million of 7.5% unsecured senior notes, and $175 million of mortgage loans with a current interest rate of 5.66% during the fourth quarter of 2009, and the issuance of $250 million of 5.875% unsecured senior notes in September 2010, offset by the prepayment of $266.7 million of mortgage debt, and the repayment of $30 million of senior notes in August 2010.

In August 2010, GOV issued 9.2 million new common shares in a public offering for $25 per share. As a result of this transaction, our ownership interest in GOV was reduced from 31.8% to 24.6%, and we recognized a gain under the income method of accounting, totaling $18.4 million. This gain represents a partial mark to market value adjustment under GAAP that reduces the spread between our carrying value, and the price of newly issued GOV shares. The carrying value of our 9.95 million GOV shares was around $16 per share prior to GOV's recent common equity offering, and $17 per share as of September 30, 2010.

We recognized $22.8 million of gains from sale of 12 properties to GOV during the quarter, excluding $9.2 million of gains we're required to defer under GAAP that are attributable to our 24.6% ownership interest in GOV. Properties sold or held for sale to GOV are not considered discontinued operations under GAAP because of our retained equity interest in this former subsidiary.

Since its IPO in June 2009, our investment in GOV has been accounted for using the equity method of accounting. Under the equity method, we record our percentage share of net earnings and FFO of GOV in our financial statements. Our percentage share of GOV net income and FFO for the third quarter totaled $2 million and $4.2 million, respectively. We received over $4 million of GOV dividends during the third quarter of 2010. The decrease in gains on sales and income from discontinued operations reflects the sale of one property that was sold in September 2010 for $9.8 million, and seven properties that were sold during 2009 for $144.6 million.

Net income available for common shareholders for the third quarter of 2010 was $53.1 million, compared to net income of $59.5 million for the third quarter 2009. Diluted FFO available for common shareholders was $0.92 per share for the third quarter 2010, compared to $1.06 per share for the third quarter of 2009. Year-over-year results primarily reflect the issuance of 8.6 million new common shares in March 2010.

In October 2010, we declared a dividend of $0.50 per share, which represents 53% of our third quarter FFO, and 67% of third quarter CAD. This dividend is expected to be paid later in November 2010. During the quarter, we spent $10.4 million on tenant improvements and leasing costs, and $2.9 million, or $0.04 per square foot, for recurring building improvements, including roof, mechanical, life safety and roadway upgrades, and other capital projects throughout the portfolio. We paid $5.9 million on development and redevelopment activities during the quarter.

Turning to the balance sheet, on September 30, we held $175 million of unrestricted cash, reflecting excess proceeds from capital finance transactions completed in September. Rents receivable includes approximately $169 million of accumulated straight line rent accruals, as of September 30. Other assets include approximately $101 million of capitalized leasing and financing costs.

On September 30, we had $168 million of floating rate debt, $358 million of mortgage debt, and $2.3 billion of fixed rate senior unsecured notes outstanding. The weighted average contractual interest rate on all of our debt was around 6% at the end of the quarter, and the weighted average maturity was over five years.

Our senior unsecured notes are rated BAA 2 by Moody's, and BBB by Standard & Poor's. The undepreciated book value of our unencumbered property pool totaled about $6.1 billion at the end of the quarter. Our secured debt represents 6% of total assets, and floating rate debt represents 6% of total debt. At the end of the third quarter, our ratio of debt to booked capitalization was 46%. Our EBITDA and fixed charge coverage ratios were 2.6 times and 2.0 times, respectively. As of the end of the quarter, we were comfortably within the requirements of our public debt and revolver covenant.

In August 2010, we entered a new $750 million unsecured revolving credit facility. The new facility replaces our previous $750 million facility, which had a maturity date of August 22, 2010. The maturity date of the new facility is August 8, 2013, and it includes an option to extend for one year to August 8, 2014. The new facility also includes a feature under which the maximum borrowing may be increased to up to $1.5 billion in certain circumstances. Interest paid under the new facility is set at LIBOR plus 200 basis points. We had nothing outstanding on the facility as of September 30.

In September 2010, we issued 7.5 million common shares in a public offering, raising net proceeds of approximately $192 million. We used a portion of the net proceeds from this offering to repay amounts outstanding under our revolving credit facility, and we deposited the balance in interest bearing money market accounts. In October 2010, we repaid at maturity all $20 million of our 8.625% unsecured senior notes due 2010, using cash on hand.

Today, we have $250 million outstanding on our revolving credit facility, reflecting the $175 million redemption of our 8.75% Series B preferred shares in October, and acquisitions and debt repayments completed subsequent to quarter end. The issuance of common shares in September, offset by the redemption of our 8.75% Series B preferred shares in October is expected to reduce quarterly FFO per share by around $0.04.

In summary, this quarter produced results we expected in light of a challenging market environment. Our strong balance sheet, solid dividend payout ratio, and $500 million of availability on our revolving credit facility, position us to opportunistically grow cash flow.

That concludes our prepared remarks. Operator, we are now ready to take questions.

Thank you. (Operator Instructions). Our first question will come from the line of James Feldman representing Banc of America. Please go ahead.

Hi, this is Andrew Lee. I'm here with Jamie Feldman. Just had a quick question. If I go to your supplemental on page 23, just wanted to get a better understanding of the two markets, and what's happened there, particularly DC and Boston. Looks like you guys lost some occupancy, and your margins eroded a little bit. Can you talk about those markets?

Sure. The markets you want to talk about are Boston and DC, is that right?

Correct.

Yes, Boston, that just is a reflection of what we've been talking about for several quarters, about how the suburban Boston portfolio we own was going to have some leasing challenges. And that's just something -- we just have some increased vacancies in the suburbs around Boston, but this is something we've been talking about for several quarters. In Washington, DC, it's a slight decline in the occupancy, but that represents, again, some suburban properties that we had some lease roll, and we weren't able to lease 100% of it back up. That's principally what's going on there.

Got it. Just sticking with the Boston market, looks like you guys have quite a bit of leases expiring in 2011. I guess, when we think about next year, how does that look in terms of like the releasing spread, or what are you anticipating? And have you guys actually started having conversations with tenants yet, and have any of the leases already been filled?

We have started conversations with many tenants for 2011, and even a little bit for 2012 expirations. But we have about -- I think it's about 130,000 square feet expiring in the Boston area, and actually the in-place rents are actually below market in Boston, what we have coming due over the next year. And so my hope is that we're able to at least keep things relatively flat. The last year in Boston for this portfolio has been pretty tough, but I think we've worked through most of the declines, and most of what we thought was going to go vacant. And I think for 2011, things will be better than they've been in 2010 for us.

Great. That's helpful. Thank you.

(Operator Instructions). We will go to John Guinee's line with Stifel. Please go ahead.

Couple of quick questions. John, right now you are accounting for your convertible preferreds on an as convert basis, as I understand it. But I think the strike price is maybe $52 a share. Is there sort of a rationale as to why that's treated on an as convert basis?

It's simply adhering to technical accounting standards, John. I believe it's FAS 128 EPS. We don't have a choice.

Okay. And then a couple of things. You went down to Monterey, California, seven assets, $28 million. What's sort of the thought process there?

Sure, John, to get into detail regarding that acquisition, specifically that is not a building acquisition. Those are actually vineyards. Those are seven parcels of vineyards that we bought, and it's a new type of acquisition for the Company. It's not one that I expect us to make a lot more of, but it was a unique opportunity presented to us. The Wine Group, which is a privately held -- the largest privately held spirit manufacturer in the country approached us, or approached a very select group of parties to see whether or not we'd be interested in sale-leaseback.

It's safe to say, even though it's a private company, when you look at the financials, it's an investment grade rated credit, or equivalent to an investment-grade rated credit. It's an opportunity to enter into a 16-year lease at above a 10% yield, with an investment grade rated tenant with investment grade rated credit. It is vineyards, it is a different asset class, but I think you can count this as sort of a one-off opportunistic acquisition with a good credit tenant for a long-term lease, with a good cap rate, but I don't think we're going to be making a lot more acquisitions like this. Unless of course, the Wine Group, now that we have a relationship with them, they may show us some other opportunities, but I do not anticipate this being a large part of our portfolio by any means.

Okay, thank you.

Next question comes from the line of Josh Attie with Citi. Please go ahead.

Good afternoon, it's Michael Bilerman here with Josh. Adam, in terms of cap structure, share issuance versus share buyback, and buying assets, you look at where your stock trades, and issuing equity throughout the year, and then going out and buying the assets upon where you're buying them, why wouldn't capital be better served for shareholders buying back stock?

Well, it's a complicated question, Michael. Is that Michael that asked that?

It is.

Okay. It's something we think about. I will point out that most of what we have financed -- most of the acquisitions we have financed over the last two years have come, I think 80% of it has come through asset sales, so we haven't been a frequent issuer of stock. We did issue stock in March of this year, is the first time we had gone back to the public markets in, I think it was over 2.5 years. Most of the activity you have seen us do in the capital markets in the last couple years has simply been refinancing existing debt, and so stock buybacks can make sense. If we were to do it, we'd obviously, probably -- we may have to increase our leverage, so that would be something we'd consider, but we're trying -- what we've been trying to do over the last couple years is upgrade the portfolio, improve the quality of the assets we own without having to access a lot of capital to do it.

And we've been doing that by basically recycling assets. We've been selling assets, and I think there may even be some more of that, or as we think about how we deploy capital, we'd probably look to maybe selling assets before we would think about raising equity again. So that's what we're trying to do. If we were to buy back stock, I think there's some concern about the leverage levels of the Company, or how we would do it. And so that's essentially what we've been trying to do over the last couple years.

But even if, you raised almost $500 million of equity between the September and the March raise, and your NAV, if you believe your NAV is north of the stock, and everyone can have different opinions as to whether it is, but you seem to be of the belief that you're trading at a discount to NAV. By issuing equity at a discount, you're just narrowing that gap, and you're destroying shareholder value rather than creating shareholder value.

Well, Michael -- .

You've reduced your dividend to allow for -- to have positive free cash flow. So on a leverage neutral basis, why wouldn't you just be taking that free cash flow and just buying back stock, then issuing new stock to shareholders?

Michael, keep everything in the context. I know you're looking through your glasses in today's market, but keep in mind the fact that in 2009 we never issued stock. We never did any recapitalization equity issuances, and I know maybe it was -- maybe everybody got a free pass in 2009, but a large amount of what we were raising in equity in 2010 dealt with repaying debt, and fixing the capital structure of the Company.

We were doing some of the things that our competitors were doing in 2009, except we were doing it at a much higher stock price at which they did it at. If you want to compare us to the market, and say what we did versus what our competitors have done, you have to compare our equity issuances in the context that we're largely doing to repay debt, because all the acquisitions have virtually been paid through asset sales. And you have to compare that to the fact that everybody else, when they were effectively fixing their balance sheets, were doing it at stock prices that were 20% of where we issued stock price at.

I think that's fair.

That's the context by which I respond to that. So I understand the math of your argument, but you have to look at the whole picture over the last two, three years.

Going forward, as you sit here today, and you look at where your stock is, and the opportunities, rather than buying $30 million of vineyards, which, the whole point of simplifying your story and becoming narrow and really focusing, why even take that $30 million and buy vineyards even if it's good credit and a long-term lease? Take that $30 million and buy your stock.

In the future -- let me answer it this way. I think that going forward, it is more likely for us to sell properties or issue debt than it is for us to issue equity. We understand where our equity -- where our stock price trades. We're acutely aware of it. So I think we'll keep that in mind. But I can't tell you that -- I think a lot of companies got in trouble buying back stock, and it may help your stock in the short term, but long term a lot of companies got in trouble with it in the 2007 and 2008 time period, because suddenly they had an overlevered balance sheet.

So we're just very careful and very wary about reducing our equity base in this environment. We're not completely out of the woods yet in the office market. We're not -- the office fundamentals across the country have not suddenly -- they've stabilized, but they haven't turned the corner. I think we would have to see some real improvement in the office fundamentals, at the fundamentals of the Company before we would, and simultaneously having our stock trading at the same place, for us to have a serious discussion about a stock buy back. We'd have to have a lot of wind at our back. The reason we have $60 million of free cash flow on an annualized basis, you look at our occupancy, we hope in 2011 and 2012 that that (inaudible) show a decline significantly, because we're going to be leasing up the portfolio, so you have to keep that in mind, too.

Okay, thank you.

We have a question from the line of Steve Swett with Morgan Keegan, please go ahead.

Thanks very much. Adam, I was going to ask you about the thoughts on dispositions, but I think you addressed that. But can I ask you, as you look at, another part of your balance sheet is the GOV shares, would you look at selling those at some point to use as capital to reinvest?

Yes, Steve, the short answer is, yes, we would. I'm not sure that's on the top of the list of things we're thinking about in terms of sales or asset sales, but it would be -- it's one of the tools in our tool chest that we could draw upon, and some day we will sell those shares, but it's not something that I would say is on the short-term horizon.

Okay. And then just last question, did you mention the size of the Birmingham transaction in the fourth quarter?

Square feet, 900,000 square feet, but because of CAs we can't disclose the purchase price.

Can you provide any more color on the pipeline or the opportunities that you're looking at, and how you feel about the pace of volume into 2011?

We're still seeing some opportunities. I would say that real screaming buys, class-A1 CBD properties that we were buying in 2009, or maybe the first few months of 2010, there's less and less of those. I'd say that my gut is telling me that acquisition pace may slow a little bit going forward, simply because we're not seeing the type of opportunities the way we did a year ago.

Okay, thanks for the color.

Yes.

We'll go to David Rothchild's line with Raymond James Financial. Please go ahead.

I got on a little late, so if this was addressed earlier, I apologize. Could you address what the thought process you guys went through to reverse split your stock, how you thought that benefited your public shareholders?

Sure. This is something we did, I think two quarters ago, but we went through the reverse stock split analysis because a lot of shareholders pay -- there's a lot of things that went into it. One, a lot of shareholders pay to trade on a per share basis. And there was also the issue of -- it was very hard for accounts to -- many institutional shareholders won't even buy below a $5 share price, and it's not that we were at $5 when we did this reverse split, but we were just a little bit above it. And there's also a lot of limitations on shareholders' ability to put leverage or margin account on a stock that's below $5. So between commissions, limiting your investor universe in terms of, in some institutions just won't buy a stock that trades at a certain dollar price, those were the things that went into the decision.

I'm a retail broker. Just from my angle, my clients hated it. They were not very pleased with you folks. So, I guess the sooner you can forward split it back, we'd like to see that go. Thank you.

Thank you.

And I'd now like to turn the conference back over to Adam Portnoy for closing comments.

Thank you all for joining our call this afternoon. We will be at the NAREIT investor conference later this month, and we hope to see you there. Thanks.

Ladies and gentlemen, that does conclude our conference for today. We thank you for your participation, and for using the AT&T Executive Teleconference service. You may now disconnect.