Equity Commonwealth (EQC) 2017 Q1 法說會逐字稿

Greetings, and welcome to the Equity Commonwealth First Quarter 2017 Conference Call. (Operator Instructions) As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Sarah Byrnes, Vice President of Investor Relations. Please go ahead.

Thank you, Kevin. Good morning, and thank you for joining us to discuss Equity Commonwealth's results for the quarter ended March 31, 2017. Our speakers today are David Helfand, President and CEO; David Weinberg, COO; and Adam Markman, CFO.

Please be advised that certain matters discussed during this conference call may constitute forward-looking statements within the meaning of federal securities laws. We refer you to the section titled forward-looking statements in yesterday's press release, as well as to the section titled risk factors in our most recent annual report on Form 10-K for a discussion of factors that could cause actual results to materially differ from any forward-looking statements. The company assumes no obligation to update or supplement any statements made today that become untrue because of subsequent events or otherwise. Today's remarks also include certain non-GAAP financial measures. Please refer to yesterday's press release and supplementals containing our first quarter 2017 results for a reconciliation of these non-GAAP performance measures to our GAAP financial results, which is available on our website.

With that, I will turn the call over to David Helfand.

Thank you, Sarah. Good morning, and thank you all for joining us. I'll begin with brief comments on market conditions and then provide an update on the company's progress so far in 2017.

The U.S. economy grew 7/10 of a percent in the first quarter, continuing the tepid rate of expansion we've experienced this cycle. In March, the economy added 98,000 jobs and the unemployment rate declined to 4.5%.

With respect to interest rates, the yield on the 10-year treasury, up almost 80 basis points to 2.6% following the election, has since fallen to 2.3%. Equity markets are off to a strong start, with the NASDAQ up 13% year-to-date and the S&P 500 up 7%. The Morgan Stanley REIT index, or RMS, is roughly flat.

Financial market seems to be sending somewhat divergent signals with the equity markets implying higher growth ahead and the bond markets suggesting more modest expectations.

In terms of U.S. office fundamentals, the first quarter experienced evidenced of continued signs of modestly decelerating growth. Vacancy ticked up, rent growth slowed, net absorption was sluggish and deliveries were up. Softening in occupancy and rent growth appears to be broad-based. We expect deliveries in 2017 to be roughly 90 million square feet, up from 60 million feet in 2016. We think it's unlikely that demand keeps pace with supply this year.

With respect to real estate capital markets. Gradual decline in transaction volume that began last year continued in the first quarter. Transaction volume remains healthy by historical standards, but is well below the 2015 cyclical peak. There are fewer bidders in the market generally, underwriting is less frothy and deals are taking longer to complete especially outside of gateway markets.

On the other hand, real estate debt capital markets remain strong with plenty of availability and a recent tightening of spreads. At EQC, it was relatively quiet quarter, leasing activity includes the renewal of a large tenant in Philadelphia and in April, we competed another large renewal at our Delaware property, further reducing our near-term expiration risk.

In terms of dispositions, we closed on the sale of 3 properties in the quarter, and another 2 subsequent to quarter end for a total of $178 million.

In summary, we closed on the sale of 111 Market Place, a 589,000 square-foot office building in Baltimore for $60.1 million. Pricing was in the low 5% cap rate range, including adjustments for the scheduled move out of the property's largest tenant. We sold 2 neighboring office properties on Seton Center Parkway in Austin for $52.5 million. The properties totaled 238,000 square feet and were 96% leased. Pricing was in the mid-7% cap rate range. We also sold a 10.2 acre vacant land parcel in Mansfield, Massachusetts for $575,000. And subsequent to quarter end, we closed on the sale of 2 properties that were held for sale. We closed on the sale of Parkshore Plaza, a 271,000 square foot, 73% leased office property in Folsom, California, for $40 million. Pricing was in the mid-6% cap rate range.

Finally, we sold 25 South Charles Street, a 359,000 square foot office property in Baltimore, for $24.5 million or $68 a foot. The building was 94% leased at the time of sale. The building's largest lease is scheduled to expire in 2018.

We currently have 11 properties in the market totaling 5.7 million square feet, we will continue to sell assets selectively when we can achieve attractive pricing.

Since taking ownership of EQC, we've had success selling assets into a strong transaction market. We've completed sales now exceeding $4.3 billion. The team at EQC has done an outstanding job adding value to our portfolio through entrepreneurial leasing and repositioning of assets. These efforts have improved the marketability of our properties and our portfolio repositioning has occurred at a pace that exceeded our initial expectations.

Today, we own a higher-quality portfolio that is more concentrated and in better markets.

As we said before, we are an unconventional REIT. We have deliberately and meaningfully shrunk our asset base and rationalized our footprint. By retaining the proceeds from these sales, we positioned ourselves for outsized growth in the future. We have no intention of remaining a subscale company. We have significant investment capacity with $2.9 billion of liquidity, and are focused on identifying the right opportunities to deploy capital.

The combination of our people, platform and balance sheet provides a tremendous opportunity to create long-term value for shareholders. We are keenly focused on that objective.

Now I'll turn the call over to David.

Thank you, David. Good morning, everyone. I will begin by reviewing our first quarter leasing activity, provide an update on our 5 largest markets. Then I will give an overview of our lease roll for 2018.

Our same property portfolio was 89% occupied at the end of the first quarter, down 230 basis points from the fourth quarter and down 260 basis points from a year ago. As we previously discussed, this decrease in occupancy was expected given the concentration of move outs in the first quarter. 400,000 square feet of space was vacated during the quarter, which is almost 2/3 of all the space that we expect to get back for the full year. During the quarter, we signed 331,000 square feet of leases, including 67,000 square feet of new leases and 264,000 square feet of renewals. Rental rates increased 21.6% on a GAAP basis, and declined 4.9% on a cash basis. Our largest lease during the quarter was at 1600 Market Street in Philadelphia. PNC Bank extended its lease for 233,000 square feet through May 2031. We believe this extension enhances the value of the asset by securing a high-quality credit anchor tenant for 14 years. An additional 129,000 square feet that PNC currently leases will expire in January 2019. Most of this is desirable upper floor space, and we've got time to work out its (inaudible).

At the end of the quarter, we signed a 241,000 square-foot renewal with Capital One at our property in Wilmington, Delaware. They will continue to occupy the entire building until the end of 2028. As part of this deal, their lease was changed to a net structure and Capital One will manage the property themselves. We believe this new lease structure increases the value of the asset. This deal was executed after the end of the quarter and is still included in the 2019 expirations in our (inaudible) .

I will now turn to our 5 largest markets where 74% of our annualized rental revenue is generated. Boston had another quarter of positive net absorptions, and its vacancy rate of 9.5%, however, it has 2 million square feet under construction and we are starting to see some early signs of the market slowing with technology companies taking more time to make leasing decisions.

In Bellevue, demand for space continues to be strong. The vacancy rate is 16%, which reflects a delivery of a new 725,000 square-foot building in the first quarter. Considering leases signed but not commenced, Bellevue's vacancy rate is closer to 12%. In terms of our portfolio, as we have discussed, we've been working for 18 months on securing additional development licenses at Bellevue Corporate Plaza. We believe this is one of the best sites in Bellevue, located across the street from the new transit terminal. Our development plan was recently approved. The plan includes the existing 10-story, 200,000 square foot building and the right to build an additional 1.1 million square feet. This right is good for 10 years. Our team has steered this plan through the approval process, has created significant value whether we develop the site or monetize the development rights by selling the property.

Turning to the Chicago CBD, with the recent delivery of 2 properties in the west (inaudible) totaling 2.3 million square feet, its vacancy rate increased 180 basis points to 13%. While the CBD has benefited from the in-migration of tenants, the market is likely to soften given the growing availability of quality sublease space and over 4 million square feet of additional supply delivering in the next 2 years.

In the Denver CBD, leasing is challenging with the vacancy rate around 17%. The market continues to be impacted by new supply. We have a 128,000 square feet of vacant space at 17th Street Plaza and expect another 50,000 square feet to vacate through 2018.

We are completing a lobby renovation and other upgrades that will help maintain the property's position as one of the top buildings in Denver.

In the Philadelphia CBD, the vacancy rate decreased 30 basis points to 10.7%. While Philadelphia had another quarter of positive net absorption, it remains a competitive market. We continue to focus on our vacant inventory and making sure our properties show well.

(inaudible), 1735 Market Street our leasing pipeline (inaudible) and rooftop deck should open this summer.

Finally, I would like to comment on our lease roll in 2017 and '18. In total, through the end of 2018, we only have 1 million square feet roll or just 7.9% of lease square footage. Out of this amount, we expect about 550,000 square feet to vacate. As Adam will walk you through, these totals compare favorably to the square footage that is leased, but not currently generating rent. With that, I will turn the call over to Adam.

Thanks, David, good morning. I will review our financial results for the quarter and discuss a few details about free rent and occupancy. FFO was $0.27 per share compared to $0.30 per share in the first quarter of 2016. Normalized FFO was $0.24 per share compared to $0.29 a year ago. This decrease in normalized FFO was primarily due to the success of our disposition program, partially offset by interest expense savings from debt repayments, lower preferred dividend distributions, following the Series E redemption, an increase in interest income from higher rates and higher cash balances and a lower share count due to share repurchases.

Same property NOI was up 3.4% in the first quarter compared to a year ago. The growth was driven by increases in tenant reimbursements, parking revenue and approximately 85,000 square feet of new leases that commenced during the first quarter.

These gains were partially offset by tenant move outs, and an increase in operating expenses, driven by tax refunds received in the first quarter of 2016, which lowered expenses during that period. Same property cash NOI was roughly flat when compared to the first quarter of last year. Cash NOI increases from the burn off of free rent and higher escalation income at 600 West, Chicago were offset by free rent related to the 1.1 million square foot renewal we signed at Research Park in Austin in the fourth quarter.

Cash NOI does not include revenue from another 600,000 square feet of leases that were also in abatement. In total, free rent for the quarter was $5.4 million. If added, property-by-property commenced occupancy information in the supplemental. At the end of the first quarter, 89% of the portfolio was leased and 86.3% had commenced, with the difference being 390,000 square feet of occupancy that had not commenced and therefore, was neither in cash nor GAAP NOI during the quarter.

The cash flow benefit of our leasing activities will begin to show up during the second half of the year.

Moving to dispositions, we have sold $178 million of properties to-date in 2017. These sales generated a net taxable loss and increased the balance on our existing net operating loss carryforwards.

We have $425 million of senior notes with a weighted average interest rate of 6.3% that are prepayable at par in the third quarter. The larger of these notes is a $250 million, 6.65% bond due in early 2018, with a $175 million balance being 5.75% baby bonds that open at par in August, but aren't due until maturity in 2042.

Given the flexibility of this debt, we'll continue to evaluate our options. Our cash and marketable securities total $2.2 billion or $17 per share. During the quarter, the board authorized $150 million in repurchases, following the expiration of our previous share buyback authorization in March. We did not buy back any shares during the first quarter.

Our balance sheet remains strong with $2.9 billion of capacity and $1.1 billion of debt. This liquidity and balance sheet flexibility continue to be a competitive advantage that positions us well for future opportunities.

Thank you. And with that, I will open it up to Q&A.

(Operator Instructions) Our first question today is coming from Jamie Feldman of Bank of America Merrill Lynch.

I guess, starting with Adam, some of the numbers you laid out in terms of future revenue and income. So $5.4 million of free rent, that's annualized?

No, that was the amount of free rent in the quarter.

Okay. The first quarter itself. And then 390,000 square feet not yet commenced, can you quantify the GAAP impact and cash impact?

Well -- we haven't provided that information. But I think by giving you the commenced and leased numbers property-by-property in the supplemental, you can kind of walk your way there, because we provide ARR by property, and so, I think with those different ingredients, you will get where you need to go. I think, Jamie, it's interesting to think about the topic. So there's 2.1 million square feet in free rent or that haven't yet commenced, that's on a 14.6 million square foot portfolio. So it's over 14% of our portfolio and if you think about as a percentage of our leased portfolio, it's over 16% of our leased square footage.

Okay, definitely helpful. And then thinking about the assets you have in the market for sale. It sounds like, a little bit more shakiness in some of the secondary markets for sale. I think just maybe update us on handicapping your likelihood of getting those done or maybe some of the volatility we might see in getting those done?

Jamie, it's David. I think it's likely we'll get some done. But as we started communicating a few quarters ago, it's clearly harder, transactions are taking longer. So I couldn't handicap the likelihood of any individual deal getting done or what the total amount will be.

Okay. Have you seen anything fall apart?

Oh, I think we've had deals kind of assigned to buyers, they didn't get the ball across the goal line, we've had to repackage or move on to the second buyer. As we've said, we're just going to kind of work our way through it. We are not necessarily a price taker, but if we find a buyer at the right price, who can close, then we will engage and execute.

Okay. And then finally, we get a lot of questions just on what kind of assets would you guys buy. I know you've talked about it on recent calls, but can you kind of give latest thoughts of what is -- what types of assets would be on the list and what types of the assets definitely would not?

Well, we've talked about the markets that we're in and that we like and we've talked about the markets where we've transacted in the past and where we're comfortable and we've described that as generally being west focused from Chicago. Bellevue, Denver, Austin, California, and we've talked about situations where we can have a meaningful presence in those markets. And where there is real demand drivers and I don't think that story has changed. Importantly, we've also talked about being opportunistic. And we've clearly had opportunities to deploy the capital if -- if we were willing to pay today's pricing. But as we sit today, we still have had a challenge in finding value.

And in terms of property types beyond office?

Yes. We've talked about being open-minded to other sectors. But we've also acknowledged that the vast majority of our efforts and time have been focused in the office sector.

(Operator Instructions) Our next question today is coming from Manny Korchman from Citi.

I think it was David earlier that mentioned that your primary (inaudible) concern when looking at a disposition is getting the best price or being opportunistic from a better pricing perspective. How do you weigh that against market exposures or market share positions in some of the markets you're in. So if we look, you sold a couple of buildings in Baltimore, does that mean you want to fully exit Baltimore or are you comfortable selling a couple of buildings there, but remaining in the market?

The answer is yes. We did exit Baltimore with those 2 sales. And I can tell you, we don't really think in terms of market share. What we're doing is looking at the individual assets, the way it's set up, whether we've created value, value is stabilized and where the market may pay us a premium and so we've got a number of assets in the market. David mentioned we likely won't close on all of them but at appropriate pricing, we're sellers of those assets.

And then you spoke about thinner buyer pools. Could you talk about more of the flavor that you see amongst buyers and also types of financing that they are utilizing to buy?

Yes, sure Manny. With the assets we're selling in, I would say the secondary and tertiary locations, especially the smaller commodity like assets, we're seeing local buyers who tend to pass the hat, raise money and fortunately, the debt markets are open, debt capital is readily available. So that doesn't seem to be the governor, it's really whether they can raise the equity. And then for larger assets, we're seeing more traditional buyers, more credible buyers, who may have the equity and just try to match up the opportunity with their money.

It is Michael Bilerman speaking. Adam, what's the duration of the treasury that you've invested in the quarter and I guess should we expect you to put any other cash in any other short-term securities?

Yes. So the treasury investments, actually started earlier in the year and you'll see in the 10-K, there is a subsequent event, where we mentioned the initial purchases that we made. The duration is all less than 2 years on those treasuries. And we -- depending on where interest rates move, we may continue to utilize treasuries as a way to maximize our return on our significant cash position.

Okay, the question is how much of that cash do you want to put away for a couple of years versus having full access to have a range of strategic alternatives and not have this invested in something?

Well, we don't perceive it as being put away for a couple of years. Because it is U.S. treasuries, it's the most liquid market there is. And really, so from our perspective, it was more about maximizing interest income, but without sacrificing liquidity, because your point is a good one. The intention here isn't to put money under the mattress for 2 years, but rather to have the capacity to grow when it's needed.

You didn't look at like, I'm making the assumption here, did you look at like other equity securities or anything that may carry the opportunity to even invest in other REITs that may be trading at discounts. Had you looked at that side of things?

We do and we always evaluate those kinds of opportunities.

If any of that in that $257 million or that's all treasuries?

There is -- the vast majority is treasuries, but there is a common stock position there as well.

How large is that?

It's really not significant, over 90% of the investment is treasuries.

Okay. And then just in terms of dead deal costs, how should we think about that? Do you have any of that in your numbers already like in terms of deals that you've done, that you've looked at either on the security side or -- sorry, on the asset side or on the M&A front, how are those being treated in your financials? I don't know if you have anything that's been capitalized to-date that may be subject to a write-off or if you've already written off certain deal costs.

To-date, we have incurred deal costs and those have run through G&A.

And do you have anything that's capitalized on the balance sheet at all?

No.

Our next question today is coming from John Guinee from Stifel.

Two questions. Where are you, what's your thinking, Adam, in terms of a potential special dividend? And then second, within your G&A, how much of it is paid to -- I think it's CBRE, maybe it's JLL, who handles all your property management and leasing?

Yes. So let's start with the second part of the question. The expenses related to CBRE are property level expenses that don't run through G&A.

And that's just property management, not leasing.

And then can you repeat, John please, the first part of your question?

Just what's your thinking on the -- a special dividend?

Right. We have -- obviously, a very significant cash position and that cash position is something that we think about and debate constantly here. And we think about a whole bunch of uses for that capital. The one that's obvious is growth, right. But we also think about our share buyback program. And we think about special distributions and there's a continuum that we continue to talk about and evaluate, as you -- as I mentioned in my prepared remarks, there is a net operating loss carryforward from last year that's been added to with our year-to-date dispositions. So the requirement for a special distribution currently isn't there. Also as I've talked about previously, that could change depending upon which assets are sold. But it's certainly something we debate and discuss with regularity here and with our board.

And then probably, David, the last question is when I talk to investment sale brokers in the marketplace, they tend to imply they think there's more equity capital available for your type of asset in the second half of this year than in 2016 and that, that capital is fairly aggressive, a lot of it overseas' capital. Would you agree or disagree with that and how does that affect pricing?

Well, we hope that's right. We don't know, we try to strike a balance when we prepare for the call. We think things have slowed just a little bit, but in general, the dispositions that we've executed on, we feel very good about those prices and we still think it's generally a seller's market. So I've heard the same, John, that there is equity on the sidelines. As David mentioned, the debt markets are robust, there's plenty of availability. So if that is the case, that would be fine because we still have some things that, at elevated prices, we'd be willing to sell.

Great. And then last question, it looks to me just looking at your list, that you've got at least 3 100% leased assets, Wilmington, Boca Raton, Florida and the deal in Austin, 1 million square feet in Austin. What's the pricing expectation on those sort of big sale-leaseback deals or big single tenant deals?

John, I think it's across the board, I couldn't begin to get into specifics, each of the unique assets -- I could, I'm just not sure I'm capable, right? It's just they are each, Boca is a large asset, sub-10 years remaining. Obviously in Wilmington, we just extended that tenant, converted to a net lease, we think we've created a significant value there. And then the asset you referenced in Austin, it's not just a lease it's on a 177 acres of land. So you got to look at that one differently as well.

And we just extended that lease as well.

Right.

Our next question is coming from [Chris Polaszek] from Green Street Advisors.

Most of my questions have been answered. So I just have one for you. So kind of weighing the known move outs that you guys had and the free rent that was burning off that you discussed earlier, where do you expect cash same store NOI growth to trend for '17. Do you think it could be positive for the year or is that more likely an '18 event?

We haven't provided NOI guidance. As I said in my remarks, we're going to start to see the benefit of that very significant chunk of leased, but not commenced plus leases currently in free rent, begin to impact us the back half of this year, and growth will continue from there.

(Operator Instructions) Our next question is coming from Mitch Germain from JMP Securities.

Is there any assets that are on the -- in your mind on a do not sell list right now or is it pretty much anything is fair game if the pricing is right?

We do not have a do not sell list.

That's the way I like to hear it. And then you guys had mentioned -- you guys had mentioned obviously, we're hearing consistent feedback in the investment sales market, longer deal time. But you had said underwriting a little more conservative. So are you seeing a change in pricing for an asset today versus a similar type of asset, maybe 1 year ago or 2 years ago, when you commenced this line?

It's hard to answer that specifically. I can just tell you when you've got fewer bidders and you're dealing with secondary and tertiary assets, they look at things a little more closely. You may have gotten lucky a couple of years ago, packaged up some assets in a portfolio sale, and law of large numbers. But now with these one-off sales, especially to local buyers, it's just a little harder and they look at things, as I said, a little more closely.

Okay, great. And then last from me. Where do you find yourself to be most competitive as a buyer, is it one-off opportunities or is it maybe bigger portfolios?

Well, it's hard to stay, it's deal specific, but in general, in the past we've had better luck with complicated situations where you have to tailor a response to a need of a seller and we pride ourselves on flexibility and pricing risk. So we would prefer a situation that is a little bit complicated, a little bit complex, where hopefully, we can come up with a solution that's less generic or homogenous and therefore, less competition.

Thank you. We've reached the end of the question and answer session. I'd like to turn the floor back over to management for any further or closing comment.

Thanks for joining us and we'll see you again soon.

Thank you. That does conclude today's teleconference. You may disconnect your line at this time. And have a wonderful day. We thank you for your participation today.