Equity Commonwealth (EQC) 2017 Q2 法說會逐字稿

Greetings, and welcome to the Equity Commonwealth Second Quarter 2017 Earnings Conference Call. (Operator Instructions) As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Ms. Sarah Byrnes, Vice President, Investor Relations.

Thank you, Ms. Burns. You may begin.

Thanks, Michelle. Good morning, and thank you for joining us to discuss Equity Commonwealth's results for the quarter ended June 30, 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 statement. The company assumes no obligation to update or supplement any forward-looking statements made today. Today's remarks also include certain non-GAAP financial measures. Please refer to yesterday's press release and supplemental containing our second 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.

Thanks, Sarah. Good morning. Thank you 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.

Broadly speaking, the economy remains stable. The rate of economic expansion in the U.S. is projected to remain in the low-2% range for the year, about where it's been for the past few years. On the employment front, nonfarm payrolls grew by 222,000 in June, leaving unemployment unchanged at 4.4%. Despite the low unemployment rate, wage growth has been modest. Equity Markets continue to move higher, with the NASDAQ up 19% for the year, the S&P 500 up 12% and the Morgan Stanley REIT Index up 3% for the year.

While the Fed has increased rates on the short-end of the curve, the yield on the 10-year treasury has remained around 2.3%, partly due to market concerns around the long-term trajectory of the economy.

Office fundamentals in the second quarter continue to show signs of decelerating growth. Vacancy ticked up due to new supply, rent growth weakened further and net absorption slowed versus prior year. Deliveries totaled 38 million square feet in the first half of 2017, the highest first half in 8 years. New supply will weigh on occupancy for the remainder of the year, with a total of 90 million square feet of completions expected in 2017.

With respect to real estate capital markets, office transaction volume in the second quarter was higher than the first quarter, with approximately $25 billion in sales volume, though still down 10%-or-so compared to 2016. Real estate debt capital markets remained strong with significant availability at attractive pricing. CMBS spreads have been unusually stable so far this year, with AAA spreads steady at 90 to 95 basis points. As a result, CMBS issuance is robust at $36 billion year-to-date, and we expect issues to hit roughly $80 billion for the full year, up 10-plus billion dollars versus 2016.

We ended the second quarter with a 21-property, 11.7 million square foot portfolio, which excluded 6 properties held-for-sale. The success of our disposition efforts has resulted in a significantly better portfolio with high-quality assets in good markets. The portfolio today is more concentrated, with our 10 largest properties contributing 74% of revenue.

Leasing activity during the quarter was healthy. We signed 190,000 -- 196,000 square feet of new leases and 252,000 square feet of renewals. In terms of dispositions, we closed on the sale of 3 properties in the quarter and 1 subsequent to quarter end. Asset sales totaled $540 million year-to-date. We closed on the sale of Parkshore Plaza, a 271,000 square foot, 73% leased office property in Folsom, California, for $40 million, with pricing in the mid-6% cap rate range. We sold 25 South Charles Street, a 359,000 square foot office property in Baltimore, for $24.5 million or $68 per square foot. The building was 94% leased at the time of sale, though the building's largest lease, roughly 60% of square footage, expires next year. Finally, we sold 802 Delaware in Wilmington for $34 million. Pricing was in the low 7% cap rate range. This sale is a prime example of strong execution by the EQC team. Last year, we were faced with the expiration of Capital One's 241,000 square-foot lease. Our Asset Management and investment teams worked out a complex agreement with the tenant and an adjacent property owner, resulting in a new 10-year lease and related parking arrangement that allow us -- allowed us to renew Capital One and subsequently sell the asset creating substantial value. Subsequent to quarter end, we closed to the sale of 1500 Market, a 1.8 million square foot, 91.2% leased office property in Philadelphia for $328 million. Pricing, including the impact of approximately 150,000 square feet of leases signed but not commenced, was in the mid-7% cap rate range.

We currently have 9 properties totaling 3.1 million square feet in the market, including the 5 remaining held-for-sale assets. We will continue to sell properties selectively where we can achieve attractive pricing.

Since taking ownership of EQC, we've been focused on creating value. We've sold $4.7 billion of assets and used the proceeds to repay more than $2.4 billion of debt in preferred and over $2 billion of cash on our balance sheet. Our goal has been to aggressively lease and operate our properties and to take advantage of a robust investment sales market that has valued office assets at record low cap rates. Our portfolio repositioning is intended to narrow the discount between the trading value of EQC shares and the market value of our assets and position the company with ample liquidity should an opportunity arise where we can invest capital to create long-term value.

As we have said, we have no intention of running a subscale business that has no reason to be. That said, there is still much to be done to realize the substantial value in our portfolio and at the same time, explore growth opportunities. We're keenly focused on both efforts.

With that, I'll turn the call over to David.

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

Our 21-property, same-store portfolio was 88.4% leased at the end of the second quarter, up 20 basis points from the first quarter. During the quarter, we signed 448,000 square feet of leases, including 196,000 square feet of new leases and 252,000 square feet of renewals. Rental rates increased 17.6% on a GAAP basis and 10.7% on a cash basis.

Our largest lease this quarter was an 86,000 square-foot renewal at 1601 Dry Creek, a property outside of Denver. Most of our other leasing activity was in Chicago, Philadelphia and Boston.

In terms of our 5 largest markets, conditions are largely unchanged. Demand for space in Bellevue and Austin continues to be strong. In Bellevue, considering signed leases that have not commenced, the vacancy rate is trending below 10%. Austin's vacancy rate is 9.3%. While new supply in Austin has been absorbed, there is 2 million square feet of office space under construction that we continue to watch. In the Philadelphia CBD, the vacancy rate is a healthy 11.1%. At 1735 Market Street, we signed 41,000 square feet of new leases this quarter, and our pipeline is active. This property's new amenity center, an outdoor deck, should open later this summer.

Turning to the Chicago CBD, due to the recent delivery of 1.3 million square feet, the market's vacancy rate increased to 13.6%. While the CBD has benefited from the immigration of tenants, the market is likely to continue to soften given the availability of quality sublease space and over 5 million square feet under construction or redevelopment. Our property, 600 West Chicago, continues to perform well and is 96% leased. It is in Chicago's tightest submarket, River North, and benefits from strong organic tenant demand. In the Denver CBD, leasing continues to be challenging and its vacancy rate is 16.1%. The market has been impacted by new supply, sublease space and a slowdown in leasing activity. We have a 114,000 square feet of vacant space at 17th Street Plaza. The leasing environment in Denver is competitive and we're aggressively trying to get deals done.

Finally, I would like to comment on our lease roll in 2017 and '18. In total, through the end of 2018, we only have 720,000 square feet rolling or just 7% of our leased square footage. From this roll, we expect 440,000 square feet to vacate the next 6 quarters. This compares favorably to the 350,000 square feet that vacated in the first 2 quarters of this year alone, putting us in a good position to increase the occupancy going forward.

With that, I will turn the call over to Adam.

Thanks, David. Good morning. I'll provide a review of our financial results for the quarter.

Funds from operations were $0.25 per share compared to $0.36 per share in the second quarter of 2016. Normalized FFO was $0.22 per share compared to $0.42 a year ago. The decrease in normalized FFO was primarily due to $1.3 billion of dispositions completed over the comparative period, a large termination fee we collected last year related to a lease with Salesforce in Indianapolis prior to our sale of their building and lower same property NOI. Partially offsetting these declines were the benefit of interest expense savings from debt repayments, lower preferred dividend distributions following the Series E redemption and an increase in interest income due to the combination of higher rates and higher balances of cash and marketable securities. Same property net operating income was down 5.5% in the second quarter compared to a year ago. The decrease was primarily driven by higher real estate tax expense. The year-over-year increase in real estate tax was partially due to a 9.3% rate increase in Chicago that impacted 2017. More significantly in 2016, the second quarter included an unusually large accrual adjustment that decreased real estate tax expense in Chicago for that period. Without this second quarter 2016 adjustment, the year-over-year NOI decline would have been 2.5%.

Same property cash NOI was 7.5% lower than the second quarter of last year. The decline in cash NOI would have been 4.3% without the prior year accrual adjustment in real estate tax expense I just mentioned. Free rent related to the 1.1 million square foot renewal we signed at Research Park in Austin in the fourth quarter of last year was the other large component of the decline. This quarter's cash NOI also does not include revenue from an additional 500,000 square feet of leases that were in abatement. In total, free rent in the quarter was $4.7 million. Tenants with commenced leases that are in free rent periods represent over $19 million of annual rent.

The portfolio was 88.4% leased and 86.3% had commenced by quarter end, with the difference being 237,000 square feet that had not commenced and therefore was neither in cash nor GAAP NOI during the quarter. Once these leases start and get through their free rent periods, they will generate nearly $7 million in annual rent. The $19 million in free rent and the $7 million in rent that has not yet commenced will begin flowing through our results by the end of the year. These increases in revenue, assuming normal growth in expenses, would result in annual same-store cash NOI growth approaching double digits in 2018, although these growth rates will change as we continue to sell assets.

Moving to dispositions, including 1500 Market, we have sold $540 million of properties to date in 2017. These sales generated a net taxable gain which decreased but did not eliminate our existing net operating loss carryforward. We sold Parkshore Plaza in April and repaid the $41.3 million mortgage loan in covering the property. We redeemed the $250 million 6.65% bond that was due in early 2018 on July 15. We currently have $175 million of 5.75% baby bonds that open at par in August but don't mature until 2042. Given the flexibility of this debt, we will continue to evaluate our options considering our $2.3 billion or $18 per share balance of cash and marketable securities.

We have board authority to buy back up to $150 million of additional shares. We did not buy back any shares during the quarter. Our balance sheet remains strong with over $3 billion of capacity and only $850 million of debt. Liquidity and balance sheet flexibility continue to be a competitive advantage that positions us well for future opportunities. Thank you.

And with that, we'll open it up to Q&A.

(Operator Instructions) Our first question comes from the line of Manny Korchman with Citi.

Just sort of going back to thinking about market strategy. You sold a large asset in Philly, and still you've got several other assets in the market. How do you think about or how do you approach selling sort of a large holding like that versus having more control of the market? Or maybe said differently, is that an indicator that you will then be selling it, the other Philly assets?

Well, I think in the case of Philadelphia, we were substantially overweight given the 3 large assets we have. 1500 Market, the asset we sold, was a good example of our ability to stabilize an asset that for a long time, sort of, was mired in a mid-70s kind of occupancy. We took over the building, aggressively leased the asset to the low 90s, and thought it was a good time to exit, given our overweight position in Philly.

And then maybe -- can you talk about the transaction market in Philly more generally? I thought the cap rate you guys sold, that was probably a little bit higher than we would have expected?

Yes, Manny. It's David. Keep in mind, the sale of 1500 Market was the largest office building in Philadelphia by size, 1.8 million square feet, which means we probably had fewer bidders given the size of that bet. That, combined with substantial capital requirements, given the oversized lobby that is very dated, put upward pressure on our cap rate.

Our next question comes from the line of Jamie Feldman with Bank of America Merrill Lynch.

I guess, David, can you talk more about the 440,000 square feet to vacate? And what -- how big those leases are, and your prospects to backfill?

Sure. So in 2017, for the balance of the year, we have 215,000 square feet rolling. Out of that amount, we expect a 100,000 square feet to vacate. Only one tenant, about 40,000 square feet, is of any size, the rest are 10,000 square feet or smaller. And then in 2018, we have 504,000 square feet rolling, of which we expect to get 340,000 square feet back. There are 3 tenants ranging from 30,000 to 40,000 square feet, and the rest are smaller. So unlike in the past year, 1.5 years, we don't have any large exposure the next 6 quarters. It tends to be spread out across our portfolio. So the backfill opportunities, as always, will vary by market. But as we said earlier, for the most part, we're seeing good leasing activity today, and we think we're in a good position to grow occupancy going forward.

Okay. And in what markets are the 40,000 square footers?

The markets in the 40,000-square-footers are: it's in Austin, our suburban asset; downtown Austin; and 8750 Bryn Mawr, which is the office building we now own near O'Hare.

Okay. And then can you just talk generally about the transaction market? I mean are you seeing any change in pricing? I think David you had mentioned, it was still a robust sales market. Just kind of any change in valuations or underwriting that we're seeing or you're seeing?

Yes. I don't think we've seen signs of any change the last 6 to 12 months. It is the summer where things tend to be a little slower and we expect a lot more offerings hitting the market, September, and I think we'll have more data points then to give you a better answer.

Okay. And then when we met with you guys at NARIET, you talked about the fork in the road in terms of remaining a growing concern versus finding investments. Can you just talk about your latest thoughts on that, on where the fork is and how far away?

It's Adam. We started this process with a 156 assets, we're down to 21. So the fork is clearly closer, but we don't think that we're there yet. And the one thing that you heard in David Helfand's comments, we are focused on creating value, that's where our focus has been from the beginning, and we'll evaluate that crossroads when we get there with that in mind.

Our next question comes from John Guinee with Stifel.

Putting on my shareholder fiduciary hat, Adam, David, going from 150-plus assets down to sub-20 assets, G&A is now $12 million a quarter, which is an astounding 25% of cash NOI, yet we're still not paying a dividend. Can you sort of talk through the G&A and the dividend plans?

Well, I'm happy to try and address that. We've had this conversation, I think, on every call, so we appreciate you raising it. We're mindful of the G&A. We try to run the business as tightly as we can. But we've said from the beginning that we weren't going to sacrifice the team we've created and the capability we've created to avail ourselves of opportunities should it come in an effort to save a little bit of G&A. Given that if we aren't able to find that opportunity, all of the G&A is going to go away. So we recognize that there is a load right now that our shareholders and we are bearing to maintain the optionality of the company and its attempt to find a growth opportunity. And as we said before, it won't persist for long. So while it's high today, it will be either be right-sized through growth or it will be reduced to 0.

Our next question comes from Jed Reagan with Green Street Advisors.

So are you getting any traction on potential growth, external growth opportunities? Have you been close on anything recently? And then, have there been any changes in the types of opportunities you're exploring?

Jed, it's David. I'd say, we continue to devote a lot of time and energy trying to identify growth opportunities. You're not close until you get a deal done. I don't know if there's been a change in the opportunity set. I can just tell you, especially now that we're down to 21 properties, that is the lion's share of our focus and energy on trying to identify those opportunities and work them as hard as we can.

Okay. I guess a separate question on the -- maybe one for Adam on the year-over-year increase in operating expenses related to the taxes. Is that a factor that could continue into the second half of the year? I think I heard that it was maybe a kind of a 2Q event, but any lingering effect into the back half?

Primarily, a 2Q event. Let me give you a little color that might help answer the question and give you a better understanding of our change in OpEx. So year-over-year, we had a $4 million, 15.3% increase in operating expenses. Excluding real estate tax, OpEx was up less than $200,000. So it was basically flat. So the remaining $3.8 million had 2 components. There is $1.4 million that's due to higher tax rates and assessments in Chicago and Bellevue and in Denver. Of that $1.4 million, $1.1 million is due to the 9.3% increase in the Chicago tax rates that I mentioned in my prepared remarks. So the remaining $2.3 million is a prior year accrual adjustment in Chicago that resulted in a significant reduction in tax expense in the second quarter of '16, and that thereby made the increase year-over-year, greater by that same amount. So the adjustment in the second quarter of last year was a reversal of what we anticipated would be a large real estate tax increase. That eventually turned out to be a 1.24% decrease in tax rate in Chicago. So if you disregard that second quarter '16 adjustment, that 15.3% OpEx increase that we reported goes to 5.8%. As I mentioned, again, in my prepared remarks, that 5.5% GAAP NOI decrease becomes 2.5%, the 7.5% cash NOI decrease goes to 4.3%. So I guess the last comments on it is, is for the 2017 tax increase, we expect to recover about 2/3 of that in reimbursements from our tenants over time.

Okay, that's helpful. I appreciate it. And then, can you give any color on the buyer of 1500 Market? What kind of financing they may be using? And then just maybe any general comments on kind of what the bid intent was like for that asset, maybe the debt -- depth or breadth?

Sure. I'll answer the latter question first. We started that marketing, as you probably recall, maybe 15 months ago. It took some time. I think it's an example that we could have sold it earlier but we're not a price taker. We had to work through multiple buyers until we found the right one, meaning the one who was at a price we thought was fair and that would close to a private buyer, a syndicator, and they've levered up. I think it was with CMBS debt. I don't recall the leverage ratio, but it wouldn't surprise me if they try to match proceeds given their profile.

Our next question comes from the line of Mitch Germain with JMP Securities.

The 5 assets for sale other than the Philly asset, 2 Maryland, 2 Minneapolis, 1 Missouri. Any rhyme or reason behind those assets, those markets?

I think it's consistent with some of the strategies we've articulated in the past. There are 2 of them, the Minnesota ones are industrial buildings. So those are nonoffice. And then the other 3 are smaller office buildings in secondary, tertiary location, the type of assets that we've been culling from the portfolio from day one.

Got you. I think Adam, you mentioned a gain on the, I believe year-to-date or the most recent sales. How should we think about the potential for a special dividend as the year unfolds?

My answer is the same as I've given in the past. It's that, that number will fluctuate greatly depending on which of the assets that we expose to the market and that are closing. Some have significant gains, some have significant losses. We've whittled away at the NOL, which we talked about in the prepared remarks, but where that ends up at year-end will be dependent on transactions.

Great. And the last question, just back to those items that are held-for-sale. Were all of those part of that group of assets that were being marketed as of the end of last quarter, just curious as to what was being marketed? What has -- what's been sold? And kind of what's being marketed today, like the population of that group?

Yes. I think the population is largely unchanged. Those 5 properties would have all been included in the disclosure we provided last quarter.

Our next question comes from the line of Jamie Feldman with Bank of America Merrill Lynch.

Just two questions. One is, can you quantify the amount of NOLs left or carryforwards left?

We haven't disclosed that.

Okay. And then I guess just more generally about downtown Philadelphia. Maybe to help frame the cap rate on 1500 Market versus what do you think is reasonable for your other assets? If you could provide any color there? And then also just bigger picture of the market itself. We've heard from some brokers that there is some space coming back to market or that's expected to come back to market. Just your general thoughts on like, downtown CBD, Philly, how you see fundamentals there over the next couple of years?

Sure. So it sounds like there are 2 questions. The first, how does the cap rate on the sale of 1500 Market Street apply to our other 2 towers, and I'd say, it really doesn't. When you think of cap rate math, obviously, 1735 Market Street is a trophy tower. It's only 75% leased. So you wouldn't expect, even at stable cap rates to be applied at that asset. So if we were to sell it today, you would expect it to trade inside. And then, 1600 Market Street, now that's 84% leased, but that cap rate math is a little tricky, because as we walk through -- PNC, last quarter we announced we extended their lease. They're giving space back. But that's not effective until 2019. So if you're capping at in-place, income you got to be mindful of the give back which would have upward pressure on what you would otherwise see as a cap rate. In terms of the market overall, I think we described it as healthy. Leasing activity, if you read the third party reports, was a little slower this quarter. Now we're still seeing very good interest in activity at 1735 Market Street. In terms of our other property, 1600 Market, I'd say that's more in the middle of the bell curve. It's commodity Philly A product. We have upper floor space, which is helpful. But as you alluded to, it feels like that market's going to be a little more competitive going forward. There are some tenants moving around downsizing and several larger tenants are rolling in '19 and '20, which should create some more activity that people are looking forward to.

Our next question is a follow-up from Manny Korchman with Citi.

It's Michael Bilerman here with Manny. David, you and the team have done an admirable, an exceptional job in turning clunkers into cash. And you talked a little bit in relation to John Guinee's question about optionality. How long should shareholders be expected to pay for that optionality in terms of the cash that you've built up? And at what point does a decision need to be made? Is that 3 months? Is it 6? Is it 12? How long should we wait?

Thanks, Mike, and that's a fair question. It's a question we debate around here quite a bit. We don't have a great answer other than given how small the portfolio has become, it's sooner than later. Having said that, it's going to depend a little bit on the circumstances. As we get further into '17 and into '18 and try to determine what the market looks like, what the opportunities look like, how are the debt capital markets, how is the overall economy? I would say, if things remained as they are today, which is relatively stable, debt markets are not providing over leveraged situations, there is no distress that you can see near term, that would shorten the window and we would look to exit sooner. If things start to fall apart and we start to see opportunities that are created and we have a greater pipeline of choices in terms of what we do, then we'd probably hold out a little bit longer. But I don't think it's long time. We set out on this path a while ago, we've executed on the bulk of what we have to do in our portfolio. But there are still, as I said, opportunities to create value and stabilize assets before we sell them into the market. So the 2 things are happening in parallel. It's not a few months, but it's also not a few years.

And when you think about the opportunity that you're looking at, you know obviously, paying the highest price allows you to win, and there certainly has been a tremendous amount of transaction volume over the last 12 to 24 months, even though it's down slightly this year. What is it about the opportunities that you're looking at that don't make sense for Equity Commonwealth?

Well, I think you referenced it in your question, which is to say, we are not buyers today at market in general. The price per pound and the yields to us don't represent attractive entry points. But as you know, there is always opportunity and our history in this building and the equity world and in EQC, is that we look for dislocation, we look for complication, we look for opportunities to gain an edge through capital, our operating capability. And while none of those are obvious today, we often point back to Equity Commonwealth. And in beginning of 2014, when we started to look at Equity Commonwealth, most of those facts were the same. The markets were stout, pricing was aggressive and we generally didn't think we would have a lot of opportunity. And Equity Commonwealth was a complicated situation that required a variety of skills and persistence and focus, and we applied those. We bought the portfolio, we've added a substantial value. So I think we can do it again, if we find the right opportunity. We have to be disciplined and we have to stick to our knitting in terms of what we know best, what we have an advantage doing. And we probably have to find a situation where we're not in a competitive bid because we're not likely (inaudible) a competitive bid.

It's been a while since the equity organization was in retail, at least in the U.S. What type of experience do you guys have on the team today to evaluate retail opportunities? I would assume that there's got to be some level of distress or taking a contrarian view, and is that something you're spending a lot of time on, whether that be in malls or strips?

So we know just enough about retail to know that we don't want to go into it.

That was a pretty quick answer.

And our final question is a follow-up from Jed Reagan with Green Street Advisors.

Just a quick housekeeping follow-up here. It looks like there is a larger Georgetown expiration in a couple of years. Is there any sense of their plans? And then is there any more insight on whether Expedia might keep some of their space up in Bellevue? Are you having conversations with other tenants for that space at this point?

Jed, it's David. Georgetown, their lease expires in 2019 -- September 2019. It's actually a 2-building property, and they subleased one of their buildings to another user, and we've -- we're engaged in conversations with both Georgetown and the other user about their long-term plans. In terms of Bellevue, we do not expect Expedia to remain in any space beyond the expiration, December 2019. Obviously, given what's going on in that market, phenomenal absorption statistics, and that building being a high-profile vacant building, we are reaching out to multiple large users in the Seattle Bellevue area to gauge their level of interest.

And what would this sort of a decision window be like for a tenant like that? Is that 12 months out or could it be 2 years out?

Larger tenants tend to look 2, 3 years out.

Thank you. There are no further questions at this time. I would like to turn the call back over to Mr. David Helfand, for closing remarks.

Thank you for joining us today. As always, we appreciate your interest in Equity Commonwealth. Enjoy the rest of your summer.

Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation, and have a wonderful day.