Equity Commonwealth (EQC) 2018 Q1 法說會逐字稿

Greetings, and welcome to the Equity Commonwealth First Quarter 2018 Earnings 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. Thank you, Ms. Byrnes. You may begin.

Thank you, Doug. Good morning, and thank you for joining us to discuss Equity Commonwealth's results for the quarter ended March 30, 2018. Our speakers today are David Helfand, President and CEO; David Weinberg, COO; and Adam Markman, CFO.

Please be advised that certain matters discussed during the 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 forward-looking statements made today. We also post important information on our website at www.eqcre.com, including information that may be deemed to be material.

Today's remarks also include certain non-GAAP financial measures. Please refer to yesterday's press release and supplemental containing our first quarter 2018 results for a reconciliation of these non-GAAP performance measures to our GAAP financial results.

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, review our first quarter results and provide an update on the company's progress so far in 2018.

In the first quarter, the U.S. economy grew 2.3%, down from 2.9% in the fourth quarter of '17. During the quarter, the economy continued adding jobs at a healthy pace of about 200,000 jobs per month, and the unemployment rate remained steady through March at 4.1%. Pace of hiring slowed a bit in April to 164,000 jobs added, and the unemployment rate fell to 3.9%, the lowest level in 17 years.

Equity markets continue to be choppy with higher volatility. The REIT index is down 4.5% year-to-date, underperforming the S&P 500, which is roughly flat; and the Nasdaq, which is up about 5%. Fixed income market has seen increases in key benchmark dollar rates, 10-year treasury yield broke 3% -- broke to 3% level in recent weeks for the first time since 2014.

On the short end of the yield curve, 1-month LIBOR is 1.9%, up 35 basis points this year to a level last seen in 2008.

Turning to the office market fundamentals. Things continue to be decent, demand is broad-based and has mostly kept pace with new supply with the national vacancy rate of 13.3% at the end of the quarter, up 25 basis points since year-end.

Looking forward, the pace of deliveries in 2018 and 2019 is projected to exceed the pace of net absorption. While asking rates were up modestly, lease economics are more difficult given increased costs for tenant improvements.

With respect to real estate capital markets, office transaction volume declined by roughly 10% in the first quarter versus a year ago, a continuation of the slowdown in transaction volume we've noted for the past 2 years.

Despite declining volumes, we continue to successfully execute on our repositioning strategy by selectively selling assets where we can achieve attractive pricing.

The real estate debt markets remain robust, with numerous participants actively providing fixed and floating rate options, including banks, life companies, debt funds and CMBS.

So far this year, spread contraction has limited the impact of rising rates on all-in debt costs. While the 10-year treasury rate has risen 50 bps this year, spreads have contracted roughly 20 basis points.

Turning to our business in EQC. We continue to make progress on executing our plan. Year-to-date, we've repaid $575 million of debt and invested $88 million in share repurchases.

During the first quarter, we leased 117,000 square feet and our leasing pipeline is healthy. In addition, April was a strong month for lending, and David will provide more color on that a little later.

Finally, as expected, same property cash NOI growth turned positive this quarter, the results of our strong leasing execution of the past 2 years.

With respect to dispositions, in the first quarter, we closed on the sale of 3 properties totaling 2.6 million square feet for a gross sales price of $785 million; 2 of these sales were previously disclosed. We sold 1600 Market Street, an 826,000 square foot office building in downtown Philadelphia that was 85% leased. Gross sales price was $160 million and pricing was in the 5% cap rate range. We also closed on the sale of 600 West Chicago Avenue, a 99% leased 1.6 million square foot building in the River North submarket of Chicago. The gross sale price was $510 million and pricing was in the low 5% cap rate range.

Finally, we closed on the sale of a 100% leased 249,000 square foot single-tenant office building leased to RE/MAX in suburban Denver, Colorado. Gross sale price was $115 million, and pricing was in the high 6% cap rate range.

We currently have 3 properties totaling 1.5 million square feet in various stages of the sale process, including 1601 Dry Creek, a 553,000 square foot building in Longmont, Colorado. 1601 Dry Creek was held for sale at quarter-end. Additionally, we're in the market with 8750 Bryn Mawr, a high-quality 636,000 square foot office building in Chicago's O'Hare submarket. And we are marketing 97 West -- 97 Newberry, a 289,000 square foot industrial building in East Windsor, Connecticut.

In total, we've sold almost $6 billion in assets in the past 4 years. We've used the proceeds to bolster our balance sheet, reducing debt and preferred equity by $3 billion. Our cash and marketable securities balance today pro forma for debt repayment post quarter-end is about $2.7 billion. Essentially, we've transformed EQC from a disparate group of average quality properties with our focus on our operating platform into an integrated operating business with demonstrated execution capability. In doing so, we have significantly derisked the company. We now own high-quality assets with embedded growth and value-creation opportunities in growth markets.

Our portfolio and balance sheet provide the option to grow off a base of high-quality assets and tremendous liquidity to pursue long-term value-creation opportunities.

As a result of our disposition activity and mindful of the cost of managing our business, we recently reduced our staffing level to reflect the workload associated with the smaller portfolio. As a result, G&A was about $1.3 million higher for the quarter due to severance costs.

Our strategy will continue to be informed by market conditions. But the real estate investment sales market has softened somewhat in the last couple of years, prices remain high by historical standards, with low cap rates and projected returns and high prices per pound relative to replacement costs.

The pricing environment today for high-quality assets does not, in our view, lend itself to achieving superior returns. And as a result, we are being patient. We will focus balance of the year on aggressively leasing and managing our assets, preparing select properties for sale and exploring investment opportunities.

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

Thank you, David, and good morning, everyone. I will begin by reviewing our first quarter leasing activity and giving an overview of our largest markets. Then, I'll cover our lease roll through year-end.

Our same property portfolio was 88.6% leased at the end of the first quarter, down 60 basis points from the fourth quarter and up 140 basis points year-over-year.

Please keep in mind that as our portfolio has gotten smaller, there likely will be greater fluctuations in our leased occupancy.

For the quarter, rental rates increased 10.8% on a GAAP basis and 2.8% on a cash basis.

The largest lease we signed in the quarter was at 17th Street Plaza in Denver. We renewed a 22,000 square foot tenant, who also expanded into another 4,000 square feet. In the quarter, we signed 117,000 square feet of leases. Leasing volume has since picked up, and the second quarter has started much stronger. In just the month of April, we signed 238,000 square feet of leases, consisting of 155,000 square feet of new leases and 83,000 square feet of renewals.

Turning to our markets. Austin and Bellevue continue to be strong. The vacancy rate in Austin is 9.7%. Our 176,000 square foot property in Downtown Austin, 206 East Ninth Street, was 64% leased as of the end of the quarter. However, in April, we signed a new 26,000 square foot lease at this building, which brings its current leased occupancy to 78%.

The vacancy rate in Bellevue CBD is 9% and is expected to be even lower later this year. As we have previously said, given the strength of this market and the quality of Tower 333, we believe this property is well positioned for expeditious lease expiration in December 2019. We continue to actively pursue new tenants in anticipation of this upcoming move-out.

In the Philadelphia CBD, the vacancy rate is 12.1%. Our property, 1735 Market Street, is one of the premier office buildings in the city, and the vacancy rate for trophy proprieties is under 9%. Most of the available space at this building is on its lower floors, and we continue to see good large-prospect activity.

In the Denver CBD, the vacancy rate is 17.5%, which is 220 basis points higher than last quarter. The vacancy rate is temporarily elevated due to the first quarter delivery of 950,000 square feet of new supply. These buildings are 79% pre-leased and tenants will start to take occupancy later this year. As we have said on recent calls, leasing 17th Street Plaza has been challenging, as we continue to compete with new construction. Denver is a very attractive city for millennials and other well-educated workers, and we like this market over the long term.

In Boston, we are own a well-located asset, a few blocks from Fenway Park near the Longwood Medical District with easy access to public transportation. 109 Brookline was built in 1915 and was formerly a Jeep factory. The 286,000 square foot building has a brick facade, 12- to 15-foot ceiling heights and an above-standard floor load capacity. It is 95% leased, and current tenants include office, data center and lab space users. The resurgence of the Fenway area has resulted in numerous nearby retail amenities, creating a vibrant work-life dynamic. It is a unique asset that is very attractive to today's tenants and a redevelopment opportunity over the long term.

In Washington D.C.'s East End, we own a 196,000 square foot, well-located office building at 1250 H Street. It has a unique corner location, with 3.5 sides of glass line, providing tenants with an abundance of natural light. The building features a 3-level subterranean garage, and we constructed a new conference center, fitness facility and bike room. The property is 85% leased and has good leasing activity.

Finally, I would like to comment on our lease roll through year-end. The largest number of give back later this year is 40,000 square feet at 8750 Bryn Mawr in Chicago. This move-out was addressed in April when we signed a 79,000 square foot 20-year lease with Komatsu for its U.S. headquarters. The lease was a culmination of 9 months of work that included negotiating early terminations for 3 other tenants to accommodate Komatsu's needs. The success we have had at 8750 Bryn Mawr is a good example of what we have been doing for the past 4 years. The turnaround of this property was a team effort, including asset management, engineering and investment.

Two years ago, the property was 89% leased and 2 large tenants since moved out. We had a significant amount of space to lease. To attract new tenants, we upgraded the property's amenities, including creating a new tenant lounge and outdoor patio. In addition to the lease with Komatsu at the end of 2016, we signed a new 87,000 square foot 15-year lease for the headquarters of First Midwest Bank.

In total, we have signed 300,000 square feet of new lease at this property in the last 24 months. It is now 95% leased, with a weighted average lease term of just under 10 years. We have fundamentally changed the profile of this asset and are marketing it to monetize the value that has been created.

At the end of the quarter, for the remainder of 2018, we had 175,000 square feet rolling, with 3.1% of our leased square footage. Of this amount, we expect to get 3 quarters back. However, some of this space has been recently backfilled. Taking into account Komatsu and other April leasing, we believe there is approximately 85,000 square feet of space rolling that has not been backfilled. And we are well positioned to increase the leased occupancy over the course of the year.

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

Thanks, David. Good morning. I'll provide a review of our financial results for the quarter as well as an update of where we stand regarding debt repayments, taxable income and share buybacks.

Funds from operations were $0.05 per share compared to $0.27 per share in the first quarter of 2017. The majority of the decrease is a result of asset sales. For the quarter, dispositions caused about $0.19 per share of the decline. Also notable was a book loss of about $4.9 million or $0.04 per share from the write-off of unamortized deferred financing fees related to the payoff of our 2042 bonds.

State and local income tax expense triggered by gains on asset sales caused an additional decrease of $2.8 million or $0.02 per share. FFO benefited from $0.04 per share of lower interest expense. Finally, interest and other income grew by $0.01 per share, but netted from this line item is a $0.04 per share or $5 million loss related to the sale of securities. Normalized FFO was $0.14 per share compared to $0.24 a year ago. The decrease to normalized FFO was primarily due to dispositions completed over the past year, partially offset by interest expense savings from debt repayments and an increase in interest income due to the combination of higher rates with higher cash balances.

Our same property portfolio at the end of the quarter comprised 13 properties totaling 6.3 million square feet, excluding 1601 Dry Creek, which was classified as held-for-sale at quarter-end.

Same property net operating income was 2.1% lower in the first quarter compared to a year ago. The decrease was largely due to higher real estate taxes, net of reimbursements, primarily related to increases at 1735 Market Street in Philadelphia and 17th Street Plaza in Denver.

The portfolio was 88.6% leased and 83.5% had commenced occupancy at quarter-end. Same property cash NOI was 4.3% higher than in the first quarter of last year, driven by higher rental income as several tenants completed their free rent periods.

These gains were partially offset by tenant move outs and the previously mentioned increases in real estate taxes.

Results for the quarter do not include $2 million of revenue from leases in free rent. Growth will also benefit from 326,000 square feet of signed leases, which have not yet commenced and, therefore, are not in cash or GAAP NOI. These leases will eventually generate $11.7 million in annual rent, but it will take time before this grows through results.

In addition to future dispositions, we, of course, will be impacted by tenant move outs, but we anticipate solid cash NOI growth for the next couple of years.

Moving to dispositions. We sold $785 million of properties in the quarter. These sales generated a net taxable gain, which exceeded our net operating loss carryforward by roughly $150 million. As a result and for the first time since taking control of the company in 2014, we expect to generate positive taxable income this year.

Turning to the balance sheet. We've repaid an additional $175 million of 5.75% debt in the first quarter. And last week, we repaid the entire $400 million balance on our term loans. These floating rate loans had an interest rate of 3.23% at quarter-end. Including the term loans, the total liabilities repaid over the past few years is now $3 billion, including our Series E preferred.

The liability side of our balance sheet includes just 1 $250 million bond due in 2020 and 2 small mortgages. Our balance sheet remained strong, with approximately $22 per share or $2.7 billion of cash and marketable securities, following last week's term loan repayment.

We have built significant capacity and are actively looking to put it to work to create long-term value.

In the interim, we have been buying back our stock. We repurchased approximately 3 million common shares at an average price of $29.67 per share during the quarter. Since 2015, we've invested $245 million buying back approximately 9 million shares at an average price of $27.61. We have over $130 million of share buyback authorization remaining.

The liquidity and balance sheet flexibility that we've built continue to be competitive advantages that position us well for future opportunity.

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

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

Adam, the impairment on marketable securities that you mentioned, can you give us more detail as to what that was related to? And of the remaining marketable securities balance, how much of that is in debt or bond instruments and how much of it is in common stock?

Yes. Thanks, Manny. So it wasn't an impairment, it was a loss. And I'll kind of walk through our securities position. From time to time, we take positions in companies that we're interested in. In this case, we sold securities that we've had since the first quarter of 2017. We generated about $24 million in proceeds in March. That sale was at a price that was about $3 million less than what we paid for the shares in 2017, but the accounting hit was $5 million because the market value of the shares was above our purchase price at year-end, as was reflected in the year-end balance sheet. And we don't currently hold any common stock, but from time to time, we will.

And then just in terms of the buyback, you guys were sort of reticent to do that earlier in the sales process but have done it now. What change may be in your approach or thinking? Or what parameters were you looking for when making that decision, more specifically?

Well, just generally, we opportunistically have been in the market for our shares when we can. And as we mentioned in prepared remarks, we've got an authorization of an additional $130 million, and obviously, we have plenty of cash. I guess my last point is that we've not had trouble getting the board support for incremental buyback authorization when it's been appropriate.

David, it's Michael Bilerman. So how much of the current securities balance today represents shares and other companies you may be targeting, if any?

Yes. Good question. We don't currently hold any common stock, but as I mentioned before, we may from time to time.

And so this was a $24 million of proceed to $29 million -- a $27 million investment that was -- that you've sold down to $24 million that had been marked up at the end of the year?

That's right.

That was a $5 million loss?

You got it.

So you went from $24 million to $29 million, and then you sold it for $24 million, took a $3 million loss, but a $5 million GAAP loss?

That's it.

And was this a company that you took a position in and arguably you had discussions with and tried to get a seat at a table? Or this was just sort of taking a position and hoping something would happen?

We're not going to get into detail on how far things went or look what our purposes were. But clearly, we're not in the business of buying common securities except if there is a strategic purpose to doing so.

Our next question comes from the line of John Guinee with Stifel.

I'm just looking at Page 7, and you've got weighted average common shares year-over-year. Looks like the basic went down by $200,000, but the diluted went up by $2 million while you sold 3.1 million shares. Can you help us understand the math here?

Yes. That's related to our Series D convertible preferred shares. They are convertible into nearly 2.4 million common shares. So each of our earnings measures, EPS, FFO or NFFO, requires us to individually assess the dilutive impact of converting Series D preferred to common to determine whether to include those in the diluted share count. And then -- so this quarter, largely due to the impact of the substantial gains on the sales of property and net income, the Series D preferred was dilutive for EPS purposes, but not for the purposes of FFO or NFFO, where you exclude the impact of the gain on sale of properties. So just to get a little more specific that Series D switched to -- from anti-dilutive to dilutive at about $80 million of net income versus the $186 million or $1,780 -- $187 million that we reported. And this happened, John, before. In the third quarter of '14, the Series D were dilutive to EPS and FFO, but not to NFFO. So from time to time, just again depending on earnings, we'll see that dilution.

A great segue into my next question. If you were to try to retire this $122 million to $123 million of preferred, what would the cost be to EQC?

The shares can be retired at par if there is a change in control, but -- or a liquidation of the company, is really when that would happen. Beyond that, the shareholders have the option to convert at a share price north of $50 a share.

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

I think you'd previously stated that lease commencements would be sort of back-end weighted this year. Is that still the case? And I guess, just thinking about sort of the pace of cash same-store NOI growth for the rest of the year, should we look for sort of that to continue ramping up?

Yes. We don't provide guidance, but maybe I can give you just a little bit of help on the topic. Really, growth is coming from 3 sources, right? It's the free rent that's getting used and then turning into cash. It's the signed but not commenced leases that are moving in. And then any incremental leasing that we're able to achieve. So of those 3, most of the free rent fees will kick in before year-end. The majority of the revenues coming from leases that are signed but not commenced will also kick in before year-end, but then, remember, those leases go into a free rent period, so the impact on cash NOI will be further out. And then lastly, given our very measured roll that David Weinberg mentioned earlier, we're optimistic that we can generate positive growth on the leasing front.

Okay. That's helpful. Real quick on Longmont, that sale under contract, are you in any position to give some clarity on pricing on that?

Not at this time. As we have done in the past, if and when a deal closes, we'll provide more information afterwards.

Okay. Fair enough. And I guess related to that, so you've got a couple more assets on the market, I think a couple lease-up properties, which may be characterized as being kind of more noncore, market-oriented, and then you start cutting more into kind of higher quality and more target-oriented market, as it would seem. Do you take a pause on the sale once you've gotten through some of those more noncore-type assets? Or does the pace of sales continue unabated?

Well, I would say the pace will have to slow down somewhat, just given as we sit here today, we own 13 properties. There's just fewer assets to take to market and, as you described, with the 2 on the market, if you look at our property list, there aren't many on the list anymore that you would think are obvious disposition candidates. So it'll become a much closer and more meaningful discussion around when is the best time to maximize the value of each of these properties, consider pricing, long-term growth opportunities and make decisions as we go.

Okay. That's helpful. And maybe just last one for me. As you kind of look around the landscape of opportunities out there today, would you say your focus has shifted more to public opportunities versus private? And has the, I guess, the flavor of deals you're looking at have been evolving at all over time? Or would you say it's been pretty consistent?

Jed, it's David Helfand. I wouldn't say our focus has changed. We try to look at everything. We monitor public companies, we looked at private portfolios. We're talking to large owners. I wouldn't say there is a notable shift in where we're spending our time.

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

I just -- I know there was a potential for Expedia to do some sort of month-to-month or short-term renewal. Is that out of the picture at this point?

Well, I'm not sure what you're referring to. Expedia doesn't have any contractual rights to extend its lease. So it would just have to depend on the facts and circumstances if and when that came to be.

Got you. I thought that they had approached you guys for some sort of short-term extension as the development still is under way.

No. We have conversations with tenants all the time.

Got you. And I just don't understand next year's lease roll. They're in next year or they're in 2020?

So in the lease expiration schedule, they will be shown in 2020 because their expiration is December 31, 2019.

Okay. So the 14% expiring next year is other than Expedia, is the way to think about that?

That is correct. They're in through '19 and they show up in 2020.

And I know you've given some great color regarding the lease rolls over the course of '18. Is there anything that we need to be -- note -- is notable that stands out in 2019?

I'll take a couple of minutes and walk you through the larger tenants. So as we published, we have 643,000 square feet rolling in '19, which is 11.4% of our leased square footage. The larger tenants tend to be expiring later in '19. I think in the last call, we talked about Georgetown. While the asset is 2 buildings, 240,000 square feet, as noted and discussed, Georgetown's subtenant extended through 2037 in 112,000 square feet now. So Georgetown is only occupying 129,000 square feet. Their lease expires in September of '19 and we're talking to them. The next largest is a 74,000 square foot tenant at Bridgepoint, but as noted in our supplemental in the footnote, in April, we extended them for 5 years. So we've addressed that roll. The next largest is a 59,000 square foot tenant at 109 Brookline Avenue. They expire in August 2019. We expect them to vacate. And then the other tenant larger than 50,000 square feet rolling in 2019 is a 57,000 square foot tenant at 1735 Market Street. Once again, they don't expire until October 2019, and we're speaking with them. Everything else is smaller, and we are having ongoing discussions with most of those tenants.

Our next question is a follow-up question from the line of Jed Reagan.

Just a couple small follow-ups just related to leasing. On the Dry Creek asset, was that -- I think there was an expiration coming up this year. Did that asset also ultimately get kind of fully stabilized? Or did you end up selling that with a little bit of kind of near-term move out embedded?

No. I think it might have been the last call or the one before that, we've talked about extending one of the larger tenants there. As part of that extension, they're going to give back space. That space comes back, I believe, in July of this year, and it has not been backfilled.

Okay. So just made more sense to sort of move forward rather than try to tackle that yourself?

Correct.

Okay. And then just mechanically, Adam, I think you mentioned the positive taxable income for the year. Is that -- should we think of that in terms of kind of a onetime special dividend later in the year or potentially a recurring dividend starting soon?

We always felt that the appropriate time for a recurring dividend was when we had a stable portfolio generating recurring cash flow. And given our disposition pace and the unique nature of what we've created here, that we are not at that point as we sit here today.

There are no further questions in the queue. I'd like to hand the call back to management for closing comments.

Thanks for joining us today. We appreciate your interest. Have a good day.

Ladies and gentleman, this does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time.