Equity Commonwealth (EQC) 2018 Q3 法說會逐字稿

Greetings, and welcome to the Equity Commonwealth Third 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, Investor Relations. Thank you. You may begin.

Thank you, Christine. Good morning, and thank you for joining us to discuss Equity Commonwealth's results for the quarter ended September 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 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 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.

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 third 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, and thanks for joining us. I'll begin with brief comments on market conditions, review our third quarter results and provide an update on the company.

U.S. economy continued its growth in September, adding 130,000 new jobs. That compares to an average monthly gain of 200,000 jobs over the past 12 months. The unemployment rate was 3.7% at the end of September, down from 4.1% at the beginning of the year.

With respect to interest rates, the yield on the 10-year treasuries is roughly 3.1%, up 65 basis points year-to-date. On the short end of the yield curve, 1-month LIBOR is currently 2.3%, an increase of roughly 70 basis points since January.

Turning to the equity markets. The Morgan Stanley REIT Index is down 70 basis points year-to-date. The S&P 500 is up 90 bps for the year, and NASDAQ is up roughly 3% as the broader market has retreated considerably since late August.

Office fundamentals remain decent. During the third quarter, national net absorption was positive 11 million square feet, with 7.4 million square feet of new supply added to inventory. The national vacancy rate was 12.8% at the end of the third quarter, down 10 basis points from the end of the second quarter.

Base rents grew moderately, while increased leasing and capital cost continue to weigh on lease economics. Looking forward, the new supply pipeline remains elevated with over 100 million square feet under construction nationally, though generally speaking, supply is concentrated in markets that are currently characterized by strong demand.

With respect to real estate capital markets, office transaction volume picked up in the third quarter after a soft first half of the year, and transaction volume year-to-date is now on par with 2017 levels. Cap rates are stable to slightly up across the country. And with the recent spike in interest rates, investment sale brokers are seeing some buyer pushback on values due to higher borrowing costs and a sense that the cycle is a bit extended.

Despite volatility in interest rates, the real estate debt capital markets remain healthy. Debt capital is readily available with active fixed and floating rate lending programs from diverse sources, including banks, life companies, debt funds and CMBS. Given the recent move in rates, certain lenders, life companies in particular, have become more selective, though in general, the supply of debt capital exceeds demand and remains a very liquid market.

Turning to EQC. We continue to focus on creating value through aggressive leasing, creative asset management and opportunistic dispositions. Overall results were strong in the third quarter. Leasing volume was robust and included a 429,000 square foot lease with Amazon at one of our assets in Bellevue. The lease with Amazon creates significant value while also mitigating risk.

We also filled our largest vacancy at 1735 Market in Philadelphia with a 97,000 square foot lease to a financial services firm, stabilizing the asset at 91% occupancy. Leased occupancy for the portfolio is up 220 basis points versus last quarter, and same-property cash NOI grew 9.1%.

Turning to dispositions. In the third quarter, we closed on the sale of 777 East Eisenhower Parkway, a 40% leased property in Ann Arbor, Michigan totaling 291,000 square feet for a gross price of $29.5 million.

We also closed on the sale of 8750 Bryn Mawr Avenue, a 96% leased property in Chicago, totaling 636,000 square feet for a gross price of $141 million. Pricing was in the low 7% cap rate range. I would point out that the EQC team leased over 400,000 square feet in the 18 months preceding the sale of the asset, creating significant value.

Year-to-date dispositions have totaled just over $1 billion. Since 2014, we've sold $6 billion of assets and repaid $3 billion of liabilities.

We have benefited from our unique tax position and have had the unique ability to retain proceeds from these sales. This is no longer the case. And as a result, on September 26, we announced a $2.50 per share special distribution, primarily to meet the distribution requirement for taxable income this year. Pro forma for the dividend, cash and marketable securities totaled $2.6 billion over $21 a share.

We've made tremendous progress to date, and we continue to focus on aggressive leasing, creative asset management and selective marketing of properties for sale when we can achieve strong pricing. Our strategy will continue to be informed by market conditions. To that end, we're currently marketing 4 properties totaling 2.9 million square feet, including 1735 Market Street in Philadelphia; Research Park in Austin, Texas; 600 108th Avenue in Bellevue, Washington; and 97 Newberry in East Windsor, Connecticut.

We continue to focus on identifying attractive opportunities to deploy capital. In our view, pricing remains elevated, and the current pricing environment for high-quality assets does not lend itself to achieving superior returns. Interest rates have remained low for a prolonged period of time. And in an increasing rate environment, there may be more opportunities. We have a long-term investment perspective and believe that if we are patient, we'll find compelling opportunities to invest.

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

Thank you, David, and good morning, everyone. I will begin by reviewing our third quarter leasing activity and giving an overview of our largest markets. Then I'll cover our lease rolls through the year-end and in 2019.

Our same-property portfolio at the end of the quarter comprised 11 properties totaling 5.4 million square feet. The portfolio was 94% leased, up 220 basis points from the second quarter and up 290 basis points year-over-year. Commenced occupancy was 91.3%, up 140 basis points from the second quarter and up 380 basis points year-over-year.

In the quarter, we signed 563,000 square feet of leases, of which all but 1,000 square feet were new. For the quarter, rental rates increased 11% on a GAAP basis and decreased 1.2% on a cash basis. The largest lease we signed in the quarter was in Bellevue, a new 429,000 square foot, 16-year lease with Amazon at Tower 333. This lease commences in late 2020 and backfills Expedia's space. There is a slight roll-down in cash rents and significant roll-up in GAAP rents.

There will be minimal downtime. And instead of the risks of a multi-tenant lease-up, we have secured a long-term net lease with a credit tenant. We are thrilled with the value created by this lease. It was a team effort, and we want to recognize the contributions from our asset management, engineering, investment and legal teams. The Bellevue CBD continues to be one of the strongest markets in the country with a vacancy rate of 8.4%.

The next largest lease we signed was 97,000 square feet at 1735 Market Street in Philadelphia. As you may recall, a few years ago, we stepped into vacancies and move-outs totaling 680,000 square feet at this property. We have backfilled most of this space, and 1735 Market is now 91% leased. The Philadelphia CBD vacancy rate for trophy properties is under 9%.

We also signed a full floor lease at 206 East Ninth Street in Downtown Austin. This property is now 92% leased. Our other multi-tenant office building in Austin, Bridgepoint Square, is also 92% leased, but we will get back 28,000 square feet at the beginning of next year. The Austin market continues to do well with a vacancy rate of 10.2%.

In Denver, 17th Street Plaza was 88% leased, and we got back 25,000 square feet earlier this month. This market remains competitive with a vacancy rate of 17.2% and new supply continuing to have an impact. We have recently seen an uptick in small tenant activity at this property.

Finally, I would like to comment on lease rolls through year-end and in 2019. For the fourth quarter of 2018, of the 54,000 square feet rolling, we expect to get back 40,000 square feet. In 2019, we have 510,000 square feet rolling. The largest exposure next year is the 128,000 square foot building in Washington D.C., leased through September 30 to Georgetown University. As you may recall, this 2-building property includes another 112,000 square foot building, which was previously backfilled with a long-term lease to a private school. We are speaking with Georgetown about its plans and working to find alternative users to backfill any space we may get back.

In addition, BT Americas will vacate 59,000 square feet at 109 Brookline on July 31, and Aberdeen Asset Management will vacate 58,000 square feet at 1735 Market on September 30.

As David said, we have made a lot of progress the last few years. We set out to create a higher-quality portfolio in fewer and better markets that will provide greater growth and stability. Our portfolio today has significantly improved from the 156 properties we started with in 2014. The quality of our assets is reflected in our NOI growth profile as well as our concentration in stronger markets. We have a great team that achieved that success, and we continue to focus on creating value through proactive asset management, leasing and dispositions.

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 as well as information on our recent special distribution.

Funds from operations were $0.17 per share compared to $0.22 per share in the third quarter of 2017. The decrease is a result of $1.7 billion in asset sales over the trailing 5 quarters. These dispositions caused the decline of approximately $0.15 per share for the quarter, which was partially offset by $0.05 per share of lower interest expense, $0.04 per share of higher interest and other income, and $0.01 per share from a decrease in G&A.

Normalized FFO was $0.18 per share compared to $0.19 a year ago. As with FFO, the decrease in normalized FFO was due to dispositions, offset by increased same-property cash NOI, interest expense savings from debt repayments, lower G&A and increased interest income due to the combination of higher rates with higher cash balances.

Net operating income in the same-property portfolio was up 1.7% in the third quarter compared to a year ago. The increase was largely due to higher commenced occupancy, with the largest contribution coming from over 160,000 square feet of newly commenced leases at 1735 Market Street in Philadelphia and a renewal with meaningful rent roll-up in our Boston asset. Partially offsetting higher GAAP revenues were a decrease in early termination fees and increases in operating expenses as occupancy has risen and as higher assessed values have caused real estate taxes to increase.

Same-property cash NOI was 9.1% higher than in the third quarter of last year, driven by higher rental income as several tenants are now through their free rent periods. On the expense side, we saw increases from the previously mentioned real estate tax assessments and in operating expenses related to occupancy.

Cash NOI for the quarter does not include $1.8 million of revenue from leases in free rent. Growth will also benefit from 148,000 square feet of leases signed, but not commenced, on spaces that are currently vacant and, therefore, are not in cash or GAAP NOI. These leases will eventually generate $6 million in annual rent but will take time before this flows through our results. In addition to future dispositions, we will be impacted by tenant move-outs, although we continue to anticipate solid cash NOI growth in our same-property portfolio.

During the third quarter, we declared a special common distribution of $2.50 per share or $305 million, which was paid earlier this week. For tax purposes, the distribution will be treated as an ordinary dividend.

Most of the special distribution was the result of taxable gains generated by the $1 billion of dispositions completed this year. Projected taxable income exceeds our net operating loss carryforward by approximately $214 million or $1.75 per share. The remainder of the distribution was allocated in order to minimize taxes by utilizing the dividends paid deduction at the state level. An additional benefit of paying out the incremental portion of the distribution is that it maintains roughly $90 million of our net operating loss carryforward.

Turning to the balance sheet. Our debt now includes just 1 $250 million bond due in 2020 and 2 small mortgages. Repaid liabilities totaled $3 billion, including our Series E preferred. Borrowing capacity includes our $750 million undrawn revolving credit facility.

Our balance sheet is strong with over $21 per share or $2.6 billion of cash and marketable securities after the payment of the $2.50 per share special dividend earlier this week.

We have built significant capacity and are actively looking to put it to work to create long-term value. As we strategically invest capital and address vacancy, we continue to look for growth opportunities where our team, liquidity and balance sheet flexibility will be a competitive advantage.

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

(Operator Instructions) Our first question comes from the line of John Guinee with Stifel.

A detailed question, then a big-picture question. The Amazon lease, 429,000 square feet, a slight roll-down cash, a roll-up GAAP. Can you be more specific on that? And then also, what sort of TIs, leasing commission and base building upgrades were required by Amazon to get that lease done?

Sure, John. It's David. In terms of the roll-up, roll-down, to give you a sense, for the quarter, our cash roll-down was 1.2%. The Amazon lease represented 95% of that math. The lease I referenced, the 1735 Market Street, that space had been vacant for more than 2 years, so it's not included. So you can basically assume that roll-down is substantially all the Amazon lease. And then in terms of the TIs, once again, if you look at kind of the TIs we disclosed in our supplemental, just given the size of that lease and the length, I think that's a good approximation for what we're spending on that deal. And I would say, because it's a single tenant lease, we did not incur any unusual landlord cost related to the backfill of the Expedia space.

Great. And then the other David. I think you said very explicitly, you have a long-term horizon, and patience will lead to success. Can you quantify that?

Quantify patience or quantify long term?

Well, both. And then also, the definition of success.

Okay. I'll just clarify, I didn't say success. You did. I said would potentially lead to opportunities to invest.

Oh, I misheard that. Sorry.

But John, we've been having this discussion with you and others for a long time. And I think what we've consistently said is we believe in the team. We have a unique situation with the capacity and capital. And we're hopeful we'll find the opportunity to invest that in a way that can create long-term value. We won't wait forever, but we may wait longer than some may be comfortable. And balancing that is what we talk about and think about with Sam and with the board every quarter.

Our next question comes from the line of Manny Korchman with Citigroup.

David, maybe to follow up on John's question and your reply. In the past, you were maybe a little bit more willing to put an end date, if you will, on sort of the go-forward here. Now if I remember correctly, it was in early 2019. Have you backed off of that? Is it now sort of more of a wait-and-see than it was in the past?

I think we've tried to be consistent in what we said. We talked last year about -- or early this year, right, about determining our fate next year and then going in whichever direction that took us, either growing the portfolio and investing or liquidating the portfolio. I don't think much has changed. We continue to make progress. We have things to do. We have specific asset management and leasing milestones that we want to accomplish. We have a few more assets in the portfolio that probably don't need to be in the portfolio. And as we go about doing that business, we'll hopefully find opportunity. If we get through that, then we'll make an assessment of whether we want to wait or whether we want to liquidate and distribute the capital.

So then if we think about sort of the order of priorities for the management team right now, is that harvesting value first? Is it finding opportunities first? Is it managing that eventual dissolution of entity if it doesn't work out? Sort of where do you spend your time and your efforts right now?

Right. We'd like to think we could do both at the same time.

Manny, this is Adam. I -- just to maybe echo David's point, it's not serial, right? It's not that you finish one and then begin the next. We continue to work asset management. We obviously are very busy on the disposition front. And we spend time looking for opportunity. And as David mentioned, that is keeping us busy, and we'll work through what's on our plate before we get to the next step.

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

Can you talk about the decision to sell in Austin and Bellevue? I think over time, you guys had talked about trying to kind of pare back the portfolio to a couple of core markets and then maybe if you could find anything to buy, you'd build around those. I thought those would have been 2 of your core markets.

Jamie, it's David. Now we've always said we love Bellevue, we love Austin, continue to do so. We've also said that there isn't an asset that we necessarily have to hold in perpetuity. Both the asset in Bellevue and the asset in Austin that we have in the market now, they're both development opportunities, and we just determined they should be developed. They're worth more to someone who plans to develop. And we think it makes a lot of sense where we are in the market to take those and see how they get priced, then determine what to do.

Did you contemplate developing yourself?

We as a -- well, in Bellevue, we've explored perhaps some large build-to-suit opportunities. But at the end of the day, just given the dynamics of that market and that site, we just think it's worth more to a developer who may be more bullish, more focused. It doesn't perceive the same risk level we do, and that's why we're likely to take it to market.

Yes, Jamie, just to provide a little more color. These are both really unique assets. In Bellevue, we're talking about really the next development site and the best located development site, in our opinion, adjacent to the light rail that's coming. And just an outstanding location where there's capacity to build on the site as much as 1.6 million or 1.7 million, and then you have to contemplate the existing building there that takes up some of that capacity. And then in Austin, in the Northwest Corridor there, you've got a lease with Flex with term, essentially a covered land play, and then you have 80 acres...

80 plus.

Yes, unencumbered acres for sort of phased and planned development, and that's really not what we do. And the thinking by the board and the management team was, given the strength of those markets -- and they're both really remarkably strong, we spent time in both markets over the last few weeks -- that it was an opportune time to market the asset.

Okay, that's helpful. And then, David, you had mentioned seeing some buyer pushback based on asset prices due to higher rates and feeling like the cycle feels extended. Can you just give more color on what types of assets that might apply to in what market? And if you think that if it does feel like things are loosening up a little bit for your guys' longer-term plan?

Yes. I think we're in constant communication as most people are who are investing and selling assets. With the investment sale guys in the major markets with the major houses trying to get a beat. Particularly coming up to a call, we have regular -- both internal calls and external calls, to make sure we have a sense of where the market is. And I think it's very hard to point to specific comps, but we are definitely hearing more chatter and seeing it in some of the transactions that we track where there are probably fewer buyers than they were. Those buyers are taking more time and underwriting more closely. And one of the things that's still to be resolved in some of the in-process transactions is who is going to take the hit for the change in spreads on borrowing cost. And so I think we have heard anecdotal evidence across the country in markets that pricing is flat to backing up maybe 25 to 50 basis points. That probably excludes the very highest-quality assets. But the rest of the market, which is substantially all of the market, probably is facing downward pressure. How sustained that will be and what that means longer term? It's hard to say, but there's definitely some pushback from buyers.

Okay. And then how are you guys -- how have you guys changed your underwriting assumptions in terms of the kind of desired yields or rent growth prospects given where we are in the cycle?

Well, we haven't changed our targets. It's really more the inputs have changed and, therefore, you can pay a little less for the same to get the same returns.

Okay. And then last question from me is just on the potential distribution going forward. How should we think about, I guess, with what you have teed up for sales, the likelihood of another special distribution?

Well -- this is Adam. The future asset sales are expected to generate gains. The size and timing of those gains will be dependent on what actually sells, and then the structure and timing and pricing of a transaction. So we are anticipating gains, but we will fill you in, as we did this past year, with how those gains are looking when assets close relative to the $90 million NOL.

Okay. But as of now, you're all set with payouts and you have the $90 million to work with? Is that the right way to think about it?

That's right.

(Operator Instructions) Our next question comes from the line of Mitch Germain with JMP Securities.

So it seems like some of your underwriting has gotten a bit more conservative. But is -- the target markets that you're looking to potentially grow in, has that changed at all based upon what you're seeing in the fundamentals of today?

Mitch, it's David. We've always said we like the high-growth markets. We just like their prospects over the long term. But that's always been balanced with we're willing to look at other markets if the opportunities make sense, and we continue to do so as well. We're always kind of evaluating price versus returns, risk and upside. And it may be that in some of these other markets, we find more compelling opportunities.

Got you. And then it seems like there's some leasing to be done, Brookline and Georgetown. Is it safe to say that once that's completed, those are properties that could -- those, among others, could be queued up for sale as well?

Well, Georgetown, clearly, if you were to look at our portfolio, I think we've determined that's one that we plan to sell at some point. It's a 2-building property. One of the buildings, we secured a long-term lease with a private school. If we can address the building, we may get back or we may lease to Georgetown. It's one we will sell at some point. Another building, just to put it out there, is Tower 333. If you look at our history, we're very quick to sell assets when we think we've created a tremendous amount of value and there's little work to be done. And I'd put that one on the list as well.

Got you. And is there anything with regards to, Adam, REIT status here, if you're sitting on a pile of cash potentially? Or there wouldn't be any sort of risk in the near term?

No. The challenge over time might become that 75% of our income has to come from qualified real estate investment. But the good news is that in the short term, gains from asset sales count for real estate income. So we're well covered for now. If we ended up being patient longer, we would have to find other qualified real estate investments to make Freddie and Fannie bonds are the example that most people use when they explain sort of ways to stay liquid and meet that qualification.

And then -- I'm sorry, one more from me, I apologize. Has there been any sort of shift in philosophy with regards to asset class? Or is it still really just focused on office?

Well, what we've said in the past is it's likely to be office, very likely to be office. But we've evaluated lots of different things and broadened our mandate from our board to evaluate all sorts of opportunities. We're going to continue to do that. We would still consider office to be the likely focus. But if we find something that's compelling that we feel like we have an edge, we would also consider that.

Our next question is a follow-up question from John Guinee with Stifel.

Do you think the Forest City deal with Brookfield is a done deal? Or is there a chance that Mr. Ratner will be successful in putting that back in play?

We're all sitting here nodding our heads. Some, left to right; and others, up to down. So...

It's really hard to say. It feels like it's late.

We have no further questions at this time. Mr. Helfand, I would now like to turn the floor back over to you for closing comments.

Well, we certainly appreciate your time today, and we look forward to seeing many of you in San Francisco. Thanks a lot.

Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation, and have a wonderful day.