Franklin Street Properties Corp (FSP) 2017 Q3 法說會逐字稿

Good day, and welcome to the Franklin Street Properties Corp. Third Quarter 2017 Earnings Conference Call. (Operator Instructions) Please note, this event is being recorded.

I would now like to turn the conference over to Scott Carter, General Counsel. Please go ahead.

Good morning, and welcome to the Franklin Street Properties Third Quarter 2017 Earnings Call. With me this morning are George Carter, our Chief Executive Officer; John Demeritt, our Chief Financial Officer; Jeff Carter, our President and Chief Investment Officer; and John Donahue, President of FSP Property Management. Also with me this morning are Toby Daley, Senior Vice President and Regional Director of Atlanta and Houston; Will Friend, Senior Vice President and Regional Director of Denver and Minneapolis; and Patty McMullen, Senior Vice President and Regional Director of Dallas.

Before I turn the call over to John Demeritt, I must read the following statement. Please note that various remarks that we may make about future expectations, plans and prospects for the company may constitute forward-looking statements for purposes of the safe harbor provision under the Private Securities Litigation Reform Act of 1995. Actual results may differ materially from those indicated by these forward-looking statements as a result of various important factors, including those discussed in the Risk Factors section of our annual report on Form 10-K for the year ended December 31, 2016, which is on file with the SEC.

In addition, these forward-looking statements represent the company's expectations only as of today, November 1, 2017. While the company may elect to update these forward-looking statements, it specifically disclaims any obligation to do so. Any forward-looking statements should not be relied upon as representing the company's estimates or views as of any date subsequent to today.

At times during this call, we may refer to funds from operations, or FFO. A reconciliation of FFO to GAAP net income is contained in yesterday's press release, which is available in the Investor Relations section of our website at www.fspreit.com.

Now, I'll turn the call over to John. John?

Thank you, Scott, and good morning, everyone. On today's call, I'll begin with a brief overview of our third quarter results and talk a bit about our debt transactions. Afterwards, George Carter will discuss our performance in more detail and provide some of his remarks. John Donahue will also discuss recent leasing activities, and Jeff Carter will discuss our investment and disposition activities. And following that, we will be happy to take your questions.

As a reminder, our comments today will refer to our earnings release, supplemental package and 10-Q, which were all filed with the SEC last night and, as Scott mentioned, can be found on our website.

We reported funds from operations, or FFO, of $28 million or $0.26 per share for the third quarter of 2017. Compared to the third quarter of 2016, FFO was up about $1.3 million, though it was flat on a per-share basis from somewhat higher weighted average shares that we had last year. The FFO increase was primarily from the 3 acquisitions we made in June, August and December of 2016.

Turning to our balance sheet. At September 30, 2017, we had about $1.1 billion of unsecured debt outstanding and our debt service coverage ratio was about 4.3x. From a liquidity standpoint, we had $200 million available on the revolver at the end of Q3. But more importantly, we recast our credit facility and entered into a private placement of debt last week. We issued a press release about that last Tuesday, which has a great pro forma year-end debt schedule, or debt stack that I think really illustrates the impact of these transactions, and I suggest you take a look at that.

Some key points about those are: first, we do not increase leverage from these transactions, but we did increase revolver capacity by $100 million, so we now have $600 million available on our revolver; second, we believe we'll have about $525 million of liquidity at year-end on the revolver based on some transactions that we're going to do. We've increased our weighted average debt maturity to 4.5 years, and we now project to have about 78% of our debt at fixed interest rates. The debt stack being more termed out now, really helps us align net capital structure with the more long-term value-add properties we have in our 5 core markets.

In addition, on October 20, 2017, we've closed in a sale of East Baltimore property we own there and received $31.6 million in proceeds that were applied against the revolver. We have a great bank group, consisting of 11 banks that supported us with the credit facility. And the private placement we entered into is our first transaction like that, and we've had a number of insurance investors that made a really big commitment to Franklin Street, which we really appreciate. And we're very pleased with the outcome and the support from these lenders to our company.

We also wanted to point out that Moody's has affirmed our investment-grade rating at Baa3 for the stable outlook, and they've rated the $200 million private placement of senior unsecured notes with the same rating. I believe these transactions have addressed our near-term maturities and created a better debt stack for the company. We can cover more questions on this during Q&A if you're interested.

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

Thank you, John, and welcome to Franklin Street Properties Third Quarter 2017 Earnings Call. Since this is the last earnings call we will have in 2017, I thought it might be worthwhile to look back to our first earnings call of 2017 and try to give some of our perspective as to what's been happening in FSP and how we are doing. The #1 objective that we believe we could achieve in 2017 was a transition back to FFO growth again. This could be long-term and sustainable, and so add real value to our longer life, more land constrained CBD and urban infill office properties, located within our 5 core markets. We felt the long occurring transformation of our property portfolio from a geographically diverse eclectic set of suburban office assets to a more focused, more vertical set of urban office assets, have finally reached the tipping point with approximately 78% of our square footage now located within those 5 core markets.

Our FFO per share had declined from a peak of $1.12 per share in 2014, when the property portfolio then was about 94% leased to $1.07 in 2015 and $1.03 per share last year, 2016. This approximately 8% reduction in FFO per share over that 2-year period was primarily a result of timing differences between receiving suburban property disposition proceeds from sales and redeployment of those proceeds in the targeted acquisitions, as well as cap rate differentials that generally exist between the suburban properties we were selling and the urban office properties we were buying. The vast majority of our urban office properties acquired during this transformation have meaningful 2 to 5-year value-add components to them, such as nearer term, larger tenant lease expirations, which inherently carry with them a level of risk, which resulted in these properties being able to be acquired at a lower pricing value point, particularly on a price per square foot replacement cost basis.

Ultimately adding that value, primarily through leasing higher rent vacant space at these properties, we believe will restart FFO growth, and that growth will be more sustainable over a longer period of time than the suburban office assets we disposed of, and as a result, create better long-term value for shareholders.

So the transition to FFO growth again in 2017 we see happen. We are guiding for full year 2017 to $1.04 FFO per share, up from $1.03 in 2016. The trajectory term, the tipping point, we believe, has been reached and we feel positive about continued FFO growth prospects in 2018 and beyond. Not including the 801 Marquette, our one redevelopment project, we are currently about 87% leased in our urban infill core market portfolio, presenting approximately 1 million square feet of current vacancy per lease at average net rents of between $18 and $19 per square foot. This contrasts with our remaining 22% suburban portfolio that is currently about 95% leased at average net rents of about $15 per square foot. So it is all about adding the value-add proposition that we originally acquired and underwrote in our urban infill portfolio, and that means leasing its vacant space.

If we move occupancy close to levels we were at on our former suburban portfolio in 2014 to about 94%, then you'll really move the FFO value needle. We believe we will do that. We are very bullish on the new portfolio of urban office assets we now own. We anticipate giving 2018 FFO guidance estimates when we report full year earnings for 2017. We believe that 2018 FFO guidance will show continued FFO growth that has restarted in 2017.

Our #1 driver of future growth is leasing, our in-place vacant space. To that effort, let me now turn the call over to John Donahue, President of FSP Property Management, to give some color on leasing activity and prospects for the second half of 2017 and 2018. John?

Thank you, George. Good morning, everyone. At the end of the third quarter, the portfolio was 88.7% leased. As of year-end 2016, the portfolio was 89.3% leased. We believe the portfolio leased occupancy will be higher as of year-end 2017, approaching 90%. As expected, the third quarter was our strongest leasing quarter of the year-to-date, with 460,000 square feet of total leases. Approximately 124,000 square feet were new leases and expansions. That was the second-best quarter of total leasing in the last 3 years.

For the 9 months to date, we have leased 936,000 square feet in total and 291,000 square feet were new leases and expansions. We believe the fourth quarter has the potential to be even better. There are currently more than 300,000 square feet of high probability deals, with executed letters of intent and/or leases. Roughly half of that amount would be with new tenants. There is an additional 200,000 square feet of potential leases that are very close to the letter of intent phase. If successful with a very high batting average, barring any surprises, and assuming that we close the majority of these potential leases, the quarter may exceed 500,000 square feet of total leasing.

So the total year of leasing might finish in the range of 1.3 million square feet to 1.5 million square feet. We expect 3 of the 5 core markets to be in the range of 90% to 93% leased within the next 2 to 3 months. FSP's Dallas portfolio has been very strong, now over 92% leased and likely to reach 93% or higher by year-end. Minneapolis is now in a 2-year high, 89.7% leased, and we have increased leased occupancy in 4 straight quarters, and it is expected to be over 90% leased by year-end.

Denver, our largest core market, has improved this year with 3 straight quarters of increasing leased occupancy, which is now on a 2-year high at 89.1%. We believe Denver may be 90% leased within the next 2 to 3 months. Our Atlanta portfolio dropped to 85.6% leased at quarter end. The suburban infill properties have been experiencing a healthy amount of churn during the past 4 quarters. We continue to work through it and leased occupancy for Overton Park and the Two Ravinias are expected to rise during 2018. Our Midtown Atlanta buildings are currently 98% leased, and we have made progress on renewing the anchor tenants.

FSP's Houston portfolio appears to have turned the quarter. During the third quarter, leased occupancy improved from 73.9% to 76.4%. There has been great activity at Park Ten recently, and we believe our Houston portfolio has a great chance to be in the range of 80% to 85% leased by year-end.

With that, I'll turn it over to Jeff Carter.

Thank you, John. Good morning, everyone. Our focus at FSP is to generate long-term FFO growth and to create value for our shareholders. With this in mind, FSP saw a positive third quarter. First, our recapitalization of our debt stack provides the company with greater flexibility and matches well with our portfolio composition of longer-life infill and urban real estate assets. Secondly, and of key importance to long-term FFO growth, the third quarter saw our strongest leasing velocity this year, including a vacant space. We are optimistic that leasing progress will continue in the quarters ahead.

As we look forward, our efforts remain: number one, on leasing and tapping into potential upside in our vacancies; number two, through select new property investments; number three, through select new development and redevelopment efforts; and number four, through select disposition efforts of noncore assets that further FSP's portfolio transition into infill and urban properties.

On the acquisition front, FSP is committed to growing in our core markets, with high-quality urban and infill opportunities. We continue to look at a range of opportunities that include value-add core plus and potential development or redevelopment. Our focus in our core markets is leading to stronger local insights and to potential opportunities that include off-market transactions. The majority of opportunities during 2017 to date has been in Minneapolis, Denver and Atlanta and with fewer in Dallas. Houston at this time remains slow for investment sales. We'll continue to keep the market posted with any updates.

On the disposition and asset recycling front, to date, during calendar year '17, FSP has disposed of 3 noncore assets, totaling approximately $48 million in gross proceeds. To date, since 2014, FSP has sold properties or had mortgages repaid to us of approximately $230 million, and we continue to work on and look into additional noncore assets for potential disposition should satisfactory pricing and values be achieved, and we'll continue to keep the market posted on that front.

With that, thank you for listening to our earnings conference call today. And at this time, I'd like to open up the call for any questions. Thank you. Operator?

(Operator Instructions) Our first question will come from John Guinee of Stifel.

John Guinee here. A few quick questions. First, debt cost, with the capital restack is going up, roughly how many basis points for the whole -- your whole debt stack? That's one question.

Second question, what's the secret sauce to gaining so much occupancy? Is it down on rental rate or up on TIs and leasing commission packages?

And then, three, it looks like you have about 13% rollovers, 1.3 million square feet in each of 2018 and 2019. And what do you think about your retention of that 2.6 million square feet?

John, this is John Demeritt. I'll answer your debt question first, and John Donahue can pick up the real estate questions. I don't have an actual basis point number to quote on that. But what's -- on Page 12 of the supplemental report we filed last night, I put in some information about the deferred financing costs and the facility fees on an annualized basis. And you can look at those to model it. Some of that basis point calculation would be based on how much we think would be drawn on the revolver. Certainly, no doubt, but at least you'll know the dollar amounts, okay. I'll now pass it to John for the other question.

I'll tackle the secret to leasing, first. Why do we have the progress? And the short answer is demand and able to finalize deals that have been in the works for quite a bit of time, 6 to 12 months or longer in some cases. And then we believe that the energy markets have turned the corner a bit, especially for our properties in Denver and Houston in particular. And so we've been able to finalize and have a better batting average, if you will, over the last few months.

So has there been a tick-up in TI costs and concessions? Yes, but not dramatically so. We're still on the same track where we're in between $4 and $5 per square foot per year. And have we needed to cave on rental rates? Not necessarily so. Some of our smaller markets in Minneapolis where we did a lot of leasing in the first 2 quarters, the rental rates for the portfolio appear to be down, but that's because we did leasing in smaller markets. Rental rates are a little bit higher for this quarter, and we expect them to be higher in the fourth quarter, because we're doing more leasing in our other core markets where we have the highest rental rates. So I don't think there's any secret sauce, it's just the combination of the demand in the energy markets and we're making progress.

In regards to the rollover, it's sort of a long answer, but bear with me. If we say that we have roughly 13% of the total portfolio with expirations in calendar 2018, there are 4 significant tenants expiring that make up almost -- or roughly half of that total. Both Northrop Grumman and the IRS are engaged and we expect them both to renew. And then Burger King is likely to hold over for another months. We don't know exactly how long yet, and they will eventually depart, but that is probably going to be on a later date than expected. We'll have that space to work through. But the Blue Lagoon property in Miami is very well-positioned and we welcome the opportunity to multi-tenant that building. And then finally, Fannie Mae will depart early, although the release doesn't expire until Q4 and we're already getting a jump-start on that preleasing. And as you've probably heard us say, the Addison Circle property in Dallas have been very strong performers for us, so we expect that to re-lease fairly quickly.

So after you subtract those 4 tenants, the exposure is down to about 6.5 of the portfolio and we're making progress with engaged tenants on renewals. So barring any surprises there, we expect to renew about 60% to 70% of those remaining tenants, which then reduces our exposure to approximately 2% of the portfolio. So we think that the roll is manageable and we're seeing good things, and hopefully, we'll have a great batting average. And we'll see how things turn out. It's a very balanced staggered expiration roll over the year, with the known departures really late in the year or even slipping into 2019. In regards to 2019, we have a few anchored tenants that we're engaged with, so we expect some early renewals there, but those will take another 6 months or so to work through. Hopefully that gives you a sense of where we think we're going to end up.

Our next question will come from Dave Rodgers of Baird.

Maybe just following up on the leasing comments. Can you talk a little bit about the activity that you're seeing in Minneapolis with the TCF vacancies and the products that you have there?

Sure, Dave. Minneapolis has been a great performer over the last 4 or 5 quarters, and we have backfilled a huge percentage of the TCF space that was in 121 South 8th, and we're excited about 801 Marquette. Will Friend is here, so I'll turn it over to him to give you a little bit more color, but we're excited about what's happening in Minneapolis. Go ahead, Will.

Dave, Will Friend here. During the third quarter, activity for 801, for the vacancy there remain very strong. We've had approximately 300,000 square feet of activity from a good and diverse cross-section of user types, architectural and engineering CAD insurance, hospitality and health care, to name a few. So we're encouraged by the diversity of the type of users that are looking at the space. Of that 300,000 square feet, we're actually trading proposals with several prospects, representing about 25% of the space with 35,000 square feet. So it's nice to be engaged with prospects there, and touring about 250,000 square feet of prospects at the same time for scheduling, meetings and towards with others. So again, the activity remained strong. It's a little too early to speculate on any specific deals, those that we're in discussions with. But based on recurring activity and feedback we're getting, we believe we'll have signed leases for 20% to 30% of the project, some time over the next 3 to 6 months, with the FFO related to those leases following some time in the second half of next year. We do expect more leasing to follow in 2018, but the timing of the lease-up and more meaningful FFO will depend, in part, on whether we multi-tenant the project or lease it to a single-user. Right now, it looks like -- I think will -- it's trending towards multi-tenanting, which means it's a little bit -- it's smaller deals, but those tend to move a little more quickly, where the larger deals have a longer horizon out there. So the timing is a little hard to track. But we feel really good based on the activities we've got right now and are confident that we'll convert some of these prospects in the next 3 to 6 months and get the momentum going, or keep the momentum going, actually.

Okay, thanks for the color on that. John Demeritt, did you guys have any onetime costs? You took your FFO guidance to the low end of the prior range in the quarter. Was there any onetime refi cost in there, or increasing amortization related to the refi that you did?

Yes, there was an estimate of some of that, some of the legal fees and other things we need to write-off for the amendments that we did. A good part of it has been capitalized as well, but there was an estimate in there for it, yes.

I mean, is that a recurring impact as we think about 2018?

No, I think if you look at the supplemental we did last night on Page 12, I laid out what, I think, the deferred financing cost will be annually and what the new facility costs will be annually, so I think that will cover it. And then a couple of the other key points are on the revolver, we decreased the spread on that, 5 basis points, so we have some savings there. And on the term loan, we decreased the spread, 10 basis points on that. So we'll have some savings there that will offset some of those recurring deferred financing costs and facility fees.

So -- But I think that will give you the information for the model. And then the another thing is on the press release that we did last week, I put a pro forma debt charge there, and that gives the rates and the spreads for all the debt. So that's, I think that will be helpful for you guys to model it.

Okay, thanks. Lastly on Jeff, can you talk more about the cap rate on Baltimore? Was that stabilized or in place? If you can give kind of the details around that number. And then just more broadly, how active you are in the disposition market right now, and how quickly we might expect you to kind of cycle through the remaining noncore assets?

Sure. The in-place cap rate on Baltimore was just about 5.8 cap rate, and that was completed, October 20. As we look at -- we are actively exploring potential dispositions and looking at other potential sales. We're committed to growing in our core markets, and disposition is a key part of it. We expect to continue to chip away, over time, at the remaining roughly 22% of properties that are in our noncore markets when appropriate pricing values result, and importantly, our expectation there, as you know, is to continue to reinvest those proceeds into more infill and urban properties in our markets. So I think you're just going to see us keep chipping away at it. We are working on other dispositions now, and I'll keep you guys posted if pricing meets the expectations.

Our next question will come from Rob Stevenson of Janney.

With Marquette now done, I mean, when you take a look over the next 9 to 12 months, any sort of major capital improvement plans that you're expecting to undertake throughout the portfolio?

For 801 Marquette, there's no significant costs remaining other than the tenanting of that, obviously. As far as other properties that need to be repositioned with significant capital, we don't have anything right now that is large. Next year, and into '19, we'll be retenanting the Blue Lagoon property that we just talked about with Burger King. And we expect that to be multi-tenanted. We don't know if it will be 2 tenants or 10 tenants, but that will have some cost. But on the scale size of 801 Marquette, there's nothing on the horizon.

No, but I mean, just in terms of sort of normal sort of repositioning, the sort of more normal lobbies and mechanicals and common space and things like that, I mean, anything of size, maybe not to Marquette's level, but anything of size going on in sort of typical 5- to 10-year refreshes that we should be expecting in 2018 at this point besides Blue Lagoon?

Well, the short answer, Rob, is no. We haven't had any acquisitions since the Dominion Towers property. So there are no large numbers. Park Ten has a big block of space, where the property show well and we don't expect anything significant there. If you multi-tenant a floor, any particular building, obviously, you'll have corridors and lobbies and things. But I believe the answer to your question, are there any big numbers, and the answer is no.

Okay. And then lastly, on Houston, in terms of the activity there, was that well underway and far down the road before the hurricanes? Or if you guys got any benefits from the fact that your properties are all on the west side, and less exposure and sort of damage over there bringing you potential new clients?

Thanks, Rob. I'm actually going to let Toby Daley answer that question. Go ahead, Toby.

Rob, we had virtually no damage. Actually, we had no damage as a result of the aftermath of Harvey. And in fact, most of the damage that did result was in the west side of Houston, near the Addicks and Barker reservoirs and along Buffalo Bayou. But we were very fortunate and -- there is very little impact on office buildings. There were a few. So as a result, there weren't as many tenants seeking temporary or permanent homes as a result of the flooding damage. So we did not see a great uptick of tenants looking for new space as a result of the flooding. And so the activity that we did achieve during Q3, which is normal course of business, and we're back to business during this Q4, because I think I have about 150,000 square feet of leases out already for Q4 in Houston.

Do you think that some of that is benefiting from the fact that you didn't have any damage, where people can save and planning for the next one to make sure that they're not in an area where you're going to go end up getting massive flooding and things of that nature?...

That's actually a good point, Rob. We're working with one large tenant, and that was very much a factor for them. They went out and reassessed their buildings during their search, and our building kind of got a boost from surviving that storm well. So yes, that was helpful.

Our next question will come from Craig Kucera with FBR Capital Markets.

I want to continue the discussion on Houston. I feel like in the past, you mentioned that, earlier on -- it was some of the larger users that were looking for larger space, the larger companies. Is that still the case as far as what's driving the demand? Or have you seen any sort of recovery for people that are looking for smaller space that's out there?

Yes, Rob -- Craig, sorry. Right now we're seeing pretty much a 50-50 mix of small and large tenants in Houston. So everybody seems to be back out and looking for office space. So there's the 150,000 square feet that I have out right now are a combination of large and small tenants.

Okay. Great. And based on your earlier commentary, you actually anticipate that you'll be able to achieve something in the order of maybe 8% to 10% spreads on a GAAP basis from where you've been, as leasing activity moves forward.

I think the answer there, Craig, is yes. We continue to increase the weighted average rents because the large percentage of vacancy is in our core portfolio. And so I believe that will be a case -- that will be the case going into 2018.

Okay. And one more for me. Circling back to 801 Marquette, I guess at this point, when do you guys think you're likely to have an FFO impact from that asset, kind of base on what you're seeing in the market today?

Well the answer there is very similar to what we've been saying. We're hoping and expecting that we'll have some meaningful FFO contribution in 2018, likely in the back half of 2018. And I wish I had a crystal ball to tell you if it was going to be single-tenanted, 2-tenanted or if we're going to have 10 tenants. And the timing of FFO is largely dependent upon the size or sizes of the tenants. So right now, we believe it will be multi-tenanted. Let's just say it's about 5 or 6 tenants, and so we should have some meaningful FFO contribution in the second half of the year. I just don't know the exact timing yet.

(Operator Instructions) Our next question will come from John Kim of BMO Capital Markets.

George, in your prepared remarks, you discussed an optimistic view of FFO growth in 2018. I know you're not giving official guidance. But can you discuss the order of magnitude of the growth that you expect to achieve?

John, no, I can't. And if I could, I would give the guidance right now. And so we have so much in the Q right now as John Donahue has said, that I think will become very evident by year-end and that will really help us give guidance that is meaningful. Anything I'd say right now would be very dependent upon what's going to happen really over the next 2 months.

But scanning back from it and looking at possibilities, we are very confident that we will continue our FFO growth. So we turned the corner in '17, like to turn it harder, definitely had slower leasing velocity in the first half of the year than we had hoped for, but that leasing velocity has picked up a lot in the third quarter and it looks very strong in the fourth quarter. We should be able to continue our FFO growth into '18. We will give you that range -- guidance range as soon as we put the numbers together.

I'm trying to tie that into the noncore asset sales, because I imagine that's going to be dilutive. But do you expect to be a net seller next year, or a net acquirer, or sort of even?

I think from a pure disposition acquisition proceeds allocation, I think we will be fairly neutral. In other words, we will acquire with disposition proceeds as much as we dispose of. Accretive or dilutive in that process, we'll remain to be seen. Most of our remaining assets that would be considered for disposition are fairly well occupied, we'll get fairly good cap rates. And it depends on the acquisition of how much value-add opportunity there is there, how quickly that value-add opportunity shows itself versus more stabilized as what kind of cap rate differential we will experience. We generally, though, do experience a cap rate differential between our suburban and urban between 100 to 300 basis points.

Okay. And then just circling back on your prior comments. So the amount of leasing activity in the third quarter you expect based on your discussions and your, I guess, leasing pipeline that, that activity is going to spill over to this quarter into 2018?

Yes. That's correct.

Okay. And then John Donahue, I think you've went through the 4 major expirations in 2018, which included Burger King, Fannie Mae and a couple of others. But can you just remind us what markets those tenants are in?

Yes, absolutely. Northrop Grumman is in the Northern Virginia market; IRS is in the Denver market; Burger King is in Miami and Fannie Mae is in Dallas.

Ladies and gentlemen, this will conclude our question-and-answer session. I would like to turn the conference back over to Mr. George Carter for any closing remarks.

Thank you very much for tuning into the earnings call. We appreciate it. Hope to see many of you as we roll in Dallas in mid-November. Thank you.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines.