Highwoods Properties Inc (HIW) 2009 Q2 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the Highwoods Properties Second Quarter Conference Call. During this presentation, all participants will be in a listen-only mode. Afterwards, we will conduct a question-and-answer session. (Operator Instructions). As a reminder, this conference is being recorded, Thursday, July 30th, 2009.

It is now my great pleasure to turn this conference over to Ms. Tabitha Zane, Vice President, Investor Relations. Please go ahead, ma'am.

Thank you, and good morning, everybody. On the call today are Ed Fritsch, President and Chief Executive Officer, Terry Stevens, Chief Financial Officer, and Mike Harris, Chief Operating Officer. If anyone has not received a copy of yesterday's press release or the supplemental, please visit our website at www.highwoods.com or call 919-431-1529 and we will e-mail copies to you.

Before we begin, I would like to remind you that this call will include forward-looking statements concerning the Company's operations and financial condition, including estimates and effects of asset dispositions and acquisitions, the cost and timing of development projects, the terms and timing of anticipated financing, joint ventures, rollover rents, occupancy, revenue trends and so forth.

Such statements are subject to various risks and uncertainties. Actual results could materially differ from those currently anticipated due to a number of factors, including those identified at the bottom of yesterday's release and those identified in the Company's annual report on Form 10-K for the year ended December 31, 2008 and subsequent reports filed with the SEC. The Company assumes no obligation to update or supplement forward-looking statements that become untrue because of subsequent events.

During this call, we will also discuss non-GAAP financial measures, such as FFO and NOI. Definitions of FFO and NOI and an explanation of management's view of the usefulness and risks of FFO and NOI can be found toward the bottom of yesterday's release and are also available on the Investor Relations section of the web at www.highwoods.com.

I'll now turn the call over to Ed Fritsch.

Good morning. Thank you for joining us today. We had another productive quarter. Total FFO was $49 million compared to $42 million in the second quarter last year. This increase was mainly driven by increased contributions from new developments, lower expenses due to operating efficiencies and lower interest expense in preferred dividends.

These increases were partly offset by a decline in NOI as a result of $95 million of 95% leased dispositions over the past 12 months, lower same-store NOI and lower FFO contributions from our joint ventures. On a per share basis, FFO was $.70 for the first quarter and $1.41 per share for the first six months. We have raised and narrowed the range of our 2009 FFO guidance from $2.52 to $2.60 per diluted share, up $0.09 from the low end and up $0.02 on the high end.

The second quarter was very productive for us on a number of fronts. We leased 1.4 million square feet of second generation space, which is over 20% better than our five-quarter average. While occupancy in our wholly owned portfolio declined 100 basis points to 88%, occupancy in our office portfolio, which accounts for approximately 86% of our annualized cash revenue, declined only 10 bps from the first quarter. We reduced G&A and operating expenses through improved efficiencies and best practices.

Two development projects were placed into service during the quarter, the 100% leased build-to-suit office for the FAA in Atlanta and the office and retail portion of RBC Plaza, which is 96% leased. The stabilization of RBC Plaza was originally projected for year-end 2009, so we are pleased to place it in service two quarters ahead of schedule.

Our wholly owned development pipeline now consists of six projects encompassing 830,000 square feet that is 51% pre-leased on a weighted dollar basis. Only $16 million is left to invest to complete the construction of our development pipeline.

We sold three non-core community retail centers that were on average 55-years-old and an 8.7% cap rate generating $62 million in proceeds and a $21 million gain. Plus, we avoided over $3 million in building improvements that would have been incurred over the next few years. With this sale, we are close to the midpoint of our disposition guidance for the full year. We are actively marketing a few other small one-off non-core properties and plan to close a couple by year-end.

We also strengthened our balance sheet with our $144 million equity raise in late May. I know many of you participated in this, so on behalf of the Company, thank you for your support. We paid off $107 million secured loan and we are on track to close two new secured loans this quarter totaling $162 million on very attractive terms.

At the beginning of the year, we published a detailed liquidity plan which listed specific goals we wanted to accomplish in 2009. Once the $162 million of secured financings are closed, which should happen within the next few weeks, we'll have met or exceeded all those goals and hence our pro forma debt maturity ladder is in excellent shape.

We are very pleased that our joint venture with USA Real Estate was awarded the Charlotte FEI development project. We have a 10% ownership interest in the JV and we'll receive development fees. The stabilized cash return to Highwoods, including fees, is projected to be 11.5%. This development represents another great opportunity for us to expand our relationship with our largest customer, the federal government.

We are also thrilled to team with USAA, who, like us, also has a significant relationship with the federal government. The JV began to pursue this deal late last year. At that time, we were in the early phase of formulating our 2009 liquidity plan for Highwoods. Therefore, we conservatively decided to limit our investment in the Charlotte build-to-suit to 10%.

Congratulations are in order to everyone affiliated with Highwoods on the Company being named NAIOP's 2009 Developer of the Year. This is indeed an honor and I applaud the entire Highwoods team.

We are not yet seeing meaningful acquisition opportunities in our markets. However, with our wish list in hand, we continue to reach out to bankers, brokers and local developers. Opportunistic yet deliberate remains our mantra. In closing, I again assure you that everything we do will be in line with the goals of our long term strategic plan and we will continue to be disciplined in all of our activities. Leasing space and expense management continue to be our top priorities.

Mike?

Thanks, Ed, and good morning, everyone. Leasing activity was on par with the second quarter of last year and square footage signed was up 67% from the first quarter. In total, we signed 118 leases for 1.4 million square feet of second generation space with decent activity in all three property types.

As Ed mentioned, occupancy in our wholly owned portfolio declined 100 basis points from the first quarter to 88%, primarily driven by our industrial portfolio and to a lesser extent, the sale of the 416,000 square feet of retail in Kansas City, which was 94.5% occupied.

Occupancy in our office portfolio dropped only 10 basis points from 89.1% to 89%. Occupancy in our office portfolio, with the exception of the Triad, continues to outperform our markets. This is clearly due to the good work of our seasoned leasing team and our five-year focus on strategically developing in the best submarkets and disposing of non-core assets in less desirable locations.

The average term for office leases signed this quarter was 3.6 years, below our five-quarter average. There's not one large deal that brought the average term down significantly, rather, it simply reflects what we have been saying about customers wanting to stay put and not make long term commitments until they have better clarity on the economy.

For example, in Richmond, we recently signed a 14-month 26,000 square foot office lease, immediately backfilling a scheduled exploration. Expectations are that this customer will renew for a long term as they get better visibility into the outlook for their business.

Average in-place cash rental rates across our total portfolio rose 5.5% from a year ago and on our office portfolio, they were up 5% from the same period a year ago. Cash rent growth for office leases signed this quarter declined 2.7% and gap rents on office leases signed were up 6.2%. CapEx related to office leasing was $6.33 per square foot in the second quarter, below our five-quarter average of $8.36 per square foot and well below our long stated range of $10 to $12 per square foot. Driving this lower CapEx was the large percentage of renewals signed in the quarter, 84%.

Looking at our top five office markets, aggregate office absorption was negative 1.2 million square feet compared to negative net absorption of 1.9 million square feet in the first quarter. Office sublease space in our top five markets barely moved, with only a 20-bps increase from the first quarter to a modest 2%.

During our call with our directors of leasing last week, it was reported that concessions continued to be part of almost every deal. As you know, there are some customers, mostly driven by tenant rep brokers, who are asking for blend and extends. We evaluate each of these requests on a case by case basis.

Turning to some specific markets, Raleigh remains a challenging market. The overall Raleigh market experienced a 150 basis point drop in occupancy to 82.4%. While there was negative net absorption in the quarter, available sublease space remained negligible at only 1%. Occupancy in our Raleigh portfolio declined 180 basis points from the first quarter to 83.7%.

This decrease was the result of Kamanda fading 100,000 square feet. As I mentioned on our first quarter call, Kamanda filed for bankruptcy and subsequently rejected their lease in the second quarter. We were pleased to put RBC Plaza in service this quarter, with the office portion of this property now being 100% leased. We still have 11,000 square feet of ground floor retail space to lease.

In the second quarter, we sold five condominiums for total proceeds of $1.9 million. Since receiving the first certificate of occupancy last October, we have sold 79 of the 139 units for total proceeds of $32.4 million and a gain of $5.1 million. Five units are currently under contract with earnest money deposits.

Long term, we remain bullish on Raleigh and it continues to rank very high for places to live and conduct business. In a recent Wall Street Journal article, Raleigh was ranked one of the best housing markets in the country.

The Tampa market continues to suffer from overbuilding as well as a contraction of the employment base, as reflected in the market's 80.8% occupancy. Our Tampa portfolio is performing well during this downturn, with occupancy at 90.8%. This is clearly the result of efforts of our leasing team and our higher quality portfolio in the better submarkets.

The Richmond market has been hit with the recent loss of some corporate customers, including Circuit City and Land America, and it will take the market time to backfill these large blocks of space. While potentially a drag on the overall market, these large blocks are not direct competition for us, as we have only three vacant spaces in our portfolio in excess of 25,000 contiguous square feet. Our typical customer is the small to medium size business in search of 5,000 to 10,000 square feet. Occupancy in our Richmond portfolio actually increased 70 basis points from the first quarter to 92%.

Looking out to the rest of the year, in all of our markets we expect to see continued pressure on rental rates and a demand for concessions. Renewals will most likely continue to represent a substantial percentage of the deals we sign, which should help keep a lid on leasing CapEx.

Competition for tenants is fierce, but with many of our competitors struggling due to the lack of capital and little or no access to the debt or equity markets, our leasing reps are well positioned to take advantage of customers and prospect's concerns about the financial health of their landlord. We also benefit from having a well respected brand and a strong reputation for quality and service.

Terry?

Thanks, Mike. We are pleased with our financial and operating results for the second quarter, with FFO of $0.70 per share compared to $0.68 in second quarter 2008 and $0.70 in first quarter 2009. Core FFO, which excludes lease termination fees, gains from land and condo sales, and gains on debt extinguishments, was (inaudible - technical difficulty) for the quarter, unchanged from second quarter 2008 and first quarter 2009.

Net income per share was $0.50 for the quarter, up from $0.21 for the same quarter last year. This large increase in net income mostly reflects significant gains on property sales this quarter compared to last year. Second quarter over second quarter, total revenues from continuing operations were up $0.5 million. Revenues from same properties, those in service during both periods, were down 2.8%, reflecting a reduction in average occupancy, partly offset by higher average rental rates. In addition, revenues this quarter were impacted by $600,000 in higher bad debt expense and reserves for both build and straight-line rent receivables.

Revenues from non-same properties were up $3.3 million quarter-over-quarter from recent developments and our fourth quarter 2008 acquisition. Total cash NOI from continuing operations, which excludes straight-line rents and lease termination fees, was up 3.8% in second quarter 2009 from new development NOI, partly offset by 1.8% decline in same property cash NOI. Operating costs were also down this quarter, particularly from lower utilities, mostly reflecting savings from enhanced energy management practices.

As we have mentioned on prior calls, we typically experience seasonality in our operating expenses where the second half of the year generally runs higher. This increase is primarily driven by higher utility costs and to a lesser extent, seasonally driven repairs and maintenance. While we recover a portion of our operating costs from our customers, most of this seasonality impact -- seasonality impacts NOI and FFO.

G&A for the quarter was $1.3 million lower, or $0.02 per share than second quarter 2008. Second quarter savings were driven by $1.2 million in lower salaries and benefit costs, $1.4 million in lower dead deal costs, and $1.0 million in lower incentive compensation.

These reductions were partly offset by $1.3 million in lower capitalization of G&A and $740,000 from the deferred comp valuation adjustment, which is fully offset by an increase in other income. For the six months ended June 30, 2009, G&A was lower by $2.7 million, or 13.1%, compared to the first six months of last year. We expect second half G&A to be even lower than first half.

Net interest expenses was down $3.4 million, or $0.05 per share, due to paying down debt with proceeds raised in our September 2008 and May 2009 common stock offerings and from a 36 basis point reduction in average rates on our debt. These reductions were partly offset by $900,000 in lower capitalized interest.

Preferred dividends were lower by $1.2 million, or $0.02 per share, as a result of our retirement of $54 million of preferred stock last September. On a per share basis, the impact of these significant reductions in interest expense and preferred dividends was offset by higher common shares outstanding. During the quarter, we issued 7 million common shares for net proceeds of $144 million and paid off a $107 million secured loan bearing interest at 7.8% that was scheduled to mature in November.

We expect to close within the next few weeks a $115 million 6.5-year secured loan bearing interest at 6.875% and a $47.3 million 7-year secured loan bearing interest at 7.5%. We will use these proceeds to take our line of credit borrowings, which currently stand at $91 million, down to zero and we will invest the remainder near term in cash equivalents.

On a pro forma basis, with the closing of the two new secured loans, we will have just $4 million of debt maturities in the last half of 2009, no maturities in 2010, and only $137 million of maturities in 2011. This assumes we exercise our unilateral extension right on our construction facility and also excludes principle amortization. And in the near term, we'll have $70 million in cash equivalents in the bank.

Even though our current line of credit does not mature until May 2010 and will soon have zero drawn, we expect to execute a new line of credit by year-end. We've had preliminary discussions with a number of our banks, but it's too early in the process to speculate on specific terms or commitment levels. We're obviously very aware of today's credit markets and the interest costs and fees for recent credit lines done by others have been considerably higher than for our credit line executed in early 2006.

We raised our full year FFO guidance to $2.52 to $2.60 per share. The prior guidance range was $2.43 to $2.58 per share. While total FFO in the first half was $1.41 per share, we expect FFO per share to be lower in the second half from three primary factors. First, we will have the full impact of our recent common equity offering, which only impacted second quarter by one month.

Secondly, as I mentioned, we expect to soon close on two secured loans, aggregating $162 million at a weighted average interest rate at 7.1%. These loans will be dilutive in the short run because the proceeds will be used to pay off the $91 million in outstanding borrowings on our line of credit, with the remaining proceeds invested in cash equivalents. This year's liquidity transactions significantly improve our balance sheet and enhance dry powder for future investments. But they also come with short term dilution.

Third, we expect lower NOI in the second half compared to the first half, due mostly to the seasonality of operating expenses. This reduction in NOI should be partly offset by lower G&A in the second half and from NOI from development projects.

Operator, we are now ready for questions.

Thank you. (Operator Instructions).

And our first question comes from the line of Paul Morgan from Morgan Stanley. Please proceed with your question.

Good morning. I was hoping you could characterize lease negotiations you're having and so what are the -- what are you seeing as the key deal points right now, whether it's TIs or free rents or the face rents and what your strategy is there?

Good morning, Paul, this is Ed. I think the general personality can be described as each negotiation is not an easy negotiation. The deals are protracted. The overall leasing activity is relatively spotty. But I think as we referenced in our script that most of our customers are just looking to hold tight until they can get an improved level of visibility on where their own business is going as a result of the economy. So, hunkering down and holding still seems to be the themes reflected in our leasing statistics.

I think our folks have done a superb job of not walking in the door and offering a full menu of potential concessions and rather listening to our existing customer or prospective customer and finding out what their hot buttons are and then respond to that. So, if there are TI dollars that are needed, we're in a position to fund that, if the credit's there. If they're more sensitive to face rate, then we'll negotiate that, but the TI dollars won't be there.

So, it's really across the board but spotty and concessions are in virtually every deal in some form or another. As customers read local papers, so the Richmond paper yesterday had a large article about how tough office is and the Raleigh paper did as well today. I think both were well written and accurate. But our customers and prospects are reading them and that's something that our leasing agents have to work through.

But I think that we still do a good job of leveraging our competitive advantages with regard to fee simple title and the ability to move customers around, the fact that we have the dollars to fund commissions and TIs. And then we try to distinguish ourselves further with the quality of service.

I think there's also a little -- this is Mike, by the way, Paul, a little bit of distinction between negotiations on a renewal versus a new lease or vacant space. On the renewals, the focus tends to be more on the length of term or the tenants wanting to go shorter term just to get some clarity on their business rather than extending long term.

So, it seems to be less concession driven in terms of free rent or TI than term on a new lease. Vacant space, where it's highly competitive and a tenant has the upper hand, then you see more negotiations focused on concessions such as free rent and turnkey TI versus allowance.

Great, thanks. My other question is just on the change in the cash. I go with expectations for the year with kind of the key drivers of the change in the outlook.

Hi, Paul, this is Terry. For the second half, as I said in my remarks, we do have seasonality in OpEx. I mean, obviously, in the Southeast, utility costs go up dramatically in the third quarter and into the fourth quarter. And we do have seasonality as well in some of the repairs and maintenance and things that are easier done in the summer and early fall months. So that'll put some pressure on overall NOI.

And I think same-store NOI growth will -- well, it should be at roughly the same level as where we ended up through the six months. I really don't see that getting -- the trend getting better, but probably more staying the same as where we were through first half of the year.

Thanks.

Opus next question comes from the line of [Aaron Adlickton] from Stifel Nicolaus. Please proceed with your question.

Hey, good morning, folks.

Morning, Aaron.

Thank you. Thank you for taking --

Thank you.

-- my question. A quick question just about the retail NOI going forward. I know on your NAV page you're saying it's about $28.9 million annually, but that doesn't appear to have been updated for the recent sale.

Aaron, that's correct. This is Terry. We have not updated the NAV data page from the time we published that in the first quarter. So, the retail NOI that is there would have to be backed out for the sale of the KC centers that we did in the second quarter. And I believe the annual NOI for those centers was somewhere around -- I think it was around $4 million a year on an annual run rate basis.

About --

Maybe a little bit --

Okay. Because if you just take the [8 7] cap against the $62 million, that's about $5.4 million. But you think it's $4 million.

Aaron, I have -- you broke up a little bit here in the conference room. Didn't hear the question.

Oh, sorry about that. Can you hear me now?

Yes.

Okay. If you just take the cap rate against the sell price of -- cap rate against the sell price of $62 million that's $5.5 million, $5.4 million. But you --

I'm sorry, I --

-- about $4 million.

No, I misspoke. The in-place NOI was $5.4 million.

It was? Okay. All right, thank you.

Thanks, Aaron.

Our next question comes from the line of John Stewart from Green Street Advisors. Please proceed with your question.

Thank you. Can I just follow up on the NOI question, Terry? It looked like your guidance for total cash NOI was up from the previous set of assumptions that you'd laid out. What's the driver? Is that RBC being placed in service ahead of schedule?

That had a small effect. But the big savings that we had in the second quarter, John, really, utilities were down from where we expected. Partly, as I said in my remarks, we've been working hard over the last year or two on things to improve our usage of utility costs because we still face continuing pressure on rates.

Also, we've been working hard on contract services. We brought in-house things that in the past we used to outsource to third parties and able to do that on a cheaper basis. There's just been a continuing focus on OpEx during the last number of quarters.

And not too dissimilar from what you're hearing from other companies here reporting, not just REITs but other industries, where while top line growth might be a little bit harder to get in this environment, companies are focusing intently on expenses, as we are as well. So, it's just kind of been an across the board focus on managing our properties as efficiently as we can and spreading best practices across all of our divisions.

Okay. If I look at your same-store page, one market that kind of jumps out is Kansas City, particularly because you show a 10% decline in same-store NOI and only 170 bps of lost occupancy. What's going on there?

I think that's primarily due to some adjustments -- reserves that went through on receivables and possibly from some retail deals that were recast where we gave back some -- we adjusted the rent --

Yes. John, we did -- as you know, we had several retail tenancy gallery Mark Shale that actually blew out, took bankruptcy and vacated their space. We had a renegotiation of a very large lease with Barnes & Noble on the Plaza, converting them to a percentage rent from a fixed rent, which is the way many of our retailers, particularly the bookstores, are going.

So, that's really -- that's really the extent of that. The Plaza, though, is continuing to hold up better than most. We're seeing good activity right now, so we expect to see that turn positively for us here in the next few quarters.

I think the largest part of the KC decline was the increase in reserves that we had this period for both billed receivables and also for straight-line rent receivables out there.

Which you run through the same-store pool?

John --

Which we run through the --

And you run those through the --

Yes, that's right.

They do.

Okay. Terry, what were the $1.54 million of dead deal costs in the first quarter?

The reason it was so much better was we had high dead deal costs in the second quarter of last year. A lot of that was driven last year by several GSA deals that we were chasing up to that point in time and we didn't get those. And so we took the hit in second quarter of '08. Second quarter this year is much lower, as was first quarter this year. So it's basically just coming off higher rates last year that drove that favorable comparison.

And in addition, John, obviously there were just fewer build-to-suit development opportunities out there to be chased nowadays than they were a year ago.

Right. Makes sense. Mike, you touched on some of the drivers for the softness in Raleigh. Can you shed some light on the Piedmont Triad?

I'm sorry, the -- I missed that last part of the statement, john -- the question.

Just in terms of the Piedmont Triad.

Oh, Piedmont Triad, sure. Largely what's going on there, again, that market for us is predominantly industrial. And as I think I mentioned this on the last call, many of our customers are logistics companies and they are tied specifically to contracts, shorter term contracts. For example, the largest vacancy we created this time was a logistics company, Camco, in our Enterprise II building that was 80,000 square feet.

They basically are tying their lease terms in some respects directly to the contract they have with, for example, Procter & Gamble Gillette who's a big provider over there, big supplier over there. So it's really related more or less to that line of business that is driving those occupancy swings and the softness there.

Okay, that's helpful. Just two more quick ones and I'll yield the floor. What was the cap rate on the ADP joint venture transaction? The sale in the quarter.

[7.7], John.

Okay. And lastly, Ed, can you touch on the leasing on the pipeline. Obviously it's kind of stagnated for the past several quarters. Is that because you guys are unwilling to break face rates and adjust yields on those projects? What's the philosophy on leasing up the pipeline?

Yes, I'm not so sure that's landlord judgment. It's just there are a number or volume of prospects reverse generation space is just much more shallow prospect pool. As we talked in the past, the gap between first gen and second gen rents remains wide, even after you add concessions in. And then staple that back to my previous comment on the call about customers mostly wanting to just hunker down, just makes it difficult to find first gen prospects.

Now, we are working with some -- clearly we didn't make much progress 2Q over first Q, but we do have some prospects that are looking at all that's still in the pipeline. So we'll work through those. But I don't think it's an issue of terms unless you go all the way to the point of offering terms that are in synch with second gen space, which we, and I don't think most others, would do.

But the least -- the length of the lease in any first gen space is typically longer because you're investing significant dollars day one there versus a renewal or a re-let. So, we're looking for longer term in the way of lease length and I think that also culls down the prospect pool. And it takes longer for them to make a decision. So, we're working a number of prospects and we're being very deliberate to be sure that this initial spend to get them in space is in synch with their credit.

Okay, thanks a lot.

You're welcome.

Thanks, John.

And our next question comes from the line of Mike Bilerman from Citi. Please proceed with your question.

David Shamas here with Michael. You mentioned that you aren't seeing a lot in terms of acquisition opportunities. Just wondering if you can give us a little bit of color in terms of what you're looking for exactly, size market, yields?

Sure. We're looking for steals. What we want to -- what we want to find is properties that are in the best submarkets, the better submarkets than the markets that we're in. We want to be sure that these are infill locations and they're very tight to the bull's-eye of our strategic plan.

Obviously we're looking at the quality of the asset. We've long said that if we buy anything we want it to raise the overall average quality of our portfolio. Pricing that would be well below replacement cost. A transaction that would be accretive with upside in rents. Yields that would begin with -- certainly have a 1 in front of it.

So what we don't want to buy, David, is any real estate that looks akin to what we just recently sold. We're out trying to find distressed sellers, not necessarily distressed assets. So we've been patient with the money that we've built up through the execution of our liquidity plan and I think the key word for us and all of our division heads right now is patience.

And we've had a couple of our division heads bring in what are on the cusp of being attractive deals but we think that it's still early and we're going to continue to monitor closely. We are staying close to brokers, bankers and landlords to see if there are any very attractive deals out there for the specific assets that we've targeted. But that is yet to occur.

And has any progress been made on re-leasing the Raleigh space lost in second quarter?

On what in the Raleigh space?

The bankruptcy on the space that was lost.

We've had a few showings and we have one -- it was about 100,000 square feet. It's a quality building in a quality submarket. It's not a borderline B building by any means. It's a square A building. We have a good volume of activity right now and hopefully we'll be able to lease a portion of that space in the next 90 to 100 days.

Thanks. And just one more question on the other occupancy losses in the second half that you're aware of, that maybe we should be aware of as well.

I think the two biggest occupancy [roll downs] that we have remaining in the year are where we'll -- the largest expirations are where we'll be moving two of our existing customers from existing space to larger space. One is Williams Mullen, which currently leases space in Raleigh in Highwoods Tower, about 50,000 square feet. And we're going to upsize them to about 75,000 square feet going into RBC and that lease is signed.

And then, there's a firm in Memphis that's coming out of a building that's right there on Poplar Corridor, Apperson Crump, that will also grow about 25% in size as they go into our new building, Triage Centre III. So, those are the two largest holes that we'll have to fill that we're aware of between now and year-end.

Thank you.

You're welcome.

Our next question comes from the line of Brendan Maiorana with Wells Fargo Securities. Please proceed with your question.

Hi. Thanks. Good morning. Just wanted to circle back on the operating margins, certainly the seasonality notwithstanding, struck us that your operating margin was much lower than what we were forecasting anyway. Terry, you kind of talked about how you've taken some costs out. Should we expect to see that your annual operating margin can be a little bit lower on a go-forward basis than it's been historically in kind of that 36% to 37% range?

There's two things happening which kind of -- and they may tend to offset to a degree. One is we've been delivering new development projects. New development just tends by its nature to have a higher NOI margin than second -- older buildings where you have higher repairs and maintenance. And just a delta between the revenue level and the OpEx and newer -- new development tends to be better. And we've been delivering a lot of that, so that's been helping a little bit.

And going in the opposite direction has been just some of the pressure we've had from real estate taxes and utilities across the board, really. Along with somewhat declining occupancy as we face this -- going through this recession. So, those two things are kind of working at opposite -- in opposite directions and it's -- that's why I said earlier I think the margin should be roughly the same in the second half as the first half. There's just -- there's two opposing trends are going on for us right now.

Brendan, let me just add some additional mud to that glass of water there. I think what we're trying to balance is we're still a bit concerned about where taxes and utilities may go, particularly given local, state and federal governments' interest in pushing taxes as much as they can as they come up short on revenues and cap and trade as relates to utilities, et cetera.

So clearly, we're down on operating expenses and some of it's not just us patting ourselves on the back with better practices and having newer assets as a result of the development versus selling some of the older properties. But some of it is occupancy is down, so operating expenses go down a little bit. Density's down, even in spaces that are leased.

I think it's a significant aspect of where operating expenses are because the spaces aren't as densely occupied as they once were, as most companies have done some form of cutbacks on headcount. So we're trying to carefully balance the good work that our asset managers have done with regard to best practices and expense management against what may very well be continued pressure from the government and utilities with regard to utility expenses and taxes.

That's helpful having. And then as you sort of think about the increase in operating expenses gives a potential as you talk about utilities and taxes and lay that against where your tenants are in terms of a financial position, do you feel like your ability to recapture that increase is going to be hampered a little bit going forward relative to kind of where it's been in the past?

I don't. I don't see that as a -- as a significant component of concessions being made in lease negotiations. It's more signage, parking, TI rental rate. But as far as carving out or having to place some cap on cam reimbursements or moving base operating expense year numbers to something that's greater than what you would normally see in order to protect the customer from that, isn't commonplace in deals that we're doing.

And typically, Brendan, this is Mike, when those rare occasions when we do put caps in a lease, we exclude what we call non-controlled expenses, which are taxes, utilities, insurance, the labor component of janitorial, which is covered by the federal minimum wage Act so that there are generally no caps on those. And that's never been an issue with respect to being able to pass that through.

Okay, thanks. On the capital recycling or acquisition outlook, I know you guys are being patient. How would you characterize the level of competitors that you have out there in terms of firms that are looking to acquire that also have the capital available to do that? Do you think it's just that they're -- the sellers aren't willing yet or do you think it's somewhat of a bit more crowded marketplace than you might have expected?

Well, I think that the sellers aren't there yet as debt maturities have yet to ripen, if you will. But of course, as landlords continue to see erosion in their NOIs, stapled together against these debt maturities, that the pressure's going to come. But based on what we're seeing and hearing, that the loans are being rolled short term or maturities have yet to arisen that won't be extended or won't be replacement capital.

I think from a buyer pool perspective, it's going to be interesting to see how that plays out because we saw from the volume of assets that we sold that there were -- we put out a memorandum or offering and there'd be 43 bidders. And half of them would be more than capable at that point in time given the access to capital.

Now, when we go to bid on something that could be considered a quality asset from a distressed seller, there may be only five bidders. But if all five of those bidders are thoroughbred horses, be interesting to see where the bidding goes and whether it stays an asset that truly is an attractive price from a buyer's perspective or if it pushes the cap rate back down to where it gets out of synch with our investment profile.

I don't know that answer. I just lay out that scenario that could happen. If the top five are studs, then it may get to where it pushes the price out of range or it may be where those top five aren't all that capable and leaves us in a favorable position. I think if we look at local competition in all of our markets, and most of our competition is the local developer, that we stand in very good balance sheet dry powder capacity in comparison to them versus others. You know what the -- what our peer REITs are capable of doing and certainly where respectively compete with them in a few of our markets.

I think there is still a little bit of a distance between the bid ask, particularly on the higher quality properties that we would be going after in terms of the sellers are not yet quite as motivated and we're not as motivated to go in and pay up for it.

But we -- but we just haven't seen it yet. We have not seen a lot of high quality assets come to market at distressed pricing.

Right. Okay. And then just lastly, glad to see the GSA deal announced. I understand development deals in general are going to be down. Your development starts are going to be down. But is the pipeline of GSA pursuits still active for you guys?

That's clearly public information. You can look at all their listings. There are a fair amount of government deals that are out there. We've taken a tack of much more of a rifle approach where we're going to specific agencies and projects. So as opposed to chasing five to ten at a time, we'll chase one to three at a time.

But I don't think the GSA's going to -- based on what I'm hearing coming out of Washington, we'll all be sitting in a GSA building before it's over with. But I think their continued push towards growth will continue and will continue to provide us with opportunities to be their space provider. Once -- with the addition of this and the deals that we're about to complete, the FBI deal in Jackson, we'll be pushing about 11% of total revenues coming from government leases.

And I think from the pursuit of this particular transaction, we found that the level of competition or number of players that were pursuing these is clearly less than what it was a year or two years ago, because even with a GSA lease, financing is not as readily available, the equity requirement is there, even with 15, 20-year firm leases. You just don't have as many players that could come up with the 30%, 40% equity on these projects.

And we feel very fortunate the -- in this joint venture with USAA. We have very high regard for the entity and for the people that we interact with there. So hopefully -- it's gone well so far with getting this award and we'll be able to do more with them in that we're fortunate that there's a lot of good chemistry between the two companies.

Just to follow up on that point, understanding that it's a -- it sounds like a good relationship there, but the deal also seems like it's an attractive deal from a financial standpoint given the credit quality of the tenant, new building. Would you on new transactions, new build-to-suits, given that your financial position is on more sure footing now relative to the beginning of the year when you sort of went down the JV path, would you look to do new deals on balance sheet or would you pursue this JV structure again as well?

I think we'll look at them in joint. We'll have conversations with USAA. We'll look at each deal on a deal-by-deal basis because it's just not a financing issue. It's is it in a core market of ours, who the agency is, what their present situation is, meaning USAA versus ours, what our present position is.

So, I think that we'll figure out what's the best strategy that will enable us to benefit from it from an accretive perspective for our shareholders and win the award for both us and our partner. So, the next one we do may be 100% Highwoods or it may be a 50/50 partnership. We'll just look at them as we go forward on a deal-by-deal basis.

Okay, great. Thanks.

Thanks, Brendan.

Our next question comes from the line of Chris Lucas with Robert W. Baird & Co. Please proceed with your question.

Good morning, everyone. Mike, I noticed that the Jackson FBI delivery slid into the third quarter. Is that -- has that been completed at this point?

Chris, right now we're looking at mid August, I think August 17th is our projected CO date for that project. That was largely a result of some of the things that the FBI wanted in terms of their FF&E to get completed and moved into the building. We did have some weather delays back in Jackson in the spring that were excusable delays in that project. But right now it's on track for in the next 20 days.

But it's mostly driven by scope changes.

Yes. Directed by the customer.

Okay. And, Terry, have you -- have you gotten quotes on the unsecured market at this point given that we've heard that it's tightened up even more since [inaudible]?

I have not, Chris. As I said in the call -- in the script, we have had some discussions with a number of our bank lenders but it's been more just at a higher level. We haven't gotten broadly into details and we haven't really begun the official going out to market to redo the deal. But we have seen other deals get done and we know that rates and terms are going to be tighter.

We do feel -- let me back up. Are you talking about bonds or --

I'm talking about bonds.

-- credit? Okay, bonds.

More bonds.

I was talking to credit facility. On bonds, we did buy back a small amount of [our 2017s] at just under 80% of par. That was about four or five weeks ago. And I think since then, given everything I've seen, that's probably tightened up to some extent. That purchase was -- I think the yield to maturity at that time was in the 9s and I would guess the yield maturity would be maybe now in the high 8s. They have come in.

Okay. And then can you just review for us your bad debt policy, how you go about when you stop accruing revenues and how you go through the process of establishing a reserve?

We do essentially a tenant by tenant review of our receivables. And it's -- sometimes it's a judgment call in terms of how we feel about that tenant's credit quality and their business and just anything -- information we can gain from about that tenant will drive our decision in terms of how much we reserve against their receivables and whether we take reserves against their -- against their straight-line receivables as well. So, it's clearly tenant by tenant.

We've recently added a credit manager in the accounting group to focus on this because it's important at this time. And we'll just -- in terms of the second part, in terms of when you stop it, we just track that continuously as long as that tenant has the appearance of being troubled in any way to us.

So, I can tell you that our reserves have gone up significantly within the last year. We were probably in total when you take reserves for billed receivables and straight-line receivables and notes receivables. We were just under $2 million last June and now we're just a tad over $5 million at the end of June this year. So, we have taken reserves up significantly with higher bad debt charges during the last 12 months.

And those numbers aren't on the first half versus first half?

That's -- the reserves I talked about were just point in time, what were the total reserves in place June 30, '08 versus June 30, '09.

Okay, great. Thanks, Terry.

Our next question comes from the line of Wilkes Graham with FBR. Please proceed with your question.

Hey, good morning, guys. Just a couple of questions on the State of Georgia lease. Given the article in the Journal today and all the news we've heard recently about budget deficits among the state governments, I recognize that -- Ed, I agree, I think that GSA demand is going to be around for a long time.

But do you have any concerns over that space? It looks like 375,000 square feet expires the end of next year and maybe a third of that is renewable every year. Is that -- can you just talk about that space a little bit? Is that space that they can't really get rid of or is that something that they could possibly look to cut given the revenue short?

We've certainly taken the tack that it's space they can't afford to get of. I think it's an excellent question. We anticipated that question, in fact. But I think that it would probably be best, because we're ongoing various negotiations with them right now, for us to -- I think anything that we say publicly would probably not enhance the good faith effort of the negotiations that are underway now.

But I can tell you that it's the Department of Revenue. It's not some extraneously funded agency of the government that's working under some grant. And if there's an essential agency within the state's structure right now, it's the Department of Revenue. So, I think we feel relatively good about it and we feel very good about the location of that property as it serves them right on I-85, well within the perimeter.

Okay, thanks for that.

Thanks. And, Wilkes, one other item I just thought of, they also recently spent a fair amount of money on some FF&E. So, having put out almost $1 million of their own money towards FF&E would be an encouraging sign for us.

Sure. Thank you.

Thanks, Wilkes.

There are no further questions at this time. I'll now turn the conference back to you.

Thank you very much. We appreciate everybody taking the time to listen in. If you have any questions, as always, please don't hesitate to give us a call. Thank you.

Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your lines. Have a great rest of the day, everyone.