Paramount Group Inc (PGRE) 2018 Q3 法說會逐字稿

Good day, ladies and gentlemen. Thank you for standing by. Welcome to the Paramount Group Third Quarter 2018 Earnings Conference Call. (Operator Instructions) Please take note that this conference call is being recorded today, November 5, 2018. I would now like to turn the call over to Jacques Cornet with ICR. Please go ahead.

Thank you, operator, and good morning. By now, everyone should have access to our third quarter 2018 earnings release and the supplemental information. Both can be found under the heading Financial Information Quarterly Results in the Investors section of the Paramount website at www.paramount-group.com.

Some of the comments today will be forward-looking statements within the meaning of the federal securities laws. Forward-looking statements, which are usually identified by the use of words such as will, expect, should or other similar phrases, are subject to numerous risks and uncertainties that could cause actual results to differ materially from what we expect. Therefore, you should exercise caution in interpreting and relying on them. We refer you to our SEC filings for a more detailed discussion of the risks that could impact our future operating results and financial condition.

During the call, we will discuss our non-GAAP measures, which we believe can be useful in evaluating the company's operating performance. These measures should not be considered in isolation or as a substitute for our financial results prepared in accordance with GAAP. A reconciliation of these measures to the most directly comparable GAAP measure is available in our third quarter 2018 earnings release and our supplemental information.

Hosting the call today, we have Albert Behler, Chairman, Chief Executive Officer and President of the company; Wilbur Paes, Executive Vice President, Chief Financial Officer and Treasurer; and Peter Brindley, Executive Vice President, Leasing. Management will provide some opening remarks, and we will then open the call to questions.

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

Thank you, Jacques, and good morning, everyone. We have been very busy since our last earnings call, be it on the leasing front or on the capital allocation front where we took advantage of the even greater dislocation in our share price, stemming from the recent volatility in the stock markets. More on that in a minute.

Let me begin with leasing where trends in the third quarter were similar to what we have been seeing and describing all year. Our portfolio is 96.4% leased, practically full by any measure, with below average expirations until 2021. We remain very well positioned as cash rents ramp up and flow through our operating results. This is the result of the tremendous leasing success we have had over the past few years. And we had another very active leasing quarter, signing leases for over 203,000 square feet of space. Leasing activity for the 9 months now stands at over 800,000 square feet. With the strong activity in the third quarter, we once again surpassed the midpoint of our already increased annual leasing guidance. Recall, we began the year with a leasing goal of 500,000 to 700,000 square feet. With a strong first half of activity, on our August call, we raised that goal by 33% at the midpoint to a range of 700,000 to 900,000 square feet. Today, with another solid quarter of leasing, we are once again raising our full year leasing goal by roughly another 20%. We now expect to lease between 900,000 and 1 million square feet.

As I said earlier, we do not have any meaningful expirations until 2021, and we continue to derisk future roll by renewing tenants early. While Peter will provide more specifics about the leasing trends in our markets, let me spend a few minutes to give you my thoughts. In New York, leasing volume has been robust. Concessions have continued to stabilize and availability in Midtown is currently at 11.1%, below the 10-year average. The city's tenant base is more diverse than ever with no signs of letting up, and the Midtown market is on pace to realize more new leasing velocity this year than at any time since 2006. Four of our New York properties, or over 85% of the square footage of our New York portfolio, are in the West Side and 6th Avenue submarkets where availabilities are below the Midtown average. We have realized more than our fair share of leasing in this market and continue to be rewarded for investing in Class A trophy buildings in great locations.

This was once again evident in our third quarter leasing in New York as our initial rents of $86.74 per square foot are about 11% higher than the market average according to CBRE. Based on what we are seeing, we remain well positioned in this market.

San Francisco is still firing on all cylinders. With an availability rate of 7.5%, there continues to be upward pressure on asking rents, which are now about 10% higher than a year ago for Class A assets located in the CBD. Our 2.9 million square foot San Francisco portfolio is 97.4% leased. Some of our tenants are already engaging in renewal discussions much earlier than they usually would. They are very mindful of their space needs in this supply-constrained market. Another strength of ours, we take great pride in, is our best-in-class approach to sustainability and environmental efficiency. You may have seen our announcement last week that One Front Street and 50 Beale joined One Market in receiving LEED Platinum status. These are significant achievements that demonstrate our commitment to good corporate citizenship and sustainability initiatives, while also improving operating costs and helping to attract and retain premium tenants.

Turning to capital allocation. During the quarter, we sold 2 assets in our D.C. portfolio for an aggregate of $377 million. On our prior calls, we have repeatedly stated that if we created value in an asset, we would not shy away from harvesting and crystallizing that value. We traded 2099 Pennsylvania Avenue for $220 million or $1,054 per square foot. The property was 98.5% leased, up from 31.6% at the time we went public. The leases here had annualized rents north of $80 per square foot on a gross basis. Over a 4-year period, our leasing team converted large blocks of vacancy into tenancy, creating one of the best Class A properties in the D.C. market.

We also sold 425 Eye Street for $157 million. This property, which is located outside of the 3 core D.C. submarkets, was 98.7% leased with annualized rents of about $46 per square foot. The U.S. government, whose lease was scheduled to expire in 2021, is the largest tenant, occupying roughly 90% of the building. These asset sales resulted in us generating proceeds that we were able to retain in a tax-efficient manner. As we have stated previously, we continuously weigh different capital allocation decisions, all with an eye towards creating the best long-term value for our shareholders.

We recognize the significant dislocation between share price and NAV, and the recent volatility in the stock market further exasperated (sic) [exacerbated] that dislocation. We took advantage of that by opportunistically repurchasing $50 million of stock at a weighted average price of $14.53 under our existing $200 million stock repurchase program. We had always indicated that any stock repurchases would be done on a leverage-neutral basis and monetizing the 2 D.C assets enabled us to do just that.

When we deliberate on capital allocations decisions, whether it's acquisitions or share buybacks, we do not view them as mutually exclusive. We have sufficient liquidity and capacity, which provide us optionality to do both. And if we find situations where we can bring to bear our leasing and other strengths to add value like at One Front Street, we would certainly do that. That said, the markets are expensive, and we are mindful of our cost of capital. Acquisition opportunities, if any, would likely come in the form of joint venture structures, where we can enhance our yield on invested capital.

Looking ahead, our focus remains on creating long-term value for our shareholders. We will continue to be proactive in our approach to asset and property management and judiciously deploy capital into investment opportunities where appropriate. Both are integral to growing the company's value over the long term.

With that, I will turn the call to Peter to provide additional insights on each of our markets.

Thank you, Albert, and good morning. We continue to be encouraged by the pace of activity and demand for our properties. Strong market fundamentals, coupled with our ability to source, negotiate and close deals, have yielded yet another productive quarter of leasing. As Albert mentioned, during the third quarter, we leased approximately 203,000 square feet, addressing both immediate vacancy and mitigating our future lease roll. Through the first 9 months of the year, we have leased more than 800,000 square feet, which exceeded the high end of our own expectations heading into the year. At quarter end, our portfolio was 96.4% leased with a very manageable expiration schedule.

Let's review some market highlights. Our New York portfolio was 96.1% leased at quarter end, up from 95.9% last quarter. During the third quarter, we leased approximately 59,000 square feet, bringing our year-to-date total to approximately 464,000 square feet leased. The New York portfolio remains very well positioned with approximately 3.7% expiring per annum through year-end 2020.

Midtown leasing fundamentals continued to strengthen in many respects. The leasing velocity that occurred in the third quarter has set the stage for Midtown to have its best year of leasing since 2006. These velocity figures, combined with positive quarterly net absorption, declining availability and asking rents which have increased 2% quarter-over-quarter, reinforce the health of the Midtown market. We recognize where the strength exists in this market and continue to capture more than our fair share of the demand as evidenced by our leasing results year-to-date and the activity we have on our current and future availabilities.

In Washington D.C., as Albert previously mentioned, we sold 2099 Pennsylvania Avenue and 425 Eye Street during the quarter. Prior to the sale of 2099 Pennsylvania Avenue, we signed a lease in the third quarter that brought the building to 98.5% leased. We remain encouraged by the level of interest we have on the remaining availabilities at our other properties. The portfolio at quarter end is 98% leased, and we do not have any roll for the balance of the year. We remain very well positioned in D.C.

In San Francisco, we ended the quarter at 97.4% leased and do not have any lease roll for the balance of the year. During the third quarter, we leased approximately 123,000 square feet, bringing our year-to-date total to more than 310,000 square feet leased. The office leasing fundamentals in San Francisco remain very strong as tech tenants continue to grow and the majority of new supply has been preleased.

Net absorption remains positive and average asking rents continue to increase, up 10% year-over-year for Class A product located in the CBD. It is our expectation that rents will increase further, given the robust demand and limited supply, especially for large blocks of space in the CBD.

At One Market Plaza, we are 97.6% leased. During the third quarter, we continued to execute on our business plan by extending Duane Morris an approximately 62,000 square feet and expanding Visa by approximately 32,000 square feet, bringing them to a total of 163,000 square feet in the building. As a result of these 2 leases, we have eliminated more than 60% of our 2019 lease roll. One Market is an iconic asset that remains in high demand and continues to achieve among the highest rents in San Francisco. We expect continued success by further increasing occupancy and mitigating near-term roll going forward.

One Front is currently 96.3% leased as a result of the more than 414,000 square feet of leasing we have achieved since acquiring the property in December of 2016. This equates to approximately 65% of the building. One Front is optimally located relative to current tenant demand, and we are excited about our remaining opportunities at the property.

At 50 Beale Street, we continue to make progress. We ended the third quarter with leased occupancy at 99.7%, up from 95.8% last quarter and up from 78% a year ago. During the third quarter, we leased the last remaining availability in the office tower to a dynamic tech tenant. We realized significant rent growth in the building over the past year and have now turned our attention to the 262,000 square foot block of space we expect to get back at the beginning of 2020 after Blue Shield vacates the property. Given 50 Beale's physical attributes and highly desirable location, it is not surprising that we have garnered a high level of interest for this block of space. The timing of the Blue Shield availability is ideal, given the velocity in the market from large tenants and the limited large block supply. We view the lease-up of this space as a tremendous opportunity to create additional value at 50 Beale as the current in-place rent is roughly $55 per square foot, well below market.

With that summary, I will turn the call over to Wilbur to discuss the financial results.

Thanks, Peter. Financial and operating metrics for the quarter were once again very strong. Our core FFO for the quarter was $0.24 per share, up 9.1% from $0.22 per share in the prior year's third quarter. This is even more impressive when you consider that 2099 was sold in August and did not contribute to 2 months of earnings in the quarter. This increase was once again driven by sector leading same-store NOI growth of 7.2% cash and 11.1% GAAP.

Same-store leased occupancy stood at 96.4%. Our New York portfolio is now 96.1% leased, up 20 basis points; Washington is 98% leased, up 50 basis points; and San Francisco is 97.4% leased, down 80 basis points.

We leased over 203,000 square feet in the quarter, and mark-to-markets were 14.4% cash and 19.5% GAAP. This quarter's leasing was concentrated in San Francisco where we leased almost 123,000 square feet and mark-to-markets were 28.3% cash and 29.8% GAAP. The majority of the remaining leasing was in New York, where we leased about 59,000 square feet and mark-to-markets were 3% cash and 9.8% GAAP.

Based on our year-to-date results, the current composition of our portfolio and our outlook for the remainder of the year, we're updating our full year 2018 core FFO guidance to be between $0.93 and $0.95 per share, down $0.01 from the midpoint of our prior range of $0.93 to $0.97 per share. This decrease resulted from $0.02 of earnings that we no longer expect to receive due to the sales of the 2 Washington, D.C. assets that took place in the third quarter, partially offset by a $0.01 increase from better-than-expected portfolio operations. So on an apples-to-apples basis, this actually would have been a $0.01 bump in our earnings guidance had we not sold the 2 Washington D.C. assets. In addition, we are increasing our same-store cash and GAAP NOI guidance to now be between 8% and 10%, up from our prior range of 7% to 10%.

While we are not providing 2019 guidance at this time and will do so on our next earnings call, I wanted to address a couple of items that will undoubtedly affect 2019. First and foremost, our portfolio composition has changed and as a result of the 2 asset sales, we no longer expect to receive roughly $20 million in NOI or about $0.08 in earnings in 2019. Second is an accounting rule change that will no longer allow us to capitalize about $0.02 of internal leasing costs, which we have previously done. This one is a doozy and literally has no impact on the economics or the cash flows of our business. Think about it. If you got rid of your entire leasing department and only relied on leasing brokers, the accounting rules allow you to capitalize those costs. But if you choose to be a vertically-integrated shop with in-house leasing expertise such as ours, you are now required to expense all payroll costs.

Finally, interest rates have moved considerably this year with the 1-month LIBOR up already in excess of 70 basis points as we sit here today compared to where we were when we began the year. Notwithstanding that only 14% of our debt is variable rate, as of today, we anticipate interest expense in 2019 to be higher by $4 million to $5 million or about $0.02 per share.

Turning to our balance sheet. We ended the quarter with over $1.5 billion in liquidity, comprised of $541 million of cash and restricted cash and $1 billion of availability under our revolving credit facility. Since quarter end, we have utilized an additional $47 million towards our share buyback program, bringing our total share buyback to $50 million to date.

Our outstanding debt at quarter end was $3.1 billion at a weighted average interest rate of 3.6% and a weighted average maturity of just under 5 years. 86% of our debt is fixed and has a weighted average interest rate of 3.6%. The remaining 14% is floating and has a weighted average interest rate of 4%. We have no debt maturing until the fourth quarter of 2021. And beyond that, our maturities are well laddered.

With that, operator, please open the lines for questions.

(Operator Instructions) Our first question comes from the line of Vikram Malhotra with Morgan Stanley.

This is Adam Gabalski on for Vikram. I just wanted to talk a little bit about leasing. It looks like TIs and the leasing costs were down as a percentage of initial rent in New York this quarter versus last quarter. Just wondering if that was sort of skewed by any larger leases or if that was sort of broad-based decline?

Sure, Adam. This was based on the composition of leasing that was done this quarter. We think generally, and Peter will comment more on this, that we think TIs and leasing costs have stabilized in New York. But the quarter's activity was geared towards more shorter-term deals. If you also look at the weighted average lease term this quarter, was shorter than our usual weighted average lease terms. So we won't read too much into that because if you look at the year-to-date results, we're still trending over 10% and 10-year deals.

Got it. That's helpful. And then just on the share buyback this quarter, just considering where the stock price is now, how you're thinking about doing additional buybacks on a leverage-neutral basis versus other capital allocation priorities? And whether or not you guys might consider even expanding the buyback if the discount to NAV does keep -- persist through the rest of the year?

Yes, acquisitions and buybacks are really not mutually exclusive. So we can do both, and we want to remain disciplined and opportunistic. So you might expect us to evaluate additional buybacks, but we don't want to make further comments at this point. We have approved, as you might know, a $200 million plan by the board. And we will remain opportunistic and anything will be leverage-neutral as we had indicated before.

Our next question comes from the line of Steve Sakwa with Evercore ISI.

Let me, just kind of following on that line of questioning on the buyback. Would further buybacks, I guess, be contingent on additional asset sales? Or do you feel like given the cash and liquidity you've built, you could pursue buybacks with just the current 2 asset sales that have been done to date?

Well, Steve, we sold 2 assets for about $377 million. So we would have additional liquidity currently available. And as I had mentioned on the last question, we want to be flexible and open and potentially looking at acquisitions and buybacks. It's not mutually exclusive. So -- but we are looking at this opportunistically.

Okay. And then on the leasing. Obviously, with 800,000 done and the range being bumped up a little bit, obviously, fourth quarter is going to be much later. But could you maybe just talk a little bit about the discussions that you're having with tenants about the early renewals and pulling forward leasing? Obviously, you don't have a lot of leasing expiring next year. But I'm just curious the conversations that you and Peter are having with tenants today and how likely might those even '21 or '22 type deals get pulled forward?

Yes. The leasing market has been, as I mentioned on the call, quite active, especially in New York, but also, of course, in San Francisco. And we haven't seen such an active market for the last 24 months in New York. San Francisco always has been strong, and we're doing a lot of leasing ahead of expirations. As we had also mentioned, when we bought One Front Street, it was one of our goals that we would pull the leasing forward. So we have a lot of discussions with potentially tenants extending early, and we will take advantage of that. I mean, you know that we have very few expirations over the next couple of years already, but we are really taking this quite seriously. We want to stay highly occupied as a portfolio. I mentioned that the predecessor before we went public has been always leased around 98% and the portfolio of our quality Class A and trophy buildings should be able to achieve that level.

Okay. And I guess, last question. Is there any comments that you could provide us on the Barclays space that kind of comes due in about 2 years from now?

Steve, we have not officially begun marketing that block of space. And as I've said in the past, given that there are few -- not very many spaces as well located at the Barclays block, we have, as expected, received some inquiries. We have begun conversations about that block of space and whether or not it will be available, but at this time, not fully knowing what Barclays will ultimately do, it remains a little bit too early to comment beyond that.

Our next question comes from the line of Rich Anderson with Mizuho Securities.

Can you talk about the pipeline of redeployment, putting aside buybacks for the time being? Where you see the most activity, even if you do go the JV route?

Yes, we are looking in all of our markets. We think that -- but specifically in San Francisco and New York, we think our New York might be, if you ask me today, most probably the market where we might find an acquisition target the earliest because, I mean, there's a big differential between replacement cost in this market and acquisition opportunities. And it looks like that finally there's a couple of assets available in the market. And depending upon how they are priced, we might be interested in those on an -- in a joint venture basis, either in a joint venture with our frontline investors or in other JV opportunities as we have done in the past.

Okay, great. And as a follow-up, was just curious what your level of interest was in the Ferry Building, if you had any interest at all? Just a quick comment on that, if you're willing.

Yes, we've looked at the Ferry Building, of course, because, I mean, it's right in front of One Market Plaza, so we know the market very well. It is an asset that we then finally declined to bid on at the levels where it was asked for to be bid on. Because it's -- number one, it's a ground lease, and we normally like to control our assets' destiny. And it is -- we saw some potential high need of capital investment with some of the retail. So that's why we didn't fully execute on that.

Our next question comes from the line of Daniel Ismail with Green Street Advisors.

I think you mentioned around 2% gross asking rent growth in New York. Can you frame that in terms of net effective rent growth in the city?

Sure, Danny. The direct average asking rents have increased nominally in each of the last 4 months. It's up 2% quarter-over-quarter. Net effective rents, we think, have been relatively flat. What's interesting to look at is, absorption was actually positive in the third quarter to the tune of 467,000 square feet, which we hadn't realized since the fourth quarter of 2017. So it's our belief that as you continue -- we continue to see velocity like we're now seeing and you start to realize some positive absorption year-to-date, we're negative. But as I said, the third quarter was positive. We think at that point in select submarkets, you will start to see some upward pressure on net effective rents given that concessions have stabilized. So it's an interesting data point. It is only a quarter-over-quarter data point, but I think that relative to absorption and everything else that we're describing is encouraging.

Okay, that's helpful. Can you update us on where your in-place rents sit relative to market for the entire portfolio?

Sure, I mean, we think -- we go through this exercise periodically, and we think in each of our markets in-place rent is well below double-digit compared to if you were to mark-to-market the entire portfolio. Especially in San Francisco, we would tell you, it's considerably below. If you look at One Market Plaza for example, the in-place rents are under $77 a foot, and we've been doing deals in San Francisco consistently at the $100 mark, 90 -- the high $90 mark. In-place rents in 50 Beale sit at $61 a foot, and we have a large block coming up in 50 Beale over the next few years, which is sitting in the mid-50s. So -- and we think the mark-to-market opportunity on that is going to be in excess of 50%. So there's tremendous amount of growth that's embedded if this portfolio were to be marked-to-market.

And maybe just sticking with the San Francisco portfolio. Has Prop C impacted any of your underwriting or tenant behavior because I believe that's scheduled to kick in at the beginning of next year?

Yes. So it really has. And if you look at our portfolio, again, Prop C is on the ballot for tomorrow. Any incremental tax, as we stand, given our portfolio is over 96% leased and occupied, will get passed on to tenants. That's assuming the tax gets voted on and stays and there is no repeal. So when you think about what San Francisco contributes to our NOI and then you think about the impact it has on the 96% leased portfolio and our ability to be able to pass that on to tenants, we think the impact is negligible. Now when the whole thing rolls in 5 to 7 years, to the extent Prop C is not repealed, will it have an impact? That remains to be seen.

Okay. And just last one for me. Can you provide any update on to the Henri Bendel space and any potential of getting that space back and reutilizing it for any other purpose?

Yes. The Henri Bendel situation was publicized by the Limited Group that they want to close Henri Bendel early of 2019. We are in discussions with, of course, with the Limited Group on this. And I think we'll find a mutually amicable resolution. And I think it's also -- it's a great opportunity for Paramount to find a replacement tenant in a space that has been substantially leased below market since we acquired the asset for the predecessor in 1998. And if you keep in mind that they had an opportunity to extend the lease 2 times up to 2031, so at the same rent, at the same low rent, that they're currently paying. I think that's -- it's a great win for Paramount and its shareholders.

(Operator Instructions) Our next question comes from the line of Tom Catherwood with BTIG.

Peter, you mentioned the positive net absorption in New York City this quarter. It seems like a lot of that was coworking companies kind of taking up as much space as they possibly can. At the same point in time, the coworking companies seem to be making this push into enterprise and to trying to lease to larger companies. So the question that comes out of that is, are these actual competitors of yours, these coworking companies? And how do you kind of view them in the competitive environment of New York City?

Right. So just very quickly, we did talk about velocity being the best this year, year-to-date since 2006. We are currently at 13.8 million square feet. Coworking makes up, according to CBRE, roughly 13% of that velocity, so about 1.8 million square feet, just to put it into some context. Whether or not coworking, WeWork and others are able to penetrate the enterprise, we're obviously paying very close attention to that, but they certainly have impacted, I think, the demand for smaller spaces. If you look at our opportunities, generally, they are larger block type opportunities, a 1633, a 1301. And so I don't think we've seen tremendous competition from the likes of some of these coworking providers as it relates to what we are offering the market. And if you think about a 712 Fifth Avenue, those are the most discerning successful investors in the world. I think they require that they function independently. So we haven't really felt a lot of competition, I would say, from these coworking providers, but it's a great question. We're thinking about it. They certainly make up a good portion of the tremendous velocity that we've seen in Midtown, and we're paying very close attention to it.

Got it. I appreciate that, Peter. Then moving over to San Francisco, the Blue Shield expiration in 2020. Is that the type of space where it needs substantial CapEx in order to kind of get it up to condition and/or do you have a capital program planned for kind of the rest of the amenities in the building since you're getting so much space back. What is the spend you kind of associate with that?

Tom, this is Albert. 50 Beale when we bought the asset, we knew that it, we had to do some work, also in the lobby and that's currently in the works. We believe, and as Wilbur had pointed out, there's substantial mark-to-market in the Blue Cross Blue Shield space. It's currently leased at about $55, and we think that we have at least -- I mean, he was very cautiously talking about 50% mark-to-market opportunity. I would say, it's hopefully more than that. And it's space that has been unrenovated for a while, so we will have to -- we would expect that we will invest market TIs, but not more than that when we re-lease the space. But other than that, I think it's very straightforward execution on that re-leasing of the space. 50 Beale is an asset that is entirely column-free. It's in high demand by technology tenants as well as other traditional tenants. So we're very comfortable with leasing that asset in this market.

All right. I think that makes a lot of sense. What I'm trying to do is I'm trying to contrast it to New York City, for example, 31 West 52nd Street or the top of 1301, when you got those back, you had to white box them and then there was a -- then it was the marketing process. It doesn't seem like it will be quite the same time line at 50 Beale. Is that fair?

Yes, that's fair because I mean, we had here also -- we had the opportunity to early market it, Blue Cross has made -- has publicly announced that they're moving over to Oakland. And we -- also we have some time early to market this space. And the San Francisco market is red hot, and I think that gives an advantage to leasing it. So I would say the market activity is higher than what it was here in New York when we had to re-lease 31 West 52nd Street.

Mr. Behler, there are no further questions at this time. I'll turn the floor back to you for any final comment.

All right. Thank you all for joining us today. We look forward to providing an update on the progress and report our fourth quarter and year-end results in February. Bye-bye.

Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.