PS Business Parks, Inc.
Q4 2017 Earnings Call Transcript

Published: 20 Feb 2018

[Operator:]

Good morning. My name is Nicole. I will be your conference operator today. At this time, I would like to welcome everyone to PS Business Parks Fourth Quarter Investor's Conference Call. [Operator Instructions]. Thank you. You may begin your call.

[John Petersen:]

Good morning, everyone, and thank you for joining us for the Fourth Quarter 2017 PS Business Parks Investor Conference Call. This is John Petersen, Chief Operating Officer. Here with me are Maria Hawthorne, CEO and Acting CFO; and Trenton Groves, Vice President and Controller for PSB. Before we begin, let me remind everyone that all statements, other than statements of historical facts included in this conference call are forward-looking statements. These forward-looking statements are subject to a number of risks and uncertainties, many of which are beyond PS Business Parks' control, which could cause actual results to differ materially from those set forth in or implied by such forward-looking statements. All forward-looking statements speak only as of the date of this conference call. PS Business Parks undertakes no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. For additional information about risks and uncertainties that could adversely affect PS Business Parks' forward-looking statements, please refer to the reports filed by the company with the Securities and Exchange Commission, including our annual report on Form 10-K and subsequent reports on Form 10-Q and Form 8-K. We also provide certain non-GAAP financial measures. Reconciliation of these non-GAAP financial measures to GAAP is included in our press release, which can be found on our website at psbusinessparks.com. I will now turn the call over to Maria.

[Maria Hawthorne:]

Thanks, JP. Good morning, and thank you for joining us. Today, I will start with a brief overview of fourth quarter results, and then spend a moment putting some perspective on full year 2017 performance. Trenton will provide financial updates, and then JP will provide details on operations and markets. We have a strong fourth quarter on multiple fronts, including leasing volume with positive rent change, increased Same Park occupancy and continued occupancy growth in our Non-Same Park asset and multifamily development. Hitting Same Park occupancy of 95.1% shows that we continue to tap the growing tenant demand in nearly every one of the markets we operate. In many cases, we are pushing beyond and exceeding past peak levels in terms of rental rates and occupancy. A key driver for the company is the ability to reprice space on new and renewal transactions at today's rates. And we remain encouraged that there is no deceleration in lieu of our markets. Fortunately, we still see no new competitive supply of multi-tenant plus office or industrial space. All of our markets are experiencing job growth, low unemployment, and confidence is high among our customer base. Highgate at The Mile, which opened on June 1, continues to perform strongly. As of December 31, we were 58.5% occupied. This is up from 41.8% at September 30. We are encouraged by Highgate's success and continue to work with Fairfax County on rezoning the remaining 40 acres we owned at The Mile as well as identifying other sites within our portfolio which could be opportunities for future redevelopment. Last quarter, I announced that we were in the early stages of marketing our 3 office parks in Orange County. The assets comprise 705,000 square feet and generate approximately 3% of the company's NOI. We feel confident that these will be full this year and have moved them to held for disposition. We are working to identify acquisition assets, which we can exchange in order to protect the gain from the sales. However, the investment arena remains a challenge due to aggressive buying of all three of our product types. In particular, flex and industrial are seeing record low cap rates, especially in the markets we operate. We cannot predict that there will be a shift in the acquisition market. And we are prepared to expand in a disciplined manner. Now to reflect on our full year 2017 results. Over the last 12 months, PSB moved forward on several initiatives and saw positive results that are encouraging as we begin 2018. Here are some of the highlights, first, Same Park NOI growth of 5.7% was the highest full year NOI growth since 2001; second, healthy leasing volumes, which totaled 7.5 million square feet in over 2,000 transactions with 5.1% rent growth; third, we completed the $10 million repositioning of the 2 building, 226,000 square foot, Non-Same Park asset in Rockville, Maryland. These buildings are located in a park where we already own 3 buildings, which have historically averaged 93% occupancy. The operations team completed a rebranding of the park from Shady Grove Executive Center to The Grove 270. The capital spend included creating a small move-in suite in both buildings, common area redesign and park amenities, including free WiFi, conference and fitness center and gathering areas inside and out. Occupancy is increasing each month and, as of today, is 47%, up from 18.5% at the beginning of 2017. Fourth, PSB's full year core FFO achieved a new milestone and came in at $6.13 per share of 12.7% from 2016. Further, we raised $430 million of capital, including another record low coupon for further offering in Q4. We redeemed $580 million, including the Series T redemption on January 3, 2018. This capital activity, combined with our free cash flow, leaves us with 0 debt and takes PSB's fixed charge coverage ratio to 4.9x. We are engaged in an active search for a CFO, and we'll provide an update once the decision's made. Through the efforts of our leaders in the field and here at home office, the company is well positioned coming into 2018 as we continue to gain from the economic activity we see in the majority of our markets. The success and operation combined with positive changes to the balance sheet will drive meaningful increases in free cash flow and FFO. Now I will turn the call over to Trenton.

[Trenton Groves:]

Thank you, Maria. We reported core FFO of $1.52 per share for the fourth quarter, a 9.4% increase from $1.39 in the fourth quarter of 2016. The growth was driven by Same Park NOI, combined with lower preferred equity distribution. Fourth quarter Same Park NOI growth of 4.2% was driven by a 5% increase in revenue due mostly to higher rates. The fourth quarter Same Park operating expenses were up 6.9% due to higher repairs and maintenance cost, of which, approximately $750,000 or $0.02 of FFO was due to repairs related to Hurricane Irma. In 2017, we incurred $ 50.2 million in total capital expenditures compared to $31.9 million in 2016. $9.7 million of the increase really is the cost incurred on the 2016 acquisition in Rockville, Maryland as we completed the repositioning of the asset and prepared space for occupancy, as Maria discussed earlier. The balance of the increase occurred in our Same Park portfolio, and it was driven by leases executed in 2017 as well as carryover from the prior years. In 2017, our dividend payout ratio was 71.9% compared to 64.7% in 2016. We generated free cash of $41.9 million in 2017 compared to $55.7 million in 2016. The decrease in free cash is due to the first quarter increase in our common dividend and increased capital expenditures. Construction on our multifamily development, Highgate, is almost complete, with all the units delivered as of December 31. Through the end of the year, the balance outstanding on the construction loan we've provided the joint venture is $70.2 million. We anticipate funding the remaining construction costs over the next couple of months with a construction loan which has a limit of $75 million. We reported an equity loss from the unconsolidated joint venture of $47,000 during the quarter. This was driven by $546,000 in net operating income, less $593,000 of depreciation. Based on an amendment to the joint venture agreement, we will be consolidating Highgate as of January 1, 2018, and we'll report the operations within our net operating income. On December 7, we closed on our of 5.2% Series Y preferred equity offering, with net proceeds of approximately $194 million. Using these proceeds, we repaid the outstanding balance on our credit facility and remaining $130 million balance on our 6% Series T preferred stock on January 3, 2018. The net impact of the 2017 preferred equity transaction in the redemption of Series T has moved our average coupon rate from 5.87% to the -- at the beginning of the year to 5.4% as of today. Now I'll turn the call over to JP.

[John Petersen:]

Thanks, Trenton. As Maria discussed, fourth quarter market conditions continued to deliver a favorable leasing environment across most markets and product types. California, Texas, Florida and Seattle were, once again, leaders in job growth, low unemployment and positive new absorption, resulting in healthy rent growth. In Washington Metro, economic fundamentals, like unemployment and job growth are sound, but GSA and contractor consolidations represent an overhang on the market, preventing any meaningful net demand growth. Across our portfolio, our teams capitalized on the strong business fundamental, and we had our best quarter of the year in terms of production with a little over 2 million square feet signed. Cash rent growth of 8% was largely driven by one big lease in Northern California, which I will discuss later. Excluding this deal, cash rent growth was 3.2%. Additionally, our small business customer base was busy and growing in 2017 with over 170 existing customers expanding with us last year. I will now review fourth quarter statistics by market beginning in Northern California. It is no surprise that Northern California remains one of the most dynamic and tight land markets in the country. Large drivers like Apple, Facebook and Google continue to absorb land and existing buildings which displaces companies that still need a place to grow their businesses. Our Northern California team was able to take advantage of these conditions. In Q4, North Cal leasing volume was 593,000 square feet from 111 deals. This includes leasing our 212,000 square foot warehouse space in San Jose I mentioned on our last call. This as-is deal with only a 1-year term, including rent growth of 112%. Northern California was 96.8% occupied with 35% rent growth. In Southern California, the economy is robust, and small businesses are growing. In Q4, our team signed 147 leases totaling 321,000 square feet, an average of 2,100 square feet per deal. Blended Southern California occupancy increased 130 basis points to 97.3%, with Los Angeles leading the way at 97.8%, San Diego at 97.6% and Orange County at 96.1%. Rents in Southern California increased by 4%, and retention was 84%. Seattle continues to be a very -- to be very strong with low vacancy, strong demand from large users like Amazon and Microsoft, plus the traditional small business drivers. There is very little new competitive construction. The only industrial construction in Kent Valley are big blocks over 100,000 square feet. Occupancy in our Seattle assets grew 100 basis points in Q4 to 98.3%. In total, we signed 55,000 square feet and grew rents 13%. Retention was 92.8%, with a market vacancy of less than 3%, our customers basically only leave us if they outgrow our portfolio or buy a building. In South Florida, the economic engine keeps moving forward. Demand is healthy for our smaller industrial users. And in Q4, we completed 266,000 square feet in 67 transactions with rent growth of 7%. Occupancy increased in Florida by 50 basis points in Q4 to 97.5%. Next quarter, we will be losing a 100,000 square foot customer at MICC that finally outgrew our Park. The building lays out well for a single-user or splitting the building in 2 units. We are actively marketing the building and have strong activity from existing customers at MICC. And the general market is circling the vacancy as these spaces do not come to market often at MICC. I like our chances of finding a user in 2018. Moving to Texas. We signed 310,000 square feet in 61 transactions. The strong economy, specifically small users, helped grow rents in Austin almost 15% and 1% in Dallas. Occupancy in Austin was 95.1%, down 80 basis points from Q3. And in Dallas occupancy for the 30 basis points to 90.9%. In our Las Colinas Royal Tech property, we will be losing early in the second quarter a 100,000-square-foot call center space as their government contract expires. We are able to split the space and are targeting both full building and smaller users. Finally, in Washington Metro, not much has changed in the suburban office market, as I've discussed. We did have an active quarter and signed 464,000 square feet in 127 deals. Sequentially, Same Park occupancy improved for the third consecutive quarter, adding 50 basis points from Q3 to 91.8%, aided by fourth quarter's strong retention at 72%, plus a benefit of almost 50 customers expanding with us in 2017. Maintaining rental rates remains a challenge as we fight for occupancy growth. Rents were down 10% in Q4. Our plan in Washington Metro will be growing occupancy, minimizing rent declines and capping into our vibrant, small business customer base. As we head into 2018, I'm encouraged by strong economic and real estate fundamentals, which will keep us laser-focused on growing rents, maintaining elevated occupancy levels, improving credit quality and lengthening lease terms. To that end, we are encouraged that we have 6 million square feet of expirations in 2018, giving us plenty of opportunity to achieve these goals. Now we will open the call for questions.

[Operator:]

[Operator Instructions]. Your first question comes from the line of Eric Frankel from Green Street.

[Eric Frankel:]

Just a few quick questions here. First, can you describe the source of the operating expense increase this quarter? Though I certainly recognize that operating expenses haven't grown at that pace that's been greater than inflation the last couple of years. But this quarter, it moved up quite sharply.

[Trenton Groves:]

Yes. The primary reason was the repairs and maintenance cost attributed primarily to the hurricane repairs that we had due to Irma.

[Eric Frankel:]

Okay. And next year, do you anticipate expenses increasing at a similar pace as this year, which is pretty minimal?

[Maria Hawthorne:]

Yes, Eric. We keep a tight rein on that. And the one thing that is kind of getting us a little bit is property tax increases.

[Eric Frankel:]

Okay. And then just regarding your investment plan for this year. It certainly seems like you're going to have a lot of cash left over after the sale of the Orange County offices. So just want to get a sense of how you think you're going to reallocate that over the next 12 months?

[Maria Hawthorne:]

Yes, Eric. And we're working hard to try and identify some exchange targets. Honestly, right now, as we do want to focus in the markets we operate and focus on light industrial flats or regular industrial. And I think as everyone knows, everyone's in love with industrial these days. And in our markets, particularly on the West Coast, South Florida, we're seeing low 4 and sub-4 cap rates for stabilized assets. And even in Dallas and Austin, we're seeing sales prices that are well above replacement costs. So that part, as you know, we're very disciplined. And that's hard for us to swallow.

[Operator:]

Your next question comes from the line of Anthony Paolone from JPMorgan.

[Anthony Paolone:]

Can you give us any sense, just in terms of the asset sales, the order of magnitude in terms of price?

[Maria Hawthorne:]

Well, they're in Orange County, so they are really good assets that are well-placed, desirable right now. There's 3 of them. We do think it will be 3 different sales, Tony. So the one in Irvine will be low 5%, high 4% cap rate. The Santa Ana, which is the largest asset, we're under contract right now, so I don't really want to disclose that. And then Orange was not yet under contract. And we're marketing it, though. But again, we'll be looking, say, 5.5% cap rate.

[Anthony Paolone:]

Okay. And then as you -- just to follow up on the prior question about acquisitions and putting capital to work. As you look across that deal flow, how far off do you feel you've been versus kind of the winning bids and where the market's been clearing?

[Maria Hawthorne:]

It's pretty big. I mean, if you think about it, our in-place preferreds are 5.4%. And even if you look at the inside cap rate based on our sales, you look at those 2 numbers. And to see assets that we would like trading at the sub-4 cap rate is dilutive to our value. So we cannot get ourselves to those prices.

[Anthony Paolone:]

Got it. Okay. And then in terms of the portfolio, you mentioned sort of 100,000 square feet at MICC. Anything else big to kind of watch out for, either in terms of spacing the backfill or just the opportunities to push occupancy?

[John Petersen:]

Yes, Tony. The other one I mentioned was our call center space in Dallas that comes up in the second quarter. That's a good call center space with very good parking ratios for that use. And we'll see good activity there. Other than that, I mean, I think, as we've discussed in the prepared remarks, all our market fundamentals are strong. We have -- where we -- especially on the West Coast and then Texas and South Florida, we welcome these expirations, so we can mark-to-market there. And frankly, the more expirations we have, the better chance we have to push rents. Occupancy at 97%, 98%. I mean, we're -- honestly, we're not going to push much higher than that. It's basically impossible to get to higher than that. Although with more -- the entire Northern California division of 7 million square feet at 97%, there's a few -- opportunity is small. But our opportunity there is to push rents like we've been doing for the last couple of years, same in the California -- I mean, Southern California and Florida and Texas and then Seattle. So our challenge and opportunity, frankly, is to grow those.

[Anthony Paolone:]

Okay. And then last question. Anything else contemplated or to do on the balance sheet this year?

[Maria Hawthorne:]

Well, it will depend on if we're able to identify some assets for recycling. If not, as Eric pointed out, there's a lot of cash coming from both FFO and the sale of the assets. So there's the potential of paying down on preferred.

[Operator:]

Your next question comes from the line of Craig Mailman from KeyBanc Capital.

[Craig Mailman:]

Just a few questions here. A follow-up, JP, on the MICC and Las Colinas moveouts. Could you kind of give us order of magnitude of either rent per square foot? Or kind of FFO drag here per quarter if these things stay dark?

[John Petersen:]

Yes, Craig. In Florida, we have a really good building that's coming back to us. It's kind of been with us for 15 years and outgrew us and couldn't accommodate them. Our chances there, depending on if we subdivide it or not, if we get a single user, I think there's rent-growth opportunity there moving to high single-digit range. So I think that's an opportunity. How soon will we get a lease? I think we're going to be very selective in the user we get there. So we may be patient to get the right user in terms of credit quality and use, et cetera. So we may -- it may take a little while longer to get it leased to the right group. But having said that, the market is very interesting in space, and so we're encouraged by activity there. And in terms of Las Colinas, I think there, for a space that size, for a call center space, there's only a few in the market of that size. Again, we can subdivide this. I think there's some rent growth there, probably low to mid-single digits. Once we get that leased, that will be a longer-term probably vacancy for us in terms of several quarters to probably get it leased. But again, we have a unique 10

[Craig Mailman:]

$0.03 in aggregate or each?

[John Petersen:]

Aggregate.

[Craig Mailman:]

And just MICC, you had said next quarter, but I'm not sure if you're talking from 4Q to 1Q or 1Q to 2Q. I don't know the time frame you were referencing.

[John Petersen:]

1Q to 2Q. Sorry about that.

[Craig Mailman:]

Okay. So I guess, do you have the exact dates for both of these?

[John Petersen:]

There may be some holdover due to moveout reasons. So I don't want to pin on exact date. We'll take the vacancy or the occupancy as long as we can get it, but it's probably some time early in the second quarter without giving an exact date because we don't know.

[Craig Mailman:]

Okay. That's helpful. Then I noticed you guys had a big quarter in Silicon Valley from a leasing perspective, big around spreads. Is that -- did you guys backfill the 200,000 square feet in San Jose?

[John Petersen:]

Yes, I did. I mentioned that in my remarks. We have got -- again, we had over 100%. We've doubled rent basically there. And so that was the main driver. Even without that, we -- still, rents were in the high teens. Rent growth was in the high teens. That market, I was just up there last week, continues to be very strong, multiple bids on properties. And then we get vacancy back. So we were -- we're encouraged by our rent growth opportunities again in Northern California for 2018.

[Craig Mailman:]

And that was -- is that a one-year deal you guys did out there?

[John Petersen:]

Yes, yes.

[Craig Mailman:]

Okay. Does that tend to have any automatic renewals? Or is it -- do you guys expect to be out there leasing that again a year from now?

[John Petersen:]

Well, I'm not going to get into the specific of the lease, but we think it was the right deal, both short and long term for the building for all kinds of reasons due to the rates, for sure, but also the -- based on the user and their long-term goals for Silicon Valley.

[Craig Mailman:]

All right. And then just the last one. Maria, I know you said that maybe with that cash balance sheet that you have, maybe some preferreds get paid off. Just curious if you can't 1031 it because you don't -- that's no Fannie Mae asset that kind of fit your hurdles. How much of the availability that you have today, plus the cash coming in the door from the sales could you use for that purpose versus how much of it may -- you have to kind of special dividend out?

[Maria Hawthorne:]

Well, I think what you're asking, Craig, is if you think about it, we've owned these assets since, I think, 2002 and '03 and some -- 1 or 2 of them even before that. So our tax basis, if that's what you're asking, is very low. So we'd be looking at a significant distribution of the gain.

[Craig Mailman:]

Right. I mean, I was getting that you guys are kind of $115 million on the balance sheet at the end of the quarter. Maybe this bring in $130 million to $140-ish million maybe on a gross basis. Just trying to figure out that kind of $250-ish million, $230-ish million of cash you may have pro forma all this, how much of that could be -- it sounds like most of what you're going to get from the Orange County would have to be special that if you can't 1031 it.

[Maria Hawthorne:]

Right. And that's exactly right. The other thing that we're also looking that, Craig, in making an analysis on is what the new tax laws mean for us. So we'll have -- I'm certain that we'll have more to say on our April call when it comes to our dividend.

[Craig Mailman:]

Okay. That's helpful. And from your comments, it sounds like 2 of the 3 chunks are under contract? Is that fair?

[Maria Hawthorne:]

Yes. That's true. The two larger units, OC, DC and Corporate Point in Irvine, Irvine in Santa Ana.

[Operator:]

[Operator Instructions]. Your next question comes from the line of Manny Korchman from Citi.

[Emmanuel Korchman:]

Just going back to an earlier comment you made, referring to sort of your preferreds and mid-5s and equating that to where you need to find acquisition opportunities. What kind of box does that put you in? Does that mean you have to look outside your sort of core markets or buy redevelopment assets? Or how do you sort of solve that puzzle?

[Maria Hawthorne:]

Well, it's been hard, which is why we didn't do any acquisitions in 2017. So I'm not going to say that, that we have a perfect solution. We are looking within our markets, but we do also look if there's concentrations or portfolios in other markets that we might be interested in going. I mean, that's always the strategy. If we can get somewhere between 1.5 million and 2 million square feet, that's kind of the minimum that we would need to enter a new market, Manny. So -- and then we always look at replacement costs. And we do like the value-add opportunity. With what's been going on in the stock market, does that mean -- and also with the lack of products that's on the market in the industrial -- in our markets, does that mean that the winds might be shifting? It's possible. So we'll have to see. And -- but it's been tough. It's been very hard for us. But we'll be patient. And then when the climate changes, we'll be ready with our balance sheet to go into a massive acquisition mode, as we did in 2010 to 2014.

[Emmanuel Korchman:]

And then in terms of product side, is it safe to assume that you would be focused on industrial and maybe within that small box versus big box? And would you stay away from suburban office right now?

[Maria Hawthorne:]

That sort of thing, Manny, we prefer the low finish. I think, though, given the success of Highgate, it wouldn't be outside the box to sort of -- we might not -- we might also be looking at multifamily opportunity. That we would be much more careful on -- since that is not an area of expertise for us yet.

[Emmanuel Korchman:]

All right. And then second to Highgate, I guess you said that is performing well compared to your initial expectations. Is it exceeding plan, on plan, below plan? Just where does it sit versus where you expect it to be right now?

[Maria Hawthorne:]

Rental rates are a little bit less than we had hoped because we need -- do a development your -- three years in advance. However, our lease-up is well ahead of plan.

[Operator:]

There are no further questions at this time. I'd like to turn the call back over to John Petersen.

[John Petersen:]

Thank you, everyone, for your interest in PS Business Parks. And we'll talk to you next quarter. Have a good day. Thank you.

[Operator:]

This concludes today's call. You may now disconnect.