PS Business Parks, Inc.
Q3 2016 Earnings Call Transcript

Published: 26 Oct 2016

[Operator:]

Good afternoon, my name is Shannon and I will be your conference operator today. At this time, I would like to welcome everyone to the PS Business Parks’ Third Quarter Investor Conference Call. [Operator Instructions] After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions] It is now my pleasure to turn today's conference over to Mr. Ed Stokx. Mr. Stokx, you may begin your conference.

[Edward Stokx:]

Thank you, Shannon. Good morning and thank you for joining us for the third quarter 2016 PS Business Parks’ investor conference call. I’m Ed Stokx, CFO of the Company, and with me are Maria Hawthorne, President and Chief Executive Officer; and John Petersen, Chief Operating Officer. Before we begin, let me remind everyone that all statements other than statements of historical fact 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. Reconciliations to gap of these non-GAAP financial measures is included on 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 Ed, and good morning everyone. Thank you for joining us. I will discuss some highlights of our quarter. Then I will turn the call over to JP for specifics on operations and Ed will wrap up with financial updates. The trends we saw in the first half of 2016 continued in the third quarter. This is driving positive performance on several key metrics on both a sequential and comparative basis. Same-Park NOI increased 5.3%. We had our strongest leasing quarter this year executing 1.9 million square feet. This volume also came with a 5.6% rent growth as we mark-to-market expiring rents as strong momentum continued on the West Coast in Texas and in Florida. Sequential occupancy within the Same-Park portfolio and total portfolio increased 50 basis points to 94.1%. Non-Same-Park is maintaining 95% occupancy. Retention in the third quarter was 67.8%. PSB continues to demonstrate from no-yield competitive market product and as our occupancy has improved we are also seeing reductions in transaction costs. Our focus of only well positioned multi-building, multi-tenanted business park gives us a large customer core in each of our market and allows us to expand our aimed customer base. This combines with favorable market conditions, means that 80% of our business parks are now 90% occupied or higher. In addition, we continue to strengthen our already strong balance sheet and Ed will give you details on $189.8 million preferred offering we closed on last week at our all time low of 5.2%. For the first time since 2014, we have closed on an acquisition. On September 28, we purchased two office buildings totaling 226,000 square feet for $13,250,000. They are located within Shady Grove Executive Park in Rockville, Maryland where we already own three adjacent buildings. For the last three years, we have operated our growing at 94% occupancy. The acquisition buildings are 18.5% leased. We will execute on our plans of investing additional capital to reposition the building with improvements to the common areas and demising the fourth floor vacancies into small fleet. This is the same strategy that we have executed throughout our portfolio on multiple acquisitions. Meaning several months to complete construction and we expect to start leasing in second quarter 2017. We feel this is a great opportunity for PSB since total capital invested will be less than 50% replacement value in a park that is already have proven success. On the development front, construction continues to grow well with our 395 unit multifamily project in Tysons, Virginia knows as Highgate at the mile. We are on track to begin delivering units in mid 2017. Six apartments building have delivered in Tysons over the last two years and the market is proving that it can't attract residents to this new and evolving urban center. Therefore, we have decided to proceed with getting high density multifamily entitlements on the 123,000 square feet building that became vacant on October 1, in order to enhance the value of our parks in this vibrant market. Now, I'll turn the call over to JP.

[John Petersen:]

Thanks, Maria. Overall, we continue to see strong operating fundamentals in the third quarter with solid tour volume, improving occupancy, lower concessions and an active existing customer base. The majority of our activity is the units under 5,000 square feet indicating a healthy small business environment. In terms of deal volume, Washington Metro is amongst active in Q3 having 517,000 square feet and 113 transactions. Same-Park occupancy debt by 60 basis points in the quarter to 90.2%. This volume was driven in part by aggressive pricing with cash rents declining 6.1% in the quarter. Our small cut rates is relatively healthy and we have had over 20 existing customers expand with us so far this year. In Northern California, our third quarter was again solid on all fronts. We completed 476,000 square feet in 100 deals. Retention was 70% and rent growth was at robust 24%. Occupancy was strong at 96.5% as we are able to find the right balance between rent growth and occupancy. The Southern California economy is healthy and it continues to be a top market for us, where we executed 323,000 square feet in 170 deals, an average of 1,900 square feet. Similar to Washington Metro, existing customer expansions have contributed to our success in Southern California, with over 35 customers have taken more space so far this year. Overall, combined occupancy in Southern California was 95.5%. Our LA assets led the way at 97.6%. San Diego just over 95% and Orange County at 93.6%. Combined Southern California rent growth was 6.4%, with retention at 75% In South Florida, we executed 293,000 square feet in 70 deals of 4,100 square foot average. Rent growth was 6.7% and occupancy improved by 60 basis points from Q2 to 93.5%. In Texas, we completed 243,000 square feet and grew rents 2.7% while occupancy improved 150 basis points at 93.7%. Retention was 77% and we are still able to push rents in Austin up 15%, while running our portfolio at 97.7% of occupancy. As we look ahead to the rest of 2016, we have 1.4 million square feet or 5% of the portfolio expiring. And throughout 2016 our opportunity to capitalize on these expirations by extracting rent growth and pushing occupancy in California, Seattle, Texas and Florida while keeping our leasing volume high and growing occupancy in Washington Metro. Now I'll turn the call over to Ed.

[Edward Stokx:]

Thank you JP. FFO as adjusted for the third quarter of 2016 was $1.43 per share compared to adjusted FFO of $1.20 per share for the third quarter of 2015, an increase of 19.2%. Adjusted FFO for the third quarter of 2016 excludes $320,000 of acquisition costs as well as a $528,000 lease termination fee. Adjusted FFO for the third quarter of 2015 excludes the non-cash distribution of $0.07 per share related to preferred equity redemptions. Total portfolio NOI increased 5.8% in the third quarter with Same-Park NOI up 5.3%. Same-Park revenue increased 3.8% as a result of higher comparative occupancy combined with improving rents. The $528,000 lease termination fee which is not included in the comparative results relates to a 58,000 square foot user in Tysons, Virginia who exercised a termination option. Approximately 22% of the space, which vacated at the beginning of the third quarter has been released. Same-Park operating expenses increased a modest 26%. Recurring capital expenditures were $23.5 million for the nine months ended September 30, 2016 compared to $32.1 million in the same period of 2015. The year-over-year decrease largely tied to lower transaction costs as market conditions have enabled the company to reduce lease consumptions. During the quarter, we funded approximately $15.5 million of development costs for the Highgate multifamily development and we anticipate funding an additional $53 million through completion. Through the first nine-months of the year, we have generated nearly $42 million of free cash. Our strong free cash enabled us for funding acquisition of the Shady Grove buildings and our Highgate development cost while increasing our credit facility balance modestly from $54 million at the end of the second quarter to $16 million as of September 30. On October 20, we closed on the 5.2% Series W preferred equity offerings. With the underwriters exercising the [foam green shoe] (Ph), net proceeds from the transaction were approximately $183.7 million. With the proceeds, we repaid the outstanding balance on a credit facility and we anticipate using the remaining funds to redeem the $230 million 6.45% Series S preferred equity in January of 2017. Given or anticipated redemption of Series S, we will report non-cash distributions of $7.3 million in the fourth quarter based on the timing of the redemption numbers. In addition to the proceeds from Series W offering, the redemption maybe funded with the combination borrowings on our credit facility or other forms of unsecured term debt. We will now turn the call over to questions.

[Operator:]

[Operator Instructions] Your first question comes from the line of Craig Mailman from KeyBanc Capital Markets. Your line is open. Please go ahead.

[Craig Mailman:]

Good afternoon guys. A few here I guess maybe starting out decision to entitle for multifamily in Tysons, how are you guys going to treat that asset in the fourth quarter and going forward?

[Edward Stokx:]

We would anticipate Craig that we would transfer that into asset held for development and take it out of the Same-Park portfolio.

[Craig Mailman:]

Okay, so how much are you going to be capitalizing? What is the amount that you would be using at the base?

[Edward Stokx:]

The basis in the property you are saying?

[Craig Mailman:]

What is going to be impact on an FFO basis to capitalize in Q4?

[Edward Stokx:]

There won’t be a significant impact on FFO from a capitalization standpoint. The significant impact to earnings going forward is the fact that we lose about $900,000 a quarter effective October 1 of this year from the expired lease.

[Craig Mailman:]

Great, okay. And how much do you guys anticipate spending on that development? And kind of when do you think the timing of that actually hits?

[Edward Stokx:]

Well the entitlement process is going to take some period of time to go through that process. So over the next 12 to 18 months we may incur maybe $1 million to $2 million, $2.5 million of costs associated with the process, but the development will not start for some time.

[Craig Mailman:]

Okay that’s helpful and then just moving over to the preferred, clearly you guys have record pricing. Can you just walk us through the decision not to fully match on the $213 million kind of leave it out there and maybe expand a little bit on your comments about potential using term debt and kind of what the appetite is there?

[Edward Stokx:]

Well, Craig if you look at what is ahead of us over the first five months of 2017, we have got between the Series S and the Series T, we have got about $580 million of preferred that we can redeem that's at 6.45% and 6% between the two outstanding issuances. So that's a significant amount of preferred equity to raise in call it two quarters. So we will anticipate raising some additional preferred and we think the preferred market is very attractive right now. But we may also balance that with other forms of term debt. So we are looking at and are keeping all of our options open there.

[Craig Mailman:]

All right, that’s helpful. And then just moving on to acquisitions, you guys are back in the market with a small deal. What do you think the full - you said 50% replacement half stabilization that you guys are in for about 50 bucks, what do you think kind of full build out cost will be there and where are rents that you guys seeing into growth.

[Maria Hawthorne:]

Yes, so Craig our current asset, which today are a little over 86% almost 87% leased are in the mid-20s for rental rates and we will need to reposition the two new buildings and so if you think about it, we are putting about a 185,000 square feet of vacancy into our portfolio. So our costs are to reposition less than $30 a foot and then we anticipate getting rents in the mid-20s.

[Craig Mailman:]

All right and you guys have said in the past it could make sense to buy stuff adjacent that obviously fits that. I mean what is your appetite outside of this deal for acquisitions and what does the pipeline look like?

[Maria Hawthorne:]

Well here is what we are up again, if you think about the industrial markets and in the markets that we are dealing on the West Coast, South Florida and in Texas, those are incredibly strong markets. I know these seems a little bit counterintuitive in the suburban office, but when you see very nicely located Class-B offers and you can take them up for under 60 bucks a foot. This to us is I mean it's going to take us a couple of years to probably get it fully leased, but this seems a huge opportunity for us. And we know our small tenant portfolio strategy work, because this is what we did on Shady Grove on the first three assets when we bought them in 2010 and they were 70% leased.

[Craig Mailman:]

All right, great. Thank you.

[Maria Hawthorne:]

Okay.

[Edward Stokx:]

Thanks Craig,

[Operator:]

Your next question comes from the line of Manny Korchman from Citigroup. Your line is now open. Please go ahead.

[Manny Korchman:]

Hey guys. Maybe I missed this earlier in the call, but why would the buildings so under leased compared to what you got there, but was there just move outs, and if so how long were they vacant?

[Maria Hawthorne:]

The buildings until I would say last 18 months to two years were leased to two large users, for the two buildings that we bought, each had a single building user that consolidated out of that market.

[Manny Korchman:]

Got it. That was it for me. Thank you.

[Maria Hawthorne:]

Okay.

[Operator:]

Your next question comes from the line of Eric Frankel from Green Street Advisors. Your line is open. Please go ahead.

[Maria Hawthorne:]

Hi Eric.

[Eric Frankel:]

Hi, how are you doing, thank you. A couple of quick questions regarding one I guess this is stand upon I guess Craig's question on the capitalized value of these future development. What is the book value of that project of the 123,000 square feet office building?

[Edward Stokx:]

The book value is about - it's just a little under $30 million.

[Eric Frankel:]

Okay, that’s helpful. And so just to confirm, if there is development in probably a start wouldn’t occur for at least another year and a half roughly based on Tysons process, is that fair?

[Maria Hawthorne:]

That’s very fair Eric, because it’s a pretty intense process with accounting in sales tax as they have a very - it’s a different process in Tysons than we have in the rest of the county. So that will take at least a year maybe 18 months and then there is like a little bit of a lag before you can start construction and redevelopment. These big buildings themselves take about a year and a half to build.

[Eric Frankel:]

Sure, I know you are not going to the process, if you think the size on projects it will be comparable to what you are doing with Highgate?

[Maria Hawthorne:]

Yes, the location, this path is actually a slightly larger parcel in acreage, but what would be constructed with these continuation of a park of the park that we started with Highgate. So it fits in perfectly and then the building itself would be very similar in size and scope. And then the best part is that like I said we are building this park that it's not only great for the residents, but it's also huge enhancements for the remaining office building that are operating.

[Eric Frankel:]

It sounds like a pretty active side. I'll back in the queue if other analysts have questions. But my final question related to the funding, your funding strategy for next year. It's pretty unique for your company to issue unsecured debt. So is it just a capacity of the preferred markets that’s driving that decision? Or is it something else related to the cost of unsecured debt relative to the current quarter preferred coupons?

[Edward Stokx:]

Yes, I think it’s a combination both of those Eric. The capacity to issue the amount preferred that we need to, but also the price of the potential unsecured debt is very attractive and from a risk standpoint, or from a balance sheet standpoint I should say we have no debt on the balance sheet at all today. The debt that did have previously has all been repaid. So we have got a $4.9 billion marketing capital with zero debt on the balance sheet right now. So we are looking at all options available to us.

[Eric Frankel:]

And just a very quick follow-up. Would this be private placement debt or do you actually have an unsecured public offering?

[Edward Stokx:]

We would not likely do an unsecured public offering at this point.

[Eric Frankel:]

Okay. Thank you.

[Operator:]

[Operator Instructions] Your next question comes from the line of Anthony Paolone from JP Morgan. Your line is open. Please go ahead.

[Anthony Paolone:]

Great. Thank you. I guess I'll start on the residential side, how do you think about the decision to do the second project fully versus maybe getting the land and the density and so forth all teed up and perhaps just selling it to residential developer, how do you think about the choice?

[Maria Hawthorne:]

Well, Tony, this park is a unique location in Tysons and that it already has right adjacent who are parks that we are building, jogging trails that are in place, a natural stream as well as being a block away from athletic field. So the new development don't have that sort of accessibility for people that want an active life style. And we own a contagious 45 acre accumulation of what is of relatively flat and allows us to build these mid-rise apartment complexes versus the high rise requirement for those properties that are directly adjacent to the metro, they are very close to the metro. And so at this point, as we are developing and as the neighborhood is evolving we would like to keep control of the land at this point. Now what we would do in the future two or three years from now, I don't want to speculate at this point.

[Anthony Paolone:]

Okay, got it. And then over in the core portfolio occupancy picked up again. How do you think about just what the potential occupancy could go to here, things have crept up pretty nicely and just wondering how much you may have left across your markets?

[John Petersen:]

Yes, Tony it’s a good question and something we deal with every day and we still think at some point in the 94%, 95% ranges is very strong. Having said that we have proven in some markets, Northern California being one where we can take advantage of 96%, 96.5%, 97% occupancy with incredible rent growth. So, did I think we could do that a year or two ago, I'm not sure, I'm glad we are achieving that. So can we run this portfolio at 98%? No, I don't think we can. But I think there is still some room, we are at 94, yes, so I still think there is a room to push a little bit as long as the economy keeps the tailwind with it. So we continue to push occupancy and we have been able to grow rents also.

[Anthony Paolone:]

And is the rent picture, the market kind of holds up where it is about today, how do you think rent spreads trend as we go into next year. like do we stay in this five percentage range or do you think that bumps up as well given what is set to come due?

[John Petersen:]

Well, yes, we look at that too all the time, we look at our expirations for the remainder of this year and into next, we think there is opportunity for rent growth into 2017. Is it going to be five-ish? I'm not sure, but we still see good fundamentals in the market as I mentioned in my comments in all the markets except you know DC is on track with that before, but we certainly have the ability to continue to grow rents into 2017.

[Anthony Paolone:]

Okay and then just a last one, G&A seem to be on low side in the quarter, can you talk to just where that settles out run rate was?

[Edward Stokx:]

Yes, Tony the sequential decline in G&A was largely tied to the management change that was effective July 1. So that’s the primary driver, if you look at the composition of the G&A for the quarter, there is really two components the non-cash relative component that we isolate is about 900,000 and the balance is kind of the cash G&A. So that puts it somewhere in the $2.6 million all-in range, I think going forward that’s probably a good fair run rate.

[Anthony Paolone:]

Okay. Thank you.

[Edward Stokx:]

Sure.

[Operator:]

Your next question comes from the line of Craig Mailman from KeyBanc Capital Markets. Your line is open. Please go ahead.

[Craig Mailman:]

Hey guys just a few quick follow-ups here, JP the negative rents trend down, can you give a little bit more color on that?

[John Petersen:]

Yes, that was we expand an existing customer Craig and we [indiscernible] a low going in rate and we are going to bump that pretty quick during their term. So there is a larger deal for us and 15,000 square feet that was a good expansion and customary now and have to do that deal that was just a one off.

[Craig Mailman:]

If you pull that out what would it have been?

[John Petersen:]

I don’t know exactly, we didn’t do that. Would have been positive, probably in the mid-single-digit.

[Craig Mailman:]

Okay, that’s helpful. And then Ed, maybe just going back to the financing piece, at what point your equity cost of capitals significantly improved here. At what point does maybe taking out some of these higher coupon preferred and maybe the one that’s closer to 6.5% was equity instead term debt make sense?

[Edward Stokx:]

Well I think you know from our history, we have been very, very judicious about using equity as our currency and I think we would continue to do that. That would be something - from our perspective, it would be probably more effective use as we were expanding the portfolio through acquisitions. The other thing that you have to consider if we were to issue some level of unsecured term debt, we are generating $45 million to $55 million in free cash a year. So we have got significant cash flow that we can use to pay down that debt as well if the acquisition market doesn’t change here in the near future.

[Craig Mailman:]

Okay. Is there point where the arbitrage opportunity make sense or just not there yet or you guys just kind of oppose to doing that equity to make more growth?

[Edward Stokx:]

I think there may be a point where it would make sense, but I think just from a long-term standpoint and a dilution standpoint, it certainly would make more sense to us to use that currency for growth purposes versus refinancing purposes.

[Craig Mailman:]

Okay. And then just lastly kind of where on the curve are you guys thinking about doing term debt and have you gotten indications of pricing at all?

[Edward Stokx:]

We have certainly gotten some indications of pricing, I think that if we were to do something that was floating rate. We would probably be in the range of plus or minus a 100 basis points over LIBOR. So it's pretty attractive pricing.

[Craig Mailman:]

Okay great. Thank you.

[Edward Stokx:]

Sure.

[Operator:]

Your next question comes from the line of Eric Frankel from Green Street Advisors. Your line is open. Please go ahead.

[Vince Tibone:]

Hi, this is Vince Tibone with Green Street Advisors. I have a question on your NOI margin, it looks it decreased over a 100 basis points from Q2, after adjusting to the lease buyout revenue. Can you talk about the drivers of the expense increase and were there any one-time expense items in the quarter that we should be aware of?

[Edward Stokx:]

No one-time expense, the one thing that you should know and if you look at in our supplemental package we have a graphic shows kind of the trend of the margins and you see that typically our third quarter margins is a little bit lower and that's largely driven by utility costs. So we typically see and anticipate a higher spike in utility costs over the summer months, just based on that usage within the portfolio. So that was the large driver of kind of the impact on NOI.

[Vince Tibone:]

Great. Thank you.

[Edward Stokx:]

Thank you.

[Operator:]

Your next question comes from the line of Anthony Paolone from JP Morgan. Your line is open. Please go ahead.

[Anthony Paolone:]

Sorry to get into some of the accounting REITs, but if we look out to 2017 we start to bring in Highgate. Should we anticipate that that is like typical multifamily accounting where you start to bring in much of the cost and that at least is up so in earlier phases it maybe like dilutive or how should we think about starting with that end?

[Edward Stokx:]

Yes, your correct Anthony that's how we would expect to bring it in and that will start coming in really in early in the second half of 2017 with lease up beginning in the spring time.

[Anthony Paolone:]

Okay and is the anticipation that by the middle of 2018 you are basically more stabilized, that sort of timeline?

[Maria Hawthorne:]

Yes, probably more towards the end. As this is a big project almost 400 units and there is competitive product still coming to that market. So, you are looking at more of a two year lease up phase.

[Edward Stokx:]

And Tony just to clarify on or to expand on Maria's point, the construction of the entire 395 unit building will not be complete in the spring time, but the first phase of it will. So that construction will continue through post through the end of 2017.

[Anthony Paolone:]

Okay, got it. Thank you.

[Edward Stokx:]

Sure.

[Operator:]

As there are no further questions in queue at this time, I'll now return the call to Mr. Ed Stokx.

[Edward Stokx:]

Thank you. Thank you everyone for your time today and we look forward to talking to you in the near future. Take care. Bye now.

[Operator:]

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