PS Business Parks, Inc.
Q4 2016 Earnings Call Transcript

Published: 23 Feb 2017

[Operator:]

Good afternoon, my name is James and I’ll be your conference operator today. At this time, I’d like to welcome everyone to the PS Business Parks’ Fourth Quarter Investor Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions] Thank you. Ed Stokx, you may begin your conference.

[Ed Stokx:]

Thank you. Good morning and thank you for joining us for the fourth quarter 2016 PS Business Parks’ investor conference call. I’m Ed Stokx, CFO of the Company, and with me today 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:]

Thank you, Ed. And thank you all for joining us this morning. First, I will give a quick overview of company results for the quarter and year. Then JP will provide specifics on operations and markets while Ed will go into reported change to NOI, FFO, and free cash. In fourth quarter, performance from several metrics improved on both a sequential and comparative basis. Highlights included hitting Same Park weighted occupancy of 94.7%. For the year, the total portfolio had 5.3% rent growth on production of 7.6 million square feet. This is a strong way to set up continued success in 2017. Our outstanding operations team continues to meet the growing tenant demand nearly all markets, while accommodating our existing customer base, have seen with the retention rate of 69.3%. In number of our full company metrics continue to exceed level not seen in several years. We’re encouraged that markets remain strong as we finished our fifth consecutive year of year-over-year growth. PSB is benefiting from no new competitive products and as occupancies improved we continue to drive transaction costs down as well. Full year capital costs were $31.9 million, a reduction of 27% from 2015. Our development is proceeding on track to begin delivery of our 395 unit multi-family project in Tysons, Virginia known as Highgate at the mile. The main common areas, leasing office and first unit will open in May. Tysons continues to produce good residential statistics with strong absorption in a very under-served residential market. These revolving new urban center remain vibrant and is attracting new residents to what was mostly a suburban office market. Regarding acquisition, we closed Q4 without buying any assets. For some time, we have discussed the headwind we see in the investment arena due to aggressive buying of all three of our product types. Capital was readily available, rates and occupancy are reaching or beyond peak and cap rates remained compressed. It is too soon to judge a shift in the acquisition market for 2017, but we are tracking assets and the balance sheet is trying to consider investment opportunities and to leverage our strong position. That continues to strengthen the balance sheet and maintain an A minus rating from Standard & Poor, a rating which is enjoyed by only a handful of REIT. The balance sheet has exceptional capacity from the value we derive from high rent level and lower transaction cost. In closing, I am pleased to announce that our Board of Directors approved a 13.3% dividend increase to $0.85 per share per quarter. Now I will turn the call over to JP.

[John Petersen:]

Thank you. As Maria mentioned 2016 was an outstanding year for us and Q4 was a key component to that success. In the fourth quarter, our teams capitalized on the dynamic economy solid small business job growth and positive net absorption in all our markets including Washington Metro. Our proven track record of focusing on multi-building parks in dense infill locations, targeting small business America remains integral to our solid performance. In 2016, we executed nearly 2,200 deals, an average of no surprise to most of you 3,500 square feet. This activity led occupancy growth up 70 basis points in Q4 to 94.7%. I will now take you through Q4 statistics market-by-market starting on the West Coast. In terms of total company leasing velocity, Q4 was the strongest of 2016 and we signed 2.1 million square feet with rent growth of 5.5%. Northern California led the way saying 453,000 square feet were increasing expiring cash rents by 16.9%. This solid rent growth was achieved well maintaining Same Park occupancy of 97.8% and retention of 76%. California was strong all around as my team in Southern California executed 346,000 square feet, occupancy was 96.7%, retention 71%, and rent growth was 5.8%. As it relates to occupancy in Southern California, both San Diego and Los Angeles were north of 98%. Seattle continues to outperform at 98.6% occupancy, 87% retention, and rent growth of 8.4%. Our biggest challenge in Seattle is finding space for our customers as their businesses continue to grow. In some cases, we simply don’t have enough vacant space to meet their expansion needs. Moving to Texas, we signed 413,000 square feet including two expansions, each every 30,000 square feet in our Las Colinas portfolio, which will occupy in Q2. Rent growth was robust with Austin at 15% and Dallas at 4.6%. Occupancy in Austin was 97.7% and Dallas at 90.5%. In Florida, we increased occupancy in Q4 by 110 basis points to 94.6%. We completed 373,000 square feet of leasing including three deals 20,000 feet in over at MICC retention was elevated at 81% in spite of lack of available space at MICC to accommodate growing customers. Finally in DC, the story is about growing occupancy and continuing to outperform the market. Our competitive suburban markets are currently 82% lease and our team in Washington Metro took occupancy up 40 basis points in Q4 to 90.5%. Occupancy growth in the quarter was a result of 130 deals totaling 418,000 square feet, which falls right in our sweet spot of 3,200 square foot average deal size. Retention in Q4 was 65%, as we fought hard to keep existing customers and rent growth was down 5.9%. As far as the impact of the new administration on our business, so far we have seen no meaningful impact either way in terms of our targeted users. I would characterize as a wait and see approach from our customers. Now for a quick update on our September 2016 acquisition of Shady Grove, two office buildings comprising 226,000 square feet, adjacent to our existing three building park in Rockville, Maryland. Our repositioning efforts are moving ahead quickly and we are well underway with construction of our tried and true multi-tenant floor plans. Our first wave of space inventory is scheduled to deliver in Q2 and interest in this park is near expectations. As we look ahead to 2017, once again we have the opportunity to capitalize on our highly desirable in-field portfolio, proven operating model in a talented and experienced team buoyed by healthy economy. I am also fully aware that his landlord’s favorable markets can change quickly. So we are focused on pushing occupancy DC and Dallas while growing rents and lengthening term in California, Texas, Washington and Florida. The 6.5 million square feet expiring in 2017, we are poised to capture this upside and have another productive year. Now, I’ll turn the call over to Ed.

[Ed Stokx:]

Thank you, JP. FFO as adjusted for the fourth quarter of 2016 was $1.39 per share compared to adjusted FFO of $1.31 per share for the fourth quarter of 2015, an increase of 6.1%. Adjusted FFO for the fourth quarter of 2016 excludes $7.3 million of non-cash distributions reported in connection with the January 2017 retention of preferred equity. Same Park NOI increased 2.4% in the fourth quarter as revenues grew 3.1% and expensive increased 4.8%. The comparative increase in operating expenses were tied to increases in property tax and repairs in maintenance cost. Sequentially operating expenses were down 1.9% from the third quarter. Since the end of the third quarter of 2016 through today, we have funded approximately $21.6 million of development cost on the Highgate multi-family development and we anticipate funding an additional $31 million through completion, which is anticipated in early 2018. As we noted on our last call, we are moving forward with the entitlement process on the partial adjacent to our Highgate development, where we had a full building user vacate at the end of the third quarter. As a result we have reclassified the 123,000 square foot building as held for development. The entitlement process will take several quarters and is subject to a number of approvals and contingencies before construction can be contemplated. The net operating income associated with the building has been classified as income from assets held for development. As I noted earlier, in January we redeemed $230 million of preferred equity with a coupon of 6.45%. This redemption was funded in part with the Series W 5.2% preferred equity issued in October 2016. In January, we also renewed our $215 million credit facility extending the maturity to January 2022 and reducing our current borrowing spread from 87.5 basis points over LIBOR to 82.5 basis points. We currently have an outstanding balance of $85 million on the credit facility. In 2016, we generated 57.6% million of free cash after capital expenditures and distributions, an increase of 17% from the $49.3 million generated in 2015, providing us ample ability to fund the estimated $14 million in increase distributions resulting from the dividend increase Maria noted. We expect to maintain a very healthy dividend payout ratio, which was 63.9% in 2016. We will now open the call for questions.

[Operator:]

[Operator Instructions] And your first question comes from the line of Blaine Heck from Wells Fargo. Your line is open.

[Blaine Heck:]

Hey, thanks everyone.

[John Petersen:]

Hi, Blaine.

[Blaine Heck:]

So at this point, it seems as though occupancy has increased to pretty much historical highs. Do you think it’s fair to say any tailwind from occupancy growth is likely to be muted going forward in same-store NOI, thus is going to be more reliant on rent spreads in embedded rent bumps, and probably is likely to decrease this year versus last year.

[John Petersen:]

Blaine, this is JP, I’ll start first. In terms of occupancy, we never satisfied, right. So I do think we proven that we can operate certain markets in the mid to – 90s at not the high-90s Northern California and Southern California, we’ve done that this last year. I do also think we have opportunity as I mentioned in my comments. In Washington Metro we drive occupancy, where we have had at before into the mid-90s and it’s not easy, but we certainly I think we can do that and I think Dallas have some upside as well in terms of occupancy. So we are pushing high numbers in that question about it, we’re going to train push higher in certain key markets and another markets as I also mentioned we got a drive – continue to drive rents as we presently can do in 2016.

[Blaine Heck:]

Okay, that’s fair. And I guess, just staying with you JP, a little bit more specifically, look there was a pretty significant drop in Maryland occupancy, especially amongst the small tenants. Can you just give a little color that and what are you feeling about that market as a whole going forward. Do you think that’s one of the spots where you find an opportunity to choose occupancy little bit more in 2017?

[John Petersen:]

Yes, to begin with the answers, yes, you can reduce the occupancy. To answer, first part of your question, in fourth quarter we had three known move out that we knew were coming for the whole year. They are in small tenant parks, they are actually larger customers. So what we’re doing, as you can imagine we’re taking one of the 30,000 foot user that had multiple suites so we’re repositioning those suites to 3,000 square feet. And then we have two other users 12,000 square feet that we knew are leaving and consolidating for the location. So we’re taking those suites and also reconfiguring those to our targeted small users. So that’s opportunity for us I believe, we’ve got some more to do we get there. But we will reposition those and reconfigure those three suites in Maryland to small unit and yes, I think there’s occupancy upside though, once we do that.

[Blaine Heck:]

Okay, great. And then lastly Ed, can you just talk about any financing plans for the year, I know you guys don’t give guidance, but you have no debt on the balance sheet now relatively little on the preferred side after the redemption. So is there maybe one that you would favor over the other at this time. And are you on the market at all for either.

[Ed Stokx:]

I think Blaine, we completed the one redemption earlier, any future redemptions are questionable at this point. The next one that we have is in May. It’s a 6%, the 520s that we issued in October have certainly traded off given the volatility in the preferred market and they’re trading probably around at 5.7% today. So would make sense to take those out it with new preferred certainly. I think with the balance sheet that we have are fixed charge coverage ratio north of four times, we’ve got plenty of capacity and I think activity there would largely be driven by acquisition opportunities.

[Blaine Heck:]

Okay, fair enough. Thanks guys.

[Maria Hawthorne:]

Thanks.

[Operator:]

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

[Eric Frankel:]

Thank you. Thank you. I was hoping you could provide a little more color on the entitlement process for the rest of the build out of the Tysons Park. I know it sounds you provided from previous commentary that it’s probably going to be a much more extensive process in the first project, because it sounds like you’re entitling the lot more land. Could you give a bit of a timeline as to when that might occur?

[Maria Hawthorne:]

Sure, Eric. I don’t want to fall into guidance and you’re right. Originally for Highgate that was a five acre entitlement process. It took about 11 months once it was submitted to the county. This time now we’re going in with a little over 40 acres, because that is the balance of what was our west park campus that now has been remained into the mile. So we’ve been in communication with the county early responses from them, because we have been working in partnership with Fairfax County, is that they have a very positive toward our plan. But this is zoning, parks authority, fields, residents, multi-use, and so it can take anywhere from a year to 18 months, before we get final approval. And then from that once you get approval, it’s probably a year after that before you would be even commence construction. So that’s kind of give the little bit of a timeline there.

[Eric Frankel:]

Okay, that’s a helpful timeline. My next question just related to capital allocation, is that’s an activity. I certainly appreciate that property prices are as high as they’ve ever been and it’s a very competitive investment market. But that said, I mean, think your supplemental – your share price is up roughly 30% over the last year. And so it’s hard to see that property prices that appreciate at the same rate. So it seems like, you have some sort of cost of capital advantage. So even if price is remain high, it seems like you could still make a pretty good return for shareholders based on cost of capital, any thoughts on that.

[Maria Hawthorne:]

Eric, I have to tell you, there’s lot of properties that we’re tracking and we have actually seen some parts that we would like to own that where owners went out very aggressively on pricing. And they’ve had to pull them from the market and then they come back out. So we actually have some core markets where we are tracking some potential acquisitions and what we’re going to be disciplined, because if we’re buying a park with high occupancy at peak rent. We are still in the real estate market where we have to look at what our returns would be and in a down market. So we want to make sure that we buy assets that will be accretive for the long run.

[Eric Frankel:]

Understood. Could you differentiate a little bit in terms of this investment pool you’re looking at between suburban DC, where you seem to have brought up an attractively-priced office property last quarter to the rest of your core markets?

[Maria Hawthorne:]

Yes, DC right now I think has a black eye with a lot of investors that is second largest office market in the United States. And we’re seeing cap rates there that you haven’t seen since the 2000 quite frankly. So we can be counterintuitive to what the market is doing. There are assets like the one that we bought for $59 a foot, which is actually within a part that we already own three buildings and has been very successful for us. So if we see something like that will go for it. But there are still parts – great parts to buy in Texas, Florida and on the West Coast. So we do – we have a good acquisition team and like I said we’re actually seeing some assets on the West Coast that we think that we could be very interested.

[Eric Frankel:]

Okay, we looking forward to hearing about them. Thank you.

[Maria Hawthorne:]

No promises Eric.

[Eric Frankel:]

Understood, understood. Thank you, thank you.

[Maria Hawthorne:]

Perfect.

[Operator:]

Your next question comes from the line of Manny Korchman from Citi. Your line is open.

[Manny Korchman:]

Thanks. Maybe if we stay on acquisition for a second. When you talk about the acquisition environment and your appetite? What specific asset class that you’re talking about. Is it large user parks that you can break down as a small user parks as a more office or flex or industrial or just sort of what – goal post if you put up for your acquisition seems to look for.

[Maria Hawthorne:]

Okay, that’s a good question and here’s what we look for. We look for well positioned until we particularly like light industrial and industrial with the big thing that we always look at is when you’re looking at an aerial we like multi-building park that either are already or can be more multi-tenanted. So the other thing too, is that we absolutely are not afraid of vacancy. And we will buy zero vacancy as we proved on September 28 in 2016 because we know, if it’s in the market that we’re in, we know what we can accomplish. So very often, we will end up buying an institutional park that – and we know that our model is very management intensive and a lot of institutions they prefer the bigger tenant because it’s a private management intensive. So maybe they are underperformance in the market and then that something else we look for is that, if we’re at 90% to 95% we’re in higher lease and we can get an asset that’s under 90% that’s an immediate value add for us. Does that help, Manny?

[Manny Korchman:]

Yes. And then if we turn back to the post-presidential election comments you made earlier, we’re just curious, you said it’s a wait and see, is that the same for both the smaller and larger tenants or is there maybe a certain whether it would industry type or size of tenant that is either being more aggressive or more conservative coming out of the election?

[John Petersen:]

Yes. Good question, Manny. So, and the answer is both small business America and the larger businesses, government contracts et cetera are both in the wait and see kind of mentality. I think there is some cautious optimism that when you have Congress and the executive branch aligned that could be good for business. And there is also some eyes are wide open as to where this administration is taking things, which I’ll leave it at that but I think businesses are like hopeful potentially, especially small businesses and that there will be few regulations, more opportunity to access capital et cetera. And that could at the margin be positive for a small business America. I still do think that the government – contractors are still consolidating space using a smaller square foot per person footprint et cetera. So I don’t, I feel they’ve got – here to stay but on the other hand, I mean small businesses might benefit from an alignment in executive management and Congress.

[Manny Korchman:]

How far through that tightening office space type of trend are we JP in your mind?

[John Petersen:]

How far are we through this…

[Manny Korchman:]

Well. Yes. How many of the – it’s been a long time on the sort of the conversation block. It feels like we’re through a lot of that, and what are the downsizing or just tightening, is that 80% done and now its just another year, feeling we’re fully done or we half way through just…

[John Petersen:]

Yes. No, I think a lot that’s been – I just think that we’re now it’s just normal operating procedure. So I think in terms of some of that consolidation and contraction that just how the world’s going to be. So I think we’re through a lot of that. As I’ve said before, that the margins we’re optimistic about where specifically – is going as I mentioned in my comments it was positive net absorption generally, just barely but there is positive absorption in DC and suburban DC. So that trend we’ll see, we’ll see.

[Manny Korchman:]

Great. Thanks, JP.

[Operator:]

[Operator Instructions] Your next question comes from the line of Craig Mailman from KeyBanc. Your line is open. And your next question comes from the line of Gene Nusinzon from JPMorgan. Your line is open.

[Gene Nusinzon:]

Hi, everyone. So on the leasing and maintenance CapEx that’s been pretty well maintained in 2016 is there anything that would suggest a move up or down on that front in 2017.

[Maria Hawthorne:]

Yes, Gene. Just as we talked about last quarter and Ed mentioned in his comment, we did by two office buildings in Maryland that were only 18% occupied, they were previously occupied by single major users. So we do have to reposition them and spend capital this year. And so that will be an expense that we didn’t have last year. But overall, we have high occupancy, we’re seeing strong retention rate, which is allowing us in all our good markets to drive transaction cost down. So that’s a trend in our Same Park that that will we don’t see changing right now.

[Gene Nusinzon:]

Got it. Thank you. And with regards to pushing lease lengths while times are good. Can you just put some brackets or quantify that.

[John Petersen:]

Sure, so when rents are where we are, when transaction costs are lower, we would like to extend term as long as we can. Well, our user base would like to be flexible, because they’re preferred not to length in terms in this environment. So that the push pull that we deal with them – each and every renewal and each and every new leases. So our average term is around 3.5 years and we’d like to take that to four plus on average or we do two year deal, a small two year deal we’d like to do a three year deal instead or we have a renewal coming up and then want 18 months we’ll ask for three. And so that the push pull, how much revenue you’re going to pay, so you want to increase it 20%, I mean if that given take on each and every deal. And so we view it in those markets as I mentioned in my comments, that’s look lock and load now. We want to secure our rent role here, especially if these rates were getting. So that’s kind of what we’ve been focusing on. Is that makes sense.

[Gene Nusinzon:]

It does. Are you having more attraction on earlier renewals now maybe than a year ago?

[John Petersen:]

I would say at the margins we are, another thing we’re able to do in certain parks when we have occupancy in the 98% range. And we know an expiration is coming for whatever reason. We may have success in pre-leasing it and going out early on a renewal six or eight months earlier whereas a couple years ago may have been three to five months early. So because customers want secure those space, because their businesses are good. So that’s why retention was over 69%. So that we may think to your question, we are seeing that.

[Gene Nusinzon:]

Got it. Maybe on the large move outs that you may have in 2017 or 2018, do you think any risk could become redevelopment opportunities.

[John Petersen:]

Not specifically in terms of, do you mean in terms of higher and better use or do you mean just in terms of repositioning the assets to smaller tenants.

[Gene Nusinzon:]

Both.

[John Petersen:]

Probably less on the higher and better use. If any I can’t think of any the top of head, but I can think as Maria covered earlier and I did, if we have a large space come vacant and we have the opportunity to make several smaller spaces, we will take that opportunity almost every time.

[Gene Nusinzon:]

And then just final question on private market valuation, can you just do a quick rundown of pricing you’re seeing, you talked about Texas, Florida, West Coast assets that may be your interest kind of pricing that you seen there?

[Maria Hawthorne:]

Well there you can see a wide range, let’s say core market and it’s well leased with current market around. We are seeing deals close at even sub four and certainly in the 4 to 4.5 cap range, and that’s for industrial, and flex and light industrial. And then the gap in those strong markets even with office, those have tightened very much, as well. So if it’s – like I said, if its still in the core market but you’re seeing maybe it isn’t – the owner maybe hasn’t gotten it to much occupancy, or they don’t understand it, then that’s where we’re seeing 5.5 to 6 cap rates.

[Gene Nusinzon:]

And how about the…

[Maria Hawthorne:]

And then quite frankly suburban DC is 8 and above.

[Gene Nusinzon:]

That’s helpful. How about the bigger pool are you guys bumping up against?

[Maria Hawthorne:]

That’s pretty broad. What you didn’t see in 2016 that you saw in 2015 was there was huge portfolio take downs in 2015 that changed. There wasn’t quite as much foreign investment and that was large scale that you saw in 2015. However, we’re still up against institutional pension funds. And then the other thing that’s happened in some markets is that you’re seeing private people that are coming into markets and especially in the secondary markets, you’re seeing pricing at record high.

[Gene Nusinzon:]

Okay. I’ll throw in a final question on same-store NOI growth in 2017, do you think it will be as strong in 2017 and 2016 just given that occupancy that’s 95%?

[Ed Stokx:]

It’s – Gene I’m going to reluctantly not – I’m going to be hesitant to answer that question but I think we’re going to do everything we can to push rents. JP talked about where there is some occupancy opportunity and we’re optimistic that we have opportunities for growth ahead of us.

[Gene Nusinzon:]

Got it. Thanks a lot guys.

[Maria Hawthorne:]

Thanks.

[Operator:]

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

[Eric Frankel:]

Thank you. Just one follow-up question, I’ll try to keep it delicate obviously because they are political questions, they are delicate ones. But have you ever surveyed your tenants recently to ask, what from a regulatory standpoint how – how from a regulatory standpoint the new administration might help cut down some of their burdens or is it more of a financing issue in terms of the lending environment to small businesses as it has been pretty strict over the last few years.

[John Petersen:]

Well I got that, great question, for sure. We do as you know we survey our customers on a regular basis, won’t get into the details. But we have an active and formal process with surveying customers, both new and existing. I will say, we have not asked them although never may about those kinds of questions. So our typical customer survey is really specific to their businesses in terms of space requirements, employee requirements and how – frankly how we’re doing relative to serving their business needs. But we haven’t gotten that far into those kinds of questions yet, but it’s a good idea and something that certain things maybe into this may be we’ll insert to next survey.

[Maria Hawthorne:]

Quarter.

[John Petersen:]

Yes.

[Eric Frankel:]

All right, then remind myself to ask this question again in the two next two quarters.

[John Petersen:]

Yes, put that your ticker for us.

[Eric Frankel:]

Yes, I well thank you very much. Have a good day.

[Maria Hawthorne:]

That’s a good question there.

[John Petersen:]

Yes great question thanks.

[Operator:]

And there no further question at this time. I’ll turn the call back over to the presenters.

[Ed Stokx:]

Thank you very much. Thank you, everyone for your interest in the company. And we look forward to speaking to you in the near future, take care.

[Operator:]

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