PS Business Parks, Inc.
Q1 2013 Earnings Call Transcript

Published: 7 May 2013

[Operator:]

At this time, I would like to welcome everyone to the PS Business Parks' first quarter investor conference call. (Operator Instructions) And Mr. Ed Stokx, you may begin your conference.

[Edward Stokx:]

Good morning and thank you for joining us for the first quarter 2013 PS Business Parks' investor conference call. I am Ed Stokx, CFO of the company, and with me are Joe Russell, President and Chief Executive Officer; John Petersen, Chief Operating Officer; and Maria Hawthorne, Executive Vice President, East Coast. 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 will also provide certain non-GAAP financial measures. Reconciliation to GAAP of these non-GAAP financial measures is included in our press release, which can be found on our website at psbusinessparks.com. Now, I will turn the call over to Joe.

[Joseph Russell:]

Thank you, Ed. Good morning and thank you for joining us. I will make some brief comments on first quarter results and our most recent issuance of preferred equity, and then turn it over to JP and Maria to discuss operations. Ed will then conclude with his review of company financial performance. Same Park NOI was positive in the quarter at 0.8%, which is below the 1.4% posted in Q4, but slightly higher than the run rate for full 2012 of 0.7%. Sequentially, occupancy debts in the Same Park assets by 20 basis points, while the non-Same Park pool improved by 100 basis points, with total portfolio occupancy class 89.3%. Leasing volume was approximately 1.8 million square feet, a bit stronger than a year ago. Turning velocity and activity is healthy, and we launched the year with higher pricing on vacant units in many markets. With the ability to increase rental rates, overall small tenant rent change on spaces below 5,000 square feet turned positive at 1% for the first time since the third quarter of 2008. Large tenant rent change was negative 6.4% compared to negative 6.6% for 2012. It is typical that we would see better pricing power on smaller units at this point in the cycle and we have a good inventory of approximately 900,000 square feet of ready-to-occupy units below 5,000 square feet. So our efforts are focused on tapping into the demand we see from these sized users. No new assets were acquired in the quarter and we are continuing to assess properties for sale in many of our existing markets. Pricing expectations from sellers are still increasing, creating more challenging investment return metrics. There is more inventory to consider as wide range of both smaller deals and larger portfolios have entered the sales arena. As always, it is tough to predict the timing and volume of acquisition activity, but there is a good size pool of assets we are reviewing. On the preferred equity front, we issued another series of preferred shares with a $110 million offering that yet again beat previous company coupon level, as we price the Series V offering at 5.7%. PSB now has 995 million of preferred equity outstanding at a weighted average coupon of 6.1%, the fourth lowest in the REIT universe. We are also pleased that Moody's has recently upgraded the rating of PSB's preferred equity to Baa2, matching highest credit rating they have assigned to any office REIT. Now, I'll hand the call over to JP.

[John Petersen:]

Thank you, Joe. I will start with an overview of the current market conditions and follow with specific results of PSB's portfolio. Maria will then give an update on progress in our D.C. portfolio. From a macro perspective, the leasing environment continues to demonstrate solid fundamentals across most of our markets. Tool velocity is active and lease concessions are slowly becoming more favorable for landlords. Net absorption was positive in the fourth quarter in 10 of our 13 markets, only Maryland, Northern Virginia and Austin had negative absorption in the first quarter, which was less than one quarter of 1% in each of these three markets. In terms of positive net absorption, Northern California, Southern California and Florida, all realized solid net absorption in Q1 of over 1 million square feet in each market. Blended market occupancy, where we own assets, was 88.5%. I will now take you through PSB results for the quarter. As Joe touched on, we continued 1.8 million square feet of lease transactions, with a blended term of 3.4 years in the first quarter. Northern California had a busy quarter, executing 632,000 square feet, including a 150,000 square foot renewal with Applied Materials. Southern California continues to see improved activity and completed 290,000 square feet, while Washington metro signed 275,000 square feet. Same Park occupancy dipped 20 basis points from the fourth quarter to 92%. Still on a Same Park basis, many of our parks are now well into the mid-to-high 90% occupancy range, led by Miami at 97.7%, up 122 basis points from Q4. Austin moved occupancy up 110 basis points to 96.4%. San Diego was up 10 basis points to 95.3%. Seattle took occupancy up 125 basis points to a strong 94.9%. Maryland, Same Park occupancy increased by 92 basis points to 88%. Portland up 100 basis points to 90.5% as one customer over 15,000 square feet left the portfolio. In Orange County, occupancy was up 200 basis points to 86.2%, primarily due to one user over 10,000 square feet and a few smaller tenants leaving the portfolio. Cash rental rates fell by 3.4% over expiring rents in the first quarter, continuing the trend of improving rent declines. Positive rent change were seen in Miami 10.4%, Maryland 6.1%, San Diego 6.3%, Austin 6.2%, Phoenix rents were up 6%, Dallas 5.2% and Northern Virginia up 2.2%. In Orange County, rents dropped 17.8% as a result of three long-term leases coming back to market rents. In Northern California, rents declined 10%, primarily due to two large spaces over 25,000 square feet that were coming off leases signed at market peaks in the mid-2000. In our remaining markets, rent declines were in the low-single digit range. Retention in the first quarter was 56%, a slight decrease from the 58% achieved in 2012. In Northern California, the 5.3 million square foot industrial flex acquisition remains very active. Our teams were able to complete 431,000 square feet of leasing in the quarter. And since we acquired the portfolio, we have completed over 2.3 million square feet of total leasing over the last five quarters. Approximately 1.2 million square feet represent new leases, while 1.1 million square feet renewals. We have grown our occupancy in this portfolio from 82% at the date of acquisition to 87% today. And remain encouraged about our ability to drive occupancy and lease terms in our Northern California portfolio. Now, I will give you an update on our recent acquisition in Seattle 212 Business Park. Since our acquisition in August 2012, we have commenced a repositioning plan of demising large industrial vacancies into smaller units, where the market is more active. Construction is on plan and scheduled to be completed in June of this year with a strategy of delivering units between 14,000 and 25,000 square feet. I am pleased with the progress we have made to date on this acquisition, and we have good activity in the pipelines, including a new 40,000 square foot lease signed last week. Over the next three quarters, we have approximately 5.7 million square feet expiring, with an average size of approximately 3,800 square feet. Of that, flex represents 59%, industrial 25% and office remaining 16%. With majority of our parks close to or above 90% and fundamentals continue to improve, PSB's portfolio is well-positioned to benefit from these expirations, based on the 2013 expirations as an opportunity to push rents and continue to move occupancy higher through the balance of the year. Now, I will turn the call over to Maria.

[Maria Hawthorne:]

Thanks, JP. Let me start with a quick update of market trends in D.C. As you are aware, sequestration started on March 1, with little impact despite headline news. Most contractors have been gearing up for this over the last two years. The fact that it has now been four years since there has been a federal budget, has a greater impact since they have sold new leasing and slowed the renewal process from the government and large contractors. However, here at PSB, we continue to focus on the small customer. We are performing well, since the D.C. market have strong demographic. Unemployment is around 4.3% in the affluent suburban counties that are near D.C. and where we own our property. Our program of providing institutional ownership for the small business continues to track, despite the election, sequestration and budget impact over the last 12 months. We have leased 1,578,000 square feet in 373 deals. This includes new deal leasing of 564,000 square feet in 200 transactions for an average size of 2,800 square feet. In first quarter, we have positive rent growth of 2.71% and retention of 60.3%. Occupancy in our market is about 85%, while we ended the first quarter at 90.3%. In 2010 and 2011, we acquired 1.7 million square feet in two markets, Rockville, Maryland and Tysons, Northern Virginia. As we touched on last quarter, one of these assets is a vacant building in Tysons, which is proving to be an opportune candidate for multifamily site. Tysons continues to take major steps forward as a number of infrastructure upgrades come to completion, which included the delivery of express lanes last year and the four new metro stops at the end of this year. Excluding this vacant building, today occupancy on these assets now matches the balance of the D.C. portfolio again at 90.3%. Now, I will turn the call over to Ed.

[Edward Stokx:]

Thank you, Maria. Adjusted FFO as outlined in our press release for the first quarter of 2013 was $1.20 per share compared to $1.17 per share for the first quarter of 2012, an increase of 2.6%. The FFO increase was driven by a 3.8% or $2.2 million increase in total portfolio NOI, including a 0.8% increase in Same Park NOI. Revenues within the Same Park portfolio increased 1.4% on a comparative basis, while expenses increased 2.8% or $678,000. $278,000 or 40% of the increase in comparative Same Park operating expenses relate to higher snow removable cost, as we experienced more severe weather this year over last. Offsetting the impact of comparative increase in NOI or higher preferred equity distributions, as the company has successfully replaced short-term debt with attractively priced preferred equity. At the end of the first quarter of 2012, the company had $356 million of short-term debt outstanding, and today that balance has been reduced to $90 million. Over the same period, the company reduced its mortgage debt outstanding by $32 million, as two mortgages totaling $18.1 million were repaid during the first quarter of 2013 and we have replaced the short-term debt with permanent capital. The amount of preferred equity outstanding has gone from $670 million to $995 million, while our average in place coupon has gone from 6.73% to 6.08%. During the quarter, we had recurring capital expenditures of $8.9 million, a slight decrease from the $10 million incurred in the first quarter of 2012. The company generated $15 million in free cash during the quarter and continues to maintain a healthy FAD payout ratio of 46.8%. With that, we will now open the call for questions.

[Operator:]

(Operator Instructions) Your first question comes from the line of Jordan Sadler from KeyBanc Capital Markets.

[Jordan Sadler:]

I have Craig Mailman on with me as well. I just wanted to follow-up on the lease portfolio. The progress there, I mean the leasing volumes seem to pickup sequentially, but occupancy seems static, I think sequentially from where it was at the end of last quarter. I know one quarter does not a trend make. But curious just, if you're continuing to see the same level of traction out there that you had seen previously, and sort of what the anticipation is in terms of reaching the target lease up?

[John Petersen:]

You're right, occupancy didn't move from last quarter. We did have an expiration and we're aware of that happened. But beyond that activity is healthy in all of the submarkets in Northern California. It continues to improve and the tour volume is up. We're able to push rents, although the expiration that I mentioned did have a rent decline and we were able to kind of backfill half of that vacancy. But we're very pleased with the activity and we expect a positive momentum throughout the year.

[Jordan Sadler:]

I think Craig has one as well.

[Craig Mailman:]

Just, JP, on the rent spreads, obviously the roll down this quarter was a lot better than it had been in previous quarter, and as you're going through the markets, there is really Orange County in Northern Cal, that were the primary drag. I know you guys don't give guidance, but just as we stand today, are you seeing the same sort of trends in the markets that were up than when you pull out the expiration in the Northern Cal, I mean, could we see rent spreads turn positive this year?

[John Petersen:]

From quarter-over-quarter we may have some of these longer term leases expire. Orange County as you could probably tell we're having challenges down there, getting some traction on growing rent. Northern California that expiration was a long-term lease that we were well aware of. We planned for it. But I think with Northern California, specifically, our rents trends are moving in the right direction. And will they get positive this year? We're going to try. But again from time-to-time, we will have a long-term lease that comes back to us.

[Craig Mailman:]

And just on the acquisitions, Joe, maybe just a little bit about, what kind of portfolio you guys are looking at now. Whether it's office or industrial, east coast or west coast? And maybe if just given the rise in prices that we're seeing, what's the kind of metric you guys are most looking at now there to gauge value?

[Joseph Russell:]

A number of things going into that mix, Craig, as they typically do. So if you look at our investment strategy over the last two to three years, it's highly weighted on acquiring underperforming assets that we see good value at opportunity. And without question, that continues to play well for us. And again, even with the pressure on cap rates and pricing expectations from sellers that I mentioned, we're likely to see the best value outside, again from buying assets that we can go and then report to PSB operating strategy level, again, catering to small users. So all three product types, there is a good volume of product coming into the market, whether it's flex, industrial, or office, all the three were always going to be most careful about price points and market conditions on office products. And again, we're kind of west to east coast doing a number of things in the market right now. So I have talked about this now for more than a couple of quarters relative to the expectations that more products are coming in, which it continues to do. And our overall underwriting philosophy in no way has changed in regard to the fact that we're always going to go out and try to not be a top bidder for a stabilized asset. It's really kind of, again, going in and unlocking an opportunity that requires a little bit elbow grease and reworking. And that's, again, been a strategy that's played well and we'll continue to look for those kinds of deals. There are some of those in the mix today. And we're working hard to see what kind of value creation we can create by making the investments. You are well aware of our balance sheets, particularly well primed for us to be quick and nimble and that's always a good thing as we go on and compete for assets. So we're going to continue to work diligently to uncover those opportunities and I am confident that some good stuff will happen as time progresses here.

[Operator:]

Your next question comes from the line of Josh Attie with Citi.

[Kevin Varin:]

This is Kevin Varin with Josh. We just wanted to look for some more detail on the building that was pulled out of service in Tysons Corners, just to kind of what the long-term plans are, how soon can we see it, the development on that property?

[Joseph Russell:]

As Maria mentioned, when we acquired our portfolio in Tyson's that allowed us to think a little bit differently than we normally would because of the level of embedded vacancy that we had, which was a little over 60% again at our Westpark portfolio, which is now 45 acres. And again as Maria noted, the infrastructure upgrades, which are a little over $7 billion are coming close to completion and it has been a phenomenal impact, positive impact on that submarket, more than we even anticipated honestly when we bought the asset. So we have this one building that again when we acquired the portfolio, it was fully vacant. We held it intentionally as they last to reposition property and had been pleasantly surprised by the range of value alternatives that it may create as we look at both our tried-and-true type of product type, i.e. multi-tenant office, but now it's basically kind of switched into gear with the value creation opportunities that we're seeing with types of multi-family. We have got some time to go to figure out exact timing and exact process here, but we're very encouraged by the value creations. But the multi-year process, no questions, but we think we're well positioned to capture some good value creation there and we'll keep you updated as the definitive plan takes place.

[Operator:]

Your next question comes from the line of Michael Mueller from JPMorgan.

[Michael Mueller:]

I have a couple of questions about the lease spreads again. If you would go to, I guess, Orange County and I think you said Northern Cal, and you stripped out those big leases, what would happen to that 3.4% roll down?

[Edward Stokx:]

Mike, that number would have still been negative, but it would have been significantly much less negative, but still it wouldn't have turned positive.

[Michael Mueller:]

And then if we're looking at the balance of the year, is there a visibility on any other instances where they could be big enough for you'd be talking about them on an earnings call?

[Joseph Russell:]

Mike, we do typically if there is something that we want to signal. We're very diligent about doing that. There is nothing that is definitive at this point that we felt we need to signal.

[Michael Mueller:]

And then last question. I think you mentioned it was 1% roll up for the small tenants in Q1. I mean to put that in the perspective, do you know offhand what that number would have been for sale of 2012? Like how big if you roll down that 1% would have been for last year?

[Edward Stokx:]

For the small tenants?

[Michael Mueller:]

Yeah. You said you rolled up for the first time and it rolled up 1%, but if we look at that same pool of tenants, would they have rolled down 3% last year?

[Edward Stokx:]

That number last year, Mike, for all of 2012 was negative 5.8%.

[Operator:]

Your next question comes from the line of John Stewart with Green Street Advisors.

[Eric Frankel:]

This is Eric Frankel here with John. I was wondering if you could talk about the renovation plan in Seattle acquisition.

[John Petersen:]

We bought that Park in August and, let's say, it wasn't as well maintained as we would and it was larger user-focused. And so what we have done is we typically do, is we've embarked on our plan to reposition it and slice and dice those larger industrial vacancies to attract smaller industrial users that are more active and are typically able to pay more rent than the larger big box industrial guides. So our team up there in the process now slicing and dicing those, large base to smaller base. And as I mentioned, that's going to be between 14,000 and 24,000 square feet. That will be completed at the end of next month. We're going to deliver rent 400,000 square feet of units, smaller units to the market where we're seeing good activity. We're also doing some work on the asphalt and the driveways and the ADA in the Park and that work in fact is ongoing and we're pleased with the activities we're getting there right now.

[Eric Frankel:]

Could you possibly handicap the time frame of reaching the market occupancy in that asset?

[John Petersen:]

Yeah. We would like to get there as soon as possible of course. But what we're seeing is we started the work and people are, you know what, you build it and they will come, and they are starting to come now. But still having said that we have got, as I mentioned, several quarters to get this thing stabilized to over 90%, which is where we like to see that Park.

[Eric Frankel:]

Could you also just discuss the reclassification of the office portfolio in Northern California to flex?

[Edward Stokx:]

Yes, Eric, that was as we kind of went through the portfolio and reassessed some of the characteristics, that really was more appropriately classified as flex. We look at the characteristics of the capital that we're spending on it and the rents. That was why we made that decision. We didn't do anything physically to those assets with more of reassessment on our part.

[Eric Frankel:]

And then finally just regarding the acquisition environment, it sounds a lot more competitive. I am curious if you are thinking about going to any new markets?

[Joseph Russell:]

So Eric, obviously we're in more or less a dozen markets today, eight different states. The good news about that as we have been very intentional literally all of them have given us and will continue to give us plenty of running room and identify the opportunity because of their size, the diversity and depth of each market. So there is no pending need for us to think outside of the markets we're in. And you even fold in at some of the commentary JP opened up with, 10 of our 13 specific markets are now posting positive net absorption again on a market basis. The overall economic drivers we're seeing in our markets is healthy. And frankly we know them quite well. So those are all things that we're going to continue to rely on. And not need to think outside of what we know day-in and day-out quite well. Typically what prompts us to think about a new market is an unusually large acquisition that will give us a size of asset base that can support, the kind of day-to-day management team that we want to have like we have in all of our markets. So that's not always easy to identify, but the good news is we're deep in the markets we currently operate in and we see plenty of opportunities staying right there.

[Operator:]

There are no further questions at this time. Mr. Stokx, I'll turn the call back over to you.

[Edward Stokx:]

Thank you. Thank you everyone for joining us and we look forward to talking to you next quarter. Thank you, have a great day.

[Operator:]

Well, ladies and gentleman, this concludes today's conference call. You may now disconnect.