PS Business Parks, Inc.
Q1 2018 Earnings Call Transcript

Published: 25 Apr 2018

[Operator:]

Good afternoon. My name is Stephanie and I will be your conference operator today. At this time I would like to welcome everyone to the PS Business Parks First Quarter Investor Conference Call. [Operator Instructions] After the speakers' remarks there will be a question and answer session. [Operator Instructions] Thank you. John Petersen, you may begin your conference.

[John Petersen:]

Good morning, everyone. And thank you for joining us for the first quarter 2018 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. 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 herein 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 Web site at psbusinessparks.com. I will now turn the call over to Maria.

[Maria Hawthorne:]

Thank you, JP and good morning everyone. First, I will give a quick overview of Company’s results for the quarter. Then JP will provide specifics on operations and markets, while Trenton will finish with the financial updates. We started the year well. If you remember, there were two events that drove first quarter 2017 Same Park NOI unusually high. These events were triple net billings and a very mild winter for snow. If you strip out these two items, we would have seen 3.9% Same Park NOI growth in the first quarter of this year. We continue to see strong results from the majority of our portfolio, including 4.3% rent growth on nearly 1.6 million square feet of leasing and 70% retention. We did see occupancy dip sequentially due to natural explorations, but are encouraged that the bulk of these move-outs were in the strong West Coast and Florida markets where we will be able to re-lease these suites with higher rent. All of our markets are experiencing job growth, and confidence remains high within our customer base. Now that the development of Highgate at the Mile is complete, we revised the JV agreement with our partner, and commencing on January 1st, we took control of the partnership. Doing this allows us to consolidate Highgate in our financial. We continue to see success with lease-up, and occupancy increased to 61.5% in the quarter. Now that winter is over, we are seeing the lease up pace accelerate to last year’s level as we enter the busy spring and summer month. At the beginning of the year, we reclassified 7.6 million square feet of flex properties to industrial based on a critical review of our properties’ office to warehouse ratio. We revised our definition of industrial to include properties with both truck-loading access and less than 40% office build-out. We believe the reclassification will assist investors to better understand our business operations. On the acquisition front, bidding is aggressive for flex and industrial products no matter the size of the portfolio. We remain focused on identifying underperforming and value-add properties with an investment strategy that is tied to acquiring quality assets that are ultimately accretive. Capital flows and competitive buying behavior are at all time high in the markets we operate. In fourth quarter, I announced that we were marketing our three office parks in Orange County. The assets totaled 705,000 square feet and generated approximately 3% of the Company’s NOI. So far this year, we have sold the two larger assets, totaling 598,000 square feet for net proceeds of $115 million or $192 per square foot. That leaves two other previously announced assets, which are being held for disposition. These are the remaining small office parks in Orange County, and the large tenant flex park in Dallas. We are confident that both will close this year. We are working to identify acquisition assets, which we can exchange in order to protect the gain from the sale. However, for the reasons stated above, the investment arena remains a challenge. Regarding our CFO search, we continue to assess internal and external candidates. Now, I will turn the call over to JP.

[John Petersen:]

Thanks Maria. As far as our markets are concerned, our industrial and flex portfolios continue to operate under landlord favorable conditions in the first quarter. California, Texas and Florida and Seattle, all delivered positive net absorption rent growth and healthy user demand along with minimal new competitive constructions. I will now discuss first quarter specifics by market. In terms of market fundamentals, nothing much has changed in Washington Metro, as landlord feel GSA and government contractor consolidation headwinds. Owners remain very aggressive when competing for deals over 10,000 square feet, especially with TI and business packages. Our team in Washington Metro continues to outperform the market by focusing on small businesses, and we signed 335,000 square feet and 116 transactions, an average deal size of 2,900 square feet. Same Park occupancy dipped 140 basis points to 90.4% due to move-out and downsizing of a handful of users over 15,000 square feet. Rents declined 8.8% and retention was 69%. Looking down to South Florida, we had another strong quarter, signing 390,000 square feet with retention of 79% and cash rent growth of 3.7%. Occupancy dipped by 130 basis points to 96.2% as 144,000 square feet user vacated at the end of 2017. We have good activity, and I expect that pace to be really soon. As a reminder, we are losing a 100,000 square feet user this quarter as they outgrew their space. Our marketing efforts are bearing results and expect to re-lease that space in the next several months to a couple different users. In Texas, we signed 74 leases or 272,000 square feet, an average of 3,600 square feet. Occupancy in Texas dipped 80 basis points due to one large user moving out at the end of 2017. Retention in Q1 was 74% and rents increased 4.8%. At the end of the first quarter, a 100,000 square feet government contractor vacated, and we are in the process of margin space with good interest geared towards sub-dividing the building. Our team in Northern California continued to run an outstanding performance, increasing occupancy to 97.6% on 250,000 square feet of leasing. Rents were up almost 19% in the quarter as we are able to capitalize on strong demand and limited supply. Retention was 50%, primarily because we pushed out customers who are not willing to pay market rent and upgrade the credit quality within our portfolio. In Southern California, our team signed 131 leases, totaling 305,000 square feet, right line with our sweet spot of 2,300 square foot average deal size. Blended Southern California occupancy increased 10 basis points to 97.4% with Los Angeles leaving away at 97.9%, Orange County at 97.1% and San Diego at 96.7%. These numbers exclude our Orange county office properties that we sold or held for sale. Demand is still robust and rents in Southern California increased by 3.9% with retention of 80%. In Seattle, we are benefitting from consistent demand, a strong job market and limited new supply. We kept occupancy at 98.2% while increasing rents by 16.4%. Our retention of 22% in Seattle was a result of the lack of expansion opportunities for our customers within our parks. By economic tailwinds, healthy job growth and a strong small business climate, I am focused on the opportunities we have with the 4.3 million square feet of expirations remaining in 2018. Of this 4.3 million square feet, approximately 35% or 1.5 million square feet expire in California and 37.2% roll in Texas and Florida, giving teams plenty of opportunity to extract favorable lease terms. I will now turn the call over to Trenton.

[Trenton Groves:]

Thank you JP. We reported FFO of $1.59 per share for the first quarter, a 4.6% increase from $1.52 in the first quarter of 2017. The growth was driven by higher NOI combined with lower amortization of long-term equity compensation and preferred distribution. First quarter Same Park NOI growth of 0.7% was driven by 2.4% increase in revenue due mostly to higher rates. First quarter Same Park operating expenses were up 6.5% due to higher snow removal cost and utilities. Excluding the impact of triple net expense going from the first quarter of 2017, the Same Park revenue growth was up 4.2%. Based on our amendment to the joint venture agreement, we consolidated our multifamily asset Highgate as of January 01, 2018 and as a result, delivered 427,000 of NOI for the first quarter of 2018. During the three months ended, March 31, 2018, we incurred $7 million in total capital expenditures compared to $8.7 million in the same period in 2017. $1.3 million of the decrease relates to cost incurred on the 2016 acquisition in Rockville, Maryland as we reposition the asset in the transit space for occupancy last year. 252,000 of the decrease was a result of a reduction of capital incurred on our assets sold or held for sale. Our dividend payout ratio was 67.6% compared with 71.1% for the three months ended March 31 2018 and 2017 respectively. We generated free cash of $14.2 million during the quarter -- first quarter of 2018 compared to $12 million in the first quarter of 2017. The increase in free cash was primarily due to the decrease in capital expenditures and lower preferring distributions. On January 3rd, we redeemed the remaining $130 million balance on our 6% Series T preferred stock, which brought our average coupon rate to 5.4%. Now, we will open the call for questions.

[Operator:]

[Operator Instructions] Your first question comes from Craig Mailman with KeyBanc. Please go ahead.

[Laura Dixon:]

This is Laura Dixon here with Craig. Regarding the dispositions, are you able to provide cap rates on the Orange County dispositions that closed, and give us any color on timing or pricing for the remaining Orange County and Dallas dispositions?

[Maria Hawthorne:]

Laura, we can say for the cap rates, we were in the mid five. And the timing for Texas is coming up very shortly. And then our final office aspect, we were just giving a little bit more still in our marketing. So that will be a little bit later in the year.

[Laura Dixon:]

Would it be fair to assume additional asset sales this year?

[Maria Hawthorne:]

At this point, we don’t have anything else planned.

[Laura Dixon:]

And then switching gears, I noticed…

[Maria Hawthorne:]

Just one comment, I am sorry for interrupting. But the large flex asset in Texas, we had announced that about a year ago and now it’s closing fairly shortly.

[Laura Dixon:]

And then switching gears for the -- there was some deceleration for the rent spreads in Dallas. Is that indicative of the market or is that impacted by specific leases?

[John Petersen:]

From quarter-to-quarter, we’ll have leases that may or may not roll off higher rents or specific situation, but it’s not indicative of the market at all. As I mentioned in my comments, Dallas is a good market and we do have -- we have a large user as mentioned vacate at the end of 2017 and we’ll have to release that. But otherwise, we like the market and expect rents to continue to move forward in Dallas.

[Operator:]

Your next question comes from Manny Korchman with Citi. Please go ahead.

[Manny Korchman:]

Maria, on the vacation of the flex two industrial, just had a couple of questions. Firstly, how did your new or newer definitions compare to how for potential appraiser or buyer, or somebody else that [multiple speakers] properties to look?

[Maria Hawthorne:]

Manny you’re completely static here I can’t understand your question.

[Manny Korchman:]

So Maria, the question was on the reclassification of the properties from flex to industrial. How would a potential buyer or appraiser or some other third party look at those. Would the definition be closer to what you were looking at previously or what you’re looking at now?

[Maria Hawthorne:]

Absolutely, it would be considered industrial. And as you know, we look at every -- we see every industrial package come out. And what we recognize is that a lot of our products, which we call flex, is really defined in the market as industrial. And then also in investor meetings, Manny, JP and I spend a lot of time to finding flex. So what we wanted to do is create a consistent definition that is consistent not just for us but also consistent among our industrial peers on how we look at industrial. According to [MEHA], flex is a subset of industrial and industrial does include manufacturing, warehouse, flex and R&D. So that all falls under the industrial umbrella, but we just wanted to have a more consistent definition, both within our definition as well as consistent with our peers.

[Manny Korchman:]

And then if I look at your supplemental disclosure, it looks like some places of the stuff have been re-class between those two buckets, and then others like the lease expiration schedule haven’t. Am I looking at something correctly or is that to come?

[Maria Hawthorne:]

No it should evolve as re-class, Manny. But you know what, we’re going to check that and if something was off, we’ll definitely send a note out and repost. But we think we call that.

[Manny Korchman:]

And then my final question is going back to the CFO search that’s been on for a while. I was under the impression that you had identified somebody couple months ago or month ago. What has changed there -- is it a different type of candidate that you're searching for or something else that’s precluding you from closing that process.

[Maria Hawthorne:]

Actually, we have very good internal support, both within our own team as well as from public storage. So as we’ve been identifying external candidates, we’re also evaluating internal candidates and we just want to make sure we hire the right person.

[Operator:]

Your next question comes from Eric Frankel with Green Street Advisors. Please go ahead.

[Eric Frankel:]

My first question is related to DC suburb. So JP, can you comment on leasing activity, whether the federal budget has helped leasing at all in those markets?

[John Petersen:]

So we think it will help the defense sector, and that’s primarily Northern Virginia. Unfortunately, we don't think that really is going to kick in for a year or two until the GSA can really understand what their new requisitions are for space and contractor requirements, et cetera. What we do think in a year or two, we’ll start to see the benefit of that primarily in Northern Virginia. Does that help?

[Eric Frankel:]

That does help, thank you. And perhaps related to North Virginia and the Maryland suburbs, I note here top tenant list that Kaiser and Lockheed, while they’re still two of your larger tenants and looked at that from pretty significant rent roll down. Are those rent figures accurate or that reflect some free rent from a recent lease signing? So it looks like 20% to 30% rent roll downs for two tenants.

[John Petersen:]

No, those are two current tenants customer of ours in suburban Maryland, you’re right. And we're talking with folks right now in terms of renewing their space. But the reality in suburban Maryland is vacancy rates are in the high-teens in suburban Maryland, as you well know. And I don’t anticipate that changing at all. And thus, there is no pricing power as we renew tenants, especially the big deals like that as you know. There have only been a handful to two handful of deals over 20,000 square feet in suburban Maryland over the last four years. So where our focus is as I've discussed before is on occupancy in maintaining their customer base. So unfortunately there’s no pricing power yet in suburban Maryland, because vacancy rates are in the high teens.

[Eric Frankel:]

Final question and I can jump back in the queue, but the apartment development is -- obviously, looks that lease-up is going relatively well. When do you roughly expect stabilization to occur for that asset?

[Maria Hawthorne:]

We should be stabilized before the end of the year. And that’s assuming we have as strong leasing this spring and summer and fall as we did last year. It's a little bit difficult to predict both because Tyson is a new market and for a lot of the owners, if you think about all the new high rises in our project. And so it's hard to really trend. But just based on what we saw last year, we should be stabilized by the end of the year.

[Eric Frankel:]

It fairly looks like you guys are optimistic about doing more there with the rest of the park?

[Maria Hawthorne:]

When you are entitling for the additional acres, right now I believe that's the largest [re-titlement] occurring in Fairfax County. And that we submitted last year, and that's about an 18 months to two year process. But as soon as we can get through that, we’re preparing ourselves for launch Phase 2.

[Operator:]

[Operator Instructions] Your next question comes from Anthony Paolone with JPMorgan. Please go ahead.

[Anthony Paolone:]

Can you just talk through any seasonal impact and rolling NOI from 1Q into 2Q, or any items we should watch?

[Maria Hawthorne:]

This is the reason why if you look at the analyst package starting last year, we started breaking out by quarter and we literally call out snow, because last year was incredibly light. And what happens when we have a very mild winter, you also have low utility. This year we saw a more normalized snowfall, but it was a cold winter. And so utilities were little bit higher. If you think about expense control, our teams are doing a really good job of holding most of their controllable expenses that are 1% or 2% increase year-over-year. But utilities -- snow winter then utilities can fluctuate first quarter and then summer and fall, which really hits us in third quarter. And then the only other expense that we really see high operations wise that will continue through the year will be the property taxes. Does that help?

[Anthony Paolone:]

So yes, when I roll that up, the weather should be, from a sequential point of view, a net benefit as you roll from 1Q into 2Q. What about anything on the reimburse -- what about on the reimbursement side, anything that skews the number that way?

[John Petersen:]

This quarter, you shouldn’t -- in Q2 you shouldn’t see a big variance from that. We do have to match our expense reimbursements with the level of expense. So expense reimbursements recorded in the second quarter will be lower than the first quarter. But sequentially, from an NOI perspective, we will definitely see some benefit from the lack of snow removal and utility costs.

[Anthony Paolone:]

And then second question. Can you just -- I may have missed this. But can you just talk about what you’re seeing on the investment side, and where pricing is for assets that you all will be interested in versus maybe like where your business is?

[Maria Hawthorne:]

We love all the markets that we’re in right now, we consider them all core for PSB. The West Coast, South Florida, those markets that we’re in, everyone considers core, gateway. And so we are looking to acquire in any of our markets and on the investment sales front, activity was very low, especially compared to some of the activity last year, because there haven’t any been in the gateway markets any major industrial sales to-date. But what we’re seeing is that there you do get into a bidding war, and sales are hot right now for industrial and flex, and very often the biddings just spirals out of control with as many as five and six qualified buyers in our market. So where you’re seeing the sales happen, there in place forecast and even upon stabilization they’re not getting above 4.5 on leverage cap rate.

[Operator:]

Your next question comes from Eric Frankel with Green Street Advisor. Please go ahead.

[Eric Frankel:]

So I have a small minor question, I wanted to ask I keep forgetting. I noticed in your 10-K you have a small property near Dallas, Texas that’s under a ground lease that is coming up, that is expires in next couple of years that has a short renewal option. Is there anything to read into that property in terms of potential big expense increases or potential to buy the ground lease or renew it for longer term?

[John Petersen:]

No, there is nothing to read into that. We’re negotiating the ground lease and with the current customer on extending both for families and the customers. So we didn't do anything unusual there. Does that help? For some reason, I can’t hear you, Eric.

[Maria Hawthorne:]

Eric, if you think you can hear us, the ground leases is with the airport authority. And so it’s just taking a little bit longer just because we are negotiating with the airport authority. They don’t have these leases turn very often. So we are in the negotiations as JP said for both extending the ground lease and our customer.

[Operator:]

There are no further questions. At this time, John Petersen, I'd turn the call back over to you.

[John Petersen:]

Thank you everyone for your interest in Company, and we'll talk to you next quarter. Have a good day.

[Operator:]

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