Whitestone REIT
Q3 2013 Earnings Call Transcript

Published: 5 Nov 2013

[Operator:]

Good day, and welcome to the Whitestone REIT Third Quarter 2013 Earnings Conference Call. Today's conference is being recorded. At this time, I'd like to turn conference over to Ms. Suzy Taylor, Director of Investor Relations. Please begin.

[Suzy Taylor:]

Thank you, Aaron. Good morning and thank all of you for joining Whitestone REIT's third quarter 2013 earnings conference call. Joining me on today's call will be Jim Mastandrea, our Chairman and Chief Executive Officer; and Dave Holeman, our Chief Financial Officer. Please note that some statements made during this call are not historical and may be deemed forward-looking statements. Actual results may differ materially from those indicated by the forward-looking statements due to a variety of risks and uncertainties. Please refer to the company's filings with the Securities and Exchange Commission, including the company's Form 10-K and Form 10-Q, for a detailed discussion of these risks. Acknowledging the fact that this call may be webcast for a period of time, it is also important to note that today's call includes time-sensitive information that may be accurate only as of today's date, November 5. The company's earnings press release and third quarter supplemental operating and financial data package have been filed with the SEC, and the Form 10-Q will be filed shortly. All are or will be available on our website, whitestonereit.com, in the Investor Relations section. Also included in the supplemental data package are the reconciliations from GAAP financial measures. And with that, let me pass the call to Jim Mastandrea.

[James C. Mastandrea:]

Thank you, Suzy, and thank you all for joining us on our call today. Today, we're going to review our third quarter results and update you on the recent progress of our initiatives. Dave's portion of our call will focus on the financial results and the overall strong positive trends in Whitestone's financial position. As we have stated previously, we are focused on 5 areas to increase long-term shareholder and enterprise value. First, extracting the intrinsic value from the assets we own by leasing and redevelopment and helping our tenants grow their businesses; second, by acquiring accretive assets in high-growth target markets; third, by lowering our overall cost of capital; fourth, by developing on land we own; and fifth, by strengthening our management team as increase economies of scale and continue our growth. I would like to review some of the progress we have made and highlight our accomplishments in these areas. During the quarter, we produced strong top line and bottom line results. Our total revenue grew by 41% from the prior year, and FFO Core increased by 50% from the prior year. On a per share basis, our core FFO grew 26% to $0.29 per share in the third quarter, up from $0.23 for the same period last year and up by $0.01 from the second quarter. Book value of our real estate portfolio has now topped $500 million, including our acquisition since the end of the third quarter. We now own 58 Community Centered Properties located in Houston, Dallas, San Antonio, Phoenix and Chicago, totaling 4.7 million square feet with 1,200 tenants, 70% of which are small businesses whose services target their surrounding local communities. We focused attention on transforming properties to lease to tenants that meet the community, ethnic and demographic profile. In doing so, we were able to continue to add programs and processes that will provide increasing returns in the coming quarters and years by lowering overall cost of operations, thus increasing our profit margins. These new initiatives will sharpen our competitive edge at each and every community where we own real estate, helping to drive traffic to the centers which in turn, [indiscernible] new tenants. Our repositioning initiatives, designed to drive value for our tenants who in turn drive revenues for us, ramped up in the third quarter in each of our markets. In only 3 short years of being public, we've added over $290 million in 23 Class A value-add Community Centers, most of which we purchased at distressed prices, consisting of 1.7 million square feet and 4 future development land parcels. Our track record reflects our team's ability to seek out value opportunities, and Whitestone has emerged as a proven buyer as well as value-add operator. All of the centers we've purchased were under some level of financial distress ranging from bank owned foreclosures to over-leveraged sellers. As a result, most of the centers we have, have been undermanaged and undercapitalized. They range from 20% occupied high value-add centers to 100% occupied more stabilized properties. Our average cost of our total portfolio of 4.7 million square feet is approximately $100 including land. Our acquisition strategy includes purchasing properties that have high vacancies and has positioned us to grow our overall occupancy. In doing so, revenue net operating income and net asset value all increased. As of the end of the third quarter, our total occupancy is 85%, up from 84.6% last quarter. Subsequent to the quarter, we closed 2 acquisitions. The first, Fountain Hills Plaza, a Class A community center located in Fountain Hills, Arizona, a suburb of Phoenix. This 111,289 square foot property was purchased for $20.5 million, is 87% leased and was purchased below replacement cost. Cash on cash return was 8% at the time of closing. Fountain Hills fits perfectly within our operating business model and was immediately accretive with significant value upside. The second acquisition, Corporate Park Woodland 2, is located in the Woodland, Texas, a suburb of Houston that is strategically located between our Corporate Park Woodland property and Interstate 45, a main commuting corridor which is currently, our property is 100% leased. The property is located near the new Exxon Mobil headquarters and was acquired for $2.75 million. It is 2.5 acres with 16,200 square feet of leasable space, fully occupied. The property has excellent freeway access and visibility and will allow Whitestone to add our Corporate Wood -- to our Corporate Woodland community property with commercial retail space. Our pipeline of off-market opportunities remain very attractive and continues to be in excess of $0.5 billion. With more buyers in the market, we are seeing prices creep up, yet we're seeing them still affordable. We have completed over $96 million in acquisitions so far in 2013 and have 1 property currently under contract at approximately $35 million, as well as $125 million of properties in various stages of negotiation. Subsequent to quarter end, we completed a successful common share offering, raising approximately $60 million with the issuance of 4.6 million common shares at $13.54 per share. The offering was oversubscribed and due to the high demand, we were able to exercise the full over-allotment. This offering provided the necessary capital for us to quickly close on 2 accretive deals and pay down under our line of credit. With that, I would like to turn things over to Dave Holeman, our Chief Financial Officer. David?

[David K. Holeman:]

Thank you, Jim. I will start today by reviewing our current financial position, then turn to a review of our key operating results for the quarter and conclude with a few comments regarding our outlook. During 2013, we have grown the company in an accretive manner while maintaining a strong balance sheet. In 2013, we've added high-quality acquisitions in our Phoenix and Dallas markets. Specifically, including our October acquisitions of Fountain Hills Plaza and Corporate Woodland Park 2, we have added 5 Community Centers for approximately $96 million, 449,000 square feet of gross leasable area, over 100 new tenants and approximately $7.2 million in annual net operating income. We've also strengthened our balance sheet through refinancing of our property-level and corporate-level debt. Earlier in the year, we expanded, restructured and extended our corporate-level unsecured credit facility, growing the borrowing capacity by $50 million and adding an accordion option, giving us the ability to increase the facility another $50 million. We also reduced the interest rate by approximately 1%, resulting in interest expense savings so far in 2013 of approximately $1.1 million or $0.06 per share. During 2013, we've also been very active in refinancing our property-level debt, completing the refinancing of $47.2 million of property-level debt so far this year with $27 million completed in the third quarter. The weighted average fixed rate of our 2013 refinancings has been 4.36% with a weighted average term of 8.9 years. We've also continued to move toward a more unsecured balance sheet with our pool of unencumbered properties, that is properties without secured mortgages, increasing to 33 with an undepreciated cost basis of $285 million as of quarter end. Our debt leverage as a percent of total market capitalization was 49% as of quarter end and is 42% pro forma, reflecting the post-quarter common share offering. As of September 30, 2013, our total outstanding fixed interest rate debt had an average effective interest rate of 4.99%, and our total market capitalization was $521 million. We expect to begin to recycle capital over the next few quarters due to selective sale of lower growth properties. We currently have 3 Houston properties in the market for sale and expect the sale of these properties to be an additional source of capital to either pay down debt or redeploy in the higher growth Community Centers. Now let me turn to our operating statement. FFO Core for the quarter was $5.1 million or $0.29 per fully diluted share, which is an increase of 50% on an absolute dollar basis and 26% on a per share basis over the prior year third quarter. Total revenues for the quarter were $16.3 million, an increase of $4.7 million or 41% from the same period in 2012. For the quarter, our same-store revenues were 69% of our total revenues and were up 0.49% from the third quarter of 2013. The year-over-year increase was a result of a 2% increase in our average revenue per leased square foot, offset by a 1.3% decrease in our average occupancy. Same-store revenues are up 0.74% for the 9-month period over the prior year. Total property net operating income for the quarter was $9.5 million, an increase of $2.5 million or 36% from last year. For the quarter, same-store property NOI was 65% of our total property NOI and decreased $500,000 or 7% from the same period prior year. The decrease in quarterly property NOI was a result of increased unrecoverable property taxes, primarily in our Houston market and increased bad debt expense primarily from tenant move-outs from our re-tenanting efforts during the quarter. Same-store property NOI for the 9 months was 71% of our total property NOI and was flat with the prior year. Bad debt expense for the 9 months was 3% of our total revenue, up from 2% of revenue in the prior year. This increase has been driven primarily by tenant move-outs in our Houston region from our re-tenanting efforts. Our interest expense for the quarter increased $358,000 or 16% from the prior year. This increase was driven primarily by increased debt used for acquisition, offset by a decrease in our effective interest rate of 1.6% from the prior year. We continue to see the effects of scaling our general and administrative expenses across a larger base of assets and revenue. Over the last year, our employee count has increased by only 10 people, a 16% increase, while our quarterly revenue has increased 41%. Included in our third quarter G&A expense was approximately $118,000 of noncash expense related to common share grants to trustees as fees and $725,000 of expense from the amortization of performance-based restricted stock, which was granted over the last 5 years. The amortization of share-based compensation relates to the expected vesting period and does not reflect any actual payments made. We expect this amount of amortization to continue through 2014. As of quarter end, there was approximately $2.7 million of unrecognized noncash share-based compensation expense, which we expect to amortize over a weighted average period of 14 months. Our G&A expense for the quarter, excluding the amortization of share-based compensation and acquisition expense, was 10.7% of total revenue as compared to 12.3% a year ago. We remain focused on our cost savings efforts and expect our G&A costs as a percent of revenue to continue to decrease as we grow over time. Next, let me touch on some of our key operating measures. Our total occupancy rate was 85% as of the end of the quarter, up 40 basis points from a year ago and down slightly 60 basis points from last quarter. I remind you that our total occupancy represents physical occupancy and does not include tenants under lease which have not yet moved into our properties. Our tenant base is approximately 1,200 tenants. And during the third quarter, we signed 98 new and renewal leases, representing $13 million in total lease value with an average term of 3.3 years and an average size of 2,657 square feet. Let me touch briefly on our leasing spreads. Each quarter, we report in our supplemental data package, the leasing spreads of the ending rent on expiring leases versus the beginning rent on new or renewed leases and the leasing spread on an average basis or straight-line basis. In any given quarter, 1 or 2 leases can cause the quarterly percentage to be fairly volatile. During the third quarter, for strategic reasons, we renewed a tenant in our Dallas division at a significantly lower rental rate. This tenant alone caused a 7% point decrease in the total renewal spread for the quarter. As such, we prefer to look at the data over a longer period of time. During the 12 months ended September 30, 2013, we had a 1.3% increase on a straight-line basis for all comparable new and renewal leases signed. Excluding the Dallas tenant discussed earlier, this rate is approximately 4.2%. Lastly, let me touch briefly on our near-term performance drivers and conclude with a discussion of FFO Core per share. Subsequent to the end of the third quarter, we reached an agreement resolving a year-long co-tenancy dispute with an existing tenant that occupies an aggregate of 54,000 square feet in Whitestone's Phoenix and Houston markets. The resolution of the dispute will result in the tenant returning to market rental rate and also allow Whitestone to add 2 high-quality tenants who will occupy approximately 65,000 square feet in our centers. The 2 new tenants expect to take occupancy by year end. The impact of this settlement is expected to result in incremental annual revenue of approximately $850,000 and $1.1 million in 2014 and 2015, respectively. Approximately $75,000 from this settlement is expected to be realized in the fourth quarter of 2013. Secondly, a comment regarding the lease-up of our vacant spaces and its impact on our FFO. As of the end of the third quarter, we have approximately 150,000 square feet of new tenants expected to take occupancy in the fourth quarter. This includes the tenants previously discussed in the co-tenancy dispute resolution. These new tenants are expected to increase our overall occupancy rate by 3% in the fourth quarter. We remain very confident in our ability to lease our portfolio centers into an aggregate stabilized 93% to 95% occupancy over time. Thirdly, let me touch on future acquisitions. With our recent common share offering combined with debt, we have approximately $120 million in purchasing power. We expect to continue to acquire high-quality properties in our target markets and selective redevelopment and development opportunities. Lastly, let me conclude with a discussion of our outlook for FFO Core per share. We expect to have some dilution in FFO Core per share in the fourth quarter due to our recent offering and the timing of acquisition but expect the investment return on the capital raised from our recent offering to be accretive to our third quarter level on an FFO Core per share basis over the coming quarters. We are well positioned with a strong top and bottom line growth, a stable balance sheet and a pipeline of accretive investment opportunities. And with that, let me turn the call back to Jim.

[James C. Mastandrea:]

Thank you, Dave. As I look to the future, Whitestone's prospects remain exciting. As we grow, some of the small aberrations we experienced today will be insignificant tomorrow. Our core strength is our people. We seek and retain only those who've demonstrated a passion and the desire to continue to hone their skills for the real estate business within the Whitestone culture. We train, educate and provide the necessary tools for our associates to be successful. Specifically, our in-house training program and development of our people allows us to meet our growing needs and effectively service our tenants. Our strong results and progress this quarter are a result of our working together towards a top common goal of increasing shareholder value. We remain committed to advancing our strategic plan and unique business model and capturing the embedded cash flow or intrinsic value in our portfolio. We are pleased with the results this quarter and look forward to wrapping up 2013. In closing, I would like to thank you for your continued confidence and support for the privilege that you provide me to lead Whitestone. With that, I would like to conclude the review of our results and open it for questions. And operator, I will turn the call back to you.

[Operator:]

[Operator Instructions] And we'll go first to Paul Adornato with BMO Capital Markets.

[Paul E. Adornato:]

Jim, you mentioned that you would likely start to recycle capital and sell some properties. I was wondering if you could tell us kind of the history of those properties? Were they ones in which you kind of completed your lease-up and have created value? If you could just give us a little more color on those.

[James C. Mastandrea:]

Yes, Paul, that's a good question. We have 3 properties on the market. We took a first round of offers and they were about 25% below expectations. Now also during that time, we lost some net operating income from the time we put them out to market to the time that we've received the offers. So we felt because of that, they're really good properties, they just don't fit in our business model. We thought we should take time to go back and address some of the issues that some prospective buyers put into the properties, again, put a little bit more of an aggressive mode on leasing them up and then still sell them. So our plan is to still sell them, to still recycle some capital and basically, what they are, they're properties that don't fit in our business model, but they're also located down in the Pasadena area, so it's about an hour's drive from Houston, 2 reasons we don't think they're right. But we now have a program, we think, to gain a couple extra million dollars when we sell them.

[Paul E. Adornato:]

Okay, and could you comment on cap rates and potential dilution from these property sales?

[James C. Mastandrea:]

Dave, you want to jump in here?

[David K. Holeman:]

Well, sure. I think the short answer is we expect to deploy the -- to recycle the proceeds very quickly, Paul. So we do not expect dilution from selling the properties. We would [indiscernible] time that well with either a paydown of debt or ultimately, in the new higher-growth properties. As far as cap rates, just to add a little bit on the properties we're looking to sell, many of those are properties that were in the portfolio when we joined the company back in '06. So they do have a nice low-cost basis, so we are hopeful that we'll be able to sell the properties at a gain to what we have today. As far as cap rates, probably in the 8% to 10% range.

[James C. Mastandrea:]

They're in the single digit, Paul, not in the 12.1% [ph] we're selling [ph].

[Paul E. Adornato:]

Okay. And you mentioned that headcount increased by 10 people. Was wondering if you could tell us what functional areas you added people to.

[David K. Holeman:]

Sure. It's really been front-line leasing and property management. Really, if you look at our growth over the last year, obviously we've added a lot of GLA, added a lot of tenants. And so we've been very efficient and we've added pretty much [indiscernible] leasing and [indiscernible]

[James C. Mastandrea:]

One of the things we did is before, we had combined marketing with investor Relations, we split that off. So you've met Suzy, who's now running [indiscernible] so we split off marketing [indiscernible] we've added also 2 folks [indiscernible] because a lot of our strategic approach to properties is really how we market those, how we move those through the system [indiscernible] a couple new ones will be going onboard as well and we -- I think we're pretty full right now [indiscernible] these areas and then in Phoenix, we're -- I'd say we're fully staffed over there with around 15 or 16 people. Overall, we're still right around 70 people, total, Paul.

[Paul E. Adornato:]

Okay, and one last question. Was wondering if you could talk about the health of the small tenants in your markets. How are the -- maybe give us a little insight as to the health of the local economies and how your small tenants are doing.

[James C. Mastandrea:]

Yes. What we find is that there is a -- on the -- particularly, the retail side, we're finding there's still an abundance of people who want to lease space. Our business model works to capture them before someone else captures them. And we found our -- we'll call it bad debt or accounts receivables creep up a little bit, but they've now started to come back down. We've seen that in that particular experience and that also went to a changeover in the business [ph] that we put in place too. So we're seeing the health of the small tenants stay about the same, not improving or not changing but we're finding that their requirements are less in terms of what they require to put in for TI, they're satisfied more with the existing space. Where we had some problems this past year, and we talked about it in our report and remarks, was with the larger credit tenant. The issues that are harder to deal with are these operating covenants and a lot of the operating covenants were put in by people who were real estate developers. And the operating covenants, they were able to get occupancy levels, they were able to get financing to fund and then the properties were up and running and then the next step is they go to sell them to the REITs. And all of a sudden -- or they got foreclosed on and the REIT inherits some of these national credit tenants that have operating or co-tenancy requirements that are extremely difficult to deal with. And it took us over a year to find a resolution with the national credit tenant. So on the one hand, you got the credit tenant leased. On the other hand, basically, the private developer from time to time, will give away the bundle of rights to that lease through that lease. And so we find it, having very, very few of them, it just absolutely turbocharges our small space tenant business model, which we love and where we've had the difficulties, a bit more of the larger space tenants, seeking out their approval to get another co-tenant. We did that, we now have 2 co-tenants. We're now putting in the TI, getting the parking arrangements. So we expect that in both locations -- and it was the same tenant in both Arizona and Texas. Now, both locations, we expect those to really start to hum fairly well.

[David K. Holeman:]

I might just add one thing our leasing spreads for the quarter, Paul. We did have the one large tenant that had a fairly large rate reduction. If you exclude that tenant, that lease, primarily small base tenants, and those tenants would have been about a 4.2% straight-line increase in our spreads from the old tenant to the new or renewed tenants. So we're seeing fairly healthy renewal rates and spreads on our small base tenants.

[Operator:]

We'll go next to Mitch Germain with JMP Securities.

[Mitchell B. Germain:]

Jim, just curious. I know you mentioned deals coming out of financial distress. I'm curious if the pipeline of deals that remain in distress are as significant? Kind of -- are you still seeing those sort of transactions materialize?

[James C. Mastandrea:]

We're not seeing as many, Mitch, that's a good question. What we're seeing is some of the deals that 4 or 5 years ago, they were restructured to pretend that they were okay. And they haven't really -- the occupancy levels haven't picked up nor has the redevelopment or repositioning of property has picked up. So we're picking a couple of those, but that's where they're becoming fewer is that there are more people now who are getting low-rate financing, that are also coming in. We had a basket filled with TIC deals that now are starting to -- they're many -- there are more alternatives available because of the low rate financing and you're seeing more tenants come into the market. We are seeing more tenants coming into both -- into all of our marketplaces. So we're not seeing quite as many of the deals and it's sort of where we are in the cycle. Where they have an opportunity to look at particularly in Houston is in the development cycle is really exploding in this marketplace and it's not a good time to be buying land to develop because land prices are reaching all-time high. But some of the properties that we have to redevelopment -- and we're not talking about major redevelopment, we're talking about the bite-size deals that we like to do, that we have properties now that we can fit in that virtually have little or no land cost, so we can -- and we have a lot of development experience in-house, that we could actually put some properties onstream and flow into our -- they'll feed right into our cash flow sometime late next year. So we're seeing at that point in the cycle that you're seeing it. You're also seeing things like where you can tell where the cycle's topping out. We're starting to see, in Phoenix for example, office space being condominium-ized again. When you see those indicators, you find that the marketplace is starting to get a little bit heated up. The other thing that we watch as we watch housing starts, and we're watching a change in the housing starts now, where some of the builders are building houses that are rentable as opposed to just building family-style houses. So that's one that we're watching because the rental market is appealing both to the single-family homes and rentals. So we're seeing fewer deals but yet a little more accretive but we're in good markets. And our size deals, we're not seeing as much competition as there are for the megadeals like the $100 million, $200 million type deals.

[Mitchell B. Germain:]

And then next question, just curious, how much more of a runway do you have in Phoenix? And when you look at the pipeline of deals under consideration, well, I think you referenced 1 25 or so that was in various stages of negotiation. Is that all kind of Phoenix in the surrounding markets or is any of that kind of back into Texas or other markets?

[James C. Mastandrea:]

Yes, we think 2, 3 deals more in Phoenix, at least the ones that we've been doing the negotiations on. We've got a couple deals in Dallas that we like, we have a couple deals in San Antonio we like, and we have a couple of markets that we've talked about in the past we have started looking for deals. So I think for now, the runway in Phoenix for us is the kind of -- the way we buy properties, the way we operate properties, I think we're seeing the end of that runway for a while. unless something really comes to us that's spectacular. Just let me remind you, the kind of deals we buy don't rely on inflation to get a return on investment. We like to buy things that are either under-leased or they haven't really capitalized on the full intrinsic value. So that when we come in and add our business model to it, we can get it up into the double-digit range, so that -- and then if we get inflation when it's fully occupied, we just lift up with the tailwind. So that's it -- that's what we're beginning to see in Phoenix. Houston still has a ways to go yet on that. It's just a matter of getting the right land parcels on your [ph] position.

[Operator:]

[Operator Instructions] And we'll go next to Jonathan Pong with Robert W. Baird.

[Jonathan Pong:]

When you talk about selling lower-growth properties as part of your recycling efforts, are you solely talking about lower-quality assets in non-core submarkets or could you conceivably take a stabilized asset in the core market and sell it to demonstrate the embedded value in the portfolio, particularly I guess, given the speed by which it sounds like, you've recycled that capital.

[James C. Mastandrea:]

Good question, and the real question though underlying that would be when does the property stabilize? So there's really 2 phases in terms of when it does stabilize. The first is to bring occupancy up. And usually, you bring the occupancy up with a lower rent. So if you look at the occupancy stabilization, that's one phase of it. And then the second phase of it is it to increase the rents to where the market really should be for those rents. So in many of the properties we have where they're starting to stabilize is on the occupancy level yet, but it's not quite at the rent level where we'd like to see it. There's a lot of value to extract out of somebody's properties, particularly when replacement cost is north of $300, say, in Phoenix and even north of $300 in Houston. And we're starting to see some deals turn at about $600 in terms of replacement cost or in terms of cost per square foot. So we still think there's some time to pull some value out of our assets. And a good comparison is that -- look at your replacement cost in the cycle and then look at your income approach to value and see how close they are apart.

[David K. Holeman:]

I might just add to that, that we're very analytical in our approach to our assets, Jonathan. As you know, we look at each asset, we look at the expected rental rates versus the market, we look at the growth rate and then we look at just sources and uses of funds and look at it very much just like you'd look at a stock portfolio and if there are assets, we feel like that have kind of are at the top of their value that we can redeploy the proceeds, we'll do that. So you'll see us continue to look at our assets over the coming years and when we feel like we have a better use of proceeds, look to redeploy those.

[James C. Mastandrea:]

Jonathan, I'll give you Whitestone-isms and that is that we never fall in love with our assets, any of them, and we've never seen an award-winning property that made money.

[Jonathan Pong:]

Point taken. And then I guess one other question. When you think about your ROI-driven repositioning-related spend in 2014, it sounds like it's again, going to be a decently capital-intensive process. And I guess 2 questions from that. First, if you can share maybe, the materiality of that spend on a range basis for 2014, and then if you can speak as to whether there's any flexibility to pare that down depending on the speed of the capital markets and the lease-up performance for the rest of the operating portfolio.

[James C. Mastandrea:]

Yes, I think when you look at capital intensive, a better way for -- at least the way we look at it internally is that we're an investment company. I mean, that's what we are. We invest in real estate. So when you think about capital intensity, we're really saying we're investing in our own property. So we think the more [ph] is investing. So we put $1 in, we want to get $1.15 out, so where we analyze this with that investment can be. We separate by the way internally, the difference between an investment in property and speculating in a property. When we invest in a property, which is what we do, we look to make sure we always get our capital back. And then we look for a return on that anywhere in the double digits from 10% to 25%. Speculating is where you'd really be buying a piece of ground and you'd be speculating that you get a certain kind of zoning that would add value, maybe 25% to 35%. And we find it that in this business model, we don't really want to speculate. You're not going to see us speculating on assets in this company where we put any of the investors at risk. And that part drives where our dividend is. We pay a coupon that's right now, north of 8%. Well, the reason we can do that is because we operate so efficiently entirely. And when we operate efficiently with things like our compensation to management, we keep it in the low 25% quartile, and we incentivize with driving FFO and to a per share driven model. So we like to keep ourselves really efficient and operate, so that we can give the shareholders the types of returns they're looking for. And just one final thing I'll add to that is we have -- and we hope we can continue this, we like to keep one class of stock. And so by having one class of stock, our investors can really look at it and understand what they own. And then we don't dilute any of this by taking joint ventures or any other partnerships in any of our assets. So if an investor looks at the company, they can say, hey, we own -- this is what we own and this company owns 100% of it. So we try to be extraordinarily efficient in terms of the capital allocations and what we see it coming up in 2014. If you had to put a bracket around it, in terms of whatever you see in development, we'd never see that number at least, this time, exceeding 20% of the asset base. So we're at a $500 million or $600 million asset base, you'd never see us exceeding $100 million in development, you might see under 5%. So we practice these guidelines internally. Sorry for the long answer. Dave, you want add anything?

[Jonathan Pong:]

Maybe another way of asking the question is maybe if you think about AFFO dividend coverage, is there a line of thinking where maybe you'd stabilize your recurring cash flow to get to the point where that's fully covered and then maybe embark on these more offense-driven types of projects, if you will?

[David K. Holeman:]

Yes, I think that's a good question, Jonathan. We are obviously, very focused on driving FFO and AFFO per share. I think we've talked about the intrinsic value in the properties we've acquired in Phoenix and then throughout the portfolio. So I think you'll see us very focused on driving operations, driving rental rates, driving occupancy, driving all the things that really push that AFFO per share up. But then you'll also see us in the markets we're in, taking advantage of the cycle and the timing, and I think we've acquired some nice land parcels along with our acquisitions that have opportunities to add a small amount of GLA pass-bys [ph] that are really not speculative but are -- that are adds that will be -- have income-producing tenants very quickly. So I think we're going to tell you we're going to be focused on both. We're very focused on driving and producing the value from the properties we've acquired. We're very focused on acquiring new assets, still, that we think are very attractive. And then we'll look to do select development and redevelopment that drives that per share data as well.

[James C. Mastandrea:]

And Jonathan, we like to be tested by you all out there, which is healthy, we think, is do we do what we say we're going to do. And at the beginning of year, we said we planned on being at or covering our dividends by the third quarter of this year. Now a lot of our riders would say it wouldn't be until next year. And we said if we didn't cover it by the end of the third quarter, we would look at our dividend policy. And hopefully, you'll look at the company and how we've performed and you'd be able to see that we do, do what we say we're going to do. And that's really the test that we like to pass with you all.

[Operator:]

We'll go next to Carol Kemple with Hilliard Lyons.

[Carol L. Kemple:]

I guess following up on Jonathan's question, is the board still comfortable with the dividend?

[David K. Holeman:]

I think we very much look at the drivers. We feel like there is a tremendous amount of value embedded in the portfolio. We continue to remain very confident in our ability to extract that. We look at our current level, we look at all those drivers and feel like there is sufficient value adders to that FFO and AFFO per share to cover the dividend. So the answer to that is nothing's changed. We think we've seen our debt cost come down this year, which contributes to our operating results. We have a great pipeline of tenants which we expect to take occupancy in the fourth quarter. So I think the things we've said in the past as far as the ways that we continue to push that AFFO and FFO per share still exists and are stronger. So I would answer that with I think we're very confident in our ability to continue to drive our per share results and to drive those to an accretive level to where we are today.

[James C. Mastandrea:]

And Carol, I'd add to that, that the -- from a board perspective, that they are comfortable with the dividend level and if I can just remind you all that we have been paying that dividend quarterly since we did our IPO 3 years ago. And it's just a very, very efficient operation we have to be able to do that, and we're quite comfortable. Now the market hasn't represented what the price might be in that, but we're okay with that. Because again, we're still a small-cap company and we do what we say we're going to do. And eventually, you're going to see that price will lift according to where the dividend should be and see us as a relatively lower-risk company than we're being ascribed in the marketplace. So it's just a matter of risk and return, and we don't really focus -- we focus on the real estate side of the business and how we can really create value in this business, and I think we do a really good job at creating value. So the price will reflect that in time.

[Carol L. Kemple:]

Okay. Well then, this quarter, why did you all start adding the noncash share-based compensation back for core FFO?

[David K. Holeman:]

I think it's really for comparability purposes, Carol. If you really look at the operations and how we're performing, if you don't add that back, it makes it difficult to do period to period comparison. The compensation expense that's recorded this quarter is just in amortization, so it's an accounting of the cost of that, it's from shares that have been granted over the last 5 years, and it's just a little bit lumpy and it really affects comparability period over period. It's noncash. So we felt like really, for investors to truly look at the performance, it was more meaningful to exclude that and to have an FFO from FFO Core.

[Carol L. Kemple:]

Okay. And then the $35 million asset that you all have under contract, do you expect to close on that by year end?

[James C. Mastandrea:]

Yes. We should have, we think, a sign off on that by next week and it's been under contract for a long time. And part of the problem is that it's in the CMBS pool. And so when you're buying something out of CMBS pool that was basically a property that was short sold into the pool with an A and B note and has all kinds of complexities. So it required us to go back to just the bank servicing it and the special servicer and then it had to be -- each of the pieces have to be negotiated. We think we have that concluded now and if they come back with the right answers, then we can see that closing in probably a couple of weeks.

[Operator:]

[Operator Instructions] We'll go next to Craig Kucera with Wunderlich Investments.

[Craig Kucera:]

I have a question about the tenancy disagreement that you now have. Should that more or less flow through to your bottom line next year or will there be a lot of expenses affiliated with that?

[James C. Mastandrea:]

Good question, Craig.

[David K. Holeman:]

Absolutely. That dispute was a tenant that'd been under dispute for last year. And as a result, we really have booked very little revenue from that tenant and then also been prohibited from bringing in other tenants into the center. So what the settlement will do will drive about $850,000 of revenue, which will drop directly to FFO in 2014, about $1.1 million in 2015 that will do the same. So there really are no expenses associated with that, they're just revenue and rent from 2 new tenants and then bringing the tenant we had the dispute with back to market rates. So that will fully impact FFO.

[Craig Kucera:]

Great and can you discuss -- there were a couple of assets you had this quarter that had some pretty meaningful drops in occupancy, and I think one was maybe Lion Square in Houston and another one was a Dallas office. Can you give us some color on was it just 1 tenant that moved out or is there any story there?

[David K. Holeman:]

Yes, I'll touch on -- Jim and I will try both touching on Lion Square first. The Lion Square is an Asian-themed property located in the Chinatown area in Houston, it's one of the properties that we are currently repositioning. So there is a 22,000 square-foot space available in that property that we're currently talking to several prospective tenants. But there was a tenant we moved out during the quarter as part of that repositioning and really to add value to the property, that's Lion Square. In Dallas, in our LBJ Property in Dallas, we also had a similar story were there was a tenant that was about 10,000 square feet that moved out during the quarter. We're in the process of re-tenanting that building as well and doing some work there. So both of those were kind of repositioning related.

[Craig Kucera:]

Okay. And with your tenant improvements for the quarter, was any of that related to the co-tenancy this year or was it focused on any particular asset?

[David K. Holeman:]

Are you talking about the tenant improvement dollars?

[Unknown Analyst:]

Yes.

[David K. Holeman:]

Really spread across. We did have a couple large ones. We had one tenant in one of our Dallas office buildings that renewed and we -- it was a longer-term renewal that we spent I think -- I can't remember the exact amount but a large amount of dollars on the tenant improvement with that tenant. And then really, just spread. So none of that cost is related to the cotenancy dispute.

[Craig Kucera:]

So it sounds like it was a little bit -- I mean certainly, there was some asset concentration with that spend?

[David K. Holeman:]

I think so and I think even though that we had a lot of leasing activity this quarter, I've talked about we had about 150,000 square feet of leases that are expected to move in, in the fourth quarter. And so some of that is just related to the increased leasing activity, which hopefully, you'll see the results of in the coming quarters.

[Operator:]

And we'll take our final question from Josh Patinkin with BMO Capital Markets.

[Joshua Patinkin:]

So sticking with the leasing, I noticed that straight-line rent has come up recently. Is that just a function of the heightened activity and the younger lease vintage on average?

[David K. Holeman:]

Yes. So it is a function of the increase we've seen in leasing activity. So we've signed some new leases and you tend to -- in some of those leases, there might be 1 month or 2 of free rent, which obviously, impacts the straight-line rent balance sheet account. So it's really just the leasing activity, the newness of the leases. You'll see that turn obviously, as the leases start to age.

[Joshua Patinkin:]

So can I expect it to come down from about $0.5 million, where it was in the third quarter?

[David K. Holeman:]

I actually think you'll see it in the fourth quarter, we'll move in some new tenants, as we talked about, that will have some straight-line rent being booked at the early part of their lease. So I think you'll see that level stay there for a little while.

[Joshua Patinkin:]

Okay. And then on the leasing spreads, has that been targeted in any one of your geographies? Has there been more leasing activity in Phoenix as opposed to Texas markets?

[David K. Holeman:]

We've had really strong leasing activity in Phoenix, I'll tell you. So obviously we have a lot of our newer acquisitions in the Phoenix market and we've seen a lot of activity there, probably little more activity in the Phoenix market than we've seen in our Texas market. But we do have an active pipeline in the Texas market as well.

[Joshua Patinkin:]

Okay. And so can you break out in any way, where the leasing spreads are in Phoenix versus Texas? Is it significantly better in Phoenix or worse or how would you characterize it?

[David K. Holeman:]

I have not broken it out, but I could probably just give you my general sense in looking at the data was that it really, for the quarter, we had 1 large lease renewal that was in a pretty good drop in rate that was in our Texas market. So obviously, that affected the Texas market more. But they really did not see a significant difference between markets and spread. The assets we bought in Phoenix, we tend to have 5 properties that have been under stress and the lease rates have been reset. So I don't think I -- I don't have the exact answer with me, Josh, but my sense is that it was not a significant difference between our markets.

[James C. Mastandrea:]

Yes, Josh, let me just touch on it as well. What we are seeing is where we invest money into the properties, and we have -- we still have a number properties go through it and we do paint and lighting and maybe redirecting of traffic and things like that for our tenants. We're seeing their sales go up. For example, in 1 property in Phoenix, we redid it was called Fountain Square, Safeway sales went up 25% or 8%. In Terravita, where we redid that property, we saw Walgreens sales go up 25%. So wherever we've been able to reposition a property -- and we've just really started doing that much more ambitiously at the beginning of this year. Wherever we do that, we're able to reach for and get more rent because the tenants are -- they were able to experience that hey, we really care about our properties and we're really doing some things. We go -- if you ever get out and visit some of our properties, take a survey, tenants like to work with us. They will give comments like they are used to owners of property. The on-site property manager makes the tenant feel like they work for them. In our case, they usually like to say that they feel like we're partners and we really care about their business. Now there's a lag time behind when the tenants' businesses go up and when we can raise our rent. And we try to be out ahead of that 1 year before we start looking for lease rollovers. And I think you're going to see that continually to uptick itself as well.

[Joshua Patinkin:]

Okay. So you expect that the leasing spreads could improve as you kind of capture some of the embedded growth you've created for the portfolio?

[James C. Mastandrea:]

Yes, look for that and look for properties that we identified, that we're doing a redevelopment on and then look for the like -- when you're going to see those start to come up. And we can get as much as 25% increase in some cases with lease increases -- with leases increased and the rent rates.

[Operator:]

And this concludes today's question-and-answer session. I'd like to turn the conference back to today's presenters for any additional or closing remarks.

[James C. Mastandrea:]

Okay. Well, thank you all very much for calling in today. We hope that the new time was more agreeable to you all. And we look for your continued support and encouragement in the future, and we'll be planning an event either in Houston or in Phoenix up coming soon early in spring, hopefully. We'll get you out to try to show you some of the things we've been doing in the improvements of the properties. Thank you again, and with that, I will say conclusion to our call. Thank you.

[Operator:]

This does conclude today's conference. We thank you for your participation.