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Parkway Properties, Inc. (NYSE:PKY)

Q3 2008 Earnings Call

November 4, 2008 11:00 am ET

Executives

Steven G. Rogers –Chief Executive Officer

Mitchell Collins - Chief Financial Officer

William R. Flatt – Chief Operating Officer

James M. Ingram –Chief Investment Officer

Sarah P. Clark – Senior Vice President

Analysts

Michael Bilerman - Citi

Jordan Sadler - KeyBanc Capital Markets

Christopher Haley - Wachovia Securities

Napoleon Overton - Morgan Keegan

David Aubuchon - Robert W. Baird & Co.

Richard Anderson - BMO Capital Markets

Mitchell Germain – Banc of America Securities

Operator

Good day and welcome to the Parkway Properties third quarter earnings conference call. Today’s call is being recorded. With us today are the Chief Executive Officer, Mr. Steve Rogers, Chief Financial Officer, Mr. Mitch Collins, Chief Operating Officer, Mr. Will Flatt, Chief Investment Officer, Mr. Jim Ingram, and Senior Vice President, Ms. Sarah Clark.

At this time I’d like to turn the call over to Ms. Sarah Clark.

Sarah P. Clark

Good morning everyone and welcome to Parkway’s 2008 third quarter conference call. Before we get started with this morning’s presentation I’d like to direct you to our website at pky.com where you can click on the third quarter conference call icon and find a printable version of today’s slide presentation. On our website you will also find copies of yesterday’s press release and the supplemental information package for the third quarter, both of which include a reconciliation of non-GAAP measures that will be discussed today with our most directly comparable GAAP financial measure.

Certain statements contained in this presentation that are not in the present tense or that discuss the company’s expectations are forward-looking statements within the meaning of the Federal securities laws. Although the company believes that the expectations reflected in such forward-looking statements are based upon reasonable assumptions, it can give no assurance that its expectations will be achieved.

Please see the forward-looking statements disclaimer in Parkway’s press release for factors that could cause material differences between forward-looking statements and actual results.

I would now like to turn the call over to Steve.

Steven G. Rogers

Thanks, Sarah. The turmoil that we’ve been experiencing recently in the credit markets has caused us to see things we never expected to see or experience. Today’s conference call gives us an opportunity to tell you what’s going on with Parkway.

The market is currently pricing our stock at less than half of last quarter’s consensus NAV numbers. While it’s truly humbling to see your stock price fall 50%, it is gut-wrenching to see that number take place in thirty days.

I joined Parkway in 1983 and while I’ve seen lower stock prices, a lot lower, never have I witnessed such volatility and decline as seen recently. From 1990 to 1994 we witnessed a gradual decline in value that generally paralleled the decline in credit availability and unwillingness by investment banks to touch anything in real estate. There are many similarities today, but like all historical comparisons, there is no way to call this outcome precisely.

Valuations are more academic than anecdotal at this juncture with the sales we’ve seen in the last 30 days ranging widely from 6 to 19 caps. Most practitioners are watching balance sheets more than income statements and preservation of capital is the watchword of the day. In effect, investors want to make sure that companies they invest in will be here over the long term.

Now let’s take a look at the company’s balance sheet and credit availability. To remind everyone, we’re not developers, and at present we only have one unfulfilled capital commitment outside our normal operations. We’re developing an office building in Jackson, Mississippi, our hometown, that is 91% complete and 82% pre-leased on long term leases. The first customers should occupy their space before the end of this calendar year. The company has previously pre-funded its equity and has a $37.6 million non-recourse first mortgage that is being drawn as construction is completed.

Parkway is in good shape from a debt maturity standpoint with only $22 million of maturities in 2009. We’re in compliance with all of our debt covenants and have sufficient borrowing capacity under our line of credit. All of the re-financing needs in 2009 and 2010 can be met with existing availability on the line of credit. While we prefer to use insurance company non-recourse debt, we could take care of these obligations with our line if needed.

As everyone read last night, we announced a reduction in our dividend from an annualized rate of $2.60 to $1.30. While this was a difficult decision or me and our Board, we believe that this move is a responsible action given the current markets and credit conditions. Over the next year we are anticipating a slowdown in the US economy and are preparing for this through prudent management of our balance sheet and certain operating and G&A cost reductions. This decision to reduce the dividend, while tough over the short term, is due more to our belief that preserving capital during this time of uncertainty will benefit our shareholders over the long term once the market stabilizes.

Let me take a moment and outline some other things that entered into our thinking in making this decision and the amount we established. The current credit freeze – you read about it in the Wall Street Journal every day but our determination of a credit freeze is the company’s direct daily interaction with credit providers including line of credit participants, life companies, and their intermediaries.

The credit freeze is real as evidenced by some of the biggest, most well known life companies being completely out of the market. One of them recently remarked to us that this position is unprecedented, having never been out of the market for more than a few days previously.

Commercial banks are tightening terms and evidence from other companies going in for renewals confirm that these new terms are not friendly. Our line of credit does not mature until 2011 and we have paid down this facility nearly $80 million since the first quarter. The change in our dividend policy will offer greater flexibility with an additional $20 million in annual capacity.

Price of equity – yes, there is tons of private equity on the sidelines, but until it comes out on the playing field, it simply does not help. Very low stock prices make traditional offerings difficult and even with private equity, and even private equity is very nervous, making it difficult to equitize the balance sheet. We do not know how long this condition will persist so we want to be prepared.

Asset sales – while asset sales will be challenging in this environment, we will continue to pursue sales in certain markets. We still have about 10 assets left in the GEAR UP strategic disposition group, excluding Chicago, which total about $150 million to $200 million in gross value. For all of the reasons we have articulated in the past, we still think these assets make sense to sell.

What has changed is the credit freeze which we are all experiencing and the increase in the price of equity, both of which have slowed the pace of activity and moved prices down, making sales a lot tougher. In a tougher sales market you simply have fewer tools in the tool kit, so we will revert as needed to tried and true strategies such as putting debt on the properties in advance to facilitate a sale, syndicating the equity, and/or seller financing.

We should note that even in this tough market we sold three assets totaling $86 million last quarter, and my pledge to you is we will continue to pursue these asset sales when it makes sense. Our response to the above is simple – be prudent during times of economic uncertainty and stick to the knitting by focusing on what’s important.

First, put action plans in place to manage through the downturn by holding our embedded rent growth on our existing rent roll as much as possible. Second, employ certain cost saving strategies that are least intrusive to customer service and retention. This would include G&A savings as well as operating savings that included aggressively challenging ad valorem taxes and to her non-service oriented vendors such as energy providers.

Once the market stabilizes, Parkway will come out a stronger company with our greatest asset yet to be monetized. Our $750 million discretionary fund with teacher retirement system of Texas. The pain that all real estate owners are feeling in cap rate expansion today will be more accretive to Parkway on the back side as this situation as Texas teachers is fully deployed.

We will exercise discipline on the investment front. This means we may not make any investments in 2009 which our partner is perfectly content to do. When we do, it should be highly accretive to Texas and Parkway.

In summary, our actions are simple and straightforward. Decrease the dividend 50% to preserve capital to be slightly north of our taxable income. Delay new investment until there’s further clarity in values as well as capital availability to the industry. The Texas teacher’s fund allows us up to four years from the May investment date to be made. Reduce expenses at the corporate and property level. We run a pretty lean company but there’s always room for improvement and we will improve. Exercise care with the balance sheet, pursuing select strategic asset sales previously announced in GEAR UP. Watch for opportunities, being ever mindful that real money is made when times are tough and people are scared.

I trust that these actions will help prepare us for economic uncertainty and make a better Parkway over the long term. At our December 11 earnings outlook conference call, you will see we are not only respectful of a slowdown but equally cognizant of its potential duration.

With that, I’d now like to turn the call over to Will for an operations update.

William R. Flatt

Thank you, Steve. Our third quarter performance has remained stable across a wide spectrum of metrics. Our portfolio of occupancy stands at 90.4% which is down 90 basis points from last quarter primarily due to asset sales and a large lease termination. 40 basis points of this decline is attributable to the three properties that were sold during the quarter that had an average occupancy of 98.3% and another 30 basis points reflect the early termination of Seven Worldwide in Chicago for 45,000 square feet. This lease was scheduled to expire in September of 2009. The early termination resulted in the recognition of a lease termination fee during the quarter of $1.9 million and allowed Parkway to proactively redesign and market the space for re-lease of which about 25% has been completed.

I was pleased with the leasing velocity in the third quarter. We completed 161,000 square feet of new leasing at an average rate of $22.02 and at a cost of $3.56 per square foot per year. Additionally we completed 448,000 square feet of renewal or expansion leasing at an average rate of $21.51 or a 4.3% increase over the in place rent and at an average cost of $1.80 per square foot per year.

As seen on page 14 of the web presentation, the weighted average NPV per square foot of all leases assigned during the quarter using a 9% discount rate is 771 which continues to show an overall upward trend. The embedded growth of the portfolio continues to be converted into actual leases as shown by an increase in average same-store rent of 2.5% to $22.24.

Notably, rent activity this quarter includes a three year extension with DHL in Houston for 99,000 square feet, a renewal and expansion with Steinmark for 107,000 square feet in Jacksonville, and a 31,000 square foot new lease of Bonneville in Phoenix. Customer retention for the quarter was 67% and 72% for the year-to-date.

It’s important to note that TI and Leasing commissions that served as deduction of FAD this quarter included the completion of TI projects from previous quarters but we expected these to occur this quarter based on what we’d originally budgeted from 2007 and actually came in ahead of that budget.

Since October 1, commerce has continued. Thus far in the fourth quarter we have signed 197,000 square feet of renewals and 51,000 square feet of new and expansion leasing including a 16,000 square foot expansion of Cox Communications signed last Friday in Atlanta.

A portion of this leasing is captured in the leasing status report shown in the supplemental package with the list of leases that have been signed but have not yet occupied the space and will commence paying rent in the next three quarters. As of October 10, the date of the published report, this percentage was 91.2% rolling forward to yesterday which includes all leasing for the fourth quarter, this number is 91.5%.

We now expect to end 2008 with an in place occupancy of 90.6%. While leasing continues to occur, leases are taking longer to complete, requiring more levels of approval in the customer’s organization, and in some cases, being haltered until there is further clarity in the market. In isolated instances we are seeing sublease alternatives as being used as comparable to negotiations.

We monitor our customers for signs of actual distress in their payment history as well as for other indications such as personnel reductions, trouble with other vendors, and negative published reports. Most of our customers are doing the same thing that we are doing – watching costs carefully and adjusting their business plans to reflect current near term expectations.

The embedded growth in our portfolio stands at $1.14 per square foot. This is a decline of $0.20 per square foot from the previous quarter due to asset sales and an increase in average in place rental rates from conversion of pro forma embedded growth and actual leases. These items attributed $0.08 and $0.13 per square foot respectively to the decline.

Same-store average rents for the quarter increased 2.5% to $22.24 per square foot as compared to the third quarter of 2007 and 2.7% to $22.13 for the first nine months of 2008 as compared to 2007. Same-store average occupancy was flat at 91.1% for both the third quarter 2008 and 2007 and 90.6% for both the 2008 and 2007 year-to-date.

Parkway’s share of same-store NOI in third quarter increased 4.9% compared to third quarter 2007 on a GAAP basis and 4.2% on a cash basis. For the nine month period, Parkway’s share of same-store NOI increased 1.5% on a GAAP basis and 1.7% on a cash basis.

Same-store revenue includes a lease termination fee of $2.3 million for the quarter which is primarily the Seven Worldwide early termination that was mentioned earlier as well as increases in same-store average rental rates discussed above. Excluding termination fees, straight line rent and amortization of above market rent, same-store revenue increased 4.6%.

Average same-store expenses increased $3.5 million for the quarter, with the largest increases coming at ad valorem taxes of approximately $1.6 million and increase in bad debt expense of approximately $450,000 and an increase in utility costs of $410,000. It also includes $640,000 in one time repair and clean up costs related to Hurricane Ike in Houston.

I would like to take a brief moment to recognize our Houston team and the volunteers from many areas of our companies who came to assist with the Hurricane Ike efforts. Their dedication and hard work on behalf of the customers and the shareholders was truly remarkable.

We will be providing a 2009 earnings outlook in December but I’ll make a brief commentary on what we can expect. Clearly the playing field has changed and we will respond accordingly with the operations of the company. We will do this by focusing on realizing the embedded growth for the existing rent roll, managing through the downturn by reducing operating expenses that are least disruptive to customer service, acting on the distress of other building owners to capture leasing opportunities, use opportunities for existing lease restructuring to lengthen leases, minimize capital and subsidize new leasing, and aggressively keep collections current.

These actions, combined with our leasing velocity in the last half of 2008 and recent realized rental rate increases will help mitigate the effect of any general economic slowdown in 2007. In addition we have 1.8 million square feet of lease expirations in 2009, consistent with prior history, of which 1.2 million relates to our wholly owned portfolio. The majority of this roll occurs in the latter half of 2009 with no single lease greater than 32,000 square feet expiring before August.

I’d now like to turn it to Mitch for an update on the financials.

Mitchell Collins

Thanks, Will. The capital preservation is on the forefront of everyone’s mind today. I will begin by discussing our long term debt and line of credit. As we announced yesterday, we have exercised our option to extend our line of credit, resulting in $296 million of our $311 million line capacity now maturing in 2011. At quarter end, the company owed $180 million related to our line of credit down from $258 million in the first quarter of 2008. The company is in compliance with all loan covenants. Our interest coverage improved during the quarter to 2.5 times as compared to 2.36 times for the second quarter of 2008, and a fixed charge coverage improved to 1.83 times as compared to 1.73 times in the second quarter.

As Steve mentioned earlier, our balance sheet is in good shape from a debt maturity perspective. We have refinanced all of our 2008 maturities and have only $22 million in maturing debt in 2009 and $126 million in 2010 for a total of $148 million over the next two years. Of the $126 million maturing in 2010, we have a $60 million loan on our Capital City Plaza assets in Atlanta that has a one year extension option at our discretion.

Assuming that we extend our $60 million loan on Capital City Plaza mortgage in 2010, our estimated maturities for the next two years are expected to be approximately $88 million. Our line of credit capacity stands today at approximately $130 million. What does this mean to Parkway? Our plans obviously are to refinance these assets as the credit market stabilize over the next several years but acknowledge that we do have sufficient line capacity to add these maturing mortgages to our unencumbered asset pool should the markets turn for the worse. 80% of the maturing mortgages are in the cities of Houston, Atlanta and Phoenix and these assets are currently 91.7% leased.

We have a residual $15 million of line capacity that matures in early 2009 and we are currently in discussions with this lender about extending the line and believe based on these discussions that it will be extended. Note that this $15 million line does not change the company’s overall leverage or borrowing capacity. Instead, it will simply reduce the company’s line capacity from the $130 million discussed above to $115 million, still giving the company sufficient capacity to handle its debt obligations over the next two years.

Now moving on to the operating results for this quarter, we achieved FFO for the diluted share of $0.92 which was in line with our revised forecast which was disclosed in our last call. During the third quarter, we incurred a $2.1 million debt prepayment penalty related to the sale and subsequent payoff of the mortgage on Capital City assets in Columbia, South Carolina.

As Will discussed earlier, this quarter we also recognized $2.4 million in lease termination fees and $640,000 related to repair and clean up costs in Houston following Hurricane Ike from which we expect to recover approximately 40% of these costs in related escalation incomes. Excluding these unusual and non-recurring items, Parkway achieved $0.94 in recurring FFO which also includes the sale of three assets during the quarter.

Please see our press release and website presentation for a detailed table of the unusual and non-recurring items impacting FFO for this quarter and year to date compared to 2007. We achieved $7.5 million for the three months ended September 30, 2008 versus $10.6 million in 2007. Included as reduction to our FAD was $5.5 million in custom improvements and leasing costs, nonrevenue generating capital expenditure of $1.2 million or $.10 per square foot for the third quarter.

As previously disclosed, we closed the sale of three assets in the third quarter for gross proceeds of $86.3 million and recorded total gains on a sale of $22.6 million. Net proceeds of $62.6 million were used to reduce the amount outstanding on our line of credit. These buildings were in non core markets and were 98.5% leased. Our team worked very hard to close these asset sales in a difficult environment. Additionally, the company will continue to target the asset dispositions in non core markets for optimal values for the next two years as part of our normal amount asset recycling program.

Moving on to our outlook we are reiterating our 2008 FFO outlook of $3.80 to $3.90 per diluted share. As noted last quarter, the three assets sold in the third quarter of 2008 will be approximately $0.25 diluted to 2008 FFO which includes $0.14 in debt free payment expenses and a reduction of core FFO. We are now projecting average occupancy for 2008 in the range of 90% to 91%. Please note that this guidance does not include any other asset sales or any asset acquisitions. We anticipate issuing our 2009 FFO outlook on December 11, consistent with prior year. At this time, we plan to provide our 2009 leasing expectations, planned G&A and operational savings and other operational strategies for the year.

With that, I’d like to turn the call back over to Steve.

Steven G. Rogers

These are unprecedented times in our economy and for Parkway and I want to assure you that we’re proactively managing the balance sheet, taking thoughtful measures to reduce cost, taking additional non-core assets to the market and looking at opportunities in this economic down turn. We continue to execute our plan and posture the company for the future which includes filling the $750 million discretionary fund with Texas Teachers as credit and investment markets allow. We still believe the U.S. economy is the most resilient on the planet and if given an adequate time, investors will see value in good real estate operators like Parkway. We will be happy to answer any questions you may have at this time.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Michael Bilerman - Citi.

Michael Bilerman - Citi

Will, what was the annual rent on the $45,000 square feet that terminated at quarter end? What was the timing of that termination?

William R. Flatt

The timing effective October 1 and I don’t have annual right in front of me, around $30 to $32 per square foot gross.

Michael Bilerman - Citi

When does the rent on the 25% of the square feet that you’ve already released, when does that come in?

William R. Flatt

It commenced 10/1. It’s not in the occupancy number, it’s actually a sub that we kept and so it’s not in the occupancy number, so it would be an additional 12,000 square feet that will show up in November 1 occupancy or in our next reported occupancy. It commenced October 1.

Michael Bilerman - Citi

Are there any other large lease term fees or one time items that you expect in the fourth quarter?

William R. Flatt

Not currently, no.

Michael Bilerman - Citi

Okay, I’m just trying to reconcile what kind of gets you to the high end of your range if you take the $0.95 run rate today and adjust it for this lost rent and your fourth quarter guidance is at around $0.90 to $1.00. Is there something in particular that can get you to the high end?

William R. Flatt

We’re just giving a guidance and it’s still inside those two numbers.

Operator

Your next question comes from Jordan Sadler - KeyBanc Capital Markets.

Jordan Sadler - KeyBanc Capital Markets

Just wanted to clarify something, Steve you used to refer to, I think you used to say, how much 100 basis points of occupancy is equivalent to an FFO, can you remind me of that stat?

Steven G. Rogers

It’s about a dime.

Jordan Sadler - KeyBanc Capital Markets

It’s about a dime, and so you lowered your average occupancy for 2008, your expectation by 100 basis points at the midpoint and so does that mean effectively you lowered what’s expected from the core by a dime?

Steven G. Rogers

No. There’s just too many other matters in there, Jordan, I mean occupancy is one matter, embedded growth is another matter things like that, interest expense, moves up and down. We’ve moved up real violently and then October we moved down violently here. When you take all things into account and recast your budget for the balance of the year, we were inside the dime range given and we sort of just left it alone. We figured everybody is looking more to 2009 and balance sheet items anyway so we just didn’t dwell on the small fractural move inside that range.

Jordan Sadler - KeyBanc Capital Markets

I’m not trying to focus on something that’s meaningless or be nitpicky here. The obvious offset to me is you had net fee income of $0.11 a share this quarter that nobody knew about.

Steven G. Rogers

We didn’t either.

Jordan Sadler - KeyBanc Capital Markets

Right, I understand. What I’m driving at is the occupancy expectations or occupancy seems to be slipping and I’m wondering if that is a trajectory that we should continue to anticipate as we do look forward to 2009.

Steven G. Rogers

I’ll take that. Again, I think there’s a lot of other folks commenting on what 2009 may or may not look like. Think as I said here today, there’s a reason why I usually don’t give a leaping velocity since October 1 what we’ve done. There still is commerce taking place and I think a big portion of what came out of occupancy is the termination of that large lease. There’s about 87,000 square feet of leasing that’s going to matriculate into the rent roll during the fourth quarter and that’s why I gave an occupancy number that’s actually off a little bit. Our crystal ball going into 2009 is clear to anybody, as fuzzy as anybody’s maybe these days. I’d say that there is still commerce getting done. I am encouraged by most of our roll that would possibly vacate a factor applied to it is in the latter part of the year and I think I wouldn’t at all read that as a trajectory.

Jordan Sadler - KeyBanc Capital Markets

You weren’t seeing tenants necessarily putting their leasing on hold immediately post September 30 or in the last 30 days or so?

Steven G. Rogers

Not yet and I’ll be frank that maybe it’s coming but there are still folks that are in the right part of the cycle. They’re kicking tires today. I thought at one point that maybe if some of this leasing was just momentum of folks that had already been in the process and we were just signing deals but we still continue to see the new look, people getting their first proposal out or their first tour, so there are still people both exiting the end of the leasing pipeline which culminates in a lease and beginning in the pipeline which starts at the first face tour, so it’s still there.

Jordan Sadler - KeyBanc Capital Markets

And that’s consistent throughout all your markets or are you seeing greater weakness anywhere?

Steven G. Rogers

I’d say that’s consistent throughout our markets.

Jordan Sadler - KeyBanc Capital Markets

Maybe for Mitch, just getting back to the line of credit, any restrictions from a borrowing base or covenant basis that we should be aware of, meaning do you have the full availability of the $130 million today or if you were to draw that one $130 million on a pro forma basis, would you end up bumping up against a borrowing base or covenant restriction?

Mitchell Collins

The $130 million is talking about the capacity of the lien, and that’s merely the $180 million versus the $311 million. The borrowing capacity of that is contingent on what you buy, the funding of Texas Teachers, adds to that capacity. You sell an asset, that takes away, so when we talked about the $130 million, that was more in line of talking about the debt maturity schedules out in ’09 and ’10. Our clear indication here is to go out and to seek first mortgage debt which is the traditional Parkway model and to not pull that into the line, but we were trying to give some color from a balance sheet perspective that absent that market existing on these maturing debts that we would have sufficient line capacity to move it into the unencumbered asset pool.

Steven G. Rogers

I would merely add too that it seems to be the question of the day that we receive mostly from equity investors in PKY and we want to be simply proactive in addressing it. There are still small life companies out there that are making loans today and we believe that Parkway being a good borrower with low leverage that they’re making non-recourse loans, we’ll be able to do it. But not everybody believes that. So really what we’re just trying to say is whether you believe it or not, we can still move it to the line if we have to, and that should give some degree of comfort, that there’s a Plan B even if Plan A is removed from us due to circumstances outside our control.

Jordan Sadler - KeyBanc Capital Markets

Just to boil down Mitch’s comments, I think Mitch, you’re saying if you were to pay down debt with the $130 million, you wouldn’t have an issue I guess from a covenant perspective, but if you were to buy new assets with it on an investing wholly, just using the $130 million to buy new assets with no additional debt, you might bump into some restrictions?

Mitchell Collins

Right, and that’s fair... what we’re saying today is it’s not dissimilar to what was said in the second quarter. We’re going to pay asset down, we’re going to create line capacity to come out front in Texas on the back end. If you look out counting this dividend reduction that we’re talking about, today we can go out, we will look out into the future, we’d be able to support over $300 million of the Texas fund today. So that’s kind of where we stand from a debt perspective. Not saying we would execute all that we talked about, looking at this, as cap rates settle into ’09, that’s where we stand today.

Jordan Sadler - KeyBanc Capital Markets

Last thing for Steve, Texas, we’ve had some commentary out of the media and other participants, I guess some of the pension funds are a little bit constrained in terms of liquidity, and I’m just curious about Texas Teachers commitment to fund too, and if they have the ability to sort of time or the funding of their commitment.

Steven G. Rogers

We know of no reason whatsoever that would give rise to them not funding on the fiduciary responsibilities that we both have to the fund. We have heard, I don’t even want to mention names, I’ve only heard of one or two pension funds in the United States of America that have had trouble funding and neither of those have actually refused to fund. They’ve delayed funding and I think they’ve been really isolated to specific coastal related markets that have been very distressed here in a very short period of time. That is not the situation with what Parkway invests in, of course as you know, we’re more middle America markets, nor is it really the profile of what Texas Teachers has done historically.

Jordan Sadler - KeyBanc Capital Markets

Steve, you said, when you were looking at this fund and talking about this fund, you might not invest anything in 2009 and I’m just curious from an investor’s perspective, what do you hope to see or what is it you’ll be looking for to gain increased confidence before you start putting some money to work through that fund.

Steven G. Rogers

Sure, I think that’s a good question. The first thing we’re going to need to se, Jordan, is that the credit freeze needs to fall. I’m going to be very specific how I’m going to define a credit freeze from falling. It’s real straightforward. It’s insurance companies are the ones that have to get back in the market with reasonably priced debt or the kind of stuff that we do, vanilla, principally leased office product, 85% to 90% in the mainstream, middle America markets of the United States.

That is going to be the principal thing that we’re going to be looking for. A lot of insurance companies have dropped by the wayside. Again, there’s still some commerce being done there, but we need to be able to have reasonably priced debt available to us and multiple options so that we can capitalize the partnership correctly. The second thing that we’re going to need to do is to make sure that asset pricing, that we’re comfortable with it and we just simply have pulled back right now.

I don’t mind telling you, I’m not embarrassed about it, and in fact, I feel like that’s where we ought to be and we’ve communicated with our partner very clearly. Jim Ingram and I talk to them often. I was in Austin two weeks ago on a routine visit and we sat down and discussed the capital markets. I think they were very... They’ll speak for themselves but I think they’re pleased with a partner that takes time out and says, “I don’t know if cap rates are 7 or 10 today” and I surely don’t want to be buying something at a 6.5 or 7 today if we think the market may have jumped up a bit, or a lot.

So we underwrote this at much lower cap rates and the good news is that as cap rates are going up and it’s clear they’ve moved up, the implied cap rates of the REIT industry moved up 200 or 300 basis points this month. Whether or not the private market kind of does that or not, it had moved up. You move it up 50 or 100 basis points per asset bought and the accretion to PKY and to Texas moves up pretty dramatically.

Operator

Your next question comes from Chris Haley with Wachovia.

Christopher Haley - Wachovia Securities

Your GEAR UP plan ends this quarter which is $7.18 in FAD per share. To get to that hurdle would be somewhere in the neighborhood of I guess $0.60 FAD or adjusted funds from operations for the fourth quarter. Do you note in your guidance that there is no impact, no assumed impact yet, of that $0.10 cost? Just to clarify that $0.10 cost would hit fourth quarter if you were to achieve that FAD per share?

Steven G. Rogers

Yes. What we did is, we still are too early to tell. As I’ve kind of been saying for the last couple of quarters, we’re in the bottom of the ninth inning and the ballgame is tied, and we’re just going to have to play this one out all the way to 12/31/08 and then do the accounting for it in January of ’09 and if there were any payment made under the GEAR UP plan, and I hate even sitting here talking about payments under any plans, I just simply want to outline to you that we felt like we better disclose if we did, then that’s the amount it would be, would be a dime. So that would be paid out in ’09 but it would be accrued for and run through the books in the fourth quarter of ’08.

Mitchell Collins

And let me give some color on this. This disclosure has been in our 10-Q, this is a three year plan and we’re not allowed to book this expense until it was deemed probable, and we’re still not saying it’s even probable, it’s going to be too close to call. So if it came through in the fourth quarter, it’s a non-cash charge. It would be the recording of some restricted stock expense that would vest and that is the amount that was quantified at the beginning of the plan three years ago, and that’s the amount that we would be required to book in the fourth quarter if we did hit the $7.18.

Christopher Haley - Wachovia Securities

The dividend cut of 50% is pretty significant and three years ago no one knew what was happening today would happen, and therefore setting aside this incentive pool, we on the outside might view it as, for lack of a better word, a little superfluous but recognizing your dividend cut and how severe you view what conditions we’re operating within, therefore it would appear to be most concern about people and retention, make sure you have the right cost structure, and therefore I don’t think you should be ashamed of delivering on that promise to your employees over the last two to three years.

Steven G. Rogers

I’m not, Chris, and if I gave that impression earlier, it just seems like it could be out of all the context that we’re talking about today, talking about extra pay just seems a little funny, so you’re right, we want to keep our good people here in the company. That’s most important to us, making sure that our customer retention is done, the dividend cut is done for what I call strategic reasons, it’s good capital preservation during an awkward time, so we’re fine with it. I’m just sort of focused on some other things right now to be honest with you. Big picture, it’s not going to change anybody’s life if you divide up 1 5 over a bunch of people in Parkway, 25 officers and so forth. Nobody’s lifestyle is going to be changed one way or the other because of it, that’s what I’m saying.

Christopher Haley - Wachovia Securities

We are currently expecting your FFO to decline in 2009 and the $3.50 to $3.70 range if I use my $0.90 run rate which is based upon a 90% to 91% occupancy rate, we’re assuming occupancies will decline in 2009. I think certainly this dividend cut should make folks wary that are currently holding $4.00 estimates for your company [inaudible] more cautious. I’m wondering, the dividend cut, is there anything else we need to read into what you think your cash flow potential will be, your pay FFO or FAD potential will be, in 2009 and 2010. Is there anything --

Steven G. Rogers

Back it up. My prior script on this thing, I addressed the matter, and all these guys made me take it out. I think that I wouldn’t read anything into it, Chris, and I can’t count for, I read your call note this morning, and it looked fine to me. I can’t account whether you’re right or wrong or close. I will say this, on December 11, we will give you detailed guidance as we always do in this company, and it will be very descriptive and supportable by not only what we’re doing in Parkway but what the capital markets and the external environment are allowing us to do.

Christopher Haley - Wachovia Securities

Last comment is a little bit more critical. You’re cutting the dividend in half. What does this say about what you guys have been doing for the last three years in terms of cash flow generated from investments if --

Steven G. Rogers

We covered the dividend in ’07 and I’ve covered it pretty close thus far in ’08 and that really has been more of the predominant metric for the prior three years. I mean, what’s taken place in October of 2008 has kind of emasculated what took place in ’06 and ’07. We can’t work on yesterday’s rules and people who do probably won’t be around for the next few conference calls to talk about it. We need to be playing with rules that are relevant to today’s new world order, and if credit is going to be the watch word, and companies are going to have to fight for less credit, then you need to take care of those obligations and that does not apply just to real estate operators, but it also applies to everyone, and so our watch word is just capital preservation, and it doesn’t make any commentary whatsoever about policy that we had in the old world order.

Mitchell Collins

My comment was in line with Steve’s. This is not FAD. The cutting of the dividend is more of the bucking the credit markets, looking at credit renewals, planning for the cycle to potentially get worse, hoping that it gets better, and I think we’re going to come out on the back side of this looking a lot smarter. There’s a natural arbitrage here between where we see FAD today and FFO today and on the back side, monetizing Texas Teachers and I think that probably went into our thinking as more of capital preservation, making sure we stay in control of our line and our discussions and our debt maturities, etc., and this to me is conservative and I think the management team will use it as a prudent thing to do right now.

Operator

Your next question comes from Nap Overton of Morgan Keegan.

Napoleon Overton - Morgan Keegan

Just to try to hone in a little bit more on the run rate, one of the simplistic things I’ve done in my mind here is to think there were two unusual items in the third quarter that you didn’t expect previously. One was the term fee, the other was the hurricane expense, and the net of those two is about a dime, and then your guidance remained unchanged for the year. Am I right in concluding from that little simple analysis that your fourth quarter kind of expectations are down about a dime operationally from where they had been?

Mitchell Collins

The net run rate of everything is $0.94 that we talked about, so we got $0.92 reported, Hurricane Ike affected us about $0.03. The term fees, debt prepayment, fixed expense was about $0.14 and then the lease term fee of about $0.15, so our run rate makes us with $0.94. I’m not sure you can say it’s all just operationally. Like we talked about before, interest expense goes into that calculation.

There are some operational things. We talked about ad valorem taxes. We talked about it in the second quarter, that the ad valorem and utility costs were coming up in both Steve’s and Will’s comments, we’re going to be aggressively fighting the ad valorem taxes and a lot of these guys are still basing their proposed tax bills on ’05 and ’06 numbers and we’re going to be aggressively taxing those on an appellate basis, so that’s sort of where it landed for the quarter, $0.94 recurring run rate.

Napoleon Overton - Morgan Keegan

Secondly you referred to a $1 million gain on involuntary conversion in Houston that you will expect to record. Does that get into FFO and when?

Mitchell Collins

Let me explain it a little bit. It’s unique in the sense it’s an accounting term called an involuntary conversion. What the literature requires you to do, it says basically go ahead and we’ve expensed all the repair and cleanup, that’s the $640,000 in the third quarter. Now literature tells you that you need to write off the net book value of your damaged asset and then you compare that to the proceeds you’re getting in from an insurance standpoint, and the net of that will be pushed to the income statement. In this case for us, it’s a $1 million gain. We have yet to fully determine whether or not that will or will not be in FFO because it is unique to that definition. It doesn’t follow the traditional definition of FFO but it is unique but the point of it is it’s not in our numbers. A, it’s going to take at least through the first quarter or second quarter to settle this with the insurance companies, and B, it would be non-recurring in nature, so we’re not spending a lot of time on it.

Napoleon Overton - Morgan Keegan

Okay, and then two more things. The capitalization rates that you’ve reported on the three asset sales varied widely. Could you remind us, are those cap rates on net operating income or are those cap rates on operating income after a reserve, how were those calculated?

Steven G. Rogers

They’re calculated on cash net operating income on a one year forward-looking basis. So the way the world kind of prices these assets now, is that they don’t give you as much credit as they used to for forward-looking, but they’ll take your in place income looking forward a year and then cap that, and by a year if you’ve got a rental rate that’s going up, then you’ll get credit for that. But you’re not going to get credit for pushing something up or lease up these days, and for that reason, that’s why we’ve taken assets to the market that are fully leased.

If you’ll look at this portfolio, it’s 98.5% leased, and it wasn’t actually a portfolio. In the old days it was but in 2007 and after going to the market with a couple of small portfolios in late ’07, we sort of realized that wasn’t working, so we broke up the portfolios into single assets, fully leased, partially leased. Put the partially leased back to the field, get them leased, and took the fully leased assets to the capital markets, and that’s precisely what we’re doing today.

Again, we’re going to be very prudent about this. We don’t want people to think we’ve lost our heads, but commerce is being conducted out there. There are sales taking place and we’re just going to go out. It doesn’t cost a dime for this company to go market and asset. Get a free option on a price, look at it, examine it very prudently. If it’s a good price we’ll know it, we’ll take it, and we’ll close, just like we did on these three assets.

Napoleon Overton - Morgan Keegan

Okay, but then for example the 7.9% capitalization rate you reported on the small Norfolk, Virginia asset sale. You don’t deduct any maintenance capital reserve --

Steven G. Rogers

No. It’s just cash NOI. Some people call that what you’re describing as an economic cap rate. We’ll take NOI of $1 million, subtract a recurring $100,000 of recurring CapEx and then they’ll cap $900,000. When people do that they typically cap it at a lower rate. So what we’re doing is kind of our standard definition. It’s on our website and been out for about 12 years. Really it’s a cash NOI looking forward one year.

Mitchell Collins

And it is reflective of an underwritten management fee.

Steven G. Rogers

Yes, we do throw a management fee in there of about 3%. Most people won’t give you credit for it today, it’s just a judgment call as to whether or not people will give you credit for it.

Napoleon Overton - Morgan Keegan

Then my last question, Mitch, you’ve talked around this, but your current most restrictive debt covenant and how close are you to that covenant?

Mitchell Collins

We’ve got three major covenants, and there’s a fixed charge, there’s an unencumbered interest charge, and then you’ve got a debt to asset test and we are in the terms of percents, we are out about 300 basis points, would give us borrowing capacity today of around $42 million and again that’s dependent on, as you buy into Texas, you’d be able to increase that like we talked about. It’s a natural increase in the borrowing line as you buy or sell assets, so that’s where we stand today. That is in line with where we were in the second quarter of ’08, one quarter. In compliance with all covenants and have the ability to cover all of the 2009 and 2010 debt expirations.

Operator

Your next question comes from Dave Aubuchon from Baird.

David Aubuchon - Robert W. Baird & Co.

Can you provide an update for your plans for syndication of Pinnacle and remind us kind of where your yield targets are on that development?

Steven G. Rogers

I’m looking out my window right now at a nearly finished Pinnacle. We expect to achieve a Certificate of Occupancy date in two dates. The real critical date for the go zone improvements that were spawned from the disaster of Hurricane Katrina are 12/31/08 which will be well inside that date, so that’s an important date, and that is why we’re syndicating it, because we cannot really use the massive tax benefits derived from the go zone. We’ll have about $24 million of depreciation in 2008 that will be generated from this for tax purposes and that would allow an investor, if they’re a passive investor, if they can use passive income to have kind of a mid-teens return.

So it’s an ample return to allow the investor to make a good investment here and it’s probably just what it takes in today’s world to make it work. We’re actively in the marketplace today, Dave. I don’t want to talk too much about it just to make sure that Walter Williams up the street at our big law firm doesn’t pick on me a little bit if I say something I’m not supposed to say, but we are making progress and subscriptions are being returned with checks.

David Aubuchon - Robert W. Baird & Co.

But relative to your original thought about how much of that asset you would keep?

Steven G. Rogers

Well we’re going out in the marketplace in the private placement memorandum for a 75% syndication and Parkway’s keeping 25% was our original expectation. We have not changed that.

David Aubuchon - Robert W. Baird & Co.

Okay, but if you don’t raise the required capital, you would --

Steven G. Rogers

We would keep it. It’s not our preference because of all the reasons articulated, the tax benefits are more valuable to the public than they are to us, and we can monetize the go zone benefit in the form of syndication and that’s our preference. But the world doesn’t come to an end if we don’t, we just have a very fine 100% owned asset that we’ll be pleased to continue on.

David Aubuchon - Robert W. Baird & Co.

So you’ve got to get the 75%, just so I understand it clearly, you have to get the 75% syndication for you to go forward with this deal?

Steven G. Rogers

It could go with a little less. Our goal is 75%. I think 50.1% would be the minimum and that would be the minimum threshold to make it work and we’re not at that point yet but we’re only a month into a three month syndication and usually the stuff comes pretty lumpy if I recall the last one we did on the IBM at River Oaks building. We went about six weeks with three or four subscriptions and then one gentleman bought 30 of them in one day and everybody else sort of fell in line and that hasn’t happened yet, but I kind of guess it would go that way.

David Aubuchon - Robert W. Baird & Co.

And then your anticipated yield, isn’t that in line with your pro forma? Can you --

Steven G. Rogers

It is, it’s about 15% to the investor. That’s really the kind of yield they’re looking for.

David Aubuchon - Robert W. Baird & Co.

Okay, and then to Parkway?

Steven G. Rogers

A lot higher than that because of the fees and things we derived on internal rate of return basis. It would be 20 something.

David Aubuchon - Robert W. Baird & Co.

Regarding the Texas Teachers fund, Babson, any conversations there lately? Are they still committed and are those terms negotiated or are they at risk to reprice the market?

Mitchell Collins

On the Babson side, right now they are not quoting and have been out of the market for probably five weeks, four and a half weeks. There clearly have been a partner of ours. They did 10 of our 13 assets in Fund I. We are seeing other quotes albeit few and far between and on very specific assets. I believe I have an analysis from HFF that they’ve only see three office deals in the last 60 to 90 days being done across the US and so to Steve’s points in his comments, insurance money right now at this juncture is more difficult to obtain. I’m sure as they come back into the market, we’ll be one of their first phone calls that they make, just given our alliance.

David Aubuchon - Robert W. Baird & Co.

Bad debt expense, million dollar run rates through the first three quarters of this year compared to a pretty nominal number last year. Do you anticipate that to continue at that pace or just kind of specific leases this year?

William R. Flatt

A lot of that occurred prior to the so called credit freeze. A lot of that was homebuilding related paying from last year and I think a big portion of that is our first NLC lease that we had in January that was directly related to the mortgage industry so again, I think that given the lease roll that we have and the in place rental rates, I think it’s going to be our probably biggest single risk to ’09 in the extent that the pain is felt in other customers and we have erosion to the revenue. I don’t have a run rate for you. I would say that I don’t see a trend in those. They’re isolated to very specific customers that wouldn’t surprise you, the large one being First NLC and I think that if we’re contained to those customers, I don’t see a larger trend of various industries or customers that we wouldn’t expect in that number but you should expect us to talk to you about it each quarter and ask about it and we’ll keep you updated.

David Aubuchon - Robert W. Baird & Co.

And then is your expectation right now your operating expense margin down this year versus last to continue that direction or it’s just related to your comment about being more aggressive in terms of clawing back some increased tax appraisals that you’re just going to try to be more aggressive on that area to help fight the lower operating margin going forward? I guess I’m looking for just, can you provide a range --

Steven G. Rogers

I think we’ve [inaudible] against our share count. I recognize that it can be lumpy in any one quarter but we’ve found pretty consistently between 51 to 53 depending on seasonality of the year and just any one time items, so I don’t see any change to that. I would say that going into 2009 I’m hopeful that we will get a break on energy expenses, it’s just with the price of natural gas coming down, which is a big portion of the marginal cost that energy companies have passed on to us, and so I would expect there is more directional pressure downward on expenses today if we can set aside ad valorem taxes for a minute, then upward pressure.

Operator

Your next question comes from Rich Anderson, BMO Capital.

Richard Anderson - BMO Capital Markets

Just doing some pretty impressive math here. You cut your dividend by 50% and that was a $20 million savings, that means you have $20 million of dividends still paying, and you said you were just north of your taxable net income, so I did this $20 million to roughly taxable net income for 2008, is that sort of a fair analysis?

Mitchell Collins

It’s a little lower than that but --

Richard Anderson - BMO Capital Markets

I just want to make sure I’m in the range, so when you think about 2009 and fewer disposition, maybe we’ll see but, your taxable net income probably trends down during 2009 with lower gains and lower rental income so are you open to keeping an eye on the dividend even during 2009 or do you think this will be enough for your capital needs?

Mitchell Collins

As many of the notes said this morning, a lot of people sort of looked at it as a “large increase” and I think the board probably took a lot of things into account, it’s not just a static snapshot of what took place in the credit market, it’s also a forward looking view of fourth quarter of 2008 and we very carefully looked through 2009 and beyond, the taxable income, FFO and FAD basis and I think all things considered set the dividend policy where we think is the best place for us to do, so I think we’re just fine where we are.

Richard Anderson - BMO Capital Markets

Would you characterize the board as being 100% behind this?

Mitchell Collins

Yes. There wasn’t a voice on the board that said we don’t want to do this?

William R. Flatt

No, the board is 100% behind, we don’t get board votes out on conference calls but we’re a unanimous voice on important things in the company and we’re very supportive of the activities that we’re undertaking today and we’re ready to get on with our future.

Richard Anderson - BMO Capital Markets

I think it’s the right decision, I’m just curious.

Mitchell Collins

That’s the conclusion they drew and we have good robust discussions in those rooms. The board is a very active, very capable group of men and women and have acted accordingly.

Richard Anderson - BMO Capital Markets

Okay, just another quick one, what form of G&A savings are we talking about?

William R. Flatt

Really a little of everything, as we sort of take a look at a condition like this, we want to be thoughtful and look at everything from do we have too many people in Jackson, do we have too heavy of operating expenses on utilities and all things kind of get thrown up and the board and said what can we do about improving, you know, we’re a frugal company and many of you guys are fine with me over the years when I go down to these conferences and everybody is staying at the Ritz Carlton and I stay in the Red Roof Inn a couple miles away and walk over and we’re going to continue to fly Southwest Airlines and stay in the Hampton Inns and maintain approval organization. I just think there’s always room for improvement and things like travel and conventions and maybe some recertification and I don’t want to steal all of our thunder from the December 11 call but I think we just look at everything very carefully, Rich and make sure that our company’s being as conservative as possible at a time like this.

Richard Anderson - BMO Capital Markets

You’re not cancelling my NAREIT meeting with you.

William R. Flatt

Well, it’s on the table for now and we might make Will drive up, if you can have it in Chicago, he can drive to Chicago instead of fly.

Operator

Your next question comes from Mitchell Germain – Banc of America Securities.

Mitchell Germain – Banc of America Securities

Will, it seems like you guys have had some solid leasing activity in the quarter or at least there’s still tenants out there based on your conversations, is new expansion tenant still out scouring for space or would you say that’s pretty much slowed down at this point?

William R. Flatt

They’re still out there, Mitch, again we’ll give you an up to date snapshot every quarter, so I’m not looking into the future, I’m just saying there are still customers who are across a wide spectrum of industries. We had a 1,200 foot lease in Virginia that was a breakaway financial guy that signed a new lease that left the firm; the government was still leasing in a couple cases, I think the lease signed this week for 16,000 feet with an expansion lease so there are still people moving. I think what we’re seeing probably, beginning to see some of is competition with sublease space that they’re bringing in for those new deals and I think for our particular product type is they’re steering clear or price sensitive on the super trophy class A and in some cases consolidating back into existing spaces that they had so we’re still seeing activity.

Mitchell Germain – Banc of America Securities

All the other questions I had have been answered.

Operator

That is all the time we have questions for.

William R. Flatt

Thank you operator, and thank you audience for listening to our call today. We’ll conclude that and we’ll get back on it. Thank you sir.

Operator

That concludes today’s conference.

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Source: Parkway Properties, Inc. Q3 2008 (Qtr End 09/30/08) Earnings Call Transcript
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