CapLease, Inc., Q3 2008 (Qtr End September 30, 2008) Earnings Call Transcript

CapLease, Inc (LSE)

Q3 2008 Earnings Call

November 6, 2008 10:00 am ET

Executives

Brad Cohen - Investor Relations/Media

Paul McDowell - Chairman and Chief Executive Officer

Shawn P. Seale - Senior Vice President and Chief Financial Officer

Analysts

Joshua Barber - Stifel Nicolaus & Company

Sheila Mcgrath - Keefe, Bruyette & Woods

Craig Mailman - Keybanc Capital Markets

Greg Schwartz - Citigroup

Richard Sloan

Presentation

Operator

Good morning ladies and gentlemen and welcome to the CapLease Incorporated Third Quarter ’08 Earnings Conference Call. (Operator Instructions)

It is now my pleasure to turn the call over to your host Mr. Brad Cohen, Investor Relations.

Brad Cohen

Today I would like to remind everyone that part of our discussion this morning will include guidance and other forward-looking statements and these statements are not guarantees of future performance and therefore undue reliance should not be placed on them. We refer all of you to CapLease’s third quarter 2008 earnings release and filings with the Securities and Exchange Commission for a more detailed discussion of important factors that could cause actual results to differ materially from those contained in the company’s forward-looking statements. The company disclaims any obligation to update its forward-looking statements.

Also during the call today the company will be discussing funds from operations or FFO and cash available for distribution or CAD, which are non-GAAP financial measures. Please see the company’s press release for a reconciliation of FFO and CAD to net income, the most directly comparable GAAP measure.

It is now my pleasure to turn the call over to CapLease’s Chairman and CEO Mr. Paul McDowell.

Paul McDowell

Good morning everyone. With me on the call today, as always, is my partner Shawn Seale who is our Chief Financial Officer.

This morning CapLease announced its results for the third quarter 2008 and they included FFO results of $0.26 per share in line with our prior guidance. Our high quality, $2.1 billion long-term portfolio with mostly match funded fixed-rate non-callable debt continues to perform as expected even in the midst of historic dislocations in the market.

I will not spend time on this call bemoaning the state of the credit and remarkets. We all know what’s going on. I will instead focus on CapLease and the things that distinguish us both today and over the long term: the credit quality of our portfolio and the stability of our balance sheet.

Since our founding in 1994 CapLease has always pursued a very conservative investment philosophy and we have the track record to prove it. True credit quality matters now more than ever and our focus on well located, high quality properties with long-term tenants, like the United States government, Nestle holdings and TJX Companies, our three largest tenants by investment value, provides us with a stable and predictable source of revenue, earnings, and cash flow. That portfolio is matched with a strong balance sheet with no near-term refinancing risk on our debt.

In April we successfully refinanced our only short-term borrowing facility. In doing so we replaced our warehouse line with a term facility that can be extended until the spring of 2011.

The strength of our portfolio continues to be demonstrated by the stability of our earnings and resulting cash available for distribution both on an absolute and per share basis. Our expectation is that our earnings and CAD will continue to be predictable throughout 2009 and beyond.

In light of continued difficulties in the credit markets we remain very focused on enhancing long-term shareholder value by preserving liquidity, reducing debt, and enhancing balance sheet stability. Although it is extremely difficult to make additions to the investment portfolio at this time, there are potentially attractive investment opportunities related to our own balance sheet. We are currently examining ways to reduce our outstanding debt, in some cases by pursing our debt obligations at a significant discount to par.

For now we would expect that our investment efforts for the remainder of the year and into 2009 will be directed towards debt reduction activities. As an example during the third quarter we opportunistically made a direct sale of $10 million of common stock to one of our largest stockholder, Inland American, to further bolster our balance sheet. This infusion of equity capital enabled us to pay down debt on our term loan facility and meaningfully reduce our overall borrowing cost on the line with an interest cost savings of approximately $1 million per year while reducing the outstanding balance to below $200 million. Overall, in the first nine months of 2008 we have reduced outstanding indebtedness by approximately $47 million.

Looking beyond the balance sheet, we continue to work closely with Inland and a variety of other market participants on a range of strategic opportunities, although all parties, including us, are proceeding very cautiously given market conditions. We have a powerful franchise at CapLease and we continue to remain in very close contact with key market participants as we constantly work to maintain our presence in the net lease sector. We will be very well positioned to both detract and deploy investment capital to further our growth when the market turns.

Before I turn the call over to Shawn, as I know it is of interest to some of you on this call, I would like to provide a brief update on our property in Johnston, Rode Island leased to the large insurance company FM Global. As a reminder, this property investment represents about 5% of our current portfolio on a revenue basis.

Through our legal actions we were successful during the third quarter in bringing our [succinct] concerns with the project, which relate primarily to potential traffic issues, before the town of Johnston Planning Board. The legal process, we hope, is beginning to wind down and we expect to be back before the Rhode Island Superior Court, which has retained jurisdiction of our claims, and who we hope will begin to drive the process to a reasonable solution on the traffic issue. I do want to be clear that despite some published reports to the contrary our legal efforts are not directed at blocking FM Global from constructing their building, but only at making sure that their new building does not negatively impact ours.

We also continue to move forward with our efforts to re-tenant the building at the conclusion of FM Global’s lease next summer and to our possible sale of the building. We have retained a leading commercial real estate broker in Providence, an architectural firm, and senior members of our team, including me, have been in Rhode Island recently meeting with state and Johnston Town officials about the property. We continue to believe there remain a range of possible outcomes in this matter and we hope to pursue a negotiated solution with FM Global prior to conclusion of their lease next summer.

I will now turn the call over to Shawn.

Shawn Seale

Today we reported FFO for the 2008 third quarter of $11.8 million or $0.26 per share. Our FFO included $600,000 or $0.01 per share of net non-cash charges. The net loss to common shareholders for the third quarter was $1.9 million or $0.04 per share. Total revenues for the quarter were $46.1 million. Our revenue and earnings met our guidance expectations and budget.

At quarter end our overall portfolio was over $2.1 billion in investment assets, about 78% of which are owned properties. Our diverse own property portfolio includes 63 properties across 26 states, leased to 34 different tenants, and exceeds 10 million square feet. The weighted average underlying Standard & Poor’s tenant credit rating on our entire portfolio is A- and on our own properties it is A. Our top ten tenant exposures aggregating about 50% of the total portfolio are all rated investment grade with an average credit rating of A+.

As Paul mentioned, 86% of our portfolio is financed with secured, fixed rate, non-callable, match-funded debt so we have no near-term refinance risk. Our bank term loan facility can be extended from the spring of 2010 for an additional 12 months until 2011 if we meet certain conditions. During 2009 we have only routine principal amortization on our debt, which is covered by the company’s operating cash flows.

During the third quarter we had $444,000 or $0.01 per share of non-cash hedge income representing hedge activity that was deemed ineffective under hedge accounting rules. Our hedge continues to perform operationally as expected. We have seen this accounting ineffectiveness before. As you may recall we had $2 million or $0.05 per share of primarily non-cash hedge charges in the first quarter of 2008.

As we have discussed in the past, our hedge activity is intended to manage our interest rate exposure on long-term debt we expect to issue on the assets currently financed on the term loan facility. We utilize hedge accounting and under the accounting rules the effective portion of the hedge is deferred on our balance sheet as a component of other comprehensive income until the anticipated debt is issued. Because credit market dislocations have resulted in delays in that anticipated debt issuance accounting hedge effectiveness tests have caused some material amounts of income or charges from the hedge activity to flow directly through our P&L.

If we continue to experience delays in our expected long-term debt issuance our existing hedge may no longer qualify for hedge accounting treatment. If that happens we would begin to report all of the hedge activity related to this expected debt issuance directly to the P&L rather than just a portion of it. As of September 30 the related hedge loss deferred in other comprehensive income was $10.3 million. This would have no impact on the economics of our swap nor on our operational strategy, but rather would largely be a simple change in how we report the hedge activity for financial reporting purposes. If we do make the change we will break out the hedge from our core results as we have done in the past.

At September 30 we had $1.7 billion in owned real property investments before depreciation and amortization, $288 million in loan investments, and $165 million in various net lease securities including CMBS.

As of today and after payment of our recent dividends we have approximately $15 million of cash and cash equivalents, $4.7 million of cash in the CDO pending reinvestment, and roughly $52 million available under the [TOW] facility for new investments. October is the low point for our cash position which then builds after that due to the semi-annual rent payments we receive from some of our tenants.

Let me provide a few words on our debt investment portfolio.

Our debt investments continue to perform well and we expect that to continue. The vast majority of our mortgage portfolio is made up of fully amortizing, first mortgage loans made either before or just after we went public. As of September 30, 2008 our loans had an average underlying tenant credit rating of BBB+ and on securities an average rating of BB+. We continue to believe that the value declines we have seen on these assets due to changes in market credit spreads are temporary as both the collateral continues to perform well and we intend to hold the assets for a sufficient time to allow for a full recovery in value.

Now let me discuss our guidance.

We are affirming our full year 2008 guidance. We estimate FFO to be in the range of $1.07 to $1.10 per share and earnings per share in the range of -$0.12 to -$0.09.

Our guidance for the fourth quarter of 2008 is FFO to be in the range of $0.25 to $0.26 per share and earnings per share to be in the range of -$0.04 to -$0.03.

Our guidance figures reflect no portfolio additions for the remainder of 2008 and exclude $2.4 million or about $0.05 per share of hedge and investment losses during 2008. Our guidance figures also reflect a variety of other assumptions discussed in today’s press release.

FFO includes a deduction for stock based compensation expense, which was $0.04 per share in 2007 and is estimated to be roughly $0.05 per share in 2008.

The straight-line rent adjustment for the third quarter was -$1.3 million as our straight-line rent accrual exceeded cash rents received. The total straight-line rent adjustment is expected to be about -$9.9 million for the fourth quarter of 2008 and -$6.1 million in total for all of 2008. In 2009 we expect the straight-line rent adjustment to be $1.6 million in total.

Finally, we recognize the current concern in the market about REIT balance sheet stability. CapLease has taken a defensive posture since mid-2007 and we have taken a series of steps to insulate our company, including raising a convertible and equity capital, migrating from repo to term debt, and paying down short-term borrowings. Those actions coupled with our stable investment grade portfolio leave us well positioned for 2009 and beyond. We will continue these efforts with the focus being on opportunistic debt reduction.

Although we are not prepared to give formal guidance for 2009 at this point, given market turmoil and our desire to be as transparent as we can, we do want to give you some perspective.

Assuming that we essentially freeze in place and maintain the company exactly as it is today and further assume no asset acquisitions or dispositions, no financing activity and FM Global moves out in July, our expectation for 2009 is that FFO and CAD should be more than $0.90 per share. These figures would be before any positive or negative charges if any.

I will now turn the call back over to Paul for some final comments before we open it up for questions.

Paul McDowell

The third quarter was another solid one for CapLease despite the continued historic dislocations in the market. Our portfolio of non-cancelable leased properties continued to produce positive cash flow and our results were in line with our guidance, expectations, and the budget.

We remain optimistic that our stable balance sheet with no near-term refinancing risk, combined with our long and successful track record in the single-tenant net-leased asset class will enable us to continue to attract capital to reduce debt and to reestablish portfolio growth when the market conditions stabilize.

We do not know when the market will improve, but all of us at CapLease remain committed to the enterprise and we will continue to operate the company assuming in the near to intermediate term that we will have limited if any access to external financing. Having no significant bullet maturities in 2009 certainly helps. That said, if market conditions ease where we are able to access capital on reasonable terms we will do so.

I will now open it up to any questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Joshua Barber with Stifel Nicolaus & Company.

Joshua Barber - Stifel Nicolaus & Company

I was just wondering if you guys could give a little more detail on the CMBS or loans might take a bigger impairment given the big widening that we’ve seen certainly this quarter and a little bit last quarter.

Paul McDowell

Shawn can maybe answer that question better than I can, but just to start off, you will see the widening in spread marks that is reflected in OCI as compared to the second quarter.

Joshua Barber - Stifel Nicolaus & Company

I am just meaning in terms of testing them for impairments, because the CMBS market has been pretty wide for about the last year.

Shawn Seale

Right, it is a little bit of a soft and uncertain area because there is some guidance from the SEC that has the length of time, you know, gets longer on securities being “under water”. There is more pressure to take impairments on them. On the other hand, it is our view that it really is illogical to take impairments on securities or loans where the underlying securities are performing perfectly. In other words you are getting exactly the cash flow you’re getting; there is no credit down grades etc…

Where in the past you have seen us take impairments it has been as a result of either a specific loan loss, some specific credit default, or a downgrade in the related security. If that continues than we would have impairments. I will acknowledge that there is some on going discussion among a lot of people in terms of what really constitutes the definition of other than temporary.

Joshua Barber - Stifel Nicolaus & Company

One other question, can you tell us how many loan and security maturities you have in 2009?

Paul McDowell

That’s easy. We have some loans coming due that will pay us back principle?

Joshua Barber - Stifel Nicolaus & Company

Yes.

Paul McDowell

I am not sure we have that broken out right in front of us right now, but it’s probably $15 to $20 million. With respect to principle payments we have no bullet maturities at all in 2009.

Joshua Barber - Stifel Nicolaus & Company

I was talking about your loan and CMBS portfolios. How many of those underlying loans and securities have some maturity pay offs in [inaudible].

Paul McDowell

I think it’s about two or three, with a total of, I’m not sure the exact number, but it’s between $20, $25 million.

Operator

Your next question comes from Sheila Mcgrath with Keefe, Bruyette & Woods.

Sheila Mcgrath - Keefe, Bruyette & Woods

Shawn, in the press release it says for the non-cash charges there was the hedge ineffectiveness. Would you explain that? Then it says $1 million of investment losses. Could you tell us what that is?

Shawn Seale

Yes, we had two losses: one related to a small development loan that we had and then another probably $300,000 or $350,000 was impairment on one of our investments.

Sheila Mcgrath - Keefe, Bruyette & Woods

Then on FM Global you did engage a broker to look at leasing or sale of the property. I was wondering if there was any update with regard to that.

Paul McDowell

Not a lot. Obviously the asset, we’re spending an intensive amount of management time, including myself. I was recently in Rhode Island meeting both with the architects and with our broker as well as development officials for the state of Rhode Island. The local officials in the town of Johnston were all sort of focused on trying to find the right type of user for the property to the extent that when FM Global moves out.

One of the variables that are outstanding right at the moment is that we are not exactly sure when FM Global’s building is going to be completed and how long a hold over period, if any, they may need for the property. We are hoping to have some type of negotiated solution with FM Global that would then give us clarity on when they are going to move out and would then help us on when we can get new tenants moved in, but we are actively marketing the property right now and looking for tenants.

Sheila Mcgrath - Keefe, Bruyette & Woods

So is it your sense that they will probably hold over beyond the lease expiration?

Paul McDowell

I don’t want to speculate to too much, because we are not obviously looking at their construction progress time line. It is the fall. The building has got a significant amount of time left to completion it looks like, from seeing it from the street. Then of course you have got the challenge of moving all of your personnel from one building to another; so I don’t know whether they are going to need to hold over or not. If they do we are happy to provide them with that capability and so we will have better color on that, I think, on the next call. To the extent that something comes up in the interim that is important we will, of course, make a public announcement and then talk to everyone about it.

Sheila Mcgrath - Keefe, Bruyette & Woods

Last question, can you give us the big picture on your thoughts on the dividend? Obviously you are covering the dividend currently, but a lot of REITs have cut their dividends just because it is such a capital-constrained environment. I’m just curious what your thoughts on that are.

Paul McDowell

Yes sure, I mean we hear the considerable discussions going on in the REIT universe regarding dividends. Capital preservation, balance sheet stability and the like. Just as we have done in the past quarters both the management team and our board will continue to have an on going dialogue about the dividend in light of market conditions and our outlook, all in keeping with maintaining a strong balance sheet and enhancing long-term shareholder value.

We know and recognize that many stockholders that invest in REIT do so for the income that the dividend provides. As you pointed out, Sheila, our dividend is well covered by traditional metrics such as FFO and CAD and that dividend coverage will continue in 2009. The good news is that our assets on the balance sheet produced stable and predictable returns. Those factors, of course, will be counter-balanced by ongoing expectations about access to capital and the opportunities we may be able to pursue either to continue to de-leverage the balance sheet or to grow the portfolio.

Operator

Your next question comes from Craig Mailman from Keybanc Capital Markets.

Craig Mailman - Keybanc Capital Markets

Just following up on the dividend question, is there any discussion about maybe just suspending the quarterly dividend and retaining that cash flow through out the year?

Paul McDowell

The board hasn’t made any decisions about the level of our dividend on a going forward basis. We have got significant input as a management team, but we are not going to box in the board on this call one way or the other. We are paying attention to the market environment, we are paying attention to access to capital and our needs for capital, and balance sheet stability, but we haven’t made a decision about the dividend at this point in time and so we are not able to say what we will or will not do.

Craig Mailman - Keybanc Capital Markets

Then you touched on it briefly in your prepared remarks, but is there any other color you can give us on the talks with Inland?

Paul McDowell

Not particularly. We remain close to Inland. They are our largest, if not our largest, very close to our largest shareholder. We continue to work with them on a variety of things. Obviously these market conditions that accelerated extremely rapidly in October have had an impact on everyone. So everyone is sort of taking a step back, proceeding very cautiously, and I would say that’s true for CapLease and it is true for Inland. So, that is about as much color as I can give you at the moment.

Craig Mailman - Keybanc Capital Markets

If something doesn’t come out of the talks do you guys have any other JV partners that you are still talking to?

Paul McDowell

We are extremely open-minded. We are continuing to talk to a variety of market participants, institutions, both outside of inland, so the answer is yes we are in conversations with people, but I wouldn’t want to characterize those conversations as advance or not advance at this point in time. But, we are open-minded to trying to find ways to access additional capital and continue to grow the enterprise and we will do so.

Craig Mailman - Keybanc Capital Markets

Are there any tenants on your watch list at this point?

Paul McDowell

Yes, I mean we pay enormous amount of attention to our tenants on an ongoing basis. Most of our tenants are large, Fortune 500 public companies, like TJX, like Nestlé’s, so we are able to monitor then very carefully. We have obviously got some concern about AmerCredit, as we have mentioned on past calls. We have some concern with respect to Cott, which is a very small property that we own. We keep an ongoing eye on that. We have an automated system that keeps us up to date on credit ratings and our analysts are constantly looking at them. Those are sort of the two key ones.

We were quite concerned about National City. We have a very small bank branch linked to National City, but now with the impending acquisition of National City I would say that one has been moved off of the watch list.

Craig Mailman - Keybanc Capital Markets

Then one quick question on the impairments was that specific to any CMVS trounce or was that one of your MEZ investments?

Shawn Seale

Yes that was actually related to the Cott property that Paul just mentioned and as a result of Cott’s credit weakening, in our view, and the status of us trying to sell the property, we took a small impairment on that property.

Operator

Your next question comes from Greg Schwartz from Citigroup.

Greg Schwartz – Citigroup

Are you still marketing the [loads] asset in California?

Paul McDowell

We are. That asset is a good property for a 1031 buyer to buy. The 1031 market, as you might imagine, has declined very precipitously as there is not a lot of property sales going on; so the property is available. We don’t have it on the balance sheet as available for sale, but if someone gives us a strong offer we will sell the property, but we are not going to sell it at below what we think is fair value. We are just waiting for the right 1031 buyer to come along. When and if they do we will sell the property.

Greg Schwartz – Citigroup

Have you received any bids up to this point?

Paul McDowell

We have received some informal indications of interest, but quite often those have been contingent upon the closing of the other side of the 1031 sale which in most cases has not happened.

Greg Schwartz – Citigroup

Then following up on the investment loss question, could you provide a bit more detail on the development loan loss that you had?

Paul McDowell

We had done five or six development loans back in the 2004/2005 time frame. These were kind of $0.5 million loans at a very attractive interest rate to us, along with equity participations. We had two of those remaining, one of which we wrote off this quarter, as a result of the failure of the project development was not able to get the building built. Our personal recourse guarantee has also proven to be probably not worth much recovery as the developer is in a bad state and is probably going to file bankruptcy as a consequence of all of this. We had four of the six pay off already and now we are working through the last two. This one we had a problem with. We think the other one is going to be perfectly okay and pay on its terms.

Greg Schwartz – Citigroup

Regarding future impairment possibilities, are you under going any tests right now with tenants like the AmeriCredit property you mentioned, maybe some other weaker tenants outside of the top echelon of exposure?

Paul McDowell

No. There is really no one right now that we are kind of imminently concerned about.

Greg Schwartz – Citigroup

Then finally on legal costs year-to-date where does that stand right now?

Paul McDowell

On FM Global we have spent about $1 million in legal fees. We also spent about $275,000 on the Qwest litigation

Greg Schwartz – Citigroup

Where do you think that will finish at towards the end of the year?

Paul McDowell

We are coming to the end, I think, of the legal fees on these. We’ve actually solved the Qwest issue, the FM Global we are definitely at the tail end of it. We will probably spend incremental money, but it won’t be meaningful.

Operator

Our final question comes from Richard Sloan.

Richard Sloan

I wanted to clarify, you indicated in your non-guidance guidance a number, I think, in excess of $0.90 if all assets were frozen, I mean all activities were frozen and FM Global moved out in April. Is that a correct statement?

Paul McDowell

That’s correct.

Richard Sloan

So if FM Global were to stay on beyond April, and by the way what was the number, you said $0.90 some odd cents. I didn’t get it.

Paul McDowell

We said above $0.90.

Richard Sloan

Is that basically the worse case scenario that we are looking at here as far as funds from operations?

Paul McDowell

What we are trying to say is there has been a lot of discussion in the broader REIT marketplace about stability of earnings. What we are trying to demonstrate and we are trying to explain, is to give as much comfort as we can about the stability of CapLease’s earnings.

We are saying if you took a look at the company today, froze it in place, what would the company produce in earnings for 2009. With the assumption that FM Global moves out as expected in July of next year and does not hold over, in that circumstance the earnings of the company on an FFO basis would be above $0.90 per share as would the cash available for distribution.

Richard Sloan

Thank you very much. You guys have been pretty accurate in your forecasting and I trust you are going to live up to the manner in which you have been doing business. Good luck to you.

Paul McDowell

Thank you, we try.

Operator

Again, we have no further questions at this time. I will turn the conference back over to the company for any closing remarks.

Paul McDowell

Thank you all for joining us today on the call and we look forward to speaking with you again at our next quarterly conference call.

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