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Washington Real Estate Investment Trust (NYSE:WRE)

Q4 2008 Earnings Call

February 20, 2009 11:00 am ET

Executives

Kelly Shiplet – Director of Finance

George F. McKenzie – President & Chief Executive Officer

Sara L. Grootwassink – Executive Vice President & Chief Financial Officer

William T. Camp – Executive Vice President & Chief Financial Officer Elect

Laura Franklin – Executive Vice President & Chief Accounting & Administrative Officer

Michael S. Paukstitus – Senior Vice President of Real Estate

Analysts

Mark Biffert - Oppenheimer & Co.

David Rodgers - RBC Capital Markets

John Guinee - Stifel Nicolaus & Company, Inc.

Michael Knott - Green Street Advisors, Inc.

Christopher Lucas - Robert W. Baird & Co., Inc.

Anthony Paolone - J.P. Morgan

Operator

Welcome to the Washington Real Estate Investment Trust fourth quarter 2008 earnings conference call. As a reminder, today’s call is being recorded. Before turning over the call to the company’s President and Chief Executive Officer Skip McKenzie, Kelly Shiplet, Director of Finance will provide some introductory information. Ms. Shiplet, please go ahead.

Kelly Shiplet

Thank you and good morning everyone. After the market closed yesterday we issued our earnings press release. If there is anyone on the call who would like a copy please contact me at 301-984-9400 or you may access the document from our website at www.writ.com. Our fourth quarter supplemental financial information is also available on our website. Our conference call today will contain financial measures such as FFO, NOI and EBITDA that are non-GAAP measures and in accordance with Reg G we have provided a reconciliation to those measures in the supplemental.

Please bear in mind that certain statements during this call are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements involve known and unknown risks, uncertainties and other factors that may cause actual results to differ materially.

Such risks, uncertainties and other factors include but are not limited to the effect of the current credit and financial market conditions; the availability and cost of capital; fluctuations in interest rates; tenant’s financial conditions; the timing and pricing of leasing transactions; levels of competition; the effects of government regulations; the impact of newly adopted accounting principles; changes in general and local economic and real estate market conditions; and other risks and uncertainties detailed from time to time in our filings with the SEC, including our 2007 Form 10-K and our third quarter 2008 Form 10-Q. We assume no obligation to update or supplement forward-looking statements that become untrue because of subsequent events.

Participating in today’s call with me will be Skip McKenzie, President and Chief Executive Officer; Sara Grootwassink, Executive Vice President and Chief Financial Officer; Bill Camp, Executive Vice President and Chief Financial Officer Elect; Laura Franklin, Executive Vice President and Chief Accounting and Administrative Officer; and Mike Paukstitus, Senior Vice President, Real Estate.

Now I’d like to turn the call over to Skip.

George F. McKenzie

Good morning and thank you for joining Washington Real Estate Investment Trust conference call today. The fourth quarter was a difficult one for the U.S. economy. While we in the national capital region typically outperform the country in times like these, we are not immune to the financial distress affecting every sector of the economy.

Leasing velocities are down significantly. Investment transactions and opportunities are few and far between, and the ability for our tenants to finance business expansions is difficult to say the least. In our portfolio while we are generally well leased at 94%, we continue to see signs of distress in our tenant base. Office and industrial tenants are reluctant to assume more business risk by leasing additional space or extending lease terms. Retailers are struggling with the consumer who now saves rather than spends, and residential occupants are doubling up or moving in with mom and dad.

Having said that, the good news is that the Washington region continues to add jobs, albeit not at the rate of the past five years. The unemployment rate is low at 4.7%. The overall vacancy rate is manageable at 10.5%. And we believe the Washington region will lead the nation in recovery as the newly appointed financial capital of the world and as a major beneficiary of the financial stimulus plan.

While the engine of the federal government is a slow moving one and will not dramatically improve real estate economics in 2009, critically we believe the initiatives undertaken by the financial stimulus plan will begin to break the crisis of confidence which is the root cause of the malaise affecting each sector we operate in.

In addition, our region will become ground zero for the regulators, vendors and counselors to the expanded governmental agencies these new programs will create. Throughout the region, while recent activity has been slow, our core markets have not been overbuilt and once activity rebounds we believe recovery should be expeditious.

In the fourth quarter we completed several transactions of note, improving our portfolio significantly and strengthening our balance sheet. In December we completed the previously announced acquisition of 2445 M Street, an exceptional D.C. office building. To finance the purchase we used the proceeds from the sale of two industrial properties, the Sullyfield Commerce Center and The Earhart Building, which were sold in the second quarter of 2008. We assumed $101.9 million loan and borrowed from our lines of credit.

In addition, we purchased $16 million of our convertible debt at a discount of 25%, reducing our exposure to 2011 refinancing and achieving an attractive return on investment. While we expect 2009 to be a year of transition, WRIT is well-positioned to take advantage of the investment opportunities we believe will begin to develop in 2010 and beyond. WRIT only has 9.3% of rental income rolling in 2009. Our liquidity position is sound with only $67 million out on our lines at year-end; with only $50 million multifamily portfolio mortgage maturing in 2009. We have no material exposure to the gifted expenditures and commitments, and our properties are currently well leased at 94% with average in-place rents generally below market.

There has been much discussion in the REIT world regarding dividend policies and the [inaudible] announcement allowing the issuance of REIT common shares in lieu of cash. I would like to reiterate our current commitment to paying a cash dividend and our belief that maintaining and ultimately growing dividends are an important component of the REIT story and a major reason for Washington REIT’s long-term success.

Last but not least, I would like to thank Sara for her seven years of superb performance as WRIT’s Chief Financial Officer. As previously announced, this will be Sara’s last call with us as the transition of her duties will be complete upon the filing of the 2008 10-K. Sara has been a tremendous asset to our organization and her managerial skills and financial acumen contributed significantly to WRIT’s success over her tenure. I greatly value her input, good judgment and friendship over these years and all of us at WRIT wish her the best of luck as she struggles to adapt to a perfect climate 12 months per year, leaving the six months of ice and six months of humidity in D.C. behind her. Sara, thank you for all you have done for WRIT.

Now I would like to turn the call over to Bill, who will discuss our financial performance.

William T. Camp

Thanks Skip and good morning everyone. For the fourth quarter funds from operations were $30.9 million or $0.59 per diluted share. This compares to FFO for the same period one year ago of $27.5 million or $0.59 per diluted share. Funds available for distribution were $0.46 per diluted share in the fourth quarter.

For the full year, FFO was $104.4 million or $2.12 per diluted share versus $106.6 million or $2.31 per diluted share for 2007. The $2.12 per share include a one-time gain of approximately $0.07 a share related to the repurchase of the convertible debt and a one-time loss of approximately $0.17 per share related to the extinguishment of the MOPPRS.

Fourth quarter core cash net operating income decreased by 4% compared to the same period one year ago. Although rental rate growth was 3.1%, core occupancy decreased 150 basis points to 98.3% compared to the same period one year ago, but was essentially flat compared to the third quarter 2008 results.

By center, our performance is broken down as follows. Office properties core cash NOI for the fourth quarter decreased 2.6% compared to the same period one year ago. Core economic occupancy decreased 180 basis points to 93.5%. However, we continued to see core rental rate growth. Office core rental rate growth was 2.9%. Medical office properties core cash NOI for the fourth quarter decreased 1.1%. Compared to the fourth quarter last year, core economic occupancy decreased 220 basis points to 95.9% while core rental rates increased 3.3%.

Multifamily properties core cash NOI for the fourth quarter increased 2.1% compared to the same period one year ago. Rental rate growth was 1.8% and core economic occupancy increased 200 basis points to 93.2%. Retail properties core cash NOI for the fourth quarter decreased 7.8% compared to the same period one year ago. Rental rate growth was 4.2% despite a core economic occupancy decrease of 120 basis points to 94.7%. Industrial properties core cash NOI for the fourth quarter decreased 9.5% compared to the same period one year ago. The decline was driven by 350 basis points decrease in core economic occupancy to 92.2, even though the core rental rate growth was 3.3%.

While our portfolio statistics I just highlighted are moderately weaker than they were last year at this time, it is important to reiterate that our overall economic occupancy remains relatively stable at 93.8%. We believe this is a function of having a well diversified portfolio and one of the better real estate markets in the country.

Much of the decline in the occupancy in each sector happened earlier in the year. Sequentially from the third quarter office core economic occupancy is up 80 basis points, retail is up 40 basis points, multifamily declined 150 basis points, industrial’s down 40, medical office is down 60. Mike will discuss more specifics surrounding property type in a few minutes.

From a capital markets perspective, WRIT is well positioned. In 2008 we took several steps to strengthen our balance sheet including raising over $190 million of equity; decreasing the outstanding balance on our lines of credit; and repurchasing a portion of our convertible debt which has a 2011 put date. As a result of our continued focus on our capital position, Moody’s reaffirmed our B double A One senior unsecured credit rating last October and S&P reaffirmed our triple B plus rating a few weeks ago.

In 2008 we raised equity in three separate tranches totaling $190 million at a weighted average price of $35.14. We used the proceeds to reduce the line of credit balances and other general corporate purposes. Essentially these transactions helped us fund the equity portion in the acquisitions we made last year.

As for our 2008 debt activity, we have previously reported that we expanded the capacity on one of our lines; completed the extinguishment of our MOPPRS; refinanced the debt at more favorable interest rates; and refinanced short-term debt by entering into three mortgage loans at a rate of 5.71% with an eight year maturity. Continuing with activity on the debt side of the balance sheet, in December we repurchased $16 million of our $260 million senior convertible notes at a discount of 75% of par or approximately $12 million. In conjunction with this repurchase, we reported a gain of approximately $3.5 million or $0.07 a share.

This quarter we repurchased an additional $19.5 million of those same convertible notes. Also this week we closed a ten year, $37.5 million loan on the Kenmore Apartments at a fixed rate of 5.37%.

In the fourth quarter WRIT paid a dividend of $0.4325 per share, achieving its 188th consecutive quarterly dividend at equal or increasing rates. Last night we issued a press release announcing our first quarter 2009 dividend at the same rate.

Looking forward, our only debt maturity in 2009 is a $50 million residential property mortgage due in October. This loan encumbers five multifamily properties and we estimate the current loan to value is approximately 25%, leaving us alternatives to either refinance the $50 million while encumbering only two of the five assets, or refinance all five assets and generate proceeds well in excess of the $50 million, depending on our need for capital at the time.

In 2010 we have $100 million term loan that matures. We have already had discussions with our lenders about refinancing or extending the maturity of this loan. We currently expect to be able to refinance or extend this loan successfully. In 2011 we have $150 million in bonds maturing and $224.5 million of our convertible bonds, which can be put back to us at par.

WRIT has two credit facilities. One expires in 2010 and one expires in 2011. We have the sole right to exercise an option to extend these lines for an additional year, pushing the maturities to 2011 and 2012, respectively.

Last night we announced 2009 FFO per share earnings guidance of $1.95 to $2.15. This guidance takes into account on approximately $0.10 per share interest expense adjustment related to the new convertible debt accounting rules and the fair value accounting treatment for the loan on our 2445 M Street acquisition.

Additionally our guidance includes increasing our estimated bad debt expense in anticipation of continued deteriorating economic conditions in the real estate markets, taking a more conservative projection for vacancy by assuming lower retention and longer lease up of vacant or expiring space; assuming our overall cost to capital will rise throughout the year, given rates on our lines of credit currently hover around 1%; increasing cap rate assumptions on our approximately $50 to $70 million of planned dispositions; and a nominal amount of acquisitions; and finally accounting for the full year impact of the additional shares that we issued last year.

Before I turn the call over to Mike to discuss operations, I want to say thank you to Sara. For those of you who do not know, I met Sara in 1999 when she was with Corporate Office Properties. Sara came to WRIT in 2001 when I was an analyst at A.G. Edwards covering the company. She made an immediate impact here. In my opinion, Sara’s integrity; strong work ethic; great relationships with the investment community; and the ability to comprehend all the operational details that change every day within a real estate company, particularly as it relates to the capital markets, made a tremendous positive impact at WRIT. She has been a valuable member of the senior management team. She has welcomed me to the company and has made my steep learning curve much easier to overcome. Sara, I wish you the best of luck in your future and thanks.

Now I’ll turn the call over to Mike.

Michael S. Paukstitus

Thanks Bill and good morning. As Skip indicated, leasing velocities in the market are down significantly and many companies are delaying leasing decisions due to the current economic climate. WRIT executed over 307 thousand square feet of commercial lease transactions in the fourth quarter. The average run rate increase on leases signed this quarter was 9.1% on a cash basis and 19.9% on a GAAP basis. Tenant improvement costs were $15.33 per square foot.

Residential rental rates increased 1.8% in the fourth quarter compared to the same period one year ago. Rental rates for new and renewed leases in each sector ranged from an increase of 4.6% to 20.2% on a cash basis, with $3.37 to $27.56 per square foot in tenant improvement costs.

In the office sector we executed leases for a total of 128 thousand square feet at an average rental rate increase of 4.6% on a cash basis and 15.9% on a GAAP basis. In total, our office portfolio is 94% leased. Generally, we continued to perform well in all our sub-markets as compared to the overall market metrics. For example, our Washington CBD portfolio was 3.5% vacant at year-end compared to a 5% market vacancy. In Rosslyn, Virginia, our 166 thousand square foot office tower at 1600 Wilson is at 100% occupancy compared to the 5.6% market vacancy.

In the medical office sector we signed leases for a total of 62 thousand square feet at an average rental rate increase of 0.7% on a cash basis and 26% on a GAAP basis. Our medical office portfolio is at 97% leased. This sector continues to perform extremely well, with some of our properties realizing rents equal to Washington CBD rents.

In the retail sector we executed leases for a total of 32 thousand square feet with a rental rate increase of 17.4% on a cash basis and 14.4% on a GAAP basis. Our retail portfolio is 97.8% leased and we achieved a 91.5% retention rate in this quarter. We do have a 28 thousand square foot Circuit City Store in our 332 thousand square feet center in Hagerstown. The impact of this bankruptcy has been reflected in Q4 2008.

In the industrial sector, we entered into leases for a total of 86 thousand square feet with rental rate increases of 20.2% on a cash basis and 26.3% on a GAAP basis. The industrial portfolio is 91.3% leased in total. On average our industrial portfolio is performing in line with the sub-markets in which we operate, though several of our sub-markets will remain challenging in 2009.

Thus our 2008 commercial leasing activity totaled over 300 lease transactions comprising 1.5 million square feet with total revenue potential of $185 million over the average five year terms of these leases. In the aggregate for 2008 we had a rental rate increase of 7.7% on a cash basis and 19.4% on a GAAP basis.

Leasing activity in our development projects is steady. Last quarter we announced two lease executions at our 180 thousand square foot Dulles West project. The property is now 86% leased to IBM and National Student Clearinghouse who will occupy a total of 154 thousand square feet. We now have 120 thousand square foot left for leasing in the building and we currently have a 5 thousand square foot lease transaction in negotiation.

Bennett Park, a 224-unit Class A apartment complex consisting of high and mid-rise buildings in Arlington, Virginia, was 78% leased at year-end. Clayborne Apartments, consisting of 74 units in old town Alexandria, was 64% leased at year-end. Most of these residential projects experienced slower absorption in Q4. Activity has picked up in the new year and stabilization is projected for mid-2009.

This quarter we acquired 2445 M Street, a Class A office building with two-level parking garage in downtown Washington, D.C., for $181.4 million. Twenty-four-forty-five M Street is located in the established West End neighborhood between Georgetown and the central business district. The property measures 290 thousand square feet and is 100% leased to The Advisory Board Company and Patton Boggs LLP under long-term leases. We have assumed the $101.9 million loan with an interest rate of 5.619 and the remaining balance was funded with proceeds from the sales of Sullyfield Commerce Center and Earhart Building and the balance from our credit line.

WRIT expects to achieve a first year leverage yield of 6.7% on a cash basis and 7.2% on a GAAP basis. Twenty-four-forty-five M Street is an excellent downtown asset that will provide WRIT with stable, long-term cash flow.

Now I would like to turn the call over to Sara.

Sara L. Grootwassink

Thanks Mike. I just wanted to let all of you know what an honor and pleasure it has been to work with you over the last seven years. I greatly appreciate all of your generous support and wisdom as we have navigated these capital markets. I’m confident I am leaving you in good hands and I believe that you will enjoy working with Bill as much as I have. Now we’d like to open up the call for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions)Your first question comes from Mark Biffert - Oppenheimer & Co.

Mark Biffert - Oppenheimer & Co.

Skip I was wondering if you could start off by trying to figure out the timing of this stimulus impact in the D.C. market and how that plays into your guidance. It seems like you’ve pulled down your occupancy assumptions and increased your percentage of bad debt in revenue. How do the two tie out?

George F. McKenzie

Yes, I think as I mentioned in my comments, I mean we don’t think it’ll have a material impact on real estate dynamics this year. In other words, I don’t think there’s actually going to be leases hitting the streets that you’ll actually see income from this year. What I do think the most important part is it’s really going to sort of free up sort of the crisis of confidence that’s out there. The problem that we’re seeing and really the fundamentals really across all sectors is that everybody’s playing defense right now.

And it’s extremely difficult for any tenant and even the good performing tenants to take additional space, to sign a five-year extend their lease for a long period of time. Everybody wants to go one year extension, two year extension. And it’s because they don’t know what’s going to happen next. I think the financial stimulus plan – the impact of that in 2009 will really begin to just re-establish confidence in business. And I really – and I think our guidance reflects the fact that we’re not expecting any juice from that to really impact real estate economics in 2009 in our region.

Mark Biffert - Oppenheimer & Co.

Have you seen any kind of increase in traffic in your apartments related to the new administration and seeing more people move in as a result of that? And how is that impacting retail tenants viewpoints as well?

George F. McKenzie

Nothing materially with respect to the election traffic.

Mark Biffert - Oppenheimer & Co.

What are your cap rate assumptions that you’re using on the planned dispositions that you have $50 to $75 million for?

George F. McKenzie

We have mid-sevens.

Mark Biffert - Oppenheimer & Co.

And then what are your occupancy assumptions?

George F. McKenzie

For?

Mark Biffert - Oppenheimer & Co.

Across each of the property types.

George F. McKenzie

For next year?

Mark Biffert - Oppenheimer & Co.

Yes. How much have you pulled them down or how much are you assuming they decline?

George F. McKenzie

It’s kind of a range. We’re just looking it up.

Mark Biffert - Oppenheimer & Co.

If you want, I could ask another question to Mike while you look that up. Mike I was wondering if you could talk a little bit about the retail performance in the fourth quarter. You had mentioned that Circuit City was included in that number. Was that the largest percentage of that decline in NOI that we saw?

Michael S. Paukstitus

Yes it was. And that number approached $900 thousand as a result of not only cash but FFO adjustments.

Mark Biffert - Oppenheimer & Co.

And then in terms of the rents that you have in place, where could we see – would you expect to see in ’09 some type of inflection point where your in place rents or your market rents fall below your in place rents?

Michael S. Paukstitus

On the retail front?

Mark Biffert - Oppenheimer & Co.

Yes, or any of the sectors, even the industrial side.

Michael S. Paukstitus

Well, I think the retail front is probably where we’re looking at it very closely where we could have the most exposure. The others I would identify more as a flat and that’s pretty much what’s forecast for the market in general. But as you know retail is under pressure and discussions of reductions or holidays are in the dialog daily as we talk to those tenants.

Mark Biffert - Oppenheimer & Co.

Okay. Anything on the occupancy? I can jump to the last question I have - was just related to Sunrise. We’re hearing discussions that they’re – could lead to them giving back the space potentially in terms of a bankruptcy. Have you guys had any talks with them? And have you talked with any tenants that could potentially be replacements for them?

George F. McKenzie

Yes. The status of Sunrise, I mean, they’ve been great tenants for us. They are in fact in the market, attempting to sublease some of their space. I believe two of their floors are not occupied right now which are about 60 thousand feet. And we’re working actively with them to attempt to sublease the space. In other words, we’ve told them that to the extent that they would need some help from us on the back end we would consider that. Now obviously we made no commitments specifically. But they’ve been a great tenant so far and we’ve read all the information that everybody else has in the public arena. But that’s pretty much their status.

Mark Biffert - Oppenheimer & Co.

So what could be the potential impact if they do file for bankruptcy? Is there any kind of impact in terms of FFO?

William T. Camp

It really depends. It depends obviously on timing because rent wise, you know, they’re somewhere on a full year basis. I think they’re somewhere around the $0.10 number. Yes, it’s $5 million. So on a full year basis is around $0.10 plus there would be some kind of straight line adjustment that we would have to take if they actually go away. But it’s all dependent about timing. Right now they keep paying rent.

George F. McKenzie

And as a practical matter, I don’t think it’s a situation where they could just vaporize and leave that building. They have – it’s a huge management company for a lot of different investors and we think it’s an extremely unlikely scenario that they’re just going to leave the building completely, even in the event of a bankruptcy. So it’s something that we keep an eye on. We’re as concerned as anybody. We try to keep tabs of all the news and we’re watching it very closely.

Michael S. Paukstitus

On the occupancy or vacancy, whatever way you want to look at it, we’re using for most of the sectors somewhere in the 90, 95 down to about 92 or 90 depending on the sector. Obviously industrial is probably the weakest in there but it’s also already kind of the weakest, so that’s kind of the range. We haven’t given out specifics on each property type in terms of budgeting to anyone.

Operator

Your next question comes from David Rodgers - RBC Capital Markets.

David Rodgers - RBC Capital Markets

Related to your comments at the open regarding acquisition and other opportunities likely to open up in 2010 and I heard your comments about the overall economic environment and what’s going on with the stimulus package, but you know is that a function? Originally that was 2009 everybody had expected these opportunities. Now it’s another year out. Is that more a function of why did that spread? Not much coming to market? Or is that a Wash REIT specific function today of how you feel about your capital position?

George F. McKenzie

There’s very little on the market right now. Are there some things? Yes, but given we don’t think the pricing is where it needs to be in the current market for the very few assets that are out there. And it is extremely thin in terms of investment offerings out there for anybody. And I think you’d find that there’s nobody making major acquisitions in Washington right now.

Michael S. Paukstitus

There is a statistic I mean we’re 75% off last year’s transactions.

George F. McKenzie

The fourth quarter was if you read any – if the major brokerage house’s numbers, I mean those poor guys didn’t do much in the fourth quarter even, of ’08.

David Rodgers - RBC Capital Markets

And then on the financing opportunities, comment I guess on what you’re seeing on the commercial side versus what you’re seeing on the residential side from maybe Fannie or Freddie. Do you continue to feel that there’s assets out there on both sides of that coin? And dovetailing into that, how do you feel about your controlled equity offering program at this point?

George F. McKenzie

Well, I think in terms of the debt side of the equation obviously Fannie and Freddie are still in business so we are. That continues to be probably the cheapest cost to debt, long-term debt capital. As I mentioned we closed this week alone on the apartment building, Kenmore Apartments that we bought last year. It was a ten year loan at 5.37%. It seems that since we locked in that rate we actually locked that rate in in December, and that was kind of the low point in the market for Freddie. That was a Freddie loan.

And since that time I think they’ve both Fannie and Freddie have kind of implemented quasi [inaudible]. I don’t think there’s any public statement out there, but it sure seems like no matter what treasuries do those rates kind of hover in the 6.25 to 6.5 range right now. On the commercial side, there’s certainly availability from some of the life insurance companies in terms of rates in loans, but they’re typically shorter. They’re typically a lot lower loan to value. And so you can’t get as many proceeds and the cost is 7.5, somewhere in the 7.5 to 8% range on many properties. But they’re out there. So there’s opportunities out there.

In terms of the equity program that we have in place, we’ll continue to use it opportunistically as we see fit, but right now it’s been very nominal.

David Rodgers - RBC Capital Markets

The final question on the acquisitions, is it this quarter that you were expected to close on the Kenmore Avenue Medical Office Building? Do you have pre-leasing done there? And should we expect dilution to come from that or will that be capitalized for the first year?

Michael S. Paukstitus

Yes, but Dave that was the Lansdowne not Kenmore.

David Rodgers - RBC Capital Markets

Oh, yes, you’re right. I’m sorry.

Michael S. Paukstitus

Out in Loudon County. We’re still waiting for the building to be completed and then we have 30 days after substantial completion to close. I would say where you’re sort of on the border line of potentially the very end of the first quarter to the very beginning of the second quarter. We have some leasing activity. We don’t have any actually executed leases so it would be fairly dilutive initially.

I don’t know if you’ve been following the news out here, one of the issues was that HCA was going to build a competitive hospital also in Loudon County and their application to do that was rejected so really it is a monopoly out there for Loudon Inova Hospital and our MOB – our prospective MOB would be directly across the street from that hospital. So we actually think that the interest in that building is going to pick up significantly since it’s really the only new building out there. And although initially we don’t have any leases at hand right now, but we have some interest, we do think it’s going to pick up expeditiously.

George F. McKenzie

But to build out space and the whole process, you know, you can’t really expect significant income until much later in the year in the best case scenario.

Michael S. Paukstitus

That’s a good point, Skip. I mean, there were many prospective tenants on the fence, depending upon what was going to happen with those hospitals and now there’s clear indication that we have an advantage there.

William T. Camp

In terms of the budget, we budget that dilution that Skip mentioned into our estimates.

Operator

Your next question comes from John Guinee - Stifel Nicolaus & Company, Inc.

John Guinee - Stifel Nicolaus & Company, Inc.

Hey, I did a little bit of – we’ve been covering you guys for a long time so I just did a little bit of research here, and it looks like your FFO in 2005 was $2.07 a share and your guidance for 2009 at the mid-point is about $2.05 a share. Does that make sense?

George F. McKenzie

Sounds somewhere in the neighborhood.

John Guinee - Stifel Nicolaus & Company, Inc.

And then if I look at 2006, you signed 1.6 million square feet at a 12.8 GAAP rent increase and a 2.8% cash rent increase and then if I look at 2007, you signed 1.8 million square feet at a 17.3% GAAP increase and a 6.4% cash increase. Then you look at last year or 2008, it’s 1.5 million square feet at a 19.4% GAAP increase and a 7.7% cash increase. So if I average those out over the last three years, you’re signing leases, 1.5 million square feet a year at according to your numbers a 16.5% GAAP increase and a 5.6% cash increase.

On the other side of the equation, your cost to debt during the last three years has gone from 5.9 down to 5.2%. And I guess what I can’t figure out is how do you have such incredibly good renewal rents, a decreased cost of debt and not get any juice in the FFO?

William T. Camp

Well, I think, John, as you look over those years, there’s a few things in there you see. You see some development activity that still slowed a lease up that we used a lot of equity to finance. So the share count on dilution is there. And the development yields are not quite above the current dividend yields. So you’re going to have cash flow and FFO per share and certainly dilution on that activity until those properties lease up. That’s probably the major difference.

John Guinee - Stifel Nicolaus & Company, Inc.

Was that about $200 million of development?

George F. McKenzie

You’re probably in the neighborhood there.

John Guinee - Stifel Nicolaus & Company, Inc.

Yes, but a $2.9 billion company, $200 million of development coming in at slightly below cost to capital shouldn’t cause you to have no FFO growth over four years while you’ve got a 16.5% GAAP rental rate increase, 5.6% cash rental rate increase, save 70 BIPS on your cost to debt.

Michael S. Paukstitus

John, I think the other point is you have to look at the quality of the portfolio. If you look at what was sold over those last three years versus what was purchased over the last three years, you obviously improved the quality of the cash flow and the tenant base but in those transactions you’re selling at higher cap rates and you’re buying at lower cap rates. So not only do you have the development activity lower yields, but you also have lower yields on the acquisition disposition transfer.

John Guinee - Stifel Nicolaus & Company, Inc.

Second question is, you’re obviously not going to raise capital at $20 a share and what you guys have done which I think has really helped your stock price in the last couple of years is to keep your leverage low. How much further will you lever up in 2009?

William T. Camp

The only thing that is even in the horizon that we’re talking about is obviously that we have to pay for the acquisition of Lansdowne which is roughly a $20 million purchase. And then it’s really a trade of debt, it’s not a leverage up from there. It’s really a situation of refinancing those $50 million apartments.

And like I said in my prepared remarks, if you look at the $50 million it only – you can replace the $50 by encumbering two of the properties. It’s a five property pool, so we have a choice of just doing the $50 and replacing the $50 and unencumbering three assets which is always a good thing. Or we can lever those five properties up and use those proceeds to pay other debt away. Either repurchase debt that expires out in the future or repurchase more converts like we’ve been doing in the past. So there’s options out there, but I don’t anticipate really having any more leverage, if more at all at the end of the year.

Operator

Your next question comes from Michael Knott - Green Street Advisors, Inc.

Michael Knott - Green Street Advisors, Inc.

Hey, Mike, can you [inaudible] a little bit on the CapEx on the office leases signed in the fourth quarter? It looked like it was fairly high and jumped up a bit. I don’t know if it was a mix issue or a location issue. Can you just comment on that?

Michael S. Paukstitus

TI specifically?

Michael Knott - Green Street Advisors, Inc.

Well, the combined TI and leasing commission. It looked like it was over $5 per foot per year.

Michael S. Paukstitus

I’m trying to think of any sort of major leases that would skew that number.

Michael Knott - Green Street Advisors, Inc.

Are TI’s increasing in your –

Michael S. Paukstitus

As a general rule I’d say TI’s are actually coming down to a degree. Now to the extent you have development properties, that sort of skews numbers and I don’t think any of the Dulles Station leases – I’m sort of paging through the leases, were in there.

William T. Camp

We did have a transaction on one central, Skip, that required a lot of retrofit.

George F. McKenzie

That’s right. We did a 20 thousand square feet lease at One Central Plaza that had a pretty bit TI number that we did a ten year lease on.

William T. Camp

Additionally, we brought in a major state – I’m sorry, it was Montgomery County that came in to 51 Monroe –

Michael S. Paukstitus

It looks like there were a couple of large transactions. I’m just paging through.

William T. Camp

I’m looking at about $2.6 million worth of TI’s on 127 thousand. We did have also at Crescent, Skip. We brought in a major tenant out there. So, yes, there were some situations where we had some challenged space that required some retrofitting on those projects. And the primary one being that one central location where we lost a major tenant out in that space earlier this year – I mean in 2008.

George F. McKenzie

But to answer sort of your basic question, you know I don’t see tenant improvement costs going up dramatically right now. As a matter of fact, just because of the economic climate you could drive generally better bargains with general contractors. It’s just a matter of what the condition of a specific space was. And in the particular case that Mike just mentioned those tenants signed extended term leases and the one tenant at One Central Plaza that space was not left in the greatest condition by the prior tenant, so it required a lot of retrofit.

Michael Knott - Green Street Advisors, Inc.

As far as the office lease expiration schedule for ’09 and ’10, it looks a little more – a little heavier in 2010 so just curious if you can just comment on A, how much of that you expect to maybe get a head start on in 2009?

George F. McKenzie

Yes, 2009 is actually kind of a soft year in terms of lease rollover. With respect to 2010 which sort of is the big number is World Bank – a good portion, not all of it, but a good portion of the World Bank space is coming up and we are actually in preliminary discussions with World Bank. It’s almost 150 thousand square feet of the World Bank space at 1776 G Street, which is probably I’m just thinking out loud now, probably our highest rent per square foot building in the portfolio. Certainly office building. So it’s a big number as a contributing factor to the rollover expense. And we’re actually in preliminary negotiations with them. We’re very confident they’re going to renew. It’s a matter of selecting the lease term.

Michael S. Paukstitus

And Michael that’s 20% of the rollover in 2010.

Michael Knott - Green Street Advisors, Inc.

And then lastly it sounds like there’s a good chance that you won’t do any acquisitions in ’09 given the [posity] of opportunities in the market currently and also your view on pricing, but if you were to pursue acquisitions how would you think about where to add to your portfolio, both geographically and by product type going forward? Update us on your thoughts there?

George F. McKenzie

Just to clarify your first part, I do agree that in the next few months there isn’t going to be anything. Potentially could there be something towards the end of the year? Yes, possibly. But just to get the engine rolling, to get properties on the market and due diligence and etc., etc., even if they came on – some great opportunity tomorrow, it would take awhile for the marketing process and all the other logistics to close. To have anything happen any earlier than toward the end of the year would be a stretch.

As I think we’ve said over the years, we try to be opportunistic and not really limit ourselves to any one sector, so I don’t think I would limit myself to one area as opposed to another. Certainly the areas outside the Beltway are a little softer than areas inside the Beltway so that might be our focus. But I think we sort of keep an open mind to opportunity as opposed to putting blinders on and limiting ourselves to one particular sector.

Operator

Your next question comes from Christopher Lucas - Robert W. Baird & Co., Inc.

Christopher Lucas - Robert W. Baird & Co., Inc.

Just a couple of points of clarification on the guidance I think specifically, do you guys have rather than a range is there a specific or can you give us the range in terms of the portfolio vacancy increase you’re expecting?

William T. Camp

Well, as I mentioned earlier, Chris, we kind of budgeted in for every sector somewhere between 95 and 90 with industrial being down at the low end of that range. But the movements – we’re basically taking an approach where a lot of the vacancy, just for a budgeting perspective not necessarily throwing it kind of a targeted guidance, but from a budgeting perspective we’re kind of assuming that a lot of the space that we had vacant at the year-end will kind of remain vacant for an extended period of time.

And then just in general we’re kind of thinking that while history shows retention rates actually improve during downturns, we’re actually kind of taking a budgeting approach where we’re actually thinking retention slides a little bit and that any kind of rollover that goes dark would be dark for a longer period of time. So we’ve just kind of extended everything out a little bit in our budgeting process to make sure that we have everything we can think of that might happen.

Michael S. Paukstitus

I think another big factor there, although it may not be technically vacancies, I mean we’re really hitting our bad debt expense hard. So it wouldn’t necessarily show up in the vacancy numbers, but particularly in the retail sectors and then the industrial sector we’re hitting bad debt expense pretty hard in terms of our projections. Just given where the world is, I mean we don’t know what it portends over the next I guess almost ten months or so of this year, but it’s been very difficult in those two sectors.

Christopher Lucas - Robert W. Baird & Co., Inc.

So just to follow-up on that comment, what was the tenant retention for the fourth quarter? And what is your sort of expectations for ’09 as you budgeted?

George F. McKenzie

The fourth quarter retention was right around our norm. I believe it was 62% - it was 60%. And believe it or not, our high was in the retail sector. But we had a Kmart roll in that sector so it skewed the number up. So we were in that 60% range which historically was 65 to 70, so I guess it’s down slightly. To be exact we were 61% in the – it was actually year-to-date. What was the second part of your question?

Christopher Lucas - Robert W. Baird & Co., Inc.

And what are you guys budgeting for 2009 as far as tenant retention is concerned?

William T. Camp

We don’t actually do it on an overall portfolio so we do it by property, kind of ground up property level. But I would say that we kind of have that inching down in kind of a year or two projection. It actually goes out further than just ’09, but that retention inches down from our historical average of around 65 down to as low as 55 or below in certain instances.

And then just to reiterate on Skip’s point about bad debt, historically this company has been below 1% on bad debt expense and for budgeting purposes those numbers are going up materially, north of 2 closer to 3 on average for the portfolio for budgeting purposes. And in certain instances we’ve taken – we’ve varied that and done sensitivity analysis on it so we kind of know where we’re heading and we’re watching all our tenants pretty closely.

Michael S. Paukstitus

We’ve tried to be as conservative as possible on that due to the economic climates.

Christopher Lucas - Robert W. Baird & Co., Inc.

What was the bad debt expense for the fourth quarter? What was the impact there?

George F. McKenzie

I think it was $1.3 million but I want to double check that. I know we have it here.

Laura Franklin

Including straight line was $1.7 million and Skip is correct it was $1.3 on a cash basis.

George F. McKenzie

Yes, a $1.3 on a cash basis. Another $400 thousand of straight line.

Christopher Lucas - Robert W. Baird & Co., Inc.

And what was the prior quarter number?

Laura Franklin

The prior quarter per third quarter we also have $1 million on a cash basis and a nominal amount on the straight line.

George F. McKenzie

We’re thinking it’s going up. I mean, you know, if you’re looking at trends we think bad debt’s going up. Obviously we don’t know but given where the economy is, that’s our expectation and that’s what baked into our numbers.

Christopher Lucas - Robert W. Baird & Co., Inc.

And so Laura going back to – on a percentage basis then, what was the fourth quarter percentage number then roughly?

Laura Franklin

The fourth quarter percentage of net potential on a cash basis was actually 1.75 and overall 2.2.

Christopher Lucas - Robert W. Baird & Co., Inc.

And so from these levels in the fourth quarter you’re expecting continued deterioration.

Michael S. Paukstitus

Absolutely.

Laura Franklin

That’s correct.

George F. McKenzie

Carve out one thing, you know, not expecting duplication in the Circuit City’s of the world which was a huge impact. It probably was an extraordinary impact because it was actually a 20 year lease so it had some really significant one-time hits. And we’re not expecting instances like that because as you know we don’t have a lot of 20-year leases. That’s actually was quite unique in our portfolio. So I do want to quantify that. We’re not expecting a whole lot of those to occur.

Laura Franklin

That is correct. Because that fourth quarter number – that straight line of $400 grand was almost entirely Circuit City and then also included in the cash amount was another $200 thousand. We took overall basically a $0.02 hit in the fourth quarter for Circuit City.

George F. McKenzie

As you know, we have very few other than our supermarkets really a handful of retail tenants, we don’t have 20-year leases. And that under the current accounting standards we’re straight lining and with FAS 141 adjustments because that was acquired post that, that had a really big impact.

Christopher Lucas - Robert W. Baird & Co., Inc.

And so if I think about the portfolio and going forward, it seems like a lot of the issue last year was related to those – ex-Circuit City, but in the retail and industrial portfolio, a lot of that was small tenant related. Is that broadening out to – are you expecting that to broaden out into the other areas or is that still fairly confined to the retail and industrial portfolio?

George F. McKenzie

The major impact is retail and industrial. I think it’s impacting everything to be quite honest with you. But I do think it’s a major impact. Let me just give you a little background. I mean, our industrial as you know, Chris, and I don’t know if everybody does is mostly small bay industrial and it has a very heavy consumer orientation.

You know, small bay industrial in a lot of our buildings have the contractors, the marble guys, the kitchen cabinet guys. All of those guys who are getting slaughtered right now. And that’s one of the things that the guys are struggling in some of our properties, so if you add those on top of the retailers, I mean that’s where we’re seeing the material impact. Less so in the office buildings although there’s some. I mean obviously we’ve had our handful of mortgage companies, but really predominantly its retail and industrial.

Christopher Lucas - Robert W. Baird & Co., Inc.

My last question just is on the disposition mix. What can you tell us about what your thoughts are there?

George F. McKenzie

Well, we have one property on the market currently and that’s a residential property, the Avondale Apartments. And we’re looking at possibly an office building potentially.

Operator

Thank you. Your next question comes from Anthony Paolone - J.P. Morgan.

Anthony Paolone - J.P. Morgan

Not to beat a dead horse but just to make sure I understand on the retail NOI the million dollar sequential decline, it sounds like $400 thousand of that was what we could think of as being one-time related to the write-off of the Circuit City straight line? And then is that fair?

Laura Franklin

For the straight line yes. That’s not all of it.

Sara L. Grootwassink

There was also a $475 thousand write-down of FAS 141 mid-rent.

William T. Camp

It was closer to $900 thousand.

Anthony Paolone - J.P. Morgan

So that’s the add back to get back to the run rate and then from there we can bump up the bad debt expense even more. Is that fair?

Laura Franklin

For ’09?

Anthony Paolone - J.P. Morgan

Yes, going forward.

Laura Franklin

That’s correct.

Anthony Paolone - J.P. Morgan

And then in following up on the CapEx discussion if I look at your numbers for 2008, about $11 million in TIs and $10 million in recurring and $6.5 on the leasing commission, should we take your comments to mean that those numbers will be lower in ’09?

George F. McKenzie

Well, a lot of it depends on our leasing activity. I don’t know if on a price per pound basis that there – you know, I’d factor them in nominally the same, but it’s really going to depend on our leasing activity.

Anthony Paolone - J.P. Morgan

And in terms of the MOB pre-sale, can you just refresh the yield expectations on that and where you think that will pencil out when it stabilizes?

Michael S. Paukstitus

What, Tony?

Anthony Paolone - J.P. Morgan

The yield expectations for your MOB pre-sale, like where you think that will stabilize.

Michael S. Paukstitus

That’s probably in the mid to high 8’s. And also let me clarify – you know, Bill just mentioned to me going back to your TI question we do have a large commitment this year for the IBM TI, so that would be sort of an extraordinary CapEx this coming year. I forgot about that.

William T. Camp

That’s first generation space and you know if you -

Michael S. Paukstitus

Yes. So bold pens.

William T. Camp

I would say generally Dulles.

Michael S. Paukstitus

Yes. Dulles – and so the first generation space will be pretty healthy numbers, so absent that my comments apply. So that will be a pretty big number.

Anthony Paolone - J.P. Morgan

But that would have been in the development budget I would assume and probably not show up in that line item for ’09? Is that fair or?

Laura Franklin

I think they’re probably going to break out first generation [inaudible].

Operator

Thank you. There are no further questions at this time. Actually, we have another question that just jumped in. Your next question comes from Christopher Lucas - Robert W. Baird & Co., Inc.

Christopher Lucas - Robert W. Baird & Co., Inc.

Just one real quick one on the exchangeable notes impact, two quick questions actually. One is on the – you talked about the $19.5 million you bought. What was the price paid or the gain expected?

William T. Camp

What was that?

Michael S. Paukstitus

On the $19.5 we just – the converts.

William T. Camp

Hang on. I’ll tell you.

Christopher Lucas - Robert W. Baird & Co., Inc.

And then sort of the next question that’s sort of similarly related you combine the fair value adjustment as well as the exchangeable note accounting change impact, I was just curious as to what the accounting change impact for the changeable notes by itself represents.

Laura Franklin

It’s about $4 million a year.

Sara L. Grootwassink

It’s about $0.08 of that.

Christopher Lucas - Robert W. Baird & Co., Inc.

Is that $4 million a year on the lower or on the full amount that was outstanding?

Sara L. Grootwassink

That was on the full.

Laura Franklin

Well, we’ve revised that down. So that $0.10, about $0.08 of that is now on the lower amount. And the $0.02 is basically related to we’ve got the fair value on 2445 M.

Michael S. Paukstitus

Hey, Chris, on the gains for the repurchase of this year, we’re probably at about between $3 and $3.5 million. Somewhere in there.

Laura Franklin

Thanks Chris.

William T. Camp

Thank you everybody and thanks everyone – oh. Operator, do you have any further comments or can we make our final comments?

Operator

You may make your final comments. There are no further questions.

William T. Camp

Okay. Thank you everybody for listening to our call this quarter and we’ll be back with you with better news the first quarter results this year.

George F. McKenzie

Thank you.

Operator

This does conclude today’s conference. You may disconnect your lines at this time. Thank you for your participation.

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Source: Washington Real Estate Investment Trust Q4 2008 Earnings Call Transcript
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