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Executives

Edward A. Stokx – Chief Financial Officer

Joseph D. Russell – President and Chief Executive Officer

John W. Petersen – Chief Operating Officer

Analysts

Jordan Sadler - KeyBanc Capital Markets

Michael Mueller - J.P. Morgan

David Rodgers - RBC Capital Markets

Michael Bilerman - Citigroup

[Jonathan Rycheck - Freeberg Investment]

PS Business Parks Inc. (PSB) Q4 2008 Earnings Call February 24, 2000 1:00 PM ET

Operator

Good afternoon. My name is [Teresa] and I'll be your conference operator today. At this time I would like to welcome everyone to the PS Business Parks fourth quarter investor conference call. (Operator Instructions)

At this time I would like to turn the event over to Ed Stokx. You may begin, sir.

Edward A. Stokx

Thank you. Good morning and thank you for joining us for the fourth quarter 2008 PS Business Parks investor conference call. I am Ed Stokx, CFO of the company, and with me are Joe Russell, President and Chief Executive Officer, and John Petersen, Chief Operating Officer.

Before we begin let me remind everyone that all statements other than statements of historical fact included in this conference call are forward-looking statements. These forward-looking statements are subject to a number of risks and uncertainties, many of which are beyond PS Business Parks' control, which could cause actual results to differ materially from those set forth in or implied by such forward-looking statements.

All forward-looking statements speak only as of the date of this conference call. PS Business Parks undertakes no obligation to update or revise any forward-looking statements whether as a result of new information, future events or otherwise.

For additional information about risks and uncertainties that could adversely affect PS Business Parks' forward-looking statements, please refer to the reports filed by the company with the Securities and Exchange Commission, including our annual report on Form 10-K and subsequent reports on Form 10-Q and Form 8-K.

We will also provide certain non-GAAP financial measures. Reconciliation to GAAP of these non-GAAP financial measures is included in our press release, which can be found on our website.

Now I will turn the call over to Joe.

Joseph D. Russell

Thank you, Ed. Good morning and thank you for joining us.

I will begin by briefly touching on PSB's fourth quarter results. I will then discuss PSB's unique position against the recessionary pressures at hand and conclude my remarks with comments on the investment environment. J.P. will then go into more detail on the quarter, along with our operational focus for 2009. Ed will review the quarter financial results and metrics, and then we will open the call up for your questions.

PSB's fourth quarter results were characterized by NOI growth of 2.5% and stripping out the positive impact of purchasing preferred shares, FFO was $1.19 per share or 8.2% higher than the prior year. Total occupancy declined by 150 basis points from a year ago and down 100 basis points from Q3. Leasing velocity slowed in the fourth quarter and retention slipped, which drove our occupancy to 92.7%. Without question, we experienced lighter demand, which was particularly evident on large spaces over 10,000 square feet.

The bulk of leasing continues to come from small users, and this quarter's activity produced an average lease transaction size of approximately 3,200 second feet. With larger transactions more time delays occur along with a prolonged negotiating process, which has led to less volume in these size deals.

Throughout 2008 PSB's goal was to leverage our ability to attract and retain users across a wide variety of industry segments, which gave us the ability to source deals in the most vibrant part of each of our markets. Full year transaction volume was 5.1 million square feet, characterized by over 1,400 transactions. We were able to capture that volume with lower transaction costs from the prior year or $1.25 per square foot.

Even as markets got tougher, the combination of our product type and market concentrations facilitated the ability to reduce capital expenditures. This improved another key goal, which was to retain as much cash as possible. For the year, PSB's industry low FAD payout ratio was 49.9% as we retained $49 million in cash in 2008.

So where does this position PSB as we face 2009's challenging economic environment? PSB's primary focus is to compete for transactions in a tougher leasing environment, knowing that our product type can cater to a wide array of users and our primary user size continues to be the most populous in any given market. We have strong leasing and management teams running all of our own assets who provide a competitive edge since the majority of our competition does not have the skill and professionalism that our teams do.

Furthermore, PSB's capital structure stayed strong through 2008 and is incredibly well positioned to not only weather this economic storm but when appropriate we will see meaningful growth by acquiring assets as cap rates shift higher. With less than 3% debt in PSB's capital structure, the PS team is not burdened by having to restructure the balance sheet, repay or refinance debt maturities in an onerous environment, or worrying about covering the dividend. In fact, from a stress test standpoint, company wide occupancy would need to erode by over 1,000 basis points coupled with highly negative rental rate reductions for PSB to reach industry norm payout ratios.

Instead, we are able to focus on the opportunities at hand in a market where many owners are or will soon need to delever. In terms of acquisition volume, market activity remains nominal and we have yet to see the benefit of deploying cash at this point. Intuitively, that time is nearer than it was a year ago, but the pressure to actually sell in this environment has not manifested itself. We are well positioned once it does.

Finally, as we announced this morning, we are pleased to welcome Jennifer Dunbar to PSB's Board of Directors. Jennifer is a seasoned investment professional, having been a partner with Leonard Green & Partners, and we look forward to her broad-based business knowledge and experience as she joins our Board.

Now I'll turn the call over to JP.

John W. Petersen

Thank you, Joe.

As Joe mentioned, the leasing environment we saw in the fourth quarter, like all landlords, was difficult. Competition for all deals was fierce and demand sluggish as the economy plunged deeper into recession. Tenants were reluctant to make lease commitments due to uncertainty with their own businesses and the overall economic climate.

All of our markets had negative net absorption during the quarter except for Houston and Dallas, which had positive net absorption of 980,000 square feet and 570,000 square feet, respectively. Vacancies increased across the board except for Dallas, which declined by 20 basis points. Lease length, rent, and other concessions were prevalent in lease negotiations, but mostly customers were looking for value-oriented deals in order to contain costs. As is typical of our customer base, they are not interested in high finish expensive tenant improvements, but more focused on generic space that is able to meet their challenging business needs.

Total PSB portfolio occupancy for the quarter declined 100 basis points to 92.7%. These occupancy declines were felt in Austin, which fell 400 basis points to 89.4% due to the loss of a 32,000 square foot tenant. Northern Virginia lost 292 basis points to 94.6%. Orange County fell 185 basis points to 90.2%. San Diego slipped 174 basis points to 91.6%. In Dallas, Houston and Maryland, occupancy increased during the quarter. Our geographic and market positions assisted our ability to hold occupancy declines. This was demonstrated in Dallas, which increased occupancy by 119 basis points to 94.1%, Houston grew by 132 basis points to 99%, and Maryland rose by 84 basis points to 93.4%.

Rental rates fell by negative 4.1% over expiring rents during the quarter and were down 0.9% for full year 2008. In the fourth quarter we completed 265,000 square feet of leases in Washington Metro, with rents declining 0.5%. In Southern California we did 243,000 square feet of deals and rents declined 8.3%. Fortunately, we were able to grow rents in Seattle, up 4.4%; Austin and Houston each were up 3.8%.

We completed over 300 deals in the fourth quarter totaling 980,000 square feet with an average term of 3.4 years and average size of 3,200 square feet. New leases accounted for 132 transactions. Again, customers under 5,000 square feet drove activity comprising almost 250 deals or 83% of leases in the quarter. PSB's flexible product type and diverse customer base plus the value oriented focus of our business parks, along with our aggressive leasing and management tactics, helped us capture this new activity.

Retention for full year 2008 was 57%, but 48% for the fourth quarter. Florida, Texas and Southern California were weaker for the quarter. Northern Virginia, Maryland and Phoenix were above 55%, and in Maryland retention was 61% due to a key 53,000 square foot renewal with Verizon.

In 2009 we have a normal lease expiration schedule for approximately 22% of annual rents or 4.3 million square feet. Southern California accounts for 27% of expiring rents in 2009; Washington Metro, 22%; Florida, 12%; Northern California, 13%; and Texas, 10%.

I would remind everyone that in Northern California we had a significant above market lease with the County of Santa Clara which comprised 97,000 square feet. During the third quarter we renewed 45,000 square feet at a rate that was approximately 56% lower than the existing rate. The balance of the space, with similar above-market rents, will expire during the first quarter of this year.

As we head in 2009 we are, as always, focused on staying close to our customers. More and more we find they are looking for simple space that is cost-effective and flexible, professionally managed, and reflective of the current economic realities, which allows them to meet their ongoing business needs. A common requirement that customers often seek is one of value. PSB is particularly well positioned to offer generic value-oriented space to existing and potential customers.

Now I will turn the call over to Ed.

Edward A. Stokx

Thank you, JP.

Reported FFO per share was $1.35 for the fourth quarter. Excluding the net gain on the repurchase of preferred stock, FFO was $1.19 per share, an increase of 8.2% over FFO for the fourth quarter of 2007 of $1.10 per share.

On a comparative basis, same park NOI increased 2.5%. Revenue increased 1.7% over the fourth quarter of 2007, while expenses were essentially flat, decreasing $30,000. Sequentially, operating expenses were down $1.3 million or 5.9%, primarily due to higher utility costs incurred during the summer months, lower repairs and maintenance, and slightly lower professional fees.

The gross margin for the fourth quarters of 2008 and 2007 were 70.1% and 69.5%, respectively.

For the full year ended December 31, 2008, reported FFO was $4.70 per share. Excluding the preferred gain, FFO was $4.55 per share compared to FFO for 2007 of $4.23 per share, an increase of 7.6%. For the year, same park revenue increased 2.9%, while operating expenses increased 3.6%, resulting in a 2.6% increase in same park NOI.

The revenue increase is attributed to a 2.9% in realized rental rates which is the result of the increase in new lease spreads achieved in 2007 and the first half of 2008, as well as in place contractual rate increases. The expense increase was driven by higher property taxes and utility costs.

Recurring capital expenditures for the fourth quarter were $6 million compared to $11.2 million in the fourth quarter of 2007. For all of 2008, recurring capital expenditures were $33.3 million or $1.70 per square foot compared to $37.4 million or $1.93 per square foot in 2007. The decrease from 2007 is the result of the company's disciplined capital allocation focus as well as our ability to control capital costs amidst a challenging economic environment.

PSB's historical and continued focus on maximizing our cash retention provides a great source of liquidity, particularly in the current capital constrained environment. For the three and 12 months ended December 31, 2008, the company has retained free cash of $16.4 million and $49 million, respectively. The company continues to maintain industry low payout ratios, with an FAD payout ratio of 42.6% for the fourth quarter and 49.9% for 2008.

During the fourth quarter the company repurchased 400,000 shares of its 6.7% Series P preferred stock. The purchase price of $5.5 million represented a 45% discount to the redemption value of $10 million. The purchase resulted in a net gain of $4.2 million.

In the first quarter of 2009, the company repaid a $5.1 million mortgage with retained cash and today we have approximately $54.2 million in outstanding mortgage debt.

Not unlike during periods of growth, in the current recessionary environment we continue to closely monitor our tenants, their financial stability, and their ability to meet their lease obligations. In Northern California we have two tech manufacturing companies aggregating approximately 134,000 square feet experiencing significant financial difficulty. In the event that these tenants are unable to meet their lease obligations, after taking into account existing collateral we could see a reduction in income of $164,000 in Q2 and as much as $480,000 per quarter in the second half of 2009.

Also of note, we have two retail tenants in Orange County that may not be able to continue to perform on their lease obligations. These two tenants aggregate approximately 42,000 square feet and have combined rents of approximately $76,000 per month.

Beyond these notable situations, while we have been able to maintain our non-government receivables at a respectable level, we are experiencing a greater number of tenants who are paying rent more slowly. As I have noted in the past, we maintain a very thorough and diligent underwriting and monitoring process. This diligence and our quick response to signs of stress have enabled us to keep our write-offs of uncollectible receivables at manageable levels. During the 12 months ended December 31, 2008 and 2007, our write-offs of uncollectible balances were $612,000 and $691,000, respectively.

As of December 31, 2008, we believe our reserve for billed rent receivable is appropriate at $300,000. In addition we continually monitor the realization of deferred rents receivable and make appropriate adjustments based on our assessment of our tenants' ability to fulfill their lease obligations.

Amidst the current economic crisis, liquidity and cash retention is more important than ever. With a history of maintaining significant free cash, combined with a disciplined capital structure, PSB is well positioned to respond to the economic challenges ahead.

With that, we will open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Jordan Sadler - KeyBanc Capital Markets.

Jordan Sadler - KeyBanc Capital Markets

Can you quickly clarify regarding the tenants you just went through? We're having some difficulty. Did you accrue rent for them in the fourth quarter?

Edward A. Stokx

We did accrue rent and rent was either paid or we had collateral that covered their rent in the fourth quarter.

Jordan Sadler - KeyBanc Capital Markets

So to the extent, I guess, for modeling purposes, if there were deterioration it's going to come out in 2Q and then 3Q and 4Q for the Northern California. And the Orange County guys, when would that deteriorate?

Edward A. Stokx

It's unknown at this point, Jordan. We're watching them and talking to them very closely and we'll see how long they're able to sustain their business. We're very concerned about them, though.

Jordan Sadler - KeyBanc Capital Markets

And then a question on markets. Obviously, a couple of them saw bigger decreases in occupancy sequentially and maybe you could give us a flavor - I don't know if that's a perfect picture of what's happening in your markets right now or what you're feeling in the portfolio - so maybe strongest versus weakest markets, your feeling?

Joseph D. Russell

I'll start, Jordan, and JP, if you want to add any color, feel free.

Again, what we're seeing across all markets is softness and I don't think that's any different than I'm sure you're hearing from everybody right now. The economic environment had a broad-based effect, again, around all of our market dynamics. And I would say that it's probably less noticeable at this point probably in the D.C. market and in Texas, and then it might be more heavy in Southern California and maybe even to a lesser degree Northern California.

But, again, it's pressure that we're seeing. We're very focused on it. We, however, feel frankly pretty blessed by the fact that the markets that we have chosen to be in over time continue to give us lots of opportunities to go out and capture business. And even in an environment like this, we have been and continue to be able to go out and secure both new and renewed opportunities.

And unlike what downturns we've seen historically, most of our markets have very little competing production coming in, and even though there is negative market net absorption, as J.P. mentioned, it's something that we're able to battle against and we're doing that on a day in and day out basis.

Jordan Sadler - KeyBanc Capital Markets

But are there any major tenant expirations within sort of the role you discussed for 2009 in Southern California in particular. It's 27% of the roll. Are there any sizeable lease transactions in there or is that mostly the more granular, smaller tenant business?

Joseph D. Russell

It's definitely weighted by the granular smaller guys. And that, again, day in and day out is what we're continuing to focus on. And frankly, that's where we see more activity across all of our markets.

As I mentioned, what we really did see in the fourth quarter is really almost like a complete freeze on bigger lease transactions and with that and with our portfolio we can step back and even put more focus and effort and other things in going out and capturing the smaller guys.

What really is different about what's going on today which we are right in line to see opportunity tied to it is there are a lot of companies out there that really have way too much space. As you well know, employment levels continue to decrease. Companies are ratcheting down their cost structures, they're ratcheting down their need for space, and we're seeing opportunities to go out and capture that downdraft. And our business parks can create a really good opportunity from a value standpoint for those situations.

So tactically that's something that we're even magnifying and did throughout 2008 and we'll continue to do it this year.

Jordan Sadler - KeyBanc Capital Markets

My last question's just on investment opportunities. It sounded like you were maybe doing some tire kicking to the extent there was product or any opportunities available. Can you maybe expand on that and then in that same context talk about the repurchase of the securities this quarter and how that factored in?

Joseph D. Russell

Okay. Well, yes. As we've kept track of the softening cap rate environment and still I would characterize a disconnect between seller expectations and the reality of the adjustment that I still think needs to take place as far as cap rate adjustment. We have been tire kicking. We haven't bought anything for over a year and a half. We've, in that time period, continued to boost our cash balances and kept a very close eye on all interested portfolios that have come on the market. And again, that disconnect or that seller expectation to what our expectation has been strong enough that we haven't actually, again, in the last year and a half purchased anything.

I think that as that pressure continues to build, as the delevering process continues to grow, there should be, again, some interesting opportunities. Again, we didn't see any of that and obviously didn't buy anything in the fourth quarter. Ed can talk a little bit about it. We from a capital allocation standpoint saw an opportunity to go out and we felt do a very good deal tied to one of our preferred issuances or a piece of one of our preferred issuances and used some of our cash to do that.

So, Ed, you want to talk about that?

Edward A. Stokx

Yes, Jordan. You know, that was a very opportunistic buy for us at $13.70 a share; it was a strip yield of close to 12.5%. We will certainly continue to look at share repurchases, preferred stock repurchases as a potential capital allocation. And if we can get it done opportunistically, we'll absolutely do it.

Operator

Your next question comes from Michael Mueller - J.P. Morgan.

Michael Mueller - J.P. Morgan

First of all, JP, when you were talking about the lease in Santa Clara, I think you said that was Q3. I just wanted to make sure that the large rolldown was in Q3, not Q4?

John W. Petersen

That's right, Mike.

Michael Mueller - J.P. Morgan

And then I guess to that point as well, the fourth quarter spreads were down on a cash basis 4.1%. Can you give us any color as to whether the end of the quarter was dramatically different from that average and just what you're seeing so far this month or two into 2009?

John W. Petersen

There wasn't anything that swung either way that 4.1% for the quarter. You know, kind of along the lines with what Joe mentioned in his comments and what I mentioned in mine, we're trying to capture occupancy where we can and from time to time we're going to reach to do that. It's important that we keep [inaudible] seeing the ability to do that as companies look for value-oriented deals. They want to conserve their costs and we think we're a part of that equation, both for new and renewal tenants.

Michael Mueller - J.P. Morgan

I mean, if 4.1% was the average in the quarter which ended up getting worse, is it unreasonable to assume based on what you're seeing now that early into 2009 it's lower than that 4.1%?

John W. Petersen

Well, I don't think it got worse necessarily, but that's hard to say. It's a case-by-case basis, deal by deal, expiration by expiration, Mike, how that's going to play out going forward.

Joseph D. Russell

And Mike, I wouldn't say that's anything different than, again, because of the impact quarter to quarter, sometimes you've got, for instance, like this lease that we had with the County of Santa Clara, a big tenant for us and a large rolldown because it came off kind of almost dot-com era rent levels. That's going to have a heavier weighting. Alternatively, if we do a lot of deals where we don't see those kinds of impacts, it can ebb and flow.

Michael Mueller - J.P. Morgan

Okay, but that Santa Clara, that wasn't in the 4.1%. That was in the prior quarter though, right?

Joseph D. Russell

It was in the prior quarter.

Michael Mueller - J.P. Morgan

The two tenants that you highlighted, are there any backfill prospects at this point or is it just kind of you're playing it by ear still?

Joseph D. Russell

Yes, we're just playing that by ear. Obviously, the situation is still to be determined, so with that, we're keeping an eye on that. And if things go that negative, obviously we'll be right on it from a tenant replacement standpoint. But it's too soon to tell what the timing or process would be tied to that.

Michael Mueller - J.P. Morgan

And the last question, I think, Ed, you talked about the CapEx, $1.70 versus $1.90 or $1.93 in '07. Do you see that creeping up in 2009 or, since you're doing more deals with the smaller guys, do you think you'll be able to have a little more leverage there and keep it lower?

Edward A. Stokx

Mike, it's a good question, but it's a hard question to specifically target and give you some indication of. But I will tell you that we are very focused on maintaining our cash retention and keeping our capital as tight as we can, and at this point in the market TI concessions are not a significant part of the deals that are getting done. So we're optimistic, but it'll depend on the nature of the deals that we do.

Joseph D. Russell

And, you know, again, maybe to add a little bit more color to that, Mike, the environment that we saw through 2008 with, again, our average tenant size and what so far has been different about this economic cycle and the way that we're able to deflect some of the concession consequences of it is, again, as J.P. mentioned, most of our customers are either coming to us in renewal situations and/or new customers as well, and they're really looking to contain rental costs. They're not looking for fancy upgrades. They're not looking for the things that, again, would drive those capital costs higher.

Again, that will depend where we're doing particular deals, size of deals and those kinds of things. But the premise behind a smaller tenant portfolio like ours is that that's something that we have a lot more leverage over and what we've seen and what we're going to continue to try to focus on is keeping those costs down and, by virtue of that, keep our cash balances higher.

Operator

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

David Rodgers - RBC Capital Markets

JP, are you seeing a lot of in-place leases or tenants that still have some time left on the lease coming back looking for rental concessions and how have you generally handled those conditions?

John W. Petersen

Yes, well that's a good question, not a surprising one. As I'm sure you've read in the various media, that's one of the things that small customers and all customers are looking to do. But the answer is no, we're not; generally speaking, we're not out renegotiating leases if they have time left. As Joe mentioned, the benefit of a smaller customer portfolio is if a 2,000 square foot guy can't make it, he can't make it, and we'll work real hard to replace that. But we're not going to go back and say okay, we'll lower your rent so you can survive, Mr. 2000 Square Foot User. If they can't make it, they're just going to go away and we'll re-lease it as quickly as we can.

And typically those spaces are generic, as we talked about. They're not highly finished, so we don't have a lot of re-tenanting costs and we can hopefully get a new guy in there or another customer within one of our parks to take that space. But we don't have a process of renegotiating deals.

David Rodgers - RBC Capital Markets

And for Joe or JP, again, you talked about tenants wanting to downsize out of other assets into your properties. What are you seeing among your existing tenants as they come up for renewal  or new leases, but particularly on the renewal side - are they downsizing, are they taking more space, or are they pretty much flat given your discussions with tenants that are set to roll here in 2009?

Joseph D. Russell

Yes, Dave, again, it's a whole host of all three of those elements. Believe it or not, we are seeing certain customers that need more space, and we are still seeing customers that need to downsize.

And that, from an environment standpoint in our parks, is honestly nothing new. It is one of the dynamics and the benefits that we get by owning these concentrated business parks where even when the economy was much stronger, for instance, you're always playing the puzzle relative to staying close to your tenants, so purely understanding what their needs are, and if it makes sense for both them and us midstream during an existing lease cycle or for other particular reasons to take them up or down in size.

Again, because of the variety of spaces that we might have in any particular park, we can work that puzzle pretty effectively, and in today's environment, we're doing it as actively as we ever have. And, again, the environment that we however are seeing that we're especially trying to stay focused on is, from an external standpoint, tapping into any type of company that might, say, for instance, have 15,000, 20,000, 25,000 square feet that needs a lot less. And, believe me, there's plenty of those guys out there. And we're from a market standpoint seeking out those opportunities in every single one of our markets and that's happening, too. So that is a big part of our process.

And, again, as J.P. mentioned, there is even a little wave tied to this issue of value impression and just basically I want to control my own costs. And from an impression standpoint, I don't need to be in this high a finish environment; one of your well-maintained, simple and maybe more generic business parks works absolutely fine for me. And if I'm coming out of a Class A environment and locationally it works and functionally it works and obviously size-wise it works, that's a good value for me as a customer or a business. And that's, again, something that we're able to cater to in this kind of environment.

Operator

(Operator Instructions) Your next question comes from Michael Bilerman - Citigroup.

Michael Bilerman - Citigroup

JP, maybe you can talk to that negative 4.1% in the quarter - that's cash or is that a GAAP number?

John W. Petersen

That's the cash spread.

Michael Bilerman - Citigroup

And that allocates in TIs and leasing commissions?

John W. Petersen

No, that's the base rent and expense contribution that the tenants are paying.

Michael Bilerman - Citigroup

You talked about the Santa Clara lease affecting the full year - was there anything specific in, I guess, the fourth quarter either on a lease perspective or on a market basis that was driving that?

John W. Petersen

Well, Ed and I can talk about it, but I mentioned that a little bit earlier. There was nothing specifically that was driving that, like a big lease expiration or a lease roll down, either way. There wasn't any one thing we could point to, Michael.

Michael Bilerman - Citigroup

And was there anything on maybe lease duration that would have changed in the fourth quarter how you're approaching leasing at all?

John W. Petersen

Well, again, honestly I think we were pleased by the fact that lease duration, again, in Q4 was 3.4 years. That is actually a little bit above average relative to what we saw throughout 2008. And, again, one of the flexible parts of our system is we can cater to shorter-term lease requirements; we're not adverse to doing that for the right sets of reasons. And when rents may be downward oriented because of all the things that might go into a particular market, if you're doing a shorter-term lease you're going to hopefully get an opportunity to reprice that much sooner than if you're doing a longer-term lease, five years or longer.

So, again, overall term, you know, the 300 plus transactions we did in Q4, 3.4 years. And, again, we were pleased by that.

Michael Bilerman - Citigroup

And what was the total volume square footage in the fourth quarter of leasing?

Joseph D. Russell

980,000 square feet.

Michael Bilerman - Citigroup

Maybe just a little bit on the perpetual preferred repurchase. I guess you bought it back at a 12% effectively yield. How do you think you're balancing the need to [inaudible] to preserve cash and the eventual sort of reissuance of that given the agencies' more stringent ratings on it? I'm just trying to figure out how you're going to think about your cost of capital going forward.

Joseph D. Russell

Well, yes, those are decision elements that come into play. But as Ed mentioned, in particular we saw a more extreme dislocation and felt that strip yield of 12% plus was very attractive and felt it was a very sound way to allocate some of our cash balance. So on a case-by-case basis, if we're seeing those kinds of opportunities, we're going to continue to look at that as an opportunity.

Michael Bilerman - Citigroup

I guess the flip side is how do you think, if you had to raise new capital, put aside the fact that you're generating free cash - I guess it's just a small piece?

Joseph D. Russell

Well, I mean, come on, let's not kid ourselves. We're not an organization that has typically gone out and had to raise a lot of new capital just for the sake of covering our dividend or just kind of keeping the portfolio stable. We generate a significant amount of free cash flow on an annual basis. We've continued to bolster our cash reserves. So, again, if situations like the preferred opportunity come along, we're going to continue to consider that very actively.

And I think, again, we're in a unique position to continue to do that because we're not looking at a set of maturities, whether it's our line or our mortgage obligations or anything else because it's just not there. So the alternative and the very opportunistic environment that we continue to be in is to hopefully find very attractive ways to allocate capital, and the preferred opportunity was an example of that.

Michael Bilerman - Citigroup

And then any discussions with the rating agencies in terms of how they're looking at preferred versus unsecured bonds and how that may affect eventual new issuance going forward?

Joseph D. Russell

No current discussions or updates on that.

Michael Bilerman - Citigroup

Just on occupancy, thinking about going from here into 2009, it sounds like where you were more so on an ending basis that there would probably be some other vacancies created throughout the year?

Joseph D. Russell

Well, again, that's something that we're not predicting or certainly we don't give guidance to. The reason why we wanted to point to those larger situations is because those fall into that environment that I mentioned upfront, which is the bigger you go in any given market with larger tenant situations, it's a much more time consuming and onerous process. And we still don't know what eventually could happen with any of those situations that we noted, but it's at hand and we're going to deal on a case-by-case basis with what we'll deem to be the right thing to do.

But, again, some markets may have more occupancy pressure; others may have actually more occupancy opportunity. And we've got a lot of data points out there to help us drive occupancy, and then on the flip side you're still dealing with market reality.

But, again, without doubt, we are seeing and continue to see more opportunity to sign transactions with small users, and that's, year in and year out, quarter in and quarter out, that's been our key strategy and we're continuing to see that is the most vibrant part of our markets.

Michael Bilerman - Citigroup

Heading into the first quarter, you ended the year about 92% occupied relative to about 92.7% average for the quarter. Was there certain expiries maybe you've already released or is that a sort of good position to be in for the first quarter and then thinking about the other larger expirations you mentioned before?

Joseph D. Russell

Yes. I mean, again, Michael, we're not going to give you any guidance relative to that dynamic. I'll just tell you that, as J.P. mentioned, a key focus - and it was through 2008, carrying into 2009  is to retain as much occupancy as possible. And, again, with our product type we feel like we have some good opportunities to help drive that and contain it, and that's what we're going to continue to do.

Operator

(Operator Instructions) Your next question comes from Jordan Sadler - KeyBanc Capital Markets.

Jordan Sadler - KeyBanc Capital Markets

On the retention, it sounded like retention of existing customers was much lower in the fourth quarter, which you may have given some color around, versus the full year. I'm just curious if that's sort of a trend that sort of occurred throughout the quarter or if it became more difficult later in the quarter to retain tenants?

Joseph D. Russell

Jordan, I don't, again, think you could say within the context of the quarter it trended up or down. It's just kind of what the [break in audio] ended up being. And I would say, again, it was just a quarter. We're going to do everything we can to keep retention as high as possible because obviously that helps preserve as much occupancy as possible.

And it was a tougher quarter from a retention standpoint in Q4, but the quarter to quarter through 2008 ebb and flow of retention continues to be a mix of, you know, again you've got certain situations that you do or don't have control of. And, again, our goal is to keep it as strong as possible. But as J.P. mentioned, of the four quarters, it was the lightest quarter we had in 2008.

Jordan Sadler - KeyBanc Capital Markets

Have you had any of your larger tenants come looking for rent concessions?

Joseph D. Russell

I think without a doubt all companies are being encouraged to have those discussions with landlords. Whether or not they ultimately do and various landlords end up doing anything about it, there's that kind of a dialogue that is in kind of just the commercial environment period.

But, again, the weight of that and the dialogue level, it's not overwhelming by any means; some companies are attempting it. But as J.P. mentioned, more often than not or on a highly weighted basis, we're not doing any of those re-work situations. But, you know, some companies are taking that tactic with their landlords. And we're hearing that throughout all of our markets, not just in our portfolio but in a lot of portfolios.

Jordan Sadler - KeyBanc Capital Markets

And then just coming back to the investment side, what sort of hurdles are you thinking about in terms of new investment as opposed to buying something that has lower risk, like your preferred stock in the 12%?

John W. Petersen

Yes. Well, again, I think it will depend on the strategic position a particular asset might be in, how stable that asset is, what growth we might see out of existing levels of income tied to a particular type of portfolio or asset. But we're going to want to push for close to those double-digit returns, no doubt.

Jordan Sadler - KeyBanc Capital Markets

Going in unleveraged?

John W. Petersen

Yes. I mean, I think that's what we're hoping to see. And, again, it will depend on a casebycase basis if you get that out of the box or if you're going to be able to see that in some near-term fashion. But capital's very precious, and the cost of it's quite high. And, you know, I think, again, we're going to continue to be very judicious in the way that we deploy it.

Jordan Sadler - KeyBanc Capital Markets

By the same token, to the extent you continue to have free cash flow above and beyond the dividend, consider and continue to buyback the stock above similar levels or at similar returns?

John W. Petersen

Well, again, that's always in the mix. And as we've talked to, what we saw in Q4 was even a more [break in audio] opportunity tied to the dislocation in the preferred market. So that's a newer consequence of this overall economic crisis so, again, that can be a lever for us.

Jordan Sadler - KeyBanc Capital Markets

Lastly, just on the sensitivity you guys mentioned, was that 1,000 basis points from here from year end occupancy numbers?

John W. Petersen

Yes. I mean, I think that's, you know, again, there's a lot of moving parts in that. But yes, I mean, I think we're in a position where, I mean, we would have to see a pretty dramatic downdraft to even get into like [break in audio] those maybe more industry norm ranges. So we've intentionally built the company to have a very strong cash retention formula and a very low levered capital structure. And especially in this environment, that is a very important thing to have.

Jordan Sadler - KeyBanc Capital Markets

And that thought process there was to get [inaudible] from your current [FFO] payout or cash flow [CAD] payout up to sort of an 85% average - 80% to 85%. Is that kind of what you were thinking?

John W. Petersen

Exactly. That's the scenario that Joe walked through was based on using an industry average in the mid 80s.

Operator

Your next question comes from [Jonathan Rycheck - Freeberg Investment].

Jonathan Rycheck - Freeberg Investment

I have a question on the preferred repurchase. Was there one seller that had a lot that they wanted to sell? Could you just talk about the transaction a little bit more?

Edward A. Stokx

The only thing I would say on it is it was a privately negotiated transaction with a single seller.

Jonathan Rycheck - Freeberg Investment

And then if you guys were going to repurchase more preferred, would it have to be privately negotiated or would you [break in audio] on the open market?

Edward A. Stokx

Well, we could do either. If we were to do it on the open market, we'd have to announce that and disclose that we were doing that. But at this point that has not been our approach.

Teresa - Operator - do we have any more questions?

Operator

At this time, sir, there are no further questions.

Edward A. Stokx

Okay. Thank you very much for joining the call everyone and we look forward to talking to you at the end of the first quarter. Take care.

Operator

This concludes today conference call. You may now disconnect.

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Source: PS Business Parks, Inc. Q4 2008 Earnings Call Transcript
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