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Parkway Properties Inc. (NYSE:PKY)

Q3 2009 Earnings Call

November 03, 2009 11:00 a.m. ET

Executives

Sarah Clark - SVP

Steve Rogers - CEO

Will Flatt - COO

Mitchell Collins - CFO

Analysts

Jordan Sadler - KeyBanc Capital Markets

Josh Attie - Citi

Rich Anderson - BMO Capital

Presentation

Operator

Good day and welcome to the Parkway Properties third quarter earnings conference call. Today's call is being recorded. With us today are the Chief Executive Officer, Mr. Steve Rogers; Chief Financial Officer, Mr. Mitch Collins; Chief Operating Officer, Mr. Will Flatt; Chief Investment Officer, Mr. Jim Ingram; and Senior Vice President, Miss Sarah Clark. At this time, I would like to turn the call over to Miss Sarah Clark. Please go ahead.

Sarah Clark

Thank you. Good morning everyone and welcome to Parkway's 2009 third quarter conference call. Before we get started with this morning's presentation, I would like to direct you to our website at pky.com where you can click on the third quarter conference call icon and find a printable version of today's slide presentation. On our website you will also find copies of the earnings press release from November 2 and a supplemental information package for the third quarter, both of which include a reconciliation of non-GAAP measures that will be discussed today to their most directly comparable GAAP financial measures.

Certain statements contained in this presentation that are not in the present tense are that discuss the company's expectations, are forward-looking statements within the meaning of the Federal Securities Laws. Although the company believes that the expectations reflected in such forward-looking statements are based upon reasonable assumptions, it can give no assurance that these expectations will be achieved. Please see the forward-looking statements disclaimer in Parkway's press release for factors that could cause material differences between forward-looking statements and actual result.

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

Steve Rogers

Thank you for joining us today. During the past quarter, the market has welcomed the emergence of some positive news regarding several leading economic indicators and trends. As reported last week, GDP growth in the third quarter was positive for the first time since the second quarter of 2008 indicating again, that the great recession may be near. This coupled with the psychology in the stock market and the rising confidence indicators bodes well for continued U.S. economic stabilization and signals that the recovery is gaining momentum. However, as typical with all prior recessions, the return of a healthy office industry will lag this recovery by several quarters.

As noted in the graph on page four of our web presentation, property and portfolio research does a good job of tracking the historical relationship of GDP growth with occupancy and rental rate growth and ultimately the increase in values of office assets through the past three recessions. To quote the author of this research, the return of positive growth of GDP in the third quarter should rightfully be treated as a good sign. However for investors who don't fill office space with GDP, this is still a waiting game.

While GDP is a good first step, it is just that, a first step. The recovery in office occupancy and rental rates will not take place in the same quarter that GDP turns positive. It is simply a question of how long it will lag. We went into this recession with historically low new office stock under construction which is a major difference from our prior recessions that should contribute to a faster recovery of the office fundamentals.

Another conclusion one could make from this chart is that market value of assets will return more quickly than net operating income. We further believe that public companies will see increase in enterprise values earlier in private companies. Overall, we agree with this forecast for our respective markets and it forms the base upon which we are planning for our future. It may seem somewhat conservative and I hope we can outperform these projections, but this does mirror my own experiences in the past two or three recessions. I have personally visited over 65% of our operations during the past 120 days and can tell you that the leasing environment remains tough.

Many of our customers are continuing to contract their work force and space to remain competitive. We are still proactively doing blend and extend renewals for it makes economical sense and our active relationships with our customers are helping us stay in front of potential customer attrition. As the case in point this quarter, we early renewed Bank of America and Nashville for 144,000 square feet. Although BOA contracted nearly 40,000 square feet of space, our rental rate improved 28% and we extended the lease through April 2015 with very little [TR] being expended. Our biggest concern continues to be what I refer to as the dribble effect whereby customers simply do not need the space that they are currently leasing and Parkway must work with them to achieve a balanced risk management versus NOI and value loss.

In the meantime, each and every day, we remain focused on office building basics, customer retention, leasing and operations in order to position the company for the future. For the third quarter 2009, the Parkway team worked hard to produce FFO of $0.76 per share. FFO was primarily driven by continuing to achieve our occupancy and rental rate guidance as well as diligent management of operating expenses. We also had a good quarter in leasing volume by completing over 665,000 square feet of new and renewal leasing which was better than our internal expectations.

We held the average same store occupancy for the third quarter to 88.8% led by our three largest markets, Houston, Chicago and Atlanta which all maintained occupancy above 90%. Customer retention and important metric for Parkway was approximately 58% for the third quarter as compared to 67% during the same period '08. This decrease was expected given the move out of Parker Drilling and DHL in Houston totaling 124,000 square feet. Excluding these two customers, customer retention would have been about 70%. These losses were mitigated by Southwestern Energy moving into a total of 118,000 square feet effective October 1.

Over the last year we've continued to reposition our balance sheet by selling non-strategic assets and raising capital in order to reduce our outstanding borrowings. On the disposition front, we continue to position several non-strategic assets for sale and will provide further guidance on these as these sales unfold. As a consequence today, our balance sheet remains in pretty good shape. Our trailing 12 month debt to EBITDA multiple is currently 6.6 times and remains healthy as compared to our office piers.

The mortgage market also continuous to improve, as we are now obtaining quotes at around 7% interest rates, down 50 basis points in the past few months, with loan-to-value still achieving 60 to 65%. We have over 20 insurance lenders actively providing quotes to us today. On the strategic front, we are beginning to see acquisition opportunities in our key markets related to our $750 million Texas fund too. While we stated that no acquisitions are planned for the remainder of '09, we are optimistic that we can and will return to buying in 2010 provided the U.S. economy continues to stabilize. But we are not sure now that we'll see a tidal wave of acquisitions we still believe there will be lots of buying opportunities over the next several years.

Regarding our dividend, we continue to pay an annualized dividend rate of $1.30 per share which represents approximately a 7.4% yield. Although we reported FAD per share of $0.34 during the third quarter '09, primarily due to new leasing costs, our year-to-date FAD payout ratio is still 67%.

Finally, the Parkway team continues to work hard in a tough economic environment and has exceeded our internal outlook, and as a result we are raising our 2009 FFO guidance which Mitch will discuss in greater detail in a moment. Before moving on to an update on operations, I would like to welcome Brenda Mixson to the Parkway Board. Brenda brings valuable experience in many areas that are important to the future of Parkway and we look forward to working with her. With that, I'd now like to turn the call over to Will.

Will Flatt

From a macro perspective, the leasing market remains challenged. The national office market contracted by nearly 20 million square feet during the third quarter and national office rents fell by 8.5%. Parkway is not immune from these trends. On a micro level, customers in the marketplace are taking longer to make decisions. This is driven by the numerous options they have available to them and the continued improvement in the economics they can realize by waiting. Available sub-lease space and its corresponding customer favorable economics are certainly having an impact in most of our markets. Those companies that are in the marketplace are often consolidating and/or reducing their premises as they seek ways to cut costs. Against this backdrop however, we are pleased to see the leasing activity that is available and importantly, that we are realizing our share of growth absorption. Put simply, there are deals to be made in order to maintain occupancy.

We are accomplishing the operational game plan that we laid out for you at the end of last year, resulting in same store average portfolio occupancy during the third quarter of about 89% and improved margins. Year-to-date, same store occupancy was 89.6% as compared to 90.7% for the same period last year. Our same store average rent for the portfolio was just over $23 for the quarter which is an increase of approximately 3%.

As anticipated, our embedded growth decreased this quarter to a negative $0.60 per square foot and we expect that market rates will remain under pressure into 2010. During a period where revenue growth is difficult, it is important that we focus hard on operating expense control for the benefit of Parkway and our customers. For the quarter we managed to a higher margin of 52% up 80 basis points as compared to prior year. We all realize in savings and real estate taxes and believe there should be continued reductions in this area in 2010.

We were also pleased with the significant volume of leasing activity for the third quarter. Total leasing of 665,000 square feet was in line with last quarter, as we renewed our expanded 464,000 square feet at an average rate of over $21 per square foot up 6% and at a cost of around $2.50 per square foot per year. These leases included the Bank of America renewal mentioned earlier for 144,000 square feet in Nashville, as well as Clear Channel 73,000 square foot early renewal at 233, North Michigan and Chicago. We found 203,000 square feet of new leases at an average rate of approximately $22 with around $5 per square foot in annual leasing cost. We have 635,000 square feet expiring for the balance of 2009 and only $1.4 million or 10% of our portfolio rolling in 2010. I believe our relatively low roll in 2010 will be a benefit in this environment and allow our teams to focus on net new leasing.

Of the 635,000 square feet remaining in 2009, approximately 190,000 square feet relates to our GSA lease in Chicago. This lease expires at the end of November 2009 and we will inform the capital markets once we receive the GSA's final decision. Nationally, the GSA has a 91% renewal rate. Subsequent to quarter end, we did sign the renewal and extension of Young & Rubicam for 68,000 square feet at 233, North Michigan. This lease which was scheduled to expire November 2011 will now expire in November 2018. As part of this renewal, Young & Rubicam contracted by 40,000 square feet. We are proud of our Chicago team for their hard work in retaining this important customer.

As Steve mentioned earlier, we've been able to achieve our original occupancy guidance despite the contraction of Bank of America and Young & Rubicam by a total of 80,000 square feet. By taking action today, we are able to mitigate large future lease expirations as well as large capital costs and meet the current needs of our important customers.

The leasing status report shown in the supplemental package on page 29, lists leases that have been signed but have not yet occupied the space and will commence paying rent in the next three quarters. As of October 12, our portfolio was 89.3% leased.

The schedule on page 16 of the web presentation provides additional updates on major leases expiring over 2009 and 2010. In our three largest markets, Houston, Chicago and Atlanta, our average occupancy held above 90% for the quarter. While Houston did endure some anticipated occupancy loss during the quarter due to Parker Drilling vacating, it remains our strongest market today with 450,000 square feet of leases rolling through 2010.

Even with market rents having coming down, our in place rents in Houston on average, remain $2 to $3 below market. Our Atlanta assets are 91% leased today and comprise nearly 13% of our annualized revenue. Leasing victories in Atlanta during the quarter include 56,000 square feet of new or renewal leasing at a rate of over $23.50 per square foot, with annual leasing costs of approximately $3.70 per square foot per year. Of all Parkway's markets, Atlanta is one of the most competitive leasing environment with the most new stock coming online in the Buckhead area. While Parkway's Buckhead exposure is limited to our Capital City assets, near term role is minimal with less than 25% of leases maturing before 2014. However, we do anticipate the impact of over building in Buckhead will spill over into several other submarkets.

Our Chicago portfolio remains well leased at 92% as of October 1, with Parkway CBD occupancy at approximately 93%. We now have 465,000 square feet rolling in Chicago over the next 15 months which includes the 190,000 square foot related to our GSA lease. Market rents are down approximately 6% or just under $2 per square foot as compared to average in place rents.

We are proactively working several large leases today, that would occupy either future direct vacancy and/or shadow space that we expect might be added to vacancy in future years. With 2009 coming to a close, the Chicago CBD will wrap up its current new construction deliveries, with no new construction scheduled to deliver for 2010 and 2011 and no planned additional starts on horizon.

With that, I would like to now turn the call over to Mitch for an update on financial results.

Mitchell Collins

For the third quarter 2009, we exceed out internal expectations by realizing total FFO of $0.76 per share which includes $0.02 in termination fees and $0.01 related to a non-refundable deposit net of expenses on our discontinued asset sale in Columbia, South Carolina. Parkway share of same store NOI for the quarter decrease $1.2 million or 4% compared on a GAAP basis and decreased $2.1 million or 7.1% on a cash basis. Excluding termination fees and hurricane Ike expenses in 2008, same store NOI improved $185,000 or nearly 1% on a GAAP basis and decreased $740,000 or 2.7% on a cash basis.

Margin improvement was primarily due to reductions and repairs and maintenance expense, utilities and real estate taxes as compared to the prior year. Our third quarter bad debt expense was $385,000 was lower than expected as compared to our 2009 budgeted run rate of approximately $625,000 per quarter or $2.5 million for the year.

As Steve mentioned earlier, our FAD for the quarter was $7.3 million or $0.34 per share down $0.20 from last quarter. This reduction is mainly due to leasing cost of several large new customers including $2 million of new capital related to our Tiffany & Bosco lease in Phoenix, the Katz Media lease in Chicago and Southwestern Energy in Houston. These three leases totaled almost 160,000 square feet. As we have discussed in the past, our FAD reflects the actual dollars spent on tenant improvement and leasing cost and by nature, will vary from quarter-to-quarter. Through the third quarter 2009, our dividend payout ratio is approximately 67% of FAD and is well covered.

Regarding our balance sheet beginning on page five of our web presentation, illustrates the significant improvement to our balance sheet as compared to last year. At September 30, our debt-to-EBITDA ratio was 6.6 times which is down from prior year and well below the average for our peers of approximately 7.5 times. As we discussed on our last call, the company's overall goal is a debt-to-GAV ratio of approximately 50% assuming a historical 8.5% cap rate.

Today, as noted on page 6 of our web presentation, our debt-to-GAV stands slightly above 50%. If you look at Parkway's market and product type, this cap rate is the approximate average cap rate of our acquisitions over the last 10 years. At September 30, we had $750 million in proportionate debt including our line and credit balance of $100 million, given a $100 million interest rate swap on our line at a 4.8% interest rate as well as our future capital needs, we continue to build excess cash reserves and had nearly $36 million of cash and cash equivalents at quarter end which is 25% higher than the second quarter.

Of the $36 million in cash and cash equivalents, over $23 million represent excess cash that results in a net line of credit balance of approximately $77 million. Regarding debt maturities, we have no maturities in the remainder of 2009 and only $64 million in 2010 assuming the extension options. Our balance sheet remains relatively healthy and we plan to continue to reduce our effective leverage overtime as we complete Texas fund II with targeted asset sales in non-strategic markets.

In discussing how to fund the company's $112.5 million equity investment in Texas fund II; we remind everybody that given our discretionary fund structure, every $15 million of Parkway equity will purchase $100 million in fund assets. This has accomplished through the placement of $50 million in first mortgage debt, a $35 million equity contribution by Texas and Parkway's $15 million equity contribution. Additionally, given the anticipated leverage on fund asset purchases assuming acquisition cap rates in the 9% to 10% range will result in EBITDA leverage on these acquisitions of 5 to 5.5 times.

When we think of funding Parkway's equity for Texas fund II there are several options for the company that utilize as outlined on page 17 of the web presentation. First, we have been building excess cash reserves since April of this year and currently have over $23 million in excess cash as we discussed earlier. This excess cash could purchase over $150 million in acquisitions today with no additional borrowings on our line of credit.

Second, we have targeted over $100 in asset sales with every $50 million in net cash proceeds giving the company the ability to purchase more than $300 million in fund assets.

And third, we have the ability to raise additional common equity but currently believe that this option will only be utilized with targeted and known accretive acquisitions. Having these funding options, gives the company the flexibility to ensure that we have future growth.

Moving on to our earnings outlook, we are increasing our FFO outlook for 2009 to $3.17 to $3.27 per share, up from $2.80 to $3.15 per share. Included in this FFO range are non-recurring items of $0.04 per share related to a gain on involuntary conversion from Hurricane Ike that was reported earlier. The increase in guidance is mainly due to the achievement of the high end of our previous rent and occupancy guidance, as well as better than expected NOI margin due to expense controls.

Our 2009 guidance now contemplates average annual same store occupancy of 89.0% to 89.5% and an average rental rate of $22.50 to $23 per square foot. Recurring same store net operating income for the year is now projected to be a decrease of minus 2.5% to minus 1% on a GAAP basis and a minus 5% to a minus 3.5% on a cash basis. Net G&A expenses are now projected to be in the range of $6.4 million to $6.6 million. Total capital expenditures are now projected to be in the range of $25 million to $30 million.

In closing, we want to advise you that for this year, we plan to issue 2010 FFO guidance during our fourth quarter earnings call in February 2010. While this is a slight departure from the prior year in which we typically released in December, issuing guidance in February will give us a better snapshot of how the economy or economic recovery is unfolding in Parkway's markets.

With that, I'll turn the call back over to Steve.

Steve Rogers

Before moving into Q&A we'd like to invite each of you to join us in Phoenix Arizona during the merry Phoenix in a flash Parkway's one hour property tour and reception highlighting our Desert Ridge and Squaw Peak assets. This will give you a snapshot of an OPERS fund I asset, the central asset and an opportunity to meet our management team on the ground in Phoenix. You should have already received an invitation but in the event you have not, please contact Sarah Clark. We hope to see you all there. With that, we'll be happy to answer any questions you may have at this time.

Question-and-Answer Session

Operator

The question-answer session will be conducted electronically. (Operator Instructions). Our first question comes from Jordan Sadler with KeyBanc Capital markets.

Jordan Sadler - KeyBanc Capital Markets

Just wanted to follow-up on some of the leasing commentary. I know that the biggest chunk of what's left to roll in 2009 is the GSA, and the 2010 roll you're starting to deal with now, but I also noticed that 2011 while out there is a pretty big year with some pretty large tenants rolling. Can you may be just offer some additional insight on conversations you are having with the bulkier tenants that expire to 2010 and 2011 that typically would need to give a little bit more notice or would need to be out ahead of it of expirations of size.

Will Flatt

I think that all customers we try to engage at least twelve months prior, for the large customers both they and us have an interest in making sure that we are engaging well in advance, as evidenced by the Bank of America renewal this quarter and the Young & Rubicam this quarter which were, one of them was 2011, in the case of Young & Rubicam and Bank of America was 2012. So, it is not lost on us that there are some large customers out there and I would say with very little exception, we are engaged in some form of dialogue with all of them.

Jordan Sadler - KeyBanc Capital Markets

Any visibility on anybody who has determined that they will not need the space customers of size.

Will Flatt

The only one would be the Federal Home Loan Bank in Chicago, which is at 111 East Wacker building.

Jordan Sadler - KeyBanc Capital Markets

For 113,000 or so?

Will Flatt

Yes. And so one of the benefits of knowing in advance and I referenced in my script, that we are actively working large customers to address shadow space or future vacancy and that is exactly what I was referring to with some of these larger roles and so, what we can do now is take advantage of the ability of their cash flow or perhaps their willingness to also mitigate the space because they are motivated to compete for deals in a market that on standalone may not be competitive, but using our money, a customer's money, existing customer's money, then we may be more competitive.

Jordan Sadler - KeyBanc Capital Markets

And well I have you Will, may be you could just speak to the press regarding AutoTrader, that they may be taking some space elsewhere outside of your building in Atlanta.

Will Flatt

Sure we have seen that same trade press and we have not received any sort of official notification from our other trader and so I think I would be remised at this point to comment on anything that they haven't said to us or directly to the press I would say that anytime we have a large customer that we have that risk, we are actively listing space on CoStar and working on the backfill, but that lease expires in February, I believe February 2011 and we have not received an official comment from them.

Mitchell Collins

No official notes.

Jordan Sadler - KeyBanc Capital Markets

And how much space would that be?

Will Flatt

They are just about 200,000 feet.

Jordan Sadler - KeyBanc Capital Markets

And then lastly, just as it relates to capital spending, you guys picked up the guidance and thank you for some of the color there. I guess most of that relates to just needing to be a bit more aggressive as it relates to TI and to winning some of these leases.

Will Flatt

We also have large volume and it would be when we will pay a commission on Young & Rubicam in the fourth quarter and so it's related to large volume and large size of leases.

Operator

We'll go next to Michael Bilerman with Citi.

Josh Attie - Citi

Hey guys its Josh Attie with Michael. I have two questions. Can you talk about what you are seeing in terms of acquisitions? What markets you are looking at and how much vacancy you'd be willing to acquire and put that into context of your targeted valuation range of 9 to 10 GAAP and then separately, can you tell us the mark-to-market where the portfolio is today and is it any different for what's rolling the next two years. Thank you.

Steve Rogers

Let me take account of the first part of the question and then may be the mark-to-market I'll ask somebody else to address on the portfolio. The acquisition market in general, as everyone can read from looking at real capital analytics work and the other public work that's out there in the marketplace, is anemic, and the reason it is, is just simply that the cellars are putting buildings out there at a lower cap rate and the buyers are offering higher cap rates and the spread differential is just simply too great to call those trades to take place.

We reported to you last quarter that Atlanta, Orlando, Nashville and Charlotte had not seen a trade in 2009. Now, we can say that there have been several trades in those markets. There's nothing close to normal, however there's at least we now go from zero to where we now have some trades taking place in the markets in which Parkway has historically invested in. So, that's why our commentary that we really have seen more. So we're starting to see a pick up. It is a pick up from a very low point mind you, but it is a pick up.

The vacancy in the United States today is 17% and Parkway's markets is also about high 17s in Parkway markets, low 17s in the Asian and so, we are seeing assets that have that much vacancy in many cases. We try to flip things into the marketplace that are principally full, 90% lease today. And the underwriting that is taking place out there in the marketplace has jacked the vacancy right up fairly dramatically from obviously old underwriting where people put in a 5% vacancy rate to where people are now just jumping immediately to 7%, 10% and a higher percent vacancy rate even if the asset is full. So, underwriting on vacancy has jumped up dramatically.

We would be willing to take vacancy during this time period, if we feel like that the asset is [leasible]. For instance, I think we have to get approval to go below 60% Jim, or 70%? So, in other words in our Texas Teachers allowable discretion in a box, if we saw something 68% lease, we'd have to get permission to do that. But we have permission and have discretion to take anything at 70 and we would be happy to take something at 70 and above provided we underwrite at 70 and above. So, we're not giving people credit for a lot of lease up in their projections today.

How that kind of translates into cap rates and internal rates of return and the like, we're still calling it for what we do at Parkway about a 9 to 10 cap rate market, still see some people talking 7.5 and 8s out there and may be they are out there and I see a lot of offers coming in to our assets that we have on the market as high as 12 and we haven't taken any of those, but there is a lot of offers in the 12s out there today. And so, I think you got a bunch of people just bottom fishing out there to see if they can pluck all assets. And so that's why there is just not many trades out there today, but a 9 to 10 cap with conservative underwriting, it auto translates into 10%, 11% un-leveraged internal rate of return. If you take 50% leverage as we are doing, you jack that 10 up to may be a 12.5% to 13% for our co-investee, which we translate into about 20 to 22 hour for Parkway.

So, that's kind of the math of the market places we see it today, and then you had a secondary question on mark-to-market Will?

Will Flatt

Yeah I think on page 17 on the web presentation, there is a slide called market information and it shows that our mark-to-market overall is down about 5% on total portfolio with 7% showing for 2009 and 1% showing for 2010. I would expect that we will continue to see pressure down in the 5% to 10% base both on markdown and in future reduction and rent.

Steve Rogers

I'll also add to that that on page 4 of our web presentation, you have this PPR chart I referred to in my opening remarks and it is projecting that rental rates will go down in 2010.

Will Flatt

About 9% and that's not mark-to-market mind you, that's just the market going down 9%. Parkway's rents may well be below market or above market and that number would be have a higher or lower delta but we just expect that the market as we said, on the last couple of calls, down about 5% to 10% in 2010. So, there's still a little downward pressure out there, is because GDP has turned positive, we're not out of the soup yet, we need to keep working hard. Did we answer your question?

Operator

We will take our next question from Rich Anderson with BMO Capital.

Rich Anderson - BMO Capital

So, I just guess I want to just look big picture, a lot of indications the market is really struggling, still, and yet you raised your guidance, because you'd be, in part because you raised your rent and occupancy numbers and run at the high end, but what gives you the confidence that where you are at is sustainable and you won't have to next quarter, say you know what our rents are coming in now, they are coming in below and our occupancy has sort of stabilized down. Why are you confident that what you saw in the third quarter is sustainable in light of all the stresses that you've seen in the system?

Steve Rogers

I don't think we said it's sustainable, so I want to try to be clear. All (inaudible) is the only guidance we have after the capital markets as 2009 guidance which is really November and December is the only two months left in 2009 and our stated policy on this bridge is that if we get outside of the range that we have given to you in the beginning of the year, which was 280 to 315 is we are obligated to revise that upward or downward too.

We do not, inside the year, give any guidance as you have noticed. If we are inside 280 to 315, but as we finish the quarter up and look at news that we now have, very current news, we could no longer sustain a 280 to 315 number with you and so we revised it accordingly. And I do not believe that this is necessarily an indication of what our 2010 guidance will be, we have yet to formulate fully, get more approval and actually deliver that though we will shortly.

Rich Anderson - BMO Capital

Okay. That's what I was doing. I was extrapolating and you didn't tell me to do that. So my bad.

Steve Rogers

No problem.

Rich Anderson - BMO Capital

The BOA deal that you did in Nashville, did you say that the rents were actually increased in that deal?

Steve Rogers

They were. BOA actually had a low rent when we bought the building. So you kind of have to know a little bit of the history on the building we purchased it many years ago and they had a very long-term lease that was coming up for exploration and had a very low rental rate, and so when we got together with them to do the early blend and extend, they wanted a little less space and they wanted about 40,000 to 50,000 feet less. We settled at 40. We obviously wanted more rate and no TI and more return. And after a lot of arm wrestling with BOA for a long period of time, we settled on what we reported to you today.

Mitchell Collins

That went from basically 12 and some change up to [15 37] Rich.

Steve Rogers

Those are gross rental rates. So, 12 was clearly a below market rate.

Rich Anderson - BMO Capital

12 to what?

Mitchell Collins

[15 40].

Rich Anderson - BMO Capital

You talked a little bit about this blandness and extend strategy to sort of project the downside. Can you give any color on what we're talking about? Is that the 5% to 10% rent down or is the blend in extend scenario above that range because of the specific circumstances of those types of deals.

Steve Rogers

Will, you want to take your pitch on that?

Will Flatt

I would say that the blend in extent would be different in the sense that usually you are taking space back and it's still going to be a markdown of that in place rent. So just if you want to take it against the average portfolio, you'd still be in that 5% to 10% range. If someone's paying a rent today in a mark-to-market whether they are marking the market because their lease is expired or they are marking the market because we are doing something early, then I think that is still a good range to use.

The deal specific items would be in there that I can't find all of that in the split deal, is how much square footage they want to give back and how much TI or lack they may need. And so, one of the benefits to us is that we can offer something of great value to the customer today which is the reduction in their expense in trade for something that is of less value which is TI today. And so, what we are able to do is mitigate future capital costs by giving them something today and I would say that there are some first come first serve in my mind which is I'm more willing to do in any one year, whoever steps up to the plate first in terms of customer how they build in and at some point, if you get too far out into the future, then it is not in our interest to take the space back today.

Rich Anderson - BMO Capital

On the topic of shadow space, would you be able to quantify how much space in you mind is sort of being underutilized today and how much is actively being marketed for sublease by your tenants?

Will Flatt

That would be a wild guess. On average, as I look at our market, you add somewhere between 1% to 2% of sublease space to direct vacancy expect you're looking at whether its CB or Reese and usually, it is about somewhere in there, what they are saying is direct to total vacancy and I have to just assume our portfolio is consistent with market today in that 1% to 2% range.

Rich Anderson - BMO Capital

Right, but what about underutilized? Are we talking about the same thing?

Will Flatt

I would be hard to venture a guess on that. If anything, it would just be a wild guess, I don't know because you have a chair vacant here and office vacant there and so, I'd say based on when we were renewing customers, I'd say its in that 15% range, maybe would be high. I don't really don't know. I shouldn't venture a guess.

Rich Anderson - BMO Capital

Okay. And I won't hold you to that. And then lastly, on the fund. Steve, I think you said there is a minimum occupancy threshold of 70%. I guess I thought it was 60% but is it 70%?

Steve Rogers

Its 60.

Unidentified Company Representative

My mistake.

Steve Rogers

60 is our published number and people have corrected me as I said that. I think I got it right the first time and got it wrong the second time. 60 is the number.

Rich Anderson - BMO Capital

And then what about the fund in your mind is, because you signed it a while ago and you haven't used any of it. What about it would be unattainable today in this market in terms of the terms of the deal?

Steve Rogers

We still talk to a lot of people who put money out in discretionary fund I spoke to a very large (inaudible) through the last week, put money out in discretionary funds just as a matter of course there are some questions for us and the question there about what they were doing. And the common theme I continue to see not just anecdotally is, that they probably pick on the asset management fees a little (Inaudible) but for discretion it's still very much alive and well out there. We produced, they don't want to put discretionary fund money out. It is a way to hook up capital with an operator. Most people don't want to build a big staff at a pension fund to run real estate. They want the operator to have some skin in the game and in our case, the 30% skin in the game is a big number and so, I don't think that number would go up any. That was a big number to begin with.

So, I think if we went out to redo or do our fund and new fund today, raise money fresh, we were probably looking at a smaller asset management fee, would be the only thing I'd say is really different today.

Rich Anderson - BMO Capital

Okay, full discretion is still kind of attainable.

Steve Rogers

Yes. I think so based on our discussions with our former partners, existing partners and we've heard a couple of very large West Coast pension funds are pulling that back a little bit, but that's not a rule, that's just some headline and I would say full discretion is still available today and that's a very important component of our fund strategy.

Operator

(Operator Instructions). We'll go next to the line of Brendan Maiorana, with Wells Fargo.

Unidentified Analyst

Hi yes good morning guys this is (Yung Hu) here for Brendan. My first question is in regards to your CapEx costs. Looks like your FFO to FAD differential for the quarter was about $0.40 was about $0.20 in the prior quarters. How should we think about that going forward? Is that just mostly due to timing and what should we think about Q4?

Mitchell Collins

A lot of that was timing (Yung), so we wanted to point that out and you look at it. We do have some early renewals that were not contemplated in the original guidance we gave you guys of $20 to $25 million at the beginning of the year. For example, Will indicated earlier, we got the Young & Rubicam deal that we're going to renew here, we took the Honeywell deal early in the year.

We've got other deals, BOA was not contemplated in the beginning of the year that's now has come to fruition and those have resulted in a higher leasing calls per square foot in this year's FAD. But will be less of a FAD impact obviously out in the future years because we've now taken care of those leases. So the we're going to step back and look at it again on a cumulative sort of year-to-date position we are still relatively we think well covered at 65% and we would expect those trend lines to hold into the fourth. If we get a couple of big leases signed and obviously that would impact that in Q4 and we'll update you at year end.

Unidentified Analyst

And going back to guidance, looks like your [queen] rates around $0.73 per quarter, but the implied for Q4 seems a lot lower. What is the biggest driver for that differential?

Steve Rogers

Yeah the implied would be about $0.68 for Q4 to get you to the high end of the range and we had margin improvement this quarter. We had some savings come in on the (inaudible) front. We've been talking to you guys about aggressively attacking real estate taxes and we had a couple of wins there. We had a softer summer, utilities came in better than we had expected. We had lower [R&M] that you'd expect in a recession time. We are not sure that same margin improvement will happen in the fourth and that's the reason that we pull back to the guidance of $0.68 on the high. Now, with current trend lines hold and we would expect that we'd be on the high side of that guidance and this is not too dissimilar to what we said last quarter.

Unidentified Analyst

And turning to the Career Builder space in Chicago, it seems like they are going to be vacating any backfill prospects.

Will Flatt

Nothing today. We are working on a couple of prospects so there's activity in the market, but nothing that is far enough alone that I'd be prepared to announce.

Unidentified Analyst

And finally in regards to your 2010 expirations, it looks like there's a big lease expiration in Houston including the neighbors, but the mark-to-market still looks positive and pretty decent in that market. How do you guys see that trending in 2010 and relative pricing power just from a landlord's perspective versus the tenants?

Will Flatt

In Houston it's still under pressure today. I think that even with all recovering natural gas has not in Houston is driven by natural gas as it is all today and so we are benefiting from the run off and so they is the positive spread but that spread is under pressure.

Operator

It appears there are no further questions at this time. I'd like to turn the conference back over to our speakers for any additional or closing remarks.

Steve Rogers

We have no additional comments at this stage. Thank you very much for signing up for our conference call today and we'll just get back to it. Have a great day. Thank you.

Operator

This concludes today's conference. Thank you for your participation.

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Source: Parkway Properties Inc. Q3 2009 Earnings Conference Call
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