Investors Real Estate Trust F1Q10 (Qtr End 10/31/09) Earnings Call Transcript

| About: Investors Real (IRET)

Investors Real Estate Trust (NASDAQ:IRET)

F1Q10 Earnings Call

December 11, 2009 10:00 am ET


Michelle R. Saari - Investor Relations

Timothy P. Mihalick – President and Chief Executive Officer

Diane K. Bryantt – Senior Vice President and Chief Financial Officer

Thomas A. Wentz Jr. – Senior Vice President of Asset Management and Finance


Carol Kemple - Hilliard Lyons

Guilermo Guro - RBC Capital Markets

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


Hello and welcome to the Investors Real Estate Trust second quarter fiscal 2010 earnings conference call. (Operator Instructions) Please note this event is being recorded. I would now like to turn the call over to Michelle Saari. Please go ahead.

Michelle R. Saari

Good morning and welcome to Investors Real Estate Trust’s second quarter fiscal 2010 earnings conference call. IRET’s quarterly report on Form 10-Q for the quarter was filed yesterday, December 10th, and our earnings release and supplemental disclosure package were posted to our website and also furnished on Form 8-K yesterday as well.

In the 10-Q, earnings release, and supplemental disclosure package Investors Real Estate Trust has reconciled all non-GAAP financial measures to the most directly comparable GAAP measures in accordance with the requirements set forth in Regulation G. If you have not received a copy, these documents are available on IRET’s website at in the Investor Relations section. Additionally, a webcast and transcript of this call will be archived on the IRET website for one year.

At this time, management would like to inform you that certain statements made during this call which are not historical may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Although Investors Real Estate Trust believes the expectations reflected in the forward-looking statements are based on reasonable assumptions, Investors Real Estate Trust can give no assurance that its expectations will be achieved. Factors and risks that could cause actual results to differ materially from those expressed or implied by forward-looking statements are detailed in Thursday's earnings release and from time to time in Investors Real Estate Trust’s filings with the SEC. Investors Real Estate Trust does not undertake a duty to update any forward-looking statements.

With me today from management are Tim Mihalick, President and Chief Executive Officer; Diane Bryantt, Senior Vice President and Chief Financial Officer; and Tom Wentz, Senior Vice President of and Chief Operating Officer. At this time, I would like to turn the call over to Tim Mihalick for his opening remarks.

Timothy P. Mihalick

Thank you, Michelle and good morning. It is my pleasure to speak to you to this morning in my new role as President and CEO of Investors Real Estate Trust. This past June, I completed my 28th year with IRET and have served in various capacities with the company. I have been lucky enough to have been part of a culture here at IRET that is focused on our mission statement, which is creating shareholder value. That statement has been and will continue to be at the heart of all that IRET stands for.

This morning, I will give you an update on a strategic plan that was put in place earlier this year which we believe allows us to build on the solid foundation that IRET has established over the last 39 years. I will then ask our CFO, Dianne Bryantt, to discuss this past quarter's financial results, and our COO, Tom Wentz, to discuss operations, debt issues, and market conditions.

The first of our major goals, which we have talked about repeatedly, is to internalize property management. I am happy to report that on the commercial side of our portfolio, we expect that by the end of IRET’s second quarter of fiscal year 2011, we should have that task substantially complete.

On the residential side of our portfolio, we expect to have approximately 75% of our portfolio in-house by the end of IRET’s first quarter of fiscal year 2011. As we have stated in the past, we have modeled this transition to have a mutual effect on our income statement but do believe that by gaining control of the day-to-day activities of our properties, we will be able to enhance property performance.

Goal two is to make better use of IRET’s personnel as we internalize our property management division and more IRET into a fully operating real estate company. We currently have those people in place and on the payroll but feel that by using best-in-industry practices and procedures, we can create more synergies throughout the organization.

This will allow IRET to take advantage of the local knowledge in the markets we do business in by having a more defined presence on the ground in which we currently manage through third-party contacts.

Goal three is to stay focused on the underlying acquisition fundamentals that IRET was built on. We have developed a plan to grow IRET profitably over the next five years by using a combination of investment and acquisition strategies designed to deliver stable income and reasonable asset valuation growth. This will allow us to stay consistent with our mission statement as I mentioned earlier.

We also intend to look to make acquisitions in the upper Midwestern part of the U.S., as those are markets that we currently do own property in and that we understand quite well. Some of the states we do business in were recently mentioned in an AP article regarding the analysis of economic stress to states and of the states mentioned with the least amount of stress, North Dakota, South Dakota, Montana, Nebraska, and Vermont, we do business in all but Vermont.

Unfortunately, that does not mean we are not seeing stress in some of our markets and Tom will touch on that later in his call.

The last of our major goals is concern with our capital structure. As we have in the past, we intend to use our [operating] program as a tool to acquire properties by offering the contributor the tax advantage benefits of IRET’s current [writ] and [up-writ] structure.

Also, we intend to take advantage of the traditional methods of raising capital, as evidenced by the recent offering we completed in early October. Although we have yet to deploy that capital, we have identified acquisitions that are discussed in the recently filed 10-Q that we will -- that we expect will put that money to work soon.

And finally, a couple of questions that I am asked quite frequently are one, are you seeing distressed buying opportunities in your market, and two, what is the status of your dividend? As for the answer to question 1, we have not yet seen an overwhelming amount of distressed buying opportunity in our markets. At this point, we continue to explore all of our contacts, whether it is a broker, a lender, or an owner trying to keep our finger on the pulse of potential acquisitions. I do believe we will see buying opportunities and we will continue to search them out.

As for the status of our dividend, at this point we are committed to continue the dividend history we have established. But as Dianne and Tom will touch on, we are seeing our operating results soften somewhat -- no precipitous declines, just an overall slow grind. If this continues for an extended period of time, we will have to re-examine whether our operating numbers can continue to sustain our current level of our dividend.

With that, I will now ask Dianne to review our second quarter financial results.

Diane K. Bryantt

Thank you, Tim. This morning I will highlight the most significant areas of financial results of operations for both the quarter and six months ending October 31, 2009.

The most significant financial items for discussion this quarter are real estate revenues for the quarter remained relatively flat at $59.6 million. Even though we are seeing decreases in our occupancy, most notably in our multi-family segment, rent from newly acquired properties are covering the increased vacancy lots.

Total real estate expenses increased 2.1% to $24.5 million from $24 million. This resulting in a small net increase in net operating income from our real estate portfolio. However, this small increase in net operating income from real estate was offset primarily by increases in interest expense, depreciation and amortization expense, and impairment charges taken that represent a $2 million increase in overall total expenses.

For the first six months of fiscal 2010, real estate revenues were $120.4 million compared to $118.4 million, a 1.17% increase. Again, the decrease in occupancy was offset in total rents received from acquired properties in the previous fiscal year.

Total real estate expenses increased 2.3% from $47.8 million to $48.9 million, thus resulting in an $854,000 increase in net operating income from our real estate portfolio. This increase in net operating income from real estate operations of $854,000 is offset primarily by the same factors that affected the quarterly results. Interest expense, depreciation amortization, and impairments.

As detailed in the 10-Q, page 20, factors impacting net income, interest expense comparative increase was primarily due to less capitalized construction interest in the current year as we are not in development of significant properties as we were in the prior fiscal year. Capitalized construction interest when recorded is a reduction in expense.

Depreciation and amortization is a non-cash expense that has an implied negative effect on our net income; however, is added back to funds from operations.

During the six months ended October 31, 2009, we incurred a loss of approximately $860,000 due to impairment of two properties. The company recorded charge for impairment of approximately $152,000 on its former headquarters building in Minot, North Dakota, based upon receipt of market offer to purchase.

The company also recorded impairment charge of approximately $708,000 on a retail property located in Kentwood, Michigan. This property's tenant has vacated the premises but continues to pay rent under a lease agreement that will expire on October 29, 2010.

As we mentioned in our last earnings call, a concern to IRET and all real estate owners is the issue of impairment during the current cycle of reduced trades, increased cap rates, and lower operating fundamentals.

Moving to funds from operations, on a per share and unit funds from operations basis for the three and six months ended October 31st were $0.16 and $0.36 per share in units respectively, as compared to $0.21 and $0.41 in the second quarter and six months of our prior fiscal year.

Total FFO for the six months was $85.2 million compared to the year earlier amount of $79.4 million. Although in total, absolute FFO was higher but total weighted average shares and units outstanding were also higher than a year ago. As discussed earlier, for FFO calculations, guidance provides that depreciation and amortization of real estate is added back to computer FFO. However, the non-cash expense of impairment is not. As described in footnote five of the funds from operations notes on page 31 in the 10-Q, impairment charges represented $0.02 and $0.01 respectively for the three and six months ending October 31st.

Moving to the balance sheet, the most notable expense affecting the balance sheet in the quarter were the common share underwritten offering completed in October 2009 which resulted in the issuance of 9.2 million shares and netted cash to IRET of $72,105,000. As of quarter end, the majority of the proceeds are held in cash, bringing cash on hand to approximately $103 million.

Mortgages payable as of the quarter end were $1.06 billion, with a weighted average interest rate of 6.27%. Finance activity in the quarter included the closing of five refinancing of multi-family properties with interest rate ranges of 5.69% to 5.98%, and 12 commercial properties with interest rate ranges of 6.18% to 7.3%.

Gross new loans were $66.1 million, net pay-off of 44.6 for approximately $29.3 million of cash out during the quarter.

Looking ahead for the remainder of the fiscal 2010, we have $45.9 million of mortgage debt maturing and we have loan application and commitments to refinance and close on $17.2 million of maturing debts, as well as new debt on unencumbered properties.

We will continue to monitor our refinancing strategy and pending maturities in order to protect our shareholders as the credit markets continue to be challenging.

During the second quarter of fiscal 2010, IRET acquired two properties -- a 42,100 square foot showroom warehouse property located in the western suburbs of Des Moines, Iowa. This is a triple net leased property to a single tenant for which we paid a total of $3.4 million. We also acquired a 15,000 square foot two-storey office building on 1.5 acres near IRET corporate headquarters in Minot, North Dakota, for a total of $2.4 million.

Subsequent to quarter end, we acquired a vacant parcel of land in Fargo, North Dakota, for $395,000. We will be constructing a new facility that will be leased to a single tenant with an estimated all-in cost of $4.2 million.

We have several possible acquisitions in the pipeline, as discussed in note 12, subsequent events, in Form 10-Q. We are also working on dispositions in markets that we plan to exit as we move forward with internalizing all property management. We are currently marketing for sale our 504 unit [Dakota Hill] multi-family residential property in Irving, Texas. The company is also pursuing refinancing options for the mortgage loan on this property that matures on February 1, 2010.

In October of this second quarter, IRET paid a regular quarterly distribution of $0.1710 per common share in units. Subsequent to our quarter end, the board of trustees declared a regular quarterly distribution of $0.1715 per common share in units to be paid on January 15th, 2010. The January distribution will be IRET’s 155th consecutive quarterly distribution at equal or increasing rate.

Now I will turn the discussion over to Tom Wentz Jr., Senior Vice President and Chief Operating Officer.

Thomas A. Wentz Jr.

Thank you, Dianne. From a strategic standpoint, this past quarter was very positive for IRET, despite the continued economic pressure on all aspects of the portfolio. It has now been over 12 months since the credit crisis appeared and almost two years since real estate fundamentals began to decline.

Even though IRET continues to see very meaningful near-term pressure on top line revenue, we believe that the two material threats to IRET’s continued long-term success have been resolved by IRET for at least the foreseeable future. Despite what may well eventually be the most restrictive debt market in a generation, IRET has and continues to be able to refinance the vast majority of its commercial and multi-family assets on acceptable terms and in many cases on better terms than the maturing debt.

Additionally, on the residential side, IRET is still able to access its equity by pulling cash out at loan closings. The second important event was IRET’s ability to raise a significant amount of capital for purposes of taking advantage of current accretive acquisitions and development opportunities in our market as they appear.

By demonstrating how our leverage strategy enabled us to deal with maturing debt, now combined with significant cash on the balance sheet, we are able to focus a majority of our time on growing the portfolio and improving operations.

In reviewing the past quarter once again, no positive change in that we continue to experience negative pressure on operations as confirmed by the supplemental information provided in the 8-K filed yesterday. Perhaps the only positive news is we don’t see an acceleration or further deterioration in most of our markets -- rather just dragging across what hopefully will be the bottom for the economy.

This morning, I will cover the credit markets as applicable to IRET and then provide a brief overview of IRET’s property level operations, as well as pending acquisitions and dispositions.

Like the market conditions, it is the same storyline on the debt side in that placing new or refinancing existing debt is very challenging, with the only real bright spot being interest rates. We are still pursuing the same debt strategy of placing long-term debt secured by single or groups of assets. We continue to view bank loans as a last resort but the longer traditional lenders remain less than fully active. This is a source of leverage we may yet ultimately be required to implement if the traditional longer term lenders such as life companies and CMBS lenders remain out of the market for another 18 to 24 months.

The issue with banks becoming the main source of leverage will require a modification of IRET’s leverage strategy as bank lending is traditionally shorter fixed terms, shorter amortization periods, and at least for now in contrast to lending practices earlier this decade, much lower leverage.

Current lending terms will limit IRET’s ability to pull cash from its commercial portfolio at the time of refinance. Each of these requirements do not match up well with IRET strategy of long-term fixed debt, long amortizations to maximize cash flow, and the positive impacts of inflation, and rent growth and of course the protection afforded by non-recourse debt as it pertains to the balance of the portfolio.

While this won't change IRET’s debt structure overnight due to IRET’s staggered debt schedule, as each quarter goes by and existing long-term commercial debt rolls, it is generally being replaced with bank debt or IRET is using cash out from multi-family debt to pay off maturing commercial debt.

The end result has been a deleveraging of the portfolio and a reduction of IRET’s target leverage levels with an increased level of equity. Currently for IRET, equity has a higher cost than debt, so by deleveraging and being forced to move away from IRET’s traditional leverage model, we will eventually require top line revenue growth to support increased amounts of equity, assuming our current cost of equity remain the same.

We are still maintaining our modified debt strategy to account for the decline in commercial lending by increasing leverage on our multi-family portfolio in order to maintain our overall leverage targets. We are doing this carefully and to a level that is still well within what our multi-family portfolio can handle from a coverage standpoint. We still believe that the proper long-term business model for real estate in general and IRET specifically requires long-term fixed leverage at 55% to 65% of our investment cost in real estate. To the extent possible, IRET’s debt strategy will remain unchanged.

Even by increasing our multi-family debt levels to offset a reduction in commercial leverage levels, we expect it will be difficult to maintain our desired leverage levels under current credit market conditions, as well as due to the fact that after the coming fiscal year, IRET’s maturing debt is tied more to commercial real estate than multi-family.

However, I would note that the amount of maturing debt in the next 24 months is actually only slightly more than what IRET has successfully handled over the previous 24 months.

IRET provides a detailed debt maturity schedule each quarter as part of its 8-K filing, so I won't spend any time discussing specific assets or the schedule of debt.

Despite the challenges presented by the current credit markets that first appeared over 18 months ago, we still don’t see any material liquidity or refinancing risk to IRET in the next 12 months for the same reasons previously discussed. Dianne provided details on recently closed loans. Currently, we have approximately $17 million of pending loans, which represent close to 40% of the maturing debt coming due during the balance of the current fiscal year, or over the next four months. While no assurances can be given that this debt actually closes, we fully expect that it will.

Before moving to property operations, I will briefly discuss sales plans and acquisition activities. IRET currently has two apartment complexes under contract for a total cost of approximately $4.3 million. Both are located in established IRET market in Rochester, Minnesota, with closing expected early next year, subject to debt assumption approval by the current lender. Additionally, IRET is in the final stages of due diligence on five senior housing facilities located in Wyoming. Consistent with prior quarters, IRET has no active plans to sell assets except perhaps those in markets where we have a limited presence. IRET does have a number of smaller properties for sale in various locations but the only significant asset for sale is a 504 unit apartment complex located in Irving, Texas, which is currently under contract for sale.

The current debt on the Texas property is $22.5 million maturing on February 1st, 2010. The purchase is still subject to buyer due diligence, so there is no assurance the transaction will close. As a result, we have also started the process to place new debt. If refinanced, we are projecting new debt in the $25.5 million to $27 million range, assuming either a sale or a refinance, IRET will have successfully handled the majority of its fiscal 2010 year debt maturities.

Now moving on to operating activities -- we provide detailed information in the 8-K on occupancy, new and renewal rental rates and expiring leases, so I am not planning to discuss any particular buildings or transactions in detail. Over the past quarter, IRET has seen no meaningful positive changes in any of its markets, other than reports seem to indicate that the pace of job loss has slowed and in some markets, such as Minneapolis, there have been recent reports of small job increases in the most recent months. However, as stressed in prior calls, without job growth, IRET sees no improvement to any of its commercial real estate segments.

As a result, our approach has not changed in that absent top line growth, we are focused on securing the tenants we have and reducing expenses in such a manner as does not impair the building's competitive abilities or long-term physical aspects of the asset.

Despite the continued pressure on gross revenue, we plan to continue to hold off on any meaningful reduction to discretionary capital improvements. We are in the business of long-term assets and plan to operate them as such, even though we are dealing with very real-term revenue pressures.

As in past periods, this approach has left IRET in a very strong position when the market improves, as well as when or if an asset is sold. We still believe that capital investments in our real estate now will result in stronger revenue growth in the future.

Of course, we continue to watch this very closely as the longer the market remains depressed, the sooner this policy will need to be adjusted.

We expect our strong cash position and policy on capital improvements will prove to be an advantage in retaining commercial tenants.

At this point, we see no better alternative to our strategy of focusing our capital on retaining current tenants, securing new tenants provided the credit is acceptable, and improving our assets for the long-term.

On the medical segment side, the situation in the market is most tenants are on hold, as the confusion and uncertainty concerning healthcare reform has resulted in near paralysis in new leasing and a wait-and-see approach on expansion. Overall, we view current expansion of healthcare coverage as a positive for on-campus medical assets which constitute the vast majority of IRET's medical investment.

The senior housing assets continued to remain stable with some downward pressure on occupancy that can be traced to potential residents waiting longer to make a decision on assisted living. However, the demographics remain good in all our markets and new competition has basically disappeared, with many announced or planned projects being abandoned for lack of equity and debt capital.

This is an area where we believe IRET’s balance sheet will result in a good advantage going forward as demand is likely to clearly outpace supply with no new senior housing products in the pipeline in almost all of IRET’s senior housing markets.

Unfortunately, as the current economic climate persists, the strong performance in IRET’s medical and multi-family segments have flattened and even declined in some markets. In residential, the decline in occupancy on a portfolio basis is being driven by weak economic conditions in the Minnesota market, first-time homebuyer credit, which was recently extended in IRET’s generally stronger markets, and as amazing as it seems, new competition coming online in those North Dakota, South Dakota, and Montana markets that continue to remain economically strong. In these markets, the economies have remained good to excellent for such an extended period of time as compared to the balance of the country, new projects have been developed and are coming online.

So far, the markets appear capable of positive absorption and of course, IRET has also built into these strong markets. However, the result has been to reduce the occupancy levels from close to 100% to the mid- to low-90% range.

Residential operations are still strong for IRET but have flattened out overall with some decline in certain markets. Even though we are clearly not experiencing the same conditions in most of our residential markets as many other parts of the country, we have always maintained our focus on improving on improving our residential operations, knowing that eventually the overall U.S. economic decline will find our markets as well.

Employment in IRET’s apartment markets is the number one driver of occupancy. While unemployment is not significantly increasing and still well below that of the national number and most other markets in the United States, just like commercial real estate, until employment growth returns and people feel more secure in their jobs, IRET’s focus will be on improved residential management and cost control as a way to maintain and grow bottom line in the residential portfolio.

Thank you and I will now turn the call back over to the moderator for questions.

Question-and-Answer Session


(Operator Instructions) We have a question from Carol Kemple of Hilliard Lyons.

Carol Kemple - Hilliard Lyons

In the multi-family market, do you think that you are being hurt most by unemployment or the homebuyers' credit?

Thomas A. Wentz Jr.

I would say it's a combination of both, depending on the market. In the markets where the economies have remained good to strong, the first time home buyer appears to have the most negative impact on occupancy. And in other markets, you take Minnesota, for example, Rochester, St. Cloud, that's clearly employment related.

Carol Kemple - Hilliard Lyons

Okay, and at this point, do you have any thoughts on calling the preferred, since it is a higher yield in the interest rate you are paying on your debt? Or would you want to save your cash for acquisition opportunities?

Timothy P. Mihalick

I think at this point, we would -- our intent is not to call that debt but to hold in and take a look for additional opportunities, as you just stated.

Carol Kemple - Hilliard Lyons

Okay. Thank you.


Do we have any questions that were submitted by email that you would like to go over, sir?

Timothy P. Mihalick

We do. We've had a request from an investor to address the use of proceeds from our October 2009 common stock offering. And as we said at that time, we completed our offering in October that we believe we would be able to identify opportunities to put the funds raised to work for our shareholders. In our quarterly report filed yesterday, and as Tom and Dianne have noted, we have discussed several potential acquisitions that are currently pending. Most notably, the potential acquisition of a portfolio of assisted living facilities in Wyoming for a purchase price of approximately $45 million. As we state in our 10-Q, we are in the final stages of negotiating a purchase agreement for this proposed acquisition and there are a number of contingencies and conditions to closing and accordingly, we cannot guarantee that this transaction will be completed. But we are working hard on that potential opportunity, as well as proposed acquisition of two apartment properties in Rochester, Minnesota.

We continue to see deal flow and we continue to believe, as we said at the time we concluded our share offering, that the additional equity capital we raised through our stock offering positions us to take advantage of potential acquisition opportunities that we believe will be available as the current difficult economic cycle persists.

The offering proceeds also gives us greater flexibility to manage through this cycle. As Tom Wentz has just outlined, IRET has long followed a conservative strategy of financing its real estate portfolio primarily through single asset mortgages with staggered maturities. As a result, we do not face any current material refinancing risk. However, we continue to watch with concern the limited liability available to the real estate sector. Accordingly, we are pleased to have been able to augment our existing capital base with the last equity raise.

With that, I would ask if there are any other questions.


Your next question comes from the line of [Guilermo Guro] with RBC Capital Markets.

Guilermo Guro - RBC Capital Markets

Going back to the dividend, where do you guys calculate your current [inaudible], and is there any particular timeline to grow into this dividend? I know that you mentioned that you will assess your dividend in the future. Is there a particular time, like a year or anything like that, to assess that?

Timothy P. Mihalick

I think at this point, we are looking out over the next 12 months where we will begin to evaluate the status of our dividend and our operating results, so 12 months out.

Guilermo Guro - RBC Capital Markets

And then I guess with regard to recurring capital expenditures, what is your rate for the commercial portfolio and the multi-family portfolio?

Timothy P. Mihalick

Well, as far as what we are spending per unit, as you know we don’t break out discretionary versus required capital improvements from that standpoint but again, we are watching it very closely and we are investing money with the understanding that it's going to have the long-term pay-off to the portfolio.

Guilermo Guro - RBC Capital Markets

Okay, and then going back to acquisition activity, you mentioned you talked a little bit about the fundamentals of [each sector]. Assuming that you actually close on all the pending acquisitions, and again considering the opportunities out there in the market, where will you expect to focus your acquisition efforts in the future?

Thomas A. Wentz Jr.

Really what we are seeing in our markets, the assets with the best operating fundamentals are on the multi-family side and the senior housing. I guess really the difficulty we've had is finding assets that reflect return requirements that the investment community are expecting. We are just not seeing distressed assets with income attached to them for sale. There's a lot of bad assets for sale but they have no income attached to them.

At this point, it appears just due to the constriction of capital and the demographics that housing, residential housing, and senior housing and once the healthcare bill works its way through Congress, medical appear to have the best opportunity because they appear to have stable income attached to them.

Guilermo Guro - RBC Capital Markets

Okay, that's very useful. And then I guess a couple of housekeeping questions -- with regard to the acquisitions [that closed] during the quarter, and the expected development that you announced, what are the cap rate requirements or the yield requirements that you guys are looking into that, or what are your expectations with regard to cap rates?

Thomas A. Wentz Jr.

Well, on the acquisitions that closed, the transaction in Iowa was a 9 cap, the acquisition in North Dakota was approximately an 8 cap on our adjusted basis, and the development, which is just underway, which occurred after the close of the quarter, that's expected to be at a 9 cap or above, depending on final construction costs.

Guilermo Guro - RBC Capital Markets

Okay, and then lastly, looking at your commercial leasing schedule, your new and expiring leases -- is that a cash or GAAP basis?

Thomas A. Wentz Jr.

That's an actual cash cost basis, so the cost of the transaction costs that are reflected on the commercial leases, that's actual cost and then -- are you asking about the face rates on the leases?

Guilermo Guro - RBC Capital Markets

Yeah, the renewal rates and the expiring rates, are those just cash rates or is that --

Thomas A. Wentz Jr.

Yeah, those are the actual cash net rental rates.

Guilermo Guro - RBC Capital Markets

Okay. And then lastly, looking at your leasing activities subsequent to quarter end, is there anything worth noting from that end?

Thomas A. Wentz Jr.

No, I mean -- we provide our lease maturity schedule from a commercial standpoint and an operating standpoint and like our debt strategy, we do spend some time trying to stagger our leases, so from a material standpoint, you know, there's nothing that isn’t in the K or the Q.

Guilermo Guro - RBC Capital Markets

And what about leasing activity with regard to available space already, excluding I guess the ones that are due to expire during the quarter?

Thomas A. Wentz Jr.

Well, I mean, as far as pending leases that we are negotiating?

Guilermo Guro - RBC Capital Markets


Thomas A. Wentz Jr.


Guilermo Guro - RBC Capital Markets

Or a space that was just available that is not I guess -- won't be included in the leases that are maturing in your schedule.

Thomas A. Wentz Jr.

Well, no, nothing significant, nothing out of the ordinary. I mean, I think as I indicated what we are seeing in our markets really is low activity, low leasing activity so I mean, there's no material pending leases or anything that is out there that is going to dramatically swing the operation one way or the other that we are aware of. Now obviously you've always got credit risk, but at this point we just aren’t seeing anything that's material. I think the theme that we are trying to convey is its pretty much dragging along the bottom out there. There isn’t a lot of positive activity, there isn’t a lot of negative activity. I think most of that has worked its way through the system on the commercial side with tenants. Those that were stressed credit, they've been smoked out. Those that are still there appear to be the survivors and the trick is really going to be when the economy improves and they start adding payroll, that's when we expect to see demand return to all segments in our commercial portfolio.

Guilermo Guro - RBC Capital Markets

Okay, thanks again, that was very helpful.


Your next question comes from the line of Christopher Lucas of Robert Baird.

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

Just kind of a follow-up question there, on the bad debt reserves, what has the trendline been for that?

Diane K. Bryantt

Bad debt reserves -- you're talking for the allowance for past due and --

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

Correct, yes.

Diane K. Bryantt

Overall, past due reserves are -- we maintain a level around 2%, very low. We are having some commercial retail write-offs but nothing significant. Mostly in the retail sector where you will see some tenant move out but the trendline has stayed relatively flat. Of course, it raises slightly as revenues increase in the -- increase the allowance but nothing significant, relatively level trendline.

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

And then Tom, just on the commercial side, as you are looking -- well, first of all, for the first half of the year, what's been the tenant retention rate? And then what are your expectations for the remainder of the year on that number?

Thomas A. Wentz Jr.

Well, I think as we've mentioned in the calls in the past, Chris, I mean, we track our retention rate and our success and that's really remained stable. We haven’t lost more tenants these past 12 months than in prior periods. I think what we are really seeing is the tenants that remain are really taking a very careful look at their space requirements and I would say the trend really is renew the tenants but they want to downsize or renew the tenants and they want rent reductions. That's really what we are seeing out there -- not tenants just disappearing or going to other competition, and I think really that just goes to the fact that tenants generally don’t like to move if they are going to remain in business. And we have a very diversified product mix in our markets. We've got a lot of alternatives and so if it's not going to be their existing building, we generally have other alternatives which can range from build to suit, which we've done in the past, to other buildings that are either less expensive. And again, that just goes back to our strategy in our markets that we are not all a suburban or we are not core downtown, as we try and maintain a spectrum of real estate to give our tenants solutions whether they want A, B, or various other types of space inside the commercial.

So long answer but I guess the renewal rates have remained the same but as you can see, the net income associated with them has gone down because of pressure on the rates, pressure on the total amount of space.

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

Thank you, and going forward, what is your sense as to the in-place cash rents versus where market rents will be on the renewals for the expiring leases for the next two quarters?

Thomas A. Wentz Jr.

Well, just looking at that and looking at what the trends are going to be, it's hard to make any predictions because a lot of rent is driven, base rates are driven by tenant improvements, [abated rent], there's a lot of things that go into that number. But -- and the other factors, IRET tended to buy buildings with longer lease maturities and more stable at the time of acquisition. So again, like our debt, fortunately we are coming out of periods that five, six, seven years ago and so from that standpoint, there isn’t as big of a decline.

I guess what I would expect to see going forward is consistent with what we have seen, and that's about a 5% to 10% knock-off from the existing base rate.

You know, the one benefit we've seen is the scarcity of capital among a lot of our competitors has really moved the commercial leasing market away from extensive and expensive TI, or tenant improvement packages. A lot of real estate owners are a little reluctant to commit that level of capital to retain commercial tenants. They'd rather have the commercial tenants do their own build-out or contribute more heavily to their build-out and reduce the base rate. I guess the end result for us as a long-term holder is basically neutral. You know, it doesn’t work out that way on the income statement because of expense versus amortization but from a cash investment standpoint, I think we are seeing a little bit positive movement from our tenants. We are putting less cash into deals. We end up with a lower face rate which of course could impact your building sale price but again as a long-term holder, we are really more focused on the cash flow aspect of the deal than we are at driving the face rate and putting the cap rate on it and saying this is what our building is now worth.

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

Okay, thanks. And then just in terms of just financing strategy, your Q noted that if you are successful in the senior housing transaction that you would look to put mortgage debt on that transaction. Would there be a sense to wait on that until -- to use the all cash that you have on your books right now for the acquisition and work on the refinancing later or would you do that immediately? What's your thoughts right there?

Thomas A. Wentz Jr.

Well, I think at this point, assuming the project actually clears due diligence and closes, we would not anticipate placing leverage, long-term leverage immediately and that would be a process we would work on. However, just based on our expectation on acquisition pipeline and other projects that are in preliminary stages, we would expect to leverage those assets even if we had the cash on the balance sheet and the reason I would say that is I think competitively long-term in that market with the rates that are available from the agency lenders and also from FHA, it just is going to be such a tremendous competitive long-term advantage to have that leverage in place and fixed. Because competitors will return to those markets but our expectation is they will return to the markets with a higher capital cost, and so I think to answer your question, we will leverage that regardless of what the cash is on our balance sheet.

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

Okay, and then I guess just trying to think through the opportunities, what is the general sense of the health of the banks in your footprint and are there opportunities that you see coming out of there or are they in sort of a wait and see and extend and pretend like much of the rest of the country is at it relates to the loans on their books?

Timothy P. Mihalick

I would say in that sense that we are kind of still in a wait mode up in this neck of the woods. Things continue to move along and as I mentioned earlier, we stay in touch with the lenders and all those that do business in our states and our markets. At this point, we are not seeing those opportunities but certainly are staying in front of those lenders and banks.

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

Okay, and then last question for me is just what sort of underwriting in terms of either an IRR or a return on invested capital are you looking for on acquisitions at this point in the areas that you are focused on?

Timothy P. Mihalick

Again, I think we've talked about our cap rate or our underwriting parameters in the past. We underwrite a piece of property with -- based on our cost of funds and add back two to two-and-a-half points on top of that to arrive at a cap rate based on 60% to 70% debt and that's the fundamentals that we've dealt with over the last 40 years and we will continue to use as our underwriting parameters.

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

Okay, great, thanks, Tim.


(Operator Instructions) At this time, we have no further questions. Do you have any closing remarks for today?

Timothy P. Mihalick

Sure, just to thank those of you that have participated this morning and we appreciate your interest in IRET and certainly want you to know that you are welcome to call directly to IRET with any questions that you have in the future. We are here for that purpose. Thanks again for participating this morning.


The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.

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