PS Business Parks, Inc. Q1 2010 Earnings Call Transcript

May. 5.10 | About: PS Business (PSB)

PS Business Parks, Inc. (NYSE:PSB)

Q1 2010 Earnings Call

May 4, 2010 1:00 PM EST

Executives

Ed Stokx – CFO

Joe Russell – President and CEO

John Petersen – COO

Analysts

Chris Lucas – Robert W. Baird

Michael Mueller – JPMorgan

Jordan Sadler – KeyBanc Capital

Josh Attie – Citibank

Ed Stokx

Good morning and thank you for joining us for the first quarter 2010 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 at www.psbusinessparks.com.

Now, I will turn the call over to Joe.

Joe Russell

Thanks Ed. Good morning and thank you for joining us. I would first like to give you an overview of our first quarter performance and then go into some detail on PSB’s recent acquisition activity. JP and Ed will provide more commentary on specific operational and financial metrics.

This quarter, not unlike the last several was impacted by continued challenging market conditions. We are however finding our fair share of leasing opportunities as we deploy a consistent strategy. Fundamentally, we have focused on driving leasing volume through discounting and low capital investment to keep our parks well occupied. This strategy has continued to benefit us as we saw a slight uptick in sequential occupancy with nominal capital expenditures and good leasing volume.

As we have discussed over the last several quarters, our customers wants simple, well-priced space to solve both functional and financial requirements as they adjust to the onerous impact of today’s challenging economy. We have seen little evidence that overall markets have corrected. Although I would say we have more confident that in most cases, markets seem to have bottomed. We are waiting for the positive impacts from job growth to turn market conditions upward, which has unfortunately been far too long and coming. Until then, we will stay focused on capturing customers that are either downsizing or looking for value real estate decisions.

The unique characteristics of our smaller user portfolio have performed well and keeping that portfolio occupancy above 90% will improve our position when the economy begins to grow.

Now, I would like to turn to PSB’s recent acquisition activity. In March, we announced our first acquisition in approximately 2.5 years, the Shady Grove Executive Center. We acquired the well-located 350,000 square foot multitenant office park in Rockville, Maryland, for $171 per square foot. This asset is an example of a type of deal we like best. It has underperformed this submarket for sometime and is in need of repositioning with nearly 89,000 square feet of vacancy, the majority in shell condition.

The prior owner launched a multitenant strategy having lost a major tenant and we intend to continue that process with our own set of tested repositioning, leasing, and property management techniques. Prior to this acquisition, PSB owned approximately 1 million square feet in this submarket where we currently have 96% occupancy. The addition of Shady Grove to this submarket will enhance PSB’s ability to cater to existing and new customers and the market that has historically been successful for us.

Two weeks ago, we announced the addition of approximately 700,000 square feet of flex assets in Austin, Texas. The rationale to expand our footprint in Austin is multidimensional. First, PSB has been in Austin for over a decade with similar flex product. In fact, many of the assets acquired are adjacent to or in close proximity to PSB’s existing flex parts and we have competed against them a number of times.

Second, by nearly doubling PSB’s portfolio here, we now own approximately 1.5 million square feet and will enjoy stronger economies of scale and again a far better options to offer our customers.

Third, a purchase price of $61 per square foot is well below replacement cost and will better position us to meet near-term and long-term market conditions, while generating good returns. PSB now owns nine business parks in Austin and we look forward to catering to a wide array of customers that are committed to growing their businesses in this desirable environment.

As was the case in the two recent acquisitions, we continue to be a highly qualified buyer with a pristine balance sheet and an ability to close deals efficiently. We are seeing a slightly larger population of opportunities as some sellers have come to the realization, the evaluations have stabilized, if not improved balanced by the reality that overall leasing rates remains stubbornly slow to improve.

Cap rates may have begun to tick downwards, but market conditions weigh heavily on underwriting assumptions. However, with a deep understanding of the markets where we own assets, we can often see through some of the near-term challenges that others may not. We are often viewed to be standout without today’s restrains and both imposed by lending conditions and we hope to see more opportunities into the market in the coming quarters.

Now, I will turn the call over to JP.

John Petersen

Thanks Joe. As we continue to see hints of an economy that is at or near the bottom, market conditions remain highly favorable to users in most markets and job growth is not yet playing a significant part in this recovery. While leasing conditions continue to be difficult and deal economics favor tenants, there is more user activity and interesting doing deals which could be a sign that we have reached the bottom.

New supply is also near historic lows, especially for multitenant flex, office, and industrial product. Still across most of our markets, vacancy continue to arise, rental rates continue to fall, although at a slower pace than last year.

Net absorption shows some improvement as Miami, Northern Virginia, Austin and Dallas had positive net absorption in the first quarter. In Q4 of 2009, only one of our markets Northern Virginia had positive absorption. Blended market occupancy in our markets was 85% in the quarter. Based on these current market dynamics, growing occupancy while minimizing transaction cost and rent reductions will be challenging for sometime to come and hopefully the worst is behind us.

There were several things that helped grow same-park sequential occupancy in the quarter by 20 basis points to 91.4%. We are able to provide customers value, a high-level of service, stable ownership and flexible lease terms. Northern California grew occupancy by 340 basis points to 88.9% due to several small deals across the portfolio, plus more than 10,000 square foot new lease in Santa Clara.

Also showing solid occupancy growth was Seattle of 170 basis points to 87.5%. Miami increased by 60 basis points to 96.1%. Maryland by 50 basis points to 93.6%, and Los Angeles grew by 30 basis points to 94.4%. In Austin, we had one 28,000 square foot customer outgrow our portfolio, which dropped the occupancy to 84.7%.

Orange County fell 160 basis points to 88.7% and Palm Beach fell 140 basis points to 88.4%, as both markets continued to show few signs of recovery.

Overall, same-park rental rates fell by 14.9% over expiring rents in the quarter. Orange County rents declined by 21%, largely due to 126,000 square foot office lease we were fortuned to sign in a very competitive leasing environment.

San Diego rents were up 19% and Dallas rents dropped 17%. Other market rent declines were in the 10% to 15% range. Leasing volume in the first quarter was 1.4 million square feet with an average lease term of three years. As always, small customers, those under 5,000 square feet drove activity and accounted for 361 deals or 83% of total lease production.

Our team in Florida executed 376,000 square feet or 27% of the company’s leasing volume. In Southern California, which remains a difficult operating environment, our team was able to complete 326,000 square feet in one of our more stable markets, Washington Metro, at least 217,000 square feet or 16% of the total volume. Another solid metric in the first quarter was retention of 61%. Northern Virginia led the way at 78%, Austin was 70%, Miami 67%, and Los Angeles 63%.

With an operating environment still challenging for landlords and deal economics favoring users, we continue to outperform in each of our markets. The opportunity we have in the economy and real estate markets continue to recover if you capture more than our share of the relative vibrant, small user community, and begin to turn the tide in their favor, especially in parks where occupancy is over 90%.

Remaining in 2010, we have approximately 3.1 million square feet expiring or 17% of the portfolio. As I have said before, these expirations represent a typical rollover schedule for us and we will aggressively manage these expirations to our benefit as the economy improves.

And finally, we are still sourcing new customers looking for the unique combination of value, service, and flexibility PSB can provide.

Now, I will turn the call over to Ed.

Ed Stokx

Thank you, JP. FFO for the first quarter of 2010 was $0.89 per share compared to $2.40 per share for the first quarter of 2009. FFO in the first quarter of 2009 included the gain related to preferred equity redemptions. Excluding the gain, FFO in the first quarter of 2009 was $1.13 per share.

Giving effect to the company’s August 2009 common stock offering, the pro forma FFO for the first quarter of 2009 was $0.99 per share, resulting in a comparative decrease in FFO of 10%. The decrease is attributed to a decline in same-park NOI of 5.9% as well as an increase in G&A costs.

Contributing to the decline in NOI was a 3.4% reduction in revenue driven by reductions in rental rates as well as a 1.9% increase in operating costs. During the first quarter of 2010, the company incurred $1.1 million in snow removal costs compared to $460,000 in the first quarter of 2009. Included in G&A cost for the quarter is $1.1 million of transaction costs related to the acquisition of Shady Grove Executive Center. These costs which in this case included certain transfer taxes are required to be expensed when incurred and will vary in magnitude from transaction to transaction.

Recurring capital expenditures for the first quarter of 2010 were $5 million compared to $4.9 million for the same period in 2009. While the amounts were comparable on a quarter-to-quarter basis, they will vary based on the extent of capital projects and leasing activity.

During the first quarter, the company incurred approximately $2.1 million in nonrecurring capital costs. Most of which relate to the company’s ongoing development of a 75,000 square foot industrial building in Miami as well to redevelopment of the adjacent 60,000 square foot flex building.

These projects remain on schedule and should be complete in the early part of the third quarter. PSB’s strong balance sheet and focus on cash retention have enabled the company to maintain exceptional FAD payout ratios amidst very challenging economic conditions.

For the three months ended March 31st, 2010 and 2009, the company’s FAD payout ratio was 59.5% and 45.2% respectively. While the ratio has increased in part due to the nature of the operating environment as well as the company’s common stock offering in 2009, these ratios demonstrate the strengths of PSB’s capital structure.

As I have stated on past calls, a number of our customers are working hard to sustain their businesses. In certain cases, they have been unable to do such. During the first quarter of 2010, we had write-offs of $419,000 compared to $290,000 in the same period of 2009.

The increase resulted from the early 2010 failure of a 20,000 square foot customer in Virginia. We have subsequently released all of this space with commencement having occurred early in the second quarter. Overall, write-offs remain at a very manageable level, diligent upfront credit underwriting and close monitoring of our customers’ financial stability has enabled us to keep write-offs of an uncollectible balances at levels approximating one half of 1% or less.

One situation of note, we have a 31,000 square foot office, a flex lease in Los Angeles County with a financial institution that has been seized by the FDIC. We have recently been informed that this lease which was used for back-office support and training, will likely be terminated by the end of the second quarter.

As a result of their intent to terminate this lease, during the first quarter, we reserved the balance of deferred rent receivables associated with this lease of $488,000. Until this space is released, this pending vacancy will impact revenue by approximately $195,000 per quarter.

Finally, as we announced yesterday, we intent to redeem the aggregate 74.1 million outstanding of our 7.95% Series G and Series K preferred equity. The redemptions will be funded with cash on hand and will result in a reduction in our annual distributions of 5.9 million, increasing quarterly FFO by $0.04 per share.

In connection with the redemption, the company will report a noncash charge of $2.4 million related to the write-off of the original issuance costs in the second quarter. With approximately a $133 million of cash on hand today, a history of retaining annual free cash of $30 million to $40 million, combined with an untapped $100 million credit facility, the company is exceptionally well positioned to take advantage of this redemption opportunity, while maintaining the liquidity necessary to take advantage of future acquisition opportunities.

With that, we will open the call for your questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Chris Lucas.

Ed Stokx

Hi Chris.

Chris Lucas – Robert W. Baird

Yes, hi. Can you hear me?

Ed Stokx

Yes, we can.

Chris Lucas – Robert W. Baird

Okay, great. Can you guys just comment a little bit maybe on what you are seeing in the diversity of your tenant base in terms of the strength of their business and demand and more broadly whether or not you are seeing in the breadth of your markets any pickup from small tenant interest at this point in the cycle?

Joe Russell

I will start, and JP you can add any color to it. Chris, the thing that we again saw in Q1 is the high percentage of deal activity continues to come from what we label small users, 5,000 square feet and less. And that’s certainly been consistent through the economy and there is a wide array of conditions that lead them to us whether it’s a renewal situation or a new lease taking place. A combination of some companies that are rightsizing their business and it now makes sense for them to come into our park, where they may have been in a bigger space. And obviously for cost reasons, headcount reductions, et cetera, it’s making a lot more sense to right size their business into one of our parks, so we are really trying to capture as much of that activity as possible and that’s certainly been consistent all of 2009 and even through the first quarter.

The tour volume that we are seeing is pretty healthy, meaning it continues to be a good driver for us and with again the ability to do 1.4 million square feet of leased transactions and 360 plus deals; there is a pretty good level of activity there. And I wouldn’t say it’s materially different through the first quarter, but the good news is that hasn’t tapered off, and I think that’s giving us some validity to a premise that we think that markets may certainly have bottomed, we are hoping. And as the economy starts recovering and more businesses either start hiring or have need for expansion space, we are going to tap into that too.

Chris Lucas – Robert W. Baird

Okay. Anything to add on that, JP or –?

John Petersen

No, I mean, I would just repeat what – echo what Joe said, Chris. I do think we are seeing some just to cover a couple of markets real quick. I think we are seeing some stability on a relative basis in the DC area. As you probably know also in Texas and I would say in Miami, that would be or I would say we are seeing the most stability in this turbulent economy. So that’s a quick market snapshot.

Chris Lucas – Robert W. Baird

Okay. On the acquisition side, can you give us a little more color on the San Antonio acquisition in terms of the product and what the tenancy’s like, just some color on it?

Joe Russell

Sure. Yes, Chris, it’s Austin, not at San Antonia.

Chris Lucas – Robert W. Baird

Okay.

Joe Russell

And –

Chris Lucas – Robert W. Baird

That’s a good start for me.

Joe Russell

Yes. So as I noted, we have been in that market for quite sometime north of a decade. And the thing that made sense for us as we pursue this opportunity is it’s a 13-building portfolio, average tenant size today is about 17,000 square feet. But because of the design of the buildings and their individual configuration we have a lot of ability to even take that average down as we see fit.

The thing that we like about that portfolio is it definitely it expands our footprint in that market and if you sought on an aerial basis, it really magnifies our ability to have better concentrations of assets. Now we have nine parts there. And the portfolio today is about 88% occupied, which is slightly better than the market. And what our goal to do in that portfolio is to keep it well leased, magnify the economies of scale, have far greater opportunities to cater to existing and growing customers not only in that portfolio but our own.

Again, we feel good about that particular market, because Austin has in our view a number of good long-term drivers not only because it’s a state capital, it’s got a great university system, there is a good tad community there. And then beyond those tiers, it’s just – it’s a very desirable place to live. And we feel at a $61 per square foot entry point, we have got lot of good flexibility to commence some good returns on that that portfolio, especially combined with the one that we have already got there.

So we have got it about 35 tenants in the portfolio that we have acquired a good array of industry types, it’s not over weighted by one or another, and it’s a good proxy for really our tried and true type. So it was a really good fit and we are excited about having a bigger presence in that particular market.

Operator

Thank you. Your next question is from Michael Mueller with JPMorgan.

Michael Mueller – JPMorgan

Hi. A couple of questions. Number one, Ed, the acquisition fee that’s going to be booked in the second quarter related to Austin, how big is that?

Ed Stokx

Well, Mike, as I said in my prepared comments, the cost will vary from transaction to transaction depending on whether or not we have transfer tax, whether or not we have loan assumption fees, et cetera. But generally I think it’s probably safe to assume that they will range somewhere in the 0.5%-1.0% to maybe a little bit more than that, absent transfer taxes or significant loan assumption fees, which this deal does not have.

Michael Mueller – JPMorgan

Okay so this one may be a rule of thumb the 50 BP. Okay. And then one last question on the numbers. Can you just walk through one more time the one-time items that were – that you would consider to be one- time that were booked in Q2? I know you had excess snow removal. It sounds like you had a rent write-off that may have been in there. Can you just run through those to make sure?

Ed Stokx

Certainly. Basically the one issue that we had, Mike, was the write-off of the deferred rent receivable related to the financial institution. That was $488,000. The other two things I noted in my prepared comments were snow costs at $1.1 million was higher than it has been in comparable quarters, and then our write-offs were up slightly at $417,000.

Michael Mueller – JPMorgan

And those are in the operating expense line items, those two write-offs?

Ed Stokx

Yes.

Michael Mueller – JPMorgan

Okay. Great. Thank you.

Operator

Your next question is from Jordan Sadler with KeyBanc Capital.

Craig Mailman

Hi it’s Craig Mailman here for Jordan. Ed, on the snow removal costs, are you going to be able to recover any of that later in the year or has everything been recovered that potentially could be?

Ed Stokx

We will certainly recover that. I think Craig, if you look at our historical financials, generally anywhere from 60 to 65% of our operating costs are recovered. So that may vary from market to market, but I think that’s generally a good estimate based on historical trends.

Craig Mailman

And was most of that booked in the quarter or do you guys true it up towards the end of the year?

Ed Stokx

We do a true up at the end of the year but we certainly accrue based on trends during the quarter.

Craig Mailman

Then just moving to the acquisitions, I think we tried to back into a cap rate on the Shady Grove and we were kind of coming out around the 9.5% range. Is that in the ballpark and maybe what could that stabilize to once you guys reposition that and lease it up?

Joe Russell

Craig, as you know, we don’t talk just specific cap rate expectations. The thing is it is going to weigh on the front end of that deals. I mentioned we have got about 74%-75% current occupancy. So there is about 89,000 square feet of vacancy in that part that will take us a bit of time to get leased up. And once we get to that point, I think we are going to be in a range you noted. But it has got some time (inaudible) to get us to a level of stabilization. Once it is stabilized, it should be in that high-single digit at hopefully better return rate.

Craig Mailman

And we could probably assume that the Austin would be in similar underwriting expectations for you guys in terms of returns?

Joe Russell

No. The stabilized return is going to be pretty close, but upfront, it’s going to be stronger because it’s not as weighted down by some current vacancy. So, as I mentioned, we purchased that at 88% occupied. So, we don’t have quite as much lease substitute to get that return into a better level. So, it’s closer to the numbers you talked to, higher single digits at the initiation of the acquisition. So, it doesn’t have as much ramp up tied to it.

Craig Mailman

And then maybe if you can just give a little color on what might be in the pipeline or what the deal flow might look like for you guys and kind of position that relative to the decision to redeem the preferred. Is that just in the near term you feel that you can get a better return on the redemptions versus what you’re seeing in the timeframe of closing or you are just – you have enough capital to do both in your minds?

Joe Russell

Yeah I think, there is a combination of things that led us to that decision, so, which include – there is a slightly better level of activity that we are seeing coming into the markets relative to opportunities. So, you have that component. So, that has not gone away. If anything, maybe it’s slightly better than it has been over the last few quarters. But balanced with that, as Ed noted, we still got high degree of flexibility with our balance sheet. We think we can tap into the preferred market, if need be, beyond even our current cash, and reserve tied to our Letter of Credit – line of credit. And then the other thing, it will just depend on how vibrant the pipeline becomes over the near-term here, what direction we ultimately take. But we still feel very confident. We’ve got plenty of cash to pursue some opportunities. And as that decreases with some success on the deal front, we think that what’s different in 2010 is we do have some good opportunity to bolster up the balance sheet if we need to. The preferred market has been opened up. And the 7.95 series that we are redeeming, if we went out and issue today, we’ll certainly be below that. At what point, we don’t know exactly. But we are pretty confident we’ve got some opportunity to improve that yield if we need to go out and issue. But we don’t have any need to go to that today. So we’ll see what that plays out to.

Operator

Thank you, your next question is a follow-up from Chris Lucas with Robert W. Baird.

Chris Lucas – Robert W. Baird

My question has just been answered. Thank you.

Joe Russell

Okay. Chris.

Operator

At this time, there are no further questions. I am sorry. We do have a question. A follow-up from Jordan Sadler with KeyBanc.

Jordan Sadler – KeyBanc Capital

Hi guys, just one real quick one. Going back to the acquisitions, if you had your choice, what market would you guys like to add today in terms of just given inventory or maybe economy of scale opportunities like you’d in Austin?

Joe Russell

That’s a good question Craig, and it’s a hard one to predict. I mean the benefit of what we have being in the multiple markets that we are in is we can look far and wide and make sense of a lot of things that give us many elements of advantages, whether we already have the scale or is there scale building opportunity. But we are combing all the markets that we own assets in. And again, it will depend on the particulars of any particular situation. And depending on what re-position opportunities are available or value add creation that we can put into an acquisition, we are going to look at that fundamentally as well as replacement costs et cetera. And then, later on top of that, any other advantages we get. So, there’s a good range of opportunity that we continue to source deals out of.

Jordan Sadler – KeyBanc Capital

Great. Thank you.

Operator

Your next question is from Michael Bilerman with Citi.

Josh Attie – Citibank

Thanks. It’s Josh Attie here with Michael.

Josh Attie – Citibank

Hi, it looks like Shady Grove – it was more of a traditional suburban office product, higher price per square foot than some of what’s in your existing portfolio. When you look at what’s in the pipeline and you think about where you want to be strategically, is it – do you see yourself doing more deals like that?

Joe Russell

Well again, it’s the same premise that I just talked to. We obviously have three product types in our portfolio; office, industrial, flex, with – can be (inaudible) multi-tenant bias to each of those products. And, again deals are deals, it will just vary whether it ends up having the office, industrial or flex. We are not able to specifically control our destiny and say we have to do a – we are only going to do a – for instance an industrial deal next or an office deal next. We are going to do the reverse, which is see what we can find in our variety of markets, and knowing that we are very comfortable on all three product types, all three works quite well under our operational umbrella, and we’ve been successful running all three. We are going to look at all three continually. So, as I mentioned, the thing that we really like best, especially when we got opportunities to get in and rework assets that may have been substandard performing or haven’t again done well in the recent past. We were pretty confident we can get in and probably rework some of those kinds of opportunities and we are seeing a bit of that, and we are encouraged by that.

Josh Attie – Citibank

Okay. Thank you.

Operator

There are no further questions at this time.

Joe Russell

Okay. Thank you everyone for your interest, and we look forward to talking to you next quarter. Have a good day.

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Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

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