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PS Business Parks, Inc. (NYSE:PSB)

Citi 2014 Global Property CEO Conference Call

March 4, 2014 2:15 PM ET

Executives

Joe Russell - President and CEO

Ed Stokx - EVP and CFO

Analysts

Josh Attie - Citi

Josh Attie - Citi

Citi’s 2014 Global Property CEO Conference, this session is for investing clients only and if media or other individuals are online please disconnect now. Disclosures are available up here and on the webcast on the disclosure tab.

We’re very pleased to have with us PS Business Parks, and CEO Joe Russell. Joe I’ll turn it over to you to introduce your team and get the presentation started.

Joe Russell

Okay. Thanks Josh, good afternoon. I am here with Ed Stokx our Chief Financial Officer. Sorry, now can you hear me? Okay. Good afternoon I am Joe Russell and I am here with Ed Stokx our Chief Financial Officer. So thanks Josh, I’ll make a few opening remarks and then open it up for questions. So a few highlights on PS Business Parks, we own approximately 30 million square feet of assets and they are assembled in 108 concentrated business parks in eight different states. Our focus is on multi-tenant flex, industrial and office buildings. We’re the largest public owner of flex space. The portfolio today now encompasses over 5,000 tenants with an average size of about 5,400 square feet.

We have been busy over the last four years, since 2010 we have grown the portfolio by 56% investing just over a $1 billion in new assets in about 10.7 million square feet. The theme of that investment activity has been to again focus on underperforming and undermanaged assets in very desirable markets. If you look at the stats that have come with those assets the blended in-place occupancy at time of acquisition was about 74% and today those assets have a combined occupancy of about 89%, so we’ve seen good traction and good receptivity to the repositioning efforts in that portfolio.

And if you compare that Non-Same Park portfolio to our more stabilized Same Park portfolio occupancy in those assets is approximately 92%, so we feel like we’ve got some good running room to continue occupancy growth in the 10 plus million square feet that we have acquired over the last four years. In the fourth quarter we added three new asset groups to the portfolio, in December that we closed on Bayshore Corporate Center, it’s a 340,000 square foot multi-tenant office park in the Mid-Peninsula market in the Bay area. Again for $60 million at time of acquisition about 82% leased. And then prior to that we bought three separate transactions all in the Dallas Metroplex that in total were about 1.2 million square feet. Those assets at time of acquisition were about 72% occupied.

So Same Park performance NOI continues to improve, we saw 2.1% increases in the fourth quarter, annual increase in Same Park NOI for 2013 of 1.4%. Across the portfolio we have been seeing a good trend that’s now nearly positive in terms of rent change. In 2013 our total rent change and these are expiring cash rents to new cash rents was down just 0.4%, so we’re encouraged by the traction that we have got again in the Same Park portfolio.

Another event in the fourth quarter 2013 we did a secondary common equity offering. We raised $192 million and again both with that and then in the first quarter of 2013 we raised about $110 million through a preferred equity offering. So we had some good funding in 2013, coupled with the fact that we generated about $45 million in free cash flow.

Finally I’ll end with, in December - or not excuse me in December but a couple of weeks ago we raised our dividend by 13.6% to $0.50 a share per quarter. So with that Josh I’ll open up for questions.

Question-and-Answer Session

Josh Attie - Citi

What do you think is the most misunderstood aspect of PSB by investors?

Joe Russell

Okay, yes one thing I’ll touch on is I mentioned it, we have a strategy and we focus on a small tenant, small user environment. And with that comes by design a higher than normal when you compare it to other your industrial office portfolios turnover. So the thing that comes with our product type and our tenant type is the fact that we have a annual turnover of lease expirations approximately mid-20%, 24%, 25% that’s exactly what we’re dealing within 2014. We look at that clearly as an opportunity especially if you look over the next three years about two-thirds of the portfolio will be reset as it relates to the in-place rents. And if you look at the environment that we have been in over the last four or five years where we have been subject to doing highly discounted deals in many cases to keep the portfolio well occupied. I think we’ve got a great opportunity to reset pricing over the next two to three years with the rollover that we’re dealing with.

Josh Attie - Citi

What’s the trajectory of -- I mean it sounds like your rent spreads have recently inflected positive, and I don’t know if you’ve given this number out before or you may prefer not to but what do you see as the mark-to-market on the portfolio?

Joe Russell

Yes, we’ve not talked to a specific market-to-market but I mean I think you can see the trend line that again if you look at the trots of discounting that was done say three to four years ago where we were discounting expiring rents to new rents by say plus or minus what’s 15 or so percent head, and then year-by-year since then that number has gotten less negative and just like you said, we’re -- we seem to be at an inflection point because in 2013 it’s flat but the great news again if you look at the amount of resetting that we’re going to be able to do because of our average lease term of about 3 years, we really feel like we’ve got some good traction to once again as we’ve done in prior cycles start taking that number to a positive metric. And it’s where we operate we think we’ve got some good opportunities.

In the fourth quarter if you kind of segment the portfolio we had nearly double-digit rent change in parts of Texas here in Florida where we’ve got a sizeable industrial portfolio, we saw 7% rent, positive rent change and what we’re continuing to do across the 108 business parks that we operate, is even on a park-by-park basis look for those opportunities and resetting of rents and now really trying to take advantage of the traction that we’re starting to see in some of the market fundamentals. Now the fundamentals are certainly positive in regard to it is better business activity, they are better in terms of literally no competitive products coming to any of our markets. So we’re not seeing any new inventory enter and by virtue of expanding the platform as much as we have over the last four years we even have a bigger footprint to take advantage of in the market so we continue to choose to grow in so.

Unidentified Analyst

[Indiscernible]

Ed Stokx

Well we’re giving on average anywhere from 2% to 3% escalators and what was the first part of your question?

Unidentified Analyst

[Indiscernible]

Ed Stokx

Well we’re still significantly below, if you look at our average inflation rents today versus where they were say four years ago, we’re still significantly below that across each product type, so if you look at our average rents, in-place rents on office, industrial, flex, we’re still well below that, so we think as Joe mentioned there’s significant running room there.

Josh Attie - Citi

Are you seeing market rent growth in all the major geographies that you’re in?

Joe Russell

We’re seeing it in many of those markets, which would include, I already mentioned Texas and Florida, Northern California, where we have our largest footprint from a square footage standpoint, it’s got a lot of good trending market rent statistics, parts of Southern California have finally started to show that kind of traction, in our case more so in LA and San Diego County not so much yet in Orange County. So market-by-market we’re starting to see I would say it’s across the board but we’re definitely seeing a higher population of market movement in that regard as well.

Josh Attie - Citi

And maybe just, you’re in a lot of geographies but your major markets maybe rank them kind of best to worst?

Joe Russell

So, if you had to, I think it would correlate and closely play to what we announced in the for fourth quarter results, again Boston, Austin have been very strong markets for us, both through the recession and now coming out of the recession, we’re seeing good fundamentals there. We’re seeing good fundamentals in Northern California where we now own about 7.5 million square feet of assets, Florida we’re seeing very good traction, we’ve got close to 4 million square feet here, Seattle is a market that we expanded in about 18 months ago. We are seeing good activity there. We’ve got a large asset that we bought that we’re continuing to fill up but it’s on a good occupancy clip, so we’re again seeing good metrics there. And then I would tier end of the markets that are closer to flat but again seeing bits of percolation that would again include LA and San Diego County and even honestly we’ve got a sizeable portfolio in Washington DC, we had a little bit of negative rent growth there on the fourth quarter but again we’re seeing good signs of stabilization far different there than we’ve seen over the last year or two with all the government activity that’s been highly negative but there’s a little bit more stabilization there and we feel like we’ve got some good opportunities even in that market.

Josh Attie - Citi

And is supply becoming an issue in Dallas or Austin which are stronger markets, it’s still easier to build there?

Joe Russell

Yes, even there Josh, we’re not seeing any threats of supply, there’s been a very good level of discipline and again we’re likely not to see even if some supply started to come about would be I think operators that would literally cater to the same type of tenants that we’re pursuing. That was one of the advantages that we saw in the acquisitions that we did in 2013 in the Dallas market. So all the assets that we bought there are flexed but they’re very small tenant oriented say tenancy between 3,000 to 4,000 square feet on average. And rarely do we see or do we hear about any contemplated activity that’s going to cater to that type of tenant size.

That Dallas in particular is a market that historically and this would be 10 years ago or later had a tendency to get overbuilt at certain points or certain cycles but again for the last decade, we’ve seen very little of what. And again, we feel like we’ve got a good set of assets in that particular market that we feel even if any competitive activity or construction work to come about we’ve bottled those assets well below replacement cost, we can price them very competitively and even with all that we really still don’t see any competitive threat from an inventory standpoint.

Josh Attie - Citi

Can you spend some time on DC and Northern Virginia your portfolio and also the overall market?

Joe Russell

I’m sorry I missed the first part of your.

Josh Attie - Citi

Spend some time on Washington DC and Northern Virginia both your portfolio and also trends in the overall market?

Joe Russell

Okay, so yes, as I mentioned there has certainly been a lot of negative headlines that have come out of that market over the last year and a half or so primarily government related. Our asset base and our business parks there again have a higher office orientation than flex first of all. But our average tenancy there is still below 4,000 square feet, so at the end of the day we’re not catering to or going out and trying to source large users. We cater to and look for tenants that are going to be small by nature. It’s a cross-section of the entire business community there. And again we’ve been able to source and see good activity especially in that size range.

By example in 2010, we bought about 1.2 million square feet of multitenant office product in the Tysons submarket. And when we bought those assets, they were hovering in the low 60% range or so from an occupancy standpoint and today they’re close the mid-90% occupancy range. Now the formula for that success has been again to cater to and divide space into small units and go out and source smaller users even in a market like that that’s had both net negative absorption and again a lot of negative headlines relative to big user demand. So we’re again competing and able to see absorption in occupancy primarily through again the fact we’re catering to tenant site that most other landlords do not.

And it’s a good value product. They’re well located. And again we’re seeing descent demand factors even a market that’s had relatively high level of negative headlines around it. So the things that we’re seeing going into 2014 in that particular market is there is to a degree a higher level of stability. There is a little bit more on balance confidence that we’re seeing even in the types of users we deal with just again based on the fact there doesn’t appear to be a looming government shutdown. The budget process is relatively stable for the near-term and the climate in general is feeling a bit better, so.

Josh Attie - Citi

Now that you’ve done the majority of the lease up both in Tysons and Northern California I know you probably still have a little bit to go, but can you talk about some of returns that you’ve been able achieve? I know you don’t like talk about it before you do it but now that a lot of it’s been done in hindsight what kind of deals are you getting on those?

Joe Russell

So, do you want to?

Ed Stokx

Yes I can touch on that. Josh we don’t typically give specific asset returns but our initial yields on some of these assets that are not stable and have high levels of vacancy are generally around 6% kind of going in with targets of getting them to mid-7s mid-8s as we get them stabilized and then once stabilized, we’ll get more pricing power on rents and we can get them even to a higher return levels and in some cases into the low double-digits. And what I could tell you is that across the board on all of the assets that we’ve acquired we’ve been able to generally get to our objectives. Now there has been some that may be have taken slightly longer than we’ve initially had thought but those initial hurdles are proving to be certainly attainable.

Unidentified Analyst

Hey guys. Generally speaking your tenant size has been under a lot of pressure in terms of being able to sourcing financing for their businesses.

Joe Russell

I’m sorry can speak loud.

Unidentified Analyst

So your tenant size generally speaking have been under quite a bit of pressure in terms of sourcing financing for their businesses, so what are you hearing from your tenants specifically on that point in their confidence around better environment?

Joe Russell

Okay. Yes, sure. So I think your question relates to Josh’s upfront question may be a little of a level of misunderstanding around the portfolio at large. So, there is no question because we deal in a sea of smaller company sizes. It’s easy to put the label that they are far riskier. We were potentially dealing with more onerous credit situations, defaults and those kinds of things, but in and out of the cycle that we have seen over our 16 years as a public entity and particularly in the most onerous recession that all went through. Our bad debt expense has always been 1.5 or 1% or so, I mean so what it takes however to keep that as tight as it has been is it requires an active level of upfront due diligence on the credit quality of the tenants that we are bringing into the portfolio.

There is no question that some of them aren’t going to look great statistically or as sound as bigger entities but far majority of these companies that we are dealing with and again in our case we have got over 5,000 of them in our portfolio. They are solid businesses. They have been in formation for years again they are well run. And when and if we run across any kind of a stressed situation whether it’s a default or a tenant that’s enable to for whatever reason make a monthly rental payment, we are going to act on that very quickly. So, the reason we do, do that is that we are not going to hold on to and/or try to correct a situation that may be fatal. And again because there are, in the United States 23 plus million small businesses out there, the thing that we are always very comfortable doing is re-tapping the market and going out and finding a replacement and usually we can do that in pretty quick fashion. And again that’s another reason why we cater the small users.

Unidentified Analyst

That’s fair. I think what I was getting at was less in terms of a misconception of your business but generally speaking we do know that small businesses have complained about lack of financing.

Joe Russell

Okay.

Unidentified Analyst

So, just trying to get more at what are you hearing from your tenants, so is it getting easier to get credit…?

Joe Russell

I’d say on the margin it is a bit easier and again two, kind of the collection especially the ones that we deal directly the fact that they have figured out any and all ways to survive a very onerous economic environment and set of business conditions and still have businesses that are capable of moving forward and now coming out of the economic recession. We are certainly seeing and we are having far greater numbers of conversations with our tenants that are actually growing again, okay. Now, to fund that growth, they are certainly able to tap into different sources of capital and it’s no way as easy as it was five or six years ago but I think things are easing up.

Josh Attie - Citi

What’s driving the Florida recovery, you mentioned earlier I believe that was in the top three of your list and do you expect big winners and losers by market?

Joe Russell

Sure. So, what’s happening here in Florida is, our portfolio is primarily based at the Miami International Airport, so we have got about 3.3 million square feet. It’s our largest single business park. We have over 50 contiguous industrial buildings on the 248 acre parcel that’s literally just west of the tarmac at the airport. So, again the demand factors that come into that particular park are certainly distribution in and out of both the airport and actually even the port of Miami. Miami continues to become even a broader international hub for not only South America but even Europe. And again we are seeing just a lot of good fundamental trade activity that again has been very positive for that portfolio.

Josh Attie - Citi

Can you give us an update on the residential project that you are working to get entitlements on in Tysons?

Joe Russell

Okay. So, Josh is talking about we have a 45 acre parcel in the center of Tysons Corner in Northern Virginia. We bought that park that has eight office buildings, multi-storey office buildings and one of the parcels is a perfect rectangular site that has a 125,000 square foot vacant office building on it which we have intentionally not released. When we have acquired the park, we saw and we were sensing that it was a candidate for higher and better use. There is some rezoning capabilities in that particular submarket because of the expansion of the metro line, which is providing property owners higher density and broader use. So, it was an opportunity for us to think about again not only higher and better use but higher valuation of the site even outside of an office context.

So, we structured a JV with highly regarded local developer and we have begun the re-entitlement process for the parcel. We are more or less getting through the first stage of that. It’s tracking well but it will take us a few more quarters to what that process play through but all indications at this point, it will be again a successful opportunity relative to not only getting it rezoned but the fundamentals and attributes of it for a multifamily side are quite high. And with the way that we have structured the JV we will have a level of different options to monetize that whether we end up keeping it long-term, taking it back to the market once we’ve developed it, we’ll see, but we’ll keep you posted on our progress but so far so good.

Josh Attie - Citi

And how large could that be in terms of dollars either gross or your share?

Joe Russell

Yes, it’s again Josh it’s tough to peg an exact number yet because we’ll have to go through that whole process. But it’s proving to be more or less about 400 or so unit complex. It will be stick on podium so with that we’ll continue to keep you posted as costs come through.

Josh Attie - Citi

And you already you have a partner who has the operating expertise that you…

Joe Russell

Absolutely, so both on the development and the operational side so there is no question we’re not confused about the fact that we don’t own and operate that kind of assets. It’s a great amenity that we’ll play to the 45 acres and in that park we have about 800,000 square feet directly of office ownerships so it will be a great amenity even for the companies that operate their businesses in our parks. But yes our partner is well skilled not only on the development side but on the operational side.

Josh Attie - Citi

And is this, do you think, was this really just a unique opportunity that was part of an asset that you acquired or are there other exists in the portfolio that to the extent this goes well there could be two or three more that you do?

Joe Russell

Yes, so it could be. And the reason I say that is what’s happened overtime in the 108 business parks that we own is overtime many of them have become even more main and main relative to location depending on what’s going on with specific zoning opportunities to some degree here and there, there could be higher and better uses tied to them. This was kind of an obvious opportunity again because we had a full vacant building that we were able to intentionally not lease. And so it made it that much more of an opportunity to accelerate, so we could time it relatively well. But here and there, we’ll consider to, to look at those kind of opportunities.

Josh Attie - Citi

What are you seeing in the acquisition market?

Joe Russell

So, again as I think others have talked to in the various meetings and sessions here, there is no question there is more capital coming into acquisition environment. Cap rates are under again some more pressure because of that. We feel really good about the timing of the bulk of acquisitions particularly one, two or three years ago. And even the assets that we bought more recently we still feel like we got good value. But there are more entities out there that have good access to capital that can, from time-to-time create values that we’re going to back away from.

So, if you look at again two years ago we did in a single year our highest level of acquisition volume it was well over $0.5 billion, in 2013, we did about $160 million of acquisitions. And it was the combination of not seeing as many good accretive repositioning opportunities because we’re still going to stick to finding deals that we can buy right well below replacement cost, reposition and get the upside. Again, once we’ve taken them through those repositioning efforts. So my guess is we’ll still find those even this year but there is more capital out there and there is going to probably be some pricing pressure tied to it.

So, you’re not going to see us as you have been with the $1 billion that we’ve invested over the last four years go out and buy stabilized core assets. Again, what we really feel we’re skilled at and in a relatively short time we can turnaround many of these assets and get them into good accretive returns and those are the assets we’re going to continue to go out and source, so.

Josh Attie - Citi

The REIT portfolio was really a unique opportunity both to get a lot of yield when you stabilize and also to put a lot of dollars to work at the right time.

Joe Russell

Correct. Yes.

Josh Attie - Citi

Are there big portfolios out there now?

Joe Russell

Yes, it’s a good question and typically not in that size range so that deal in and of itself was $520 million, 5.3 million square feet and has been usually large. Okay. And not that we won’t ever see another one of that size and scale but the things that led us to it that we felt were highly desirable was more or less in one geographic area great park concentrations but by virtue that asset we bought although over 20 individual parks, so well located assets, it’s simple all one storey and a great concentration. And again we don’t see very often something of that size all at once.

Now however what can be very additive and depending on opportunities we can still go out and find smaller opportunities that have equal if not better opportunities in and of themselves. So, I’d tell you the deal that we’ve bought in the fourth quarter in San Mateo in the [indiscernible] area is a great office complex. It’s on 15 acres, it fits the exact same profile, about 80% occupied, underperforming, we can in very short order retrofit it, it already has a average tenant size below 2,000 square feet, but it was a $60 million deal, so we’ll continue to go out and find those kinds of opportunities across the markets we operate in and we’ll see what kind of volume we can do.

Josh Attie - Citi

And just thinking about the yield targets that you talked about, earlier you said kind of 7% to 8% or 8.5% is what your pro forma and then if sometimes if things outperform you can get into the low double-digits. When you think about lease and the market rents have probably gone up in the market since you bought that asset, is it fair to say that that’s one that’s in the double-digits?

Joe Russell

No, it’s not there yet, so what I think Ed was talking to is you probably are going to have to take an asset through a generation or two of full leasing to probably get to that full level of return so the first stage is always let’s optimize it from an occupancy standpoint, so we’ve basically done that in the two years that we owned it taking it from about 80% to 94%, we have two things that are positive, that’s ahead of us in that portfolio, market as you just mentioned continues to do quite well and by virtue of the fact we’ve now got our own assets in an optimized occupancy level, that too gives us some additional momentum on the pricing side so those things will play through now in the next stage, but we’ll need a little bit more time to get into that range.

Josh Attie - Citi

So the average lease duration is three years for an asset like that?

Joe Russell

Pardon me.

Josh Attie - Citi

The average lease duration is three years?

Joe Russell

Portfolio wise yes, yes.

Josh Attie - Citi

Okay, before I wrap-up, three rapid fire questions, first where do you think same store NOI growth will be for your property sector in 2015?

Joe Russell

So, yes Ed do you want to take your opinion on that one?

Ed Stokx

Sure. I’ll take that. Growth in the property sector for ’15 I would probably say 2% to 4%.

Josh Attie - Citi

If you could snap your fingers today and sell a portion of your assets without any reinvestment issues, tax issues, what percentage would it be, and I guess the question really is what percentage of the portfolio you think is non-core?

Joe Russell

Yes, it’s going to be small, I mean again the fact that our asset base is concentrated around the 108 business parks, we really see long-term and enduring value and they’re not easy to get a hold off, especially in the configurations that we have today, the size and the desirable location so it would be a very small percentage.

Josh Attie - Citi

Do you think cap rates are higher or lower one year from now?

Joe Russell

One year from now? I think they might be about where they are right now.

Josh Attie - Citi

Okay, thank you.

Joe Russell

Okay.

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