Duke Realty Corp. Q2 2010 Earnings Call Transcript

Jul.30.10 | About: Duke Realty (DRE)

Duke Realty Corp. (NYSE:DRE)

Q2 2010 Earnings Call

July 29, 2010 3:00 PM ET

Executives

Randy Henry – Assistant Vice President, Investor Relations

Denny Oklak – Chairman and CEO

Christie Kelly – Executive Vice President and CFO

Mark Denien – Chief Accounting Officer

Analysts

Ki Bin Kim – Macquarie

Josh Attie – Citi

Chris Caton – Morgan Stanley

Brendan Maiorana – Wells Fargo

Mike Knott – Green Street Advisors

Vincent Chao – Deutsche Bank

Sloan Bohlen – Goldman Sachs

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Duke Realty Quarterly Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer period instructions will be given at that time. (Operator Instructions)

And as a reminder today’s conference call is being recorded. I would now like to turn the conference over to your host, Assistant Vice President of Investor Relations, Randy Henry. Please go ahead.

Randy Henry

Thank you. Good afternoon, everyone. And welcome to our second quarter earnings call. Joining me today will be Denny Oklak, Chairman and Chief Executive Officer; Christie Kelly, Executive Vice President and Chief Financial Officer; and Mark Denien, Chief Accounting Officer.

Before we make our prepared remarks, let me remind you that the statements we make today are subject to certain risks and uncertainties that could cause actual results to differ materially from expectations. Some of these risk factors include our continued qualification as a REIT, general business and economic conditions, competition, interest rates, accessibility of the debt and equity capital markets, increases in real estate construction costs and other risk inherent in the real estate business. For more information about those risk factors, we would refer you to our 10-K that we have on file with the SEC dated March 1, 2010.

Now, for our prepared remarks, I'll turn it over to Denny Oklak.

Denny Oklak

Thanks Randy, and good afternoon, everyone. It was another successful quarter for Duke Realty. We had solid operating performance and made significant strides in our ongoing strategy to reposition our portfolio. Opportunistically allocate capital to growth areas and further strengthen our balance sheet. All of which Christie and I will cover.

First, I will give some comments of what we’re seeing today in the markets and our expectations for the remainder of 2010. Then Christie will provide an update on our second quarter 2010 financial performance and capital market activities.

Our second quarter results reflect what we’re seeing from the property fundamentals in our markets. The industrial side of the business continues to improve. We again have success filling some of our larger bulk spaces.

The positive movement in industrial metrics including shipping, freight and industrial production data are translating into increased demand for industrial space. Our sense today is that we are passed the bottom of this cycle on the industrial side, but we believe it will be a slow climb from here. Customers are still being cautious, but are beginning to commit to new space as reflected by what we expect to be the first positive quarter of net absorption for industrial space nationally since 2007.

The office side of the business is lagging behind the industrial business, which is very typical of this point in the cycle. High unemployment continues to be the primary factor causing negative absorption in the office business.

In looking at economic forecast, the general consensus seems to be that unemployment rates are going to continue to be stubbornly high for an extended period. If these predictions are correct, we would not expect to see a bottom of the office business until mid 2011. This timeframe is also in line with our historical experience as the office business generally picks up four to six quarters after industrial.

One other comment on business in general. We continue to see operating pressure on many of our customers’ businesses. Continuing tenant concerns during the second quarter caused our bad debt expense to increase to back over 50 basis points of total rental revenue after taking down to our normal range of 25 to 30 basis points in the first quarter. Industries being most affected are construction and other residential housing suppliers.

The development opportunities continue to be relatively slow, with the exception of the medical office piece of our business. We are working with a number of hospitals on new projects and expect to announce the specific medical office starts in the second half of the year.

Another piece of good news, is that we are seeing some activity in the industrial build-to-suit business. These are the first meaningful discussions we’ve had on industrial build-to-suit in nearly two years. It’s still too early to say whether these projects will get started but nonetheless it’s positive news.

For the remainder of the year, we’re focused on three specific areas of strategic execution. First, our operating strategy is very straightforward, lease up the vacant space in our existing buildings to generate additional cash flow and selectively pursue development opportunities in medical, office and build-to-suits.

Second, our asset strategy will focus on the continued disposition of non-strategic properties, as well as pursuing strategic acquisitions. We are seeing good activity at good pricing for the assets that we are marketing for sale.

On the acquisition side, we are actively pursuing opportunities that are aligned with our longer-term objectives, including increasing industrial and medical office investment and suburban office in selected high-growth markets.

Third, our capital strategy remains focused on further deleveraging of the company. We have executed transactions in 2010 to buy back bonds and preferred stock and have successfully accessed the debt in equity markets.

Turning to some specific second quarter operating results, the overall occupancy in our portfolio was 87.9% at June 30th, up from 87.5% at March 31st. We stated in January that we anticipated some decrease in overall occupancy from short-term leases expiring, while we have seen some of these customers leave their space, many have continued to occupy the space through the second quarter and we are generally optimistic we will continue this temporary occupancy at or near this level.

On the leasing front, we signed approximately 6 million square feet of leases during the second quarter, a continuation of our strong first quarter activity, which exceeded 5.5 million square feet. Through June 30th, our leasing activity is at the highest volume levels since 2007.

Occupancy in our stabilized bulk distribution portfolio remained at 89.5% as of June 30th. I want to highlight a couple of new deals signed during the quarter. In Cincinnati, we signed a lease with a third-party logistics provider to fully lease a recently developed 598,000 square foot industrial building. In St. Louis, we leased nearly 600,000 square feet of space in three buildings that were in the Dugan Realty portfolio. These leases backfilled most of the space vacated during the past year by a bankruptcy.

On the suburban office side, activity is slower, but we did increase the occupancy for our stabilized portfolio to 86.0% at quarter end, nearly 50 basis points over the 85.5% reported at the end of March.

A key driver of this increase was the execution of a lease with the GSA and our Norman Pointe II office building in Minneapolis. The lease is for 244,000 square feet for three to five-year term while they rehab at existing building. This lease increases the occupancy of that property to 100%.

As of June 30th, our wholly-owned development pipeline consisted of three medical office properties, comprising 301,000 square feet, which were 92% preleased with an anticipated initial yield of 8.1%. These projects are substantially complete and require only $12.3 million of additional capital to complete. The development pipeline is consistent with our operation strategy to focus on a development of preleased medical office or build-to-suite opportunities.

Same property NOI for the three and 12 months ended June 30th was a negative 1.6% and 3.0% respectively, which is in line with our expectations. Same property occupancy is generally increasing, but we’re still seeing the effects of rent concessions and rate roll downs.

Looking forward, we expect the trailing 12 months for the calendar year 2010 should be at the better end of our negative 1% to negative 5% guidance range.

Our lease renewal percentage for the quarter was a strong 76.3% and is 79% year-to-date. As expected, we saw negative net effective rent and renewals of both industrial and office space. We continue to focus on keeping our major customers in their space, particularly on the office side. The realities in the market today are that net effective rents are rolling down between 5% and 15% on these renewals. We expect that trend to continue during the second half of 2010.

I’d also like to point out that CapEx expenditures were inordinately low this quarter as reflected by our 61% AFFO payout ratio. We expect this trend to revert to a more normal level during the second half of the year and reflect the lower end of our guidance for AFFO payout ratio of 95% to 105%.

Before I turn the call over to Christie, I wanted to highlight that Dugan Realty acquisition that we announced in June and subsequently closed on July 1st. We acquired our joint venture partner’s 50% interest in the venture for $298.2 million, including the assumption of debt. The Dugan portfolio is comprised of 106 industrial buildings totaling 20.8 million square feet located in the Midwest and Southeast markets. The portfolio was 86.6% leased as of June 30th, and as I mentioned, we are making progress on leasing this portfolio as we expected.

We developed virtually all of these properties and have managed and leased them since completion. This acquisition fits well into our strategy to increase our investment in the industrial profit. And as many of you know, we successfully launched an equity offering to fund the transaction. Christie will highlight the specifics of the offering. But we are very pleased with the execution and reception of this transaction.

And with that, I’ll turn the call over to Christie.

Christie Kelly

Thanks. Thanks very much, Denny, and good afternoon, everyone. As Denny mentioned, I would like to provide an update on our financial performance and financing activities during the quarter. We had a strong quarter overall and are pleased with our results.

Second quarter core FFO was $0.29 per share. This core FFO excludes the effects of $10.3 million or $0.09 per share of losses on debt and preferred stock transaction and $8 million or $0.03 per share of a non-cash impairment charge on a land sale. I will touch on the transactions, which created these non-cash items in a moment.

In terms of our capital objectives, we continue to make progress on strengthening our balance sheet. As Denny previously mentioned, in conjunction with the announced acquisition of our partner’s interest in Dugan Realty, we completed the issuance and sale of 26.45 million shares of common stock in June.

Executing the offering in connection with our Dugan Realty acquisition, which Denny discussed was well received by investors. Given the positive response, our underwriters exercised the green shift.

Net proceeds from the offering were just under $300 million, which covered the upfront cash portion of Dugan acquisition of approximately $160 million and will fund the additional $99 million of assumed debt that matures in October. Our capital plan had already contemplated the other half of the funds necessary to retire the Dugan debt maturing in October. I echo Denny’s sentiment, we are very pleased with this transaction.

We previously highlighted in our first quarter call that in April we issued 250 million of senior unsecured notes at 6.75% due March 15, 2020. We were able to repurchase in the open market and through a tender offer $260.7 million of principle amount of our 2011 and 2013 unsecured bonds during the second quarter.

A loss of approximately $15.8 million for the quarter was recognized in conjunction with these repurchases. Year-to-date, we have repurchased 275.7 million of our unsecured bonds. In June, we utilized the portion of the proceeds from the common stock issuance to repurchase 55.7 million face amount of our outstanding 8.375% Series O preferred stock in the open market.

In conjunction with these repurchases, a loss of approximately $4.5 million was recorded. This was again a good transaction for us, as we were able to execute the buybacks at an 8% yield and this transaction is accretive to our fixed charge coverage ratios and in line with our overall deleveraging strategy. As a result of these and previously announced capital transactions, as of June 30, 2010, we had no outstanding borrowings on our $850 million unsecured line of credit and $256.3 million of cash on hand.

During the quarter, we continued to make good progress on our asset disposition plan. Proceeds from second quarter non-strategic building dispositions were $31 million. As we have previously discussed, our property disposition closings will be greater in the third and fourth quarters than they were in the second. Today, we expect our dispositions for all of 2010 to be at the upper end of our guidance of $150 million to $350 million.

We also received proceeds of $9.7 million on the disposition of land parcels during the second quarter. The primary disposition was approximately 50 acres of industrial land in Chicago. We did record a non-cash impairment change of about $8 million on this land sale. This parcel of land had been held for future developments, so there was no previous impairment charge related to this land.

The impairment charge on this parcel was a higher percentage than average because we sold the ground to an existing customer for their future development and hope to have the opportunity to provide construction services when they move ahead.

Turning to acquisitions, in addition to the Dugan Realty properties, we also acquired three additional industrial buildings aggregating 475,000 square feet. The one building that we acquired in Phoenix, Arizona is a 100% lease. The two newly developed buildings that we acquired in South Florida are not currently leased. But they are our only industrial vacancy in this strong market.

For the remainder of 2010, we will continue to look for acquisitions that meet our strategic objective of increasing our industrial and medical office investments and redeploying our disposition proceeds into higher growth markets.

On the point of our strategy to reposition our portfolio, I want to clarify how we view possible dilution or accretion resulting from these transactions. We quote stabilized cap rates on dispositions in our supplemental package, as you all know.

The reported stabilized cap rates on dispositions over the past three quarters have averaged 8.76%. However, the in-place yield on these same assets at the time of sale was 7.72%. We believe that we can achieve similar in-place returns through our repositioning strategy while significantly improving our asset mix as we deploy capital for longer term earnings growth.

Before I turn it back over to Denny, I want to cover two additional items. First, we were very pleased to learn in mid July that Moody’s reaffirmed our BAA2 rating. We have worked extremely hard over the past year and a half to improve our leverage and coverage metrics as part of our capital strategy. The affirmation is another indication that the steps we have taken on our capital strategy are being well received.

Second, we have not yet accessed our $150 million aftermarket program, which we’ve launched earlier this year. As I noted on our April call, we view this as a tool to utilize only opportunistically and remain disciplined in using this source of capital.

And with that, I’ll turn it back over to Denny.

Denny Oklak

Thanks Christie. To close, I’d like to reemphasize our strategic focus as we continue to move forward in 2010. From an operations strategy, we’re focused on the lease up of our portfolio and development of prelease medical office buildings and another build-to-suit opportunities.

Our asset strategy is driven by the ultimate goal of repositioning our portfolio from a concentration in Midwest Suburban office assets to more investment in bulk industrial distribution and medical office properties. We’re extremely pleased with the execution of our capital strategy as we continued to reduce our overall leverage position so far this year. Our ability to execute debt, equity and disposition transactions in an efficient manner has allowed us to pursue acquisition opportunities while strengthening our balance sheet.

Yesterday, we reaffirmed our guidance of $0.95 to $1.15 of FFO per share for 2010. As we noted on our last call, we provided a wide guidance range this year because of uncertainty in the economy. However, based on our strong performance for the first six months and the positive momentum in the industrial business, we now believe we will be in the upper half of that range assuming there are no unanticipated tenant credit related or other events during the remainder of the year. Our estimate includes the anticipated dilutive effect of the shares issued in our June offering which will be greater in the second half of the year than on an annualized basis.

So, with that again, like to thank you all for joining us today. And now we will open it up for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is from Ki Bin Kim of Macquarie. Please go ahead.

Ki Bin Kim – Macquarie

Thank you. Could you comment on the customer demand or traffic -- whichever way you want to describe it? The trends you’ve been seeing from beginning of the year and maybe in June and July? Have you seen any kind of slowdown?

Denny Oklak

Ki Bin, I think that it did slowdown – it appeared to slow down a little bit from the middle of June into July, and we've been trying to figure out whether it's just a real slowdown in activity or just what a lot of our guys in the field call the summer doldrums. And today, I would tell you, we really think it’s more of the summer doldrums than a real slowdown. I think based on the discussions our folks are having with people, I think there is still some relatively positive momentum, again, particularly on the industrial side and really more sporadic on the office side. As you saw, we did improve our office occupancy during the quarter. We're very -- obviously, very pleased with that but again, I think the office business is still struggling.

Ki Bin Kim – Macquarie

And if you could describe, how would you measure your shadow space in the office portfolio?

Denny Oklak

Well, what we usually measure that by is and have for many years is really our lease terminations. If there is a lot of shadow space out there, generally speaking, our tenants are coming to us and wanting to downsize or terminate leases.

And as you know, our lease termination fees, while a little bit higher in the second quarter, are generally on the low side of what we usually see year-to-date. And I would say that we would also anticipate for the remainder of the year, for our lease termination fees to be on the low side. And again, that's for two reasons. But the main one is we're just not seeing the requests from most of our tenants to terminate those leases downsize.

Ki Bin Kim – Macquarie

Okay. Last question. It looks like your business contractions jumped a little bit this quarter. Could you give a little more color on that?

Denny Oklak

Yeah. I think that's probably skewed by one deal over in Cincinnati. We had an industrial tenant downsized by, I think, it was about 150,000 square feet. I think that was the primary transaction this quarter. So that's what it was. I don't think that's a big trend.

Christie Kelly

Yeah. That’s right.

Ki Bin Kim – Macquarie

So nothing confirming -- nothing further in that trend in July?

Denny Oklak

No.

Christie Kelly

Not that we’re seeing, Ki Bin.

Ki Bin Kim – Macquarie

Okay. Thank you.

Denny Oklak

Thank you.

Operator

Next in queue is Mike Bilerman with Citi. Please go ahead.

Josh Attie – Citi

Hello. It’s Josh Attie with Michael. Can you talk a little bit about the leasing pipeline for the second half of the year, particularly in the suburban office space? It sounds like at least some of the occupancy gain in the second quarter was from a very big lease in Minneapolis and just trying to get a sense if those occupancy gains are sustainable based on what you're seeing in the pipeline?

Denny Oklak

Sure, Josh. Again, I think in our prepared remarks today, we've laid out the position that we're not terribly optimistic about the office side. And just to add some color to that, we do, I think as you all know, review all of our major vacant spaces with our field people on at least a monthly basis, so we did that earlier this week. And I would say on the office side, there is some prospects out there. We're actually starting to see a couple of larger prospects.

But the truth is, I don't think we're going to see a lot of positive momentum in that occupancy for the rest of this year. I could be a little surprised if we would land one or two of the bigger deals that have been floating around. But I think it's going to stay relatively flat in our portfolio. I think globally in most of our markets, there is going to be some more downward pressure on occupancies on the office side for the next, as I said, six to 12 months and then hopefully we'll see some more stabilization. But our sense is the office business is going to continue to stay tough for a little while.

Josh Attie – Citi

Thanks. And with respect to the month-to-month warehouse tenants, can you just remind us what percentage of your portfolio that is?

Denny Oklak

It’s a little under 1% probably about 0.75% right…

Christie Kelly

That’s right.

Denny Oklak

Yeah.

Josh Attie – Citi

Okay. Thanks a lot. It’s helpful.

Denny Oklak

Thank you.

Operator

Next name in queue is Chris Caton with Morgan Stanley. Please go ahead.

Chris Caton – Morgan Stanley

Hello. Good afternoon. My question is on the acquisition, just looking later in the stuff in the JV section, it looks like you had about $6.1 million. So if you’d annualize that, it looks like about an $8.2 GAAP cap rate. I wonder if you could give us some color on that.

And then two, on the occupancy rate, if you go a year ago and recognizing it may not be same store, it looks like the occupancy is off about 100 bps versus gains in the broader same-store pool. Can you give us a little more color on the direction in occupancy rate for this acquisition?

Christie Kelly

Sure. I'll take the first part of that question, which is on, I think you were referring to the Dugan transaction and the run rate in Dugan?

Chris Caton – Morgan Stanley

Yeah. Thanks.

Christie Kelly

Yeah. Sure. Essentially, if you take a look historically, you probably were seeing about a $7 million run rate per quarter. And when we underwrote Dugan and took a look at the first quarter this year, we were really annualizing that more to be a $6 million run rate.

First, there was about a $1 million term fee in that quarterly performance and then second of all, we took a structural reserve, which was about another $1 million per quarter. So that's where you end up with the $24 million run rate versus what you might be seeing on the $7 million.

Denny Oklak

And then, Chris, could you ask the second part your question again on the occupancy? I'm sorry, I'm not sure I quite understood that.

Chris Caton – Morgan Stanley

Yeah, no, absolutely, glad to do it. Just trying to detective work on the portfolio itself. Looks – its $86.5, $86.6 leased at the end of the quarter and if you go to a year ago, it was maybe 100 bps higher. Can you contrast the trend in the occupancy rate in this portfolio versus your broader, whole distribution portfolio?

Denny Oklak

Yeah, yeah. I'm sorry. Now I understand. Yeah, the biggest driver on that one have been really a couple of bankruptcies in that portfolio. And, if you look at it, we had a large bankruptcy over in St. Louis which was about 600,000 square feet in that Dugan portfolio that hit in, I think the late third quarter and early first quarter this year. And then we also had another bankruptcy, I believe it was in either late first quarter or early second quarter of this year over in Cincinnati.

So generally speaking, that trend in that portfolio right now is lower than the rest of our portfolio, but I think that's a little bit of an anomaly because two of the – I would say fewer bankruptcies we're seeing now happen to be in that particular portfolio.

And if you think about it, that's about 20% or so maybe a little less, of our overall industrial portfolio today. So we just happen to have two bankruptcies in that portfolio. Now the good news is, I would tell you on that, with the activity we have in those buildings, I think we'll see continued improvement in that particular 20 million square foot portfolio between now and year end.

Chris Caton – Morgan Stanley

Yeah. And then I guess generally in the leasing environment, now that you bring it up. Have you seen any -- a shift in the type of tenants that are looking for more space? Is there a certain type of tenant type that has surfaced that wasn't there six months ago, just kind of following on your comments that bulk industrial feels a little bit better than suburban office?

Denny Oklak

I would say no, we haven't seen a whole lot of a shift. Again, a big piece of that business is always driven by retail and retail-related tenants. So it was sort of late third quarter last year, we began seeing the pickup in that business and we have really believed since that time and the data that has since come out. We believe that that was really driven by the inventory restocking and it's proved to be that. I would say today, again, I think it's by some inventory restocking and maybe now even a little bit of inventory growth going on in the bulk industrial business. But, again, a lot of the major deals that we're signing are mostly retail-related.

Chris Caton – Morgan Stanley

Okay. Thanks. I'm sorry, just last one with regard to Eveready Battery? $4.7 million of revenue in ‘11? Is that – have you been looking at that expiration? And is that -- are they utilizing the space, et cetera?

Denny Oklak

We signed the renewal today, a 10-year extension. So the next quarter, you'll see that move out 10 years. So thanks for asking.

Chris Caton – Morgan Stanley

Glad to set you up.

Denny Oklak

Thanks for asking.

Christie Kelly

That was perfect.

Chris Caton – Morgan Stanley

All right. Thanks very much.

Operator

And our next question comes from Brendan Maiorana from Wells Fargo. Please go ahead.

Brendan Maiorana – Wells Fargo

Thanks. Good afternoon. Question, Denny, you mentioned that I think your bad debt expense was picked up a little bit in the quarter? But if I look at your space-vacated analysis, the amount of bankruptcies was down pretty sharply from Q1. And certainly down a lot relative to more recent trend. Is that just a timing issue and how do you think about the level of bankruptcies or bad debts that you may get in the back half of the year?

Denny Oklak

Well, you're exactly right, Brendan, that when you look at it, the way we report that on the square footage of truly bankruptcies, it was down. But our bad debt reserve is broader than just the folks that file bankruptcy for the year. I mean we really looked through our entire portfolio. It's been our policy since forever to reserve any receivable that's over 90 days past due fully and when we have a 90-day past due receivable tenant, that means we also reserve all the straight-line rent related to that tenant.

And then also, we're – we have been, particularly for the last 18 months or so, very closely monitoring our watch list. And generally speaking, if we've got a tenant that’s over 60 days past due now, depending on what our property managers think about it, we're reserving all of that rent and again the straight-line rent. So this is more a reflection, I think, of what we're seeing the state of our – some of our tenants' business, rather than a true bankruptcies.

And I've been saying since the beginning of the year that I was still pretty cautious this year and again, hence, our wider guidance range, that I was very cautious on what was really going to happen to some of our tenants this year. And we're still seeing continued pressure. We're still getting tenants come to us and want to renegotiate, a little bit to downsize.

And again, it's not – I wouldn't call it rampant today, but it’s out there and if one of those tenants happens to be a big user, it can have a pretty significant effect even if it’s just one or two tenants. And again, as I said, in the remarks, primarily where we're seeing that is in construction-related businesses. And as you all know, in the construction business, it’s pretty slow out there today.

And then also, the tenants that we have that I would consider retail folks that are – their business is supplying to the residential development or single-family home construction business. Their business is still very tough. Because again, as you all monitor – the single-family home construction business is still pretty slow in most markets.

Brendan Maiorana – Wells Fargo

So, in the expectations for the back half of the year kind of the guidance, assuming you're at that top end or that top half of the range, you've still got a higher level of bad debt expense baked into that level of expectation.

Denny Oklak

Well, no, I would say that saying that we're going to be in the top half would put that at a normal level for the second half of the year. That’s why I just led some caution that if the bankruptcies pick up, it could be harder for us to stay up in that top half.

Brendan Maiorana – Wells Fargo

Okay. Fair enough. Christie, you mentioned that you're or you expressed some confidence with the high end of the range for dispositions. If I look at the $31 million that you did in the quarter and the sales that you highlighted, it was a single user building. It was a sale to a user and it was a sale to, I mean, municipality. Those seem like I guess easier sales to get done in kind of the current environment. Is that sort of the type of assets that you expect to sell in the back half of the year or is it something that's a little bit more of the multi-tenant variety?

Christie Kelly

It's across the board, Brendan, but it is more of the multi-tenant variety, as well. We have a list, as you know, that we've compiled that represents the $1.3 billion of non-strategic dispositions that we're teeing up for sale over the next couple of years. And together with that, we have absolute line of sight on the buildings that we are focused on selling this year.

And to that point, have a number of those that we're negotiating PSA, et cetera, on and are quite close on. So to that point, it's not specifically representative of what we experienced for the second quarter.

Brendan Maiorana – Wells Fargo

Okay. And your comments about -- call it roughly 100 basis point kind of spread between the yield that the assets were sold at versus kind of the stabilized yield.

Christie Kelly

Yeah.

Brendan Maiorana – Wells Fargo

We think about selling an additional, call it 200 in the back half of the year, is that something where you either may get some increased NOI between now and then or where the stabilized yield as reported per sale will be higher than the yield that you're currently earning on those properties?

Christie Kelly

I think, yeah, it will be higher, Brendan. And second of all, based on the timing of those transactions, if they're a little backend loaded, we would have some positive pickup from that, as well.

Brendan Maiorana – Wells Fargo

Okay. And then, just lastly on the land. I know that you didn't take the impairment because it was something you expected to put into production, but taking in an $8 million impairment on net proceeds of 10 seems pretty high. Can you just give us a sense of, maybe where the fair – where you think the fair value of that land is? And how we might relate that to the rest of your land bank that's for future production? Okay.

Christie Kelly

Okay.

Denny Oklak

Yeah. Let me take that one, Christie, because, let me specifically address that one. That was some industrial land in Chicago. It’s in a great park up on the north side of Chicago. And again, we had a very significant tenant of ours, actually very significant office tenant, come to us and say, look, we want to buy some land for a future industrial center. We like your Butterfield Park. Will you sell it to us? Well, we really like the Butterfield Park too, but the truth is we’ve got probably more than enough land there for the near-term future. We’ll have a lot of land left there – we have a lot of land left after this sale.

So, the offer wasn't the best offer in the world and we had a significant amount of discussion on that transaction. But we made the decision to go ahead and move forward with it because it did move some land, number one. But number two, again, a very significant customer. I think there's a very good chance that when they decide to pull the trigger on that building, we'll be able to get the construction project and do a third-party job and make some fees off that, too. So, it was I would say an isolated incident. And then, if you go back to what we have been saying for the past year, our impairment charge last year was on the land we identified for sale was in the 25% to 30% range.

Christie Kelly

Okay.

Denny Oklak

Our comments all along have been that we think on the development portfolio, also, that the impairment is in that kind of a range. So, I think, this was a little bit higher and I would say the other reason for this is – this was some land that I would say was purchased more recently. So probably in that 2006 or '07 range when the prices were a little bit higher. And when you look at our overall portfolio, I mean, we have got land that was purchased in a lot of different times in the 2000s, I would say. And so the basis compared to today's market varies across the Board.

Christie Kelly

Yeah.

Brendan Maiorana – Wells Fargo

Okay. Fair enough. Thank you.

Christie Kelly

This is – yeah, at that point, too, Brendan, as Denny was saying, it just really puts it at higher than our average.

Brendan Maiorana – Wells Fargo

Sure.

Operator

And our next question comes from Mike Knott with Green Street Advisors. Please go ahead.

Mike Knott – Green Street Advisors

Hi Denny. I think you touched on it a little bit in your remarks about the hold-over tenants. I know that was a big part of your occupancy in 1Q. And I think as I remember, you had said at the time it was about double the normal level, can you just give a little more color on sort of what it is now? I think it was about 100 bps of your 1Q occupancy, can you just give a little color on what it is now and what you expect to happen to that – to what you have now?

Denny Oklak

Yeah. It's gone down a little bit, Michael. We are probably at about 75 or 80 basis points of our occupancy in that now. I think there's more good news in that portfolio occupancy and from that group than there would have been at the end of the first quarter, because we've seen a few of those tenants come in and want to hold over and maybe do a three-month or a six-month extension.

So I think it's the positive news is we're going to keep I think a fair part of that occupancy throughout most of the rest of the year, which a quarter ago, we wouldn't have had near as high a confidence in that.

Mike Knott – Green Street Advisors

What do you attribute that to?

Denny Oklak

Well, again, I think I mentioned last quarter that a lot of that is made up of tenants that are sort of upsizing rather than downsizing. That temporary space can be a little bit of both. But the positive news on it was it was tenants needing more space, but just not wanting to commit to a longer term lease.

And so the good news is that their businesses have held up well enough that they want to keep that space for a longer period of time. But the bad news for us is, they still haven't gotten to the point where they feel comfortable enough entering into a long-term lease. Does that help?

Mike Knott – Green Street Advisors

Yeah. That's helpful. Thanks. And then when I look at the liquidity schedule, I know you guys don't include development on there, but in broad-brush strokes how would you have us all think about capital you might allocate over that time period to development and potentially to acquisitions as well. It sounds like you were talking about or at least evaluating some office-related acquisitions?

Denny Oklak

Well, there's – I'll make a couple of points on that. First of all, our guidance for development starts this year was in the $100 to $200 million range. Obviously, right now, we're kind of at the low end of that. We haven't had much start in the first half of the year. But we do have some things in the pipeline that I'm fairly certain will be in that range this year. I wouldn't be hugely comfortable telling you we're going to be right at the top end of that range today, but it will be within that range. And I think that's good. Again mostly that would be made up of some medical office projects that we get started but there is a few other things floating around.

So when you look forward, it's hard – it's really getting hard to see our visibility into 2011, particularly on the development side today, Michael. But I’ve got to be honest with you, I don't see anything today that makes me think that our development starts in 2011 are going to be significantly higher than that. I mean, I would tell you today that's probably going to be a range we look at for next year, again, but it's early, obviously. And so I think right now until the market starts changing, that $100 million to $200 million of starts a year is a pretty good number.

And then on the office acquisition side, there's really just a couple of our key markets that we would consider any office acquisition and for us, it's going to be more of – that to us is more of a redeployment of vision there. So if we're able to sell some office assets in some of the markets we want to downsize in and redeploy that capital into one or two markets where we wouldn't mind having a bigger office presence, we would do that. And but we – our first priority is to redeploy that into industrial acquisitions. And we've looked at a lot of things, but it's a tough market out there.

And second, obviously, to redeploy that money into medical office mostly development. But if there's an opportunity for medical office acquisition, we'll look at it. We've seen a few of those. So in the markets where we would probably consider the office acquisitions, today really to me are two markets and that would be Washington, DC, if there was something that came available and our team liked up in that area, we would certainly consider it. And then we had great success with our office product down in South Florida in the Broward County market and we're just keeping our eye open there but for the most part, that's it on the office side.

Mike Knott – Green Street Advisors

Okay. That’s helpful. Thank you.

Denny Oklak

Thanks.

Operator

(Operator Instructions) And our next question comes from Vincent Chao from Deutsche Bank. Please go ahead.

Vincent Chao – Deutsche Bank

Hey, good afternoon, everyone. Just wondering if you could give a little bit of color on the renewal spread, down pretty significantly in the quarter both in the distribution and office side of things? Is there anything unusual in those numbers?

Denny Oklak

There was, I think, one that was a little unusual this quarter that we had a rent roll down on an industrial tenant in Indianapolis and it was a little bigger than you would normally see because we had some amortization of some above standard improvements. But, quite honestly, when you look through it, it was pretty consistent across the Board, there was just some roll downs.

And the color I would put on it is, I think the roll downs on the industrial side, excluding that one, are probably going to be in the 5% to 7% range. The roll down on the office side are probably going to be higher. It may not – that may not be reflected this quarter, but we are really very focused on renewing our major tenants. As I was able to point out, we just signed a renewal with Energizer over in St. Louis for 10 years. And actually I don't remember what the numbers, but I think that one was – I don't think we have a huge roll down on that one. I think that was really a nice deal for us.

And but on some of the other markets and certain tenants, you got to meet the market to keep those tenants because there is just too much space floating around out there today. So it's still always cheaper for us to meet the market on rent because we're going to put a lot less capital into those spaces to renew the tenant. So, I think with some major office tenants, we’ve been seeing that for the last probably 12 months and I think we'll probably see it again for the next six to 12 months.

Vincent Chao – Deutsche Bank

Okay. I guess, I was just a little surprised by how big the downturn was. Was this kind of within your realm of expectations for the year as far as the level of decline?

Denny Oklak

Yeah. It really was. I think we've been saying for the past two or three quarters that we have been fortunate to hold those rental rates at – late last year we were kind of flat to slightly positive. I think in the second quarter we went down a little bit. But we had anticipated seeing some larger roll downs as we moved into this year and now it's coming about.

Vincent Chao – Deutsche Bank

Okay. That's helpful. And just a question, I thought I heard you say earlier that you're starting to see some possibilities on the industrial build-to-suit side, was that correct? And if so, can you provide some color on what you're seeing on that side of things maybe markets where you're seeing some additional activity or interest?

Denny Oklak

Yeah. It's a little hard to paint any kind of a picture right now. I would say, it's fairly sporadic. Generally speaking, we've seen some industrial tenants that want to expand their buildings. But the expansions that we're talking to people about are fairly significant. So we're talking in the 3 to 500,000 square foot range. So that’s a pretty big building in itself.

And then secondly, obviously, there is still a fair amount of industrial space available in almost all markets. But sometimes that space is not going to meet the needs of the particular tenant. And what we've seen mostly are, again, the big bulk distribution facilities. So if a tenant – in a number of markets today, if a tenant needs 800,000 to 1 million plus square feet, a lot of those spaces have been absorbed. So there's not a lot of that kind of space out there. So if they need that and want to consolidate their operations, which is what people are doing in those bigger buildings a lot of times. They're going to have to go to a build-to-suit. And, again, I think it's way too early to give you any kind of trends but there is a couple of discussions going on and they're pretty widespread geographically.

Vincent Chao – Deutsche Bank

Okay. Thank you.

Operator

And our next question comes from Mike Bilerman from Citi. Please go ahead.

Josh Attie – Citi

Hi, it’s Josh Attie with Michael. Can you just clarify what you said earlier on where the bad debts were trending today and where you said they need to trend in order to hit the mid to high-end of your guidance in the back-half of the year?

Denny Oklak

Sure, Josh. What I said was I think we – the bad debts were up some during the second quarter. Typically, I think we have been saying we'll run in that 25 to 30 basis points of rent. In the second quarter, we are back up over the 50 basis points of rent for the quarter. Again, that's sort of looking at annual rent, though, but for the quarter. And, we're – our numbers would assume that we stay in that 25 to 30 basis points of bad debts, kind of a normal range for the second half of this year.

Josh Attie – Citi

And do you see anything on the horizon that would make you go back up to 50 in the third or fourth quarter?

Denny Oklak

Well, no, but I tell you, you never see these things coming, to be honest with you or not never, but most, a lot of times you don't see it coming. So that's been our experience over the last 12 months or so. So today, there is just really no way I could give you an answer on that.

Josh Attie – Citi

Okay. Thank you.

Operator

And our last question comes from Sloan Bohlen from Goldman Sachs. Please go ahead.

Sloan Bohlen – Goldman Sachs

Thank you. Most everything has been asked and answered. Just one quick question on the rent roll down. Denny, on the information you gave 5% to 7% down on the industrial and maybe worse on the office. Can you break down how much of that net effect of rent roll down is actual market rent down versus how much of it is concession and the basis for the question is, at some point when we do kind of firm up, how quickly things could (inaudible) bottom?

Denny Oklak

Well, this is more a little bit more of a guess than science here, but I'm saying it’s probably 50-50 on net rent roll down. In other words, 50% of the decrease is kind of rolled down in the rental rates and 50% is some kind of increased concessions over maybe what the last deal was going to be. I will tell you one thing, we're very focused on at this part of the cycle, is we are more inclined to give a little bit more free rent upfront to get a higher rate and get a rate that we believe is closer to market long-term sooner in the lease.

So, what we're seeing is that I'd rather give a month or two more free rent and get that rate within three to five years in this lease back up to what we think is really more of a market rental rate than keep that market rental or that in-place rental rate pounded down below market for a longer period of time. So that's our strategy on pretty much all the deals we're looking at today.

Sloan Bohlen – Goldman Sachs

Okay. That's helpful. And then just one question on the build-to-suits, can you maybe talk a little bit about I guess other developers that are in competition for those potential build-to-suits? And the basis of this question I guess is to think about what potential tenants could come out of portfolios to go into those build-to-suits and just where you stand relative to everyone else there?

Denny Oklak

Well, I think generally speaking, on these build-to-suits we're talking about, we don't have a lot of competition right now. Most of these that we're talking to – they're only talking to us, I would tell you. And I think it's a unique situation, maybe a land position that we have and it's where they want to be located, which is always a key, especially on build-to-suits.

So and then thinking about where they would be coming out of, Sloan, I think that’s a little hard to say. I don't really have any guidance for you on that because, let me just give you an example of one we're talking to about a larger facility. They're coming out of – they would be consolidating two or three facilities into this facility. And I’ve got to be honest, I'm not sure who owns, I know who owns one of them, it’s like an institutional investor. But I don't know who owns the other two.

Sloan Bohlen – Goldman Sachs

Okay. Great. I know it's a tough thing to get at, but I appreciate the color. Thank you guys.

Denny Oklak

Okay.

Operator

And there are no further questions in queue.

Randy Henry

Thanks again, everyone, for joining our second quarter call. Our third quarter earnings call is tentatively scheduled for October 28th, and thanks again and have a good afternoon.

Operator

Ladies and gentlemen, this conference will be available for replay at 5:30 PM and will remain available through August 6th. The dial-in number for the replay is 320-365-3844, access code 163589. Again, that number is 320-365-3844, access code 163589. That does conclude our conference for today. Thank you for your participation. And you may now disconnect.

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