PS Business Parks CEO Discusses Q3 2010 Results – Earnings Call Transcript

Nov. 2.10 | About: PS Business (PSB)

PS Business Parks, Inc. (NYSE:PSB)

Q3 2010 Earnings Call Transcript

November 2, 2010 1:00 pm ET

Executives

Ed Stokx – EVP and CFO

Joe Russell – President and CEO

John Peterson – EVP and COO

Analysts

Craig Mailman – KeyBanc Markets

Jordan Sadler – KeyBanc Markets

Suzanne Kim – Credit Suisse

Michael Mueller – JPMorgan

Mark Lutenski – BMO Capital Markets

David Shamis – Citi

Operator

Good afternoon and welcome to the third quarter 2010 earnings conference call. My name is Daniele and I will be facilitating the audio portion of today's interactive broadcast. All lines have been placed on mute to prevent background noise. For those of you on the stream, please take note of the options available in your event console.

At this time I would like to turn the show over to Mr. Stokx.

Ed Stokx

Thank you. Good morning and thank you for joining us for the third quarter 2010 PS Business Parks investor conference call. I'm Ed Stokx, CFO of the company. And with me are Joe Russell, President And Chief Executive Officer and John Peterson, 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 affects 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

Thank you, Ed. Good morning and thank you for joining us. I am going to briefly review third quarter results, touch base on the investment arena and close by discussing our recent capital raising activity. J.P. will go into more detail on specific operational results and then Ed will conclude by discussing our financial metrics.

PSB's third quarter operational results were in close range to our performance over the last few quarters. Same Park occupancy trended down slight toll 91.3% but was up 190 basis points from a year ago. This is the fourth consecutive quarter where we have maintained occupancy above 91%.

Leasing volume was up slightly as we closed approximately $1.5 million square feet in deals with a total of 444 leases signed. The average lease size was approximately 3400 square feet, again similar with previous metrics.

New leases are still more onerous to close where users shop markets more aggressively and look for additional concessions to justify a move. Without that pressure, renewals can generate less onerous rent roll-downs and thus we attempt to retain every customer we can. This quarter retention was up slightly to 58%, which is also our run rate for the full year.

Finally, executed versus expiring lease rates declined 10.3% on a cash basis, the lowest roll down in six quarters. This is just one data point, albeit an important one, which is a hopeful indication that current lease rates are close to bottoming.

On our last conference call we announced the acquisition of Tycon II and III in Tysons Corner for $35.4 million in northern Virginia. Since then, we have not closed on any additional acquisitions. The investment market is still tough to predict but I am encouraged that more product is surfacing.

We are prioritizing our investment efforts around assets that have some element of repositioning. This often provides an added discount to replacement cost where we can deploy PSB's operational strategies and ultimately deliver stronger returns once the asset has been stabilized. Our teams are ready to capture these types of properties and we will hopefully see more product interior come back into the market.

Year-to-date, we have in total deployed approximately $162 million into well located business parks that fit this model. And we look forward to the long-term benefit these assets bring to PSB's platform. With a weighted average in place occupancy on the four portfolios acquired of 71% in submarkets where PSB's weighted average occupancy is 91%, our opportunity is clear.

I’d like to close by highlighting PSB's capital position and what we have accomplished over the last 15 months to further strengthen PSB's platform. In August of 2009, we raised $171 million through the sale of common equity. Year-to-date in 2010, we have acquired $162 million of assets, raised $75 million of 6.875% preferred equity and including our redemption of the series L on November 8th, we will have redeemed $122.5 million of preferred equity with an average rate of 7.8%.

As a result of this combined activity, we have a capital structure that is just 28% levered, primarily with $652 million of preferred equity with a blended yield of 7%. We have an untapped $100 million credit facility and a cash balance after the November 8th redemption of $52 million. This clearly demonstrates the strength and capacity of PSB's balance sheet and competitive posture, as we continue to pursue additional growth opportunities.

Now I’ll turn the call over to J.P.

John Petersen

Thank you, Joe. I will begin with an assessment of current – excuse me – market conditions. As I have discussed before, job growth still remains the primary driver of market net absorption and occupancy, but we have yet to see material job creation. We continue to see more positive net absorption.

In about 70% of our markets, there was positive net absorption in the third quarter. These are the most broad-based positive market absorption numbers that we have seen in approximately two years. Portland, northern California, San Diego and Austin were the only markets that had negative net absorption in the third quarter.

This is obviously an encouraging trend but in the trenches, deal economics are still challenging, leases are taking time and energy to negotiate and users still have multiple options when searching for space.

What was encouraging in the third quarter was the fact that deals were getting closed and rents and concessions were slightly more favorable to us than they have been in several quarters. It is still too early to definably say markets have bottomed, but I can say fundamentals are not getting worse. Blended market occupancy in our markets was unchanged from the second quarter at 85%.

Now to PSB results. Same Park occupancy in PSB's portfolio was 91.3% for the quarter. This 40 basis point sequential drop it was result of occupancy declines in the following markets. In Maryland, occupancy fell 240 basis points due to three deals over 10,000 square feet leaving the portfolio.

In northern Virginia, the 58,000 square foot single building user I discussed last quarter vacated, as of August 1st which attributed to 190 basis point occupancy decline to 91.8%. In San Diego, occupancy dropped 170 basis points to 93.3% in Q3. Miami dipped by 80 basis points to 95.6% and Dallas fell by 20 basis points to 91.9%.

In terms of growing occupancy, Austin led the way and increased occupancy by 450 basis points to 89.8% led by one – 3,000 square foot new deal. Driven by several small deals, Seattle pushed occupancy up 280 basis points to 91.4% and Phoenix improved 230 basis points to 87.9%. In the challenging northern California market, one 10,000 square foot deal and several smaller leases grew occupancy by 130 basis points to 90.5%.

As Joe mentioned, Same Park rental rates fell by 10.3% over expiring rents in the quarter. While this is an improvement over the last six quarters, these are still highly rent sensitive and negotiate hard on each deal for the lowest rate. Southern California continues to be a difficult leasing environment with little pricing power. Thus Los Angeles rents fell 19% and Orange County declined by 14%.

Also on the west coast, Seattle rents declined 16% as we traded rent for occupancy. On the bright side, Austin rents increased by 3%, mostly as a result of a 30,000 square foot deal I mentioned. In the relatively more stable Washington metro markets, Maryland rents fell by 3% and northern Virginia rents declined 6.5%.

The makeup of our $1.5 million square feet of leasing volume in 444 deals, represents a typical quarter as small customers, those under 5,000 square feet, drove activity and accounted for 81% of lease production. Our team in Washington metro was active and completed 317,000 square feet of transactions.

Southern California had another busy quarter executing 347,000 square feet or 23% of the company's leasing volume. Florida, one of our most stable markets, completed 338,000 square feet of deals. Combined, Portland, Seattle and northern California accounted for 280,000 square feet or 18% of leasing volume.

As Joe discussed, in his remarks retention continues to be a main focus of our teams. Overall retention in the third quarter was 58%. Dallas retention was 64%. Seattle retention was 68%. Maryland 72% and Portland 78%.

Next, I would like to update you on our 75,000 square foot multitenant industrial development in Miami that is now complete. As of today, the building is 65% leased with an average customer size of 7,000 square feet. There is solid activity on the remaining vacancy.

In addition, the redevelopment of an existing 60,000 square foot building is also complete and is 67% leased. The average size customer in this industrial building is 2500 square feet. As we head into last quarter of 2010 and with most markets beginning to see signs of stability, PSB is well positioned to capitalize on recovery.

Small deal activity remains relatively active. New speculative construction is almost nonexistent and operating fundamentals may be stabilizing. With only positive minimal job growth throughout our markets, companies continue their search for value and flexibility in the real estate decisions and we have multiple solutions for them.

When job growth does return, PSB has the ability to capitalize on their business expansion needs as well. For the last quarter of 2010, we have approximately $1 million square feet expiring, or 5.3% of the lease portfolio. Approximately 33% of the remaining expirations are in Washington metro market. 28% are in southern California with the balance spread throughout the portfolio.

Now I will turn the call over the Ed.

Ed Stokx

Thank you, J.P. Reported FFO for the third quarter of 2010 was $1.05 per share. Taking into account the company's 2009 common stock offering, pro forma FFO for the third quarter 2009 was $0.98 per share, resulting in an increase in FFO of 7.1%. The FFO increase is a result of NOI from recently acquired assets and lower preferred equity distributions offset by a 3.8% decrease in Same Park NOI and 405,000 in G&A costs incurred in connection with the acquisition of real estate.

The decline in Same Park NOI was driven by a 3.1% reduction in revenue resulting from lower rental rates, partially offset by a 1.4% reduction in operating expenses. Reported FFO for the nine months ended September 30th, 2010 was $2.89 per share. Excluding noncash distributions reported in connection with the redemption of preferred equity, FFO per share was $2.97.

For the nine months ended September 30th, 2009 pro forma FFO, excluding the gain reported on the repurchase of preferred equity was $2.97 per share. Contributing to the consistent year-to-date FFO was a 3.4% comparative decline in Same Park NOI, $2.3 million of G&A costs incurred in connection with real estate acquisitions, offset by $5.9 million of NOI from recently acquired assets.

During the third quarter of 2010, we had write-offs of uncollectible balances of $343,000 compared to 166,000 in the same period of 2009. While write-offs increased on a comparative basis, I would point out that on a quarterly and year-to-date basis, write-offs account for less than one half of 1% of revenues.

Recurring capital expenditures for the three and nine months ended September 30th, 2010 were $7.9 million and $19.3 million respectively, compared to $8 million and $19.1 million for the same periods in 2009. Through September 30th, 2010 the company incurred approximately $9.1 million in nonrecurring capital costs, primarily relayed to the recently completed projects in Miami and the renovation of the 58,000 square foot building in Virginia that J.P. mentioned in his comments.

On October 15th, the company completed a preferred equity offering raising $75 million in gross proceeds at a rate of 6.875%. We were pleased to issue $3 million shares of preferred equity at this rate. As it has been over three years since we have gone into the preferred market, it is worthy to note how dramatic the turnaround in preferred yields has been in recent months. We saw strong investor demand which enabled us to come close to matching PSB's lowest historical yield on preferred equity which is 6.7%.

Proceeds from the offering will be used in part to redeem the company's 7.6% series L preferred equity of $48.4 million, the balance of the proceeds will be used for general working capital purposes. The redemption of the series L preferred electric will be completed on November 8th. In connection with the redemption, the company will report noncash distributions in the fourth quarter of $1.6 million.

Before we open the call for your questions, I would like to remind you of two noteworthy issues that will impact revenue going forward. First, the expiration of the 58,000 square foot lease at our prosperity business park in Maryfield Virginia will result in a loss of revenue of approximately $430,000 per quarter on the outgoing rent until we release all or a portion of the premises.

Second, at the end of the third quarter the 31,000 square foot lease in Los Angeles County with a financial institution seized by the FDIC was officially terminated. Until this space is released this vacancy will impact revenue by approximately 195,000 per quarter.

In closing, I want to reiterate the strength and flexibility of PSB's balance sheet and our focus on cash retention. For the three months ended September 30th, 2010 and 2009, the company's FAD payout ratios remain some of the lowest in the industry at 53.5% and 58.7% respectively. For the nine months ended September 30th, 2010 and 2009, the FAD payout ratios were 55% and 50% respectively.

In addition to these exceptional payout ratios, we continue to maintain a fixed charge coverage ratio of 3.8 times, further demonstrating PSB's capacity to pursue attractive growth 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 Jordan Sadler with KeyBanc Markets.

Craig Mailman – KeyBanc Markets

Hi it's Craig Mailman here with Jordan. Joe, could you maybe touch a little more on the acquisitions, the geographies that you're seeing, product type, then also just maybe touch on how you think you're going to finance these, just given the favorable preferred rates, would you guys go out ahead of that, or would you finance on the line first and then clean it up with preferred afterwards?

Joe Russell

First, Craig, as far as geography is concerned, we continue to comb all the markets where we're currently located and as we've talked about in the past, we've got good, I think, candidates for potential acquisitions in many of those markets. The tough thing that's been tough to predict as we've pursued a variety of type of deals in our markets is when and if a seller actually going to truly close on an asset.

And as I mentioned, what we continue to see are certain assets that get tested to the market what I mean by that a marketing process might be going on, but then with a high degree of reluctance, because the serial may not be achieving their own hurdle rates on sales price, they'll pull it back off the market.

What I'm a little bit more encouraged about is, both some of that products resurfacing, meaning some assets that we've done some underwriting on early in the year, seem to be coming back. And then even some newer product that would be our type of asset, which again would be more multitenant oriented, combined with having the opportunity to do a fair amount of repositioning, continues to surface, too.

So, again, it's not a huge collection of assets, but it's more encouraging as time goes on. Probably no surprise, based on what we all know statistically is out there, which is, again, is looming amount of asset base of over levered underperforming assets that whether owners or banks directly are going to continue to take to the market.

We've obviously done the lion's share of our acquisitions year-to-date in the Washington Metro market. We would certainly continue to – like to grow our portfolio there. And again, East Coast, Texas has been a good market for us. And here on the West Coast, we're doing the same thing, although we haven't seen as many yet, ideal candidates and that's why you haven't seen us take down any assets, here on the West Coast year-to-date.

Then going to – okay, how do you fund or finance these properties? We were highly encouraged by the receptivity that we got in the preferred offering that we did earlier this quarter and by all indications that market continues to be very favorable to us. We do have, based on our cash balance and our untapped line of credit, just over $150 million of existing capacity, but I would tell you that we were highly encouraged, too, about the receptivity we got with the preferred market.

So those two avenues were there. Obviously, a little over a year and a half ago, we tapped a common equity market. So the good news is, we continue to be confident that there are good avenues for us to go to – when and if we need additional capital.

Craig Mailman – KeyBanc Markets

Great. And then just one on leasing. J.P., are there any markets where you're starting to feel more confident given occupancy, about pushing rents, or are you guys still taking occupancy over rate?

John Petersen

Yeah. Craig, good question. Just real quick, I think Joe mentioned on a relative basis, the D.C. market is more stable than others. Same would be said for – specifically, our Miami portfolio. We've had success leasing our new development and the redevelopments and our existing portfolio there is 95%.

So we're trying to push rents there specifically. And then as I mentioned on the west coast, it's more difficult – pricing power – to get any pricing power there. So there's just not the demand. Unemployment is higher. And then in Texas, I think, as Joe mentioned also, it's fairly stable and unemployment is lower than other parts of the country.

And so we've seen some contraction there. But then just breaking it down even further, we do break it down as you know, Craig, on a park-by-park, space-by-space basis. So where we have the opportunity to push rents on a specific space or a specific park, we will do that. But that's – that’s a decision that our leaders in the field make each and everyday.

Jordan Sadler – KeyBanc Markets

Hey, guys. It's Jordan. I just wanted to follow up also J.P., on one of the opening comments about roll-down being the lowest in six quarters and I was just curious, I know you don't give mark-to-market. There are a bunch of small spaces, given a space-by-space basis but given sort of your view that fundamentals are not getting worse. Would you expect, based on where you are in in-place rents that trend to continue, meaning the roll-downs would continue to fall, based on where we're at today?

Joe Russell

Yeah. Sure, Jordan. As you know well, this can vary deal-by-deal, space-by-space. You kind of said it in your question, quarter-by-quarter. And like I also said in my remarks, it's too early to call this a trend. And, so we're not going to, but we are pushing back in markets and spaces in parks where we can and that's what we'll do space-by-space, deal-by-deal. So I can't sit here and point any one direction because it does swing as you know quarter-to-quarter deal – the deals. So that's where we are. But our teams are focused on it and I’m covering it as I said in my remarks that fundamentals are stabilizing.

Jordan Sadler – KeyBanc Markets

Thank you.

Joe Russell

You bet.

Operator

Your next question comes from the line of Suzanne Kim with Credit Suisse.

Suzanne Kim – Credit Suisse

Hi, I'm just trying to see about the difference between your average and the end-of-period occupancy and also, how the lease up of the acquisition pool is going right now.

Joe Russell

Okay. As far as the acquisition pool, I'd tell you that we are encouraged by the traction that we've been able to create so far. Again, we've acquired about $1.6 million square feet year-to-date, four different portfolios. Three of the portfolios are in Washington Metro, the fourth being in Austin.

So we've – if you combine all those assets, the in-place occupancy at time of acquisition was about 71%. But we've seen some good leasing activity that hovers at around – about 100,000 square feet all combined, about half of it's new, half of its renewal. We'll take multiple quarters to continue that traction as the repositioning we're doing, primarily again on the Washington Metro assets. The Austin portfolio was pretty stabilized when we acquired it.

So, we'll take some additional time, but we're encouraged so far by what we've seen from an overall demand factor. The types of tenants that are coming into those parks, as the repositioning efforts that we planned to have done when we bought the assets and we continue to do now that we own them are going well. And again we're getting that good receptivity and getting some good leasing traction. What certainly is helping is the fact that the bulk of those assets are in the Washington Metro market.

So, as far as blended full quarter occupancy to end-of-year or end-of-quarter, occupancy, the numbers are very close and we're not really seeing as far as the third quarter anyway, a big discrepancy on where we ended the quarter versus what the average was.

Suzanne Kim – Credit Suisse

Okay. Great. Thank you so much.

Joe Russell

You bet.

Operator

Your next question comes from the line of Michael Mueller with JPMorgan.

Michael Mueller – JPMorgan

Question, Ed, on the two tenants you mentioned, the 430,000 of rent and the 195 of rent. Can you talk about, if we're looking at the third quarter NOI or the third quarter revenues, how much of those two combined, which I guess is about $625,000 of revenues, how much was reflected in the third quarter?

Ed Stokx

Sure, Mike. The – breaking it down to 58,000 square foot building in Prosperity.

Michael Mueller – JPMorgan

Yeah.

Ed Stokx

That's $430,000 per quarter. That lease expired at the end of July. So we had one month in the first – in the second quarter – I'm sorry in the third quarter from that lease.

Michael Mueller – JPMorgan

Okay.

Ed Stokx

The second one, the 31,000 square foot in LA. That expired or was terminated at the very end of the quarter. So we had that in place for the full third quarter.

Michael Mueller – JPMorgan

Okay. Great. And I know you have touched on the lease spreads a little bit and I understand how they can bounce around, but I was just wondering any color on what you have seen the past month or so, does it feel like if there is some element of stickiness to that improvement in the lease spreads, or is it just kind of bouncing around and really we just need to look at it as one data point?

Joe Russell

Yeah, Mike. I think I would first start by looking at it is one data point, as J.P. talked to what we'll experience with the range of deals that we do every single quarter and the location that those take place and that again there is – it's tough to predict. And so far say, we can peg a trend to it. But again the set of metrics that are I think encouraging so far is market absorption seems to be starting to improve.

Again, there is no spec construction that we're competing against. On the downside, we're not seeing really a lot of evidence of job growth. But once that starts taking place, I think we'll start seeing hopefully some better trend. But as J.P. talked to the senses that we certainly feel a bottoming is at hand.

Now the question is what kind of traction in the coming quarters would we start seeing based on these other elements that would hopefully start improving our ability to grow rent ranges and occupancy. But it's still too tough to say even as you look into the fourth quarter that there is a lot of feel going into that so far. It doesn't feel the opposite, meaning it doesn't feel like things have gone – are unwinding at all, but it's still just too soon to tell.

Michael Mueller – JPMorgan

Okay. Okay. Great. Thank you.

Joe Russell

You bet.

Operator

(Operator Instructions). Your next question comes from the line of Mark Lutenski with BMO Capital Markets.

Mark Lutenski – BMO Capital Markets

Good morning. I just wanted to touch briefly on acquisitions. Can you guys comment on what you're seeing in terms of pricing out there and also can you comment on the competitiveness of the acquisition market?

Ed Stokx

Sure, Mark. Yeah. The – pricing, it will always be highly dependent upon what markets, particular assets are in, first, second, the nature of the occupancy and overall stability of those assets. And as I talked to in my opening remarks, we've been much more comfortable and like the opportunity that we've been able to make sense of when we're out competing for assets that need that high degree of repositioning because, again, the amount of capital that's chasing those deals is typically not as deep nor as competitive as you might see for a highly stabilized, well located and maybe even a little bit more trophy-oriented asset.

So, our zone continues to be, again, in that type of asset that we can reposition by well below replacement costs and then work into a good longer term return. There is a fair amount of capital out there that we've seen that's been chasing the – again, the highly stabilized, more traditional investment Class A grade type of an asset.

But we've seen less competitive activity in the type of assets that we've been pursuing. It's still competitive. Cap rates are trending down slightly, but again that's the kind of asset that we're going to continue probably to make sense of. So…

Mark Lutenski – BMO Capital Markets

Do you see any opportunities to get maybe more opportunistic on the selling side?

Ed Stokx

On the, what?

Mark Lutenski – BMO Capital Markets

Selling assets, perhaps?

Ed Stokx

It's not a big part of our focus or strategic reorientation of the portfolio. For the most part we have got good beachheads in each of our markets, good concentrations of park and concentrations of assets. Those are tough to accumulate and for the most part, the portfolio is going to continue to operate well, because we have got those kinds of concentration. So our focus is certainly much more oriented towards growing the portfolio versus reworking or shedding certain assets.

Mark Lutenski – BMO Capital Markets

And then one final question then, in the past you guys have mentioned that you have been beneficiary of some of the larger tenants downsizing their space needs. I'm wondering are you still seeing that as a trend or are you starting to see that stabilizing perhaps and maybe even reversing, where you're seeing some of the smaller tenants looking to expand their space needs?

John Petersen

Hey, Mark. We're still able to catch them as they grow and as they contract. I mean that's why we focus on this park strategy. And yeah, definitely, some companies are still contracting. Are there companies growing? Yeah, there are. Our strategy and our model is to make sure we're talking to our customers and then we move them accordingly based on their needs within our park or sets of parks.

So – but I wouldn't say that. We're seeing a trend, yeah, one way or another on more contractions and more expansions. It's a little bit of all ball tuck-ins – it has been for the last several quarters.

Mark Lutenski – BMO Capital Markets

Great. Thank you, guys.

Joe Russell

You bet.

Operator

Your next question comes from the line of Joshua Attie with Citi.

David Shamis – Citi

Hey, guys. This is David Shamis here. Just looking at your same-store operating margin, it looks like you dropped about 150 basis points from last quarter. So I'm wondering if there is any one-time item in there

Ed Stokx

No, one-time items. One thing that we did comment on in our second quarter conference call is that we had some – seen some pretty significant reductions in operating expenses. Some of those we attributed on the call last quarter to timing. So some of those from a timing standpoint have come through in the third quarter, just in terms of repairs and maintenance and some utility things, but other than that, there are no unusual or one-time hits or revenue items.

David Shamis – Citi

Okay. And what was the average term of leases signed during the quarter? How does that compare to prior quarters?

Joe Russell

It was around three years, which is consistent with basically every quarter. It's around three years.

David Shamis – Citi

Great. Thanks, guys.

Joe Russell

You bet.

Operator

And at this time, there are no further questions.

Ed Stokx

Okay. Thank you everyone for joining us. And we'll look forward to talking to you at the end of the fourth quarter. Thank you and have a great day.

Operator

Thank you. This concludes today's conference call. You may now disconnect.

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