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CapLease Incorporated (LSE)

Q3 2010 Earnings Conference Call

November 3, 2010 10:00 am ET

Executives

Paul H. McDowell – Chairman and CEO

Shawn Seale - SVP and CFO

Brad Cohen – ICR

Analysts

Jordan Sadler - KeyBanc Capital Markets

Craig Mailman - Keybanc Capital Markets

Gabriel Poggi - FBR

Greg Schweitzer - Citigroup

Joshua Barber – Stifel Nicolaus & Company Inc

Phil DeFelice – Wells Fargo Securities

Sheila McGrath – KBW

Operator

Greetings and welcome to the CapLease Second Quarter 2010 Earnings Conference Call. At this time all participants are in listen-only mode. A brief question and answer session will follow the formal presentation. (Operator Instructions). As reminder this conference is being recorded. It is now my pleasure to introduce Brad Cohen of ICR. Thank you Mr. Cohen you may begin.

Brad Cohen

Thank you very much operator. Today I would like to remind everyone that part of our discussion this morning will include guidance and other forward looking statements, these statements are not guarantees of future performance, and therefore, undue reliance should not be placed on them. We refer all of you to CapLease's third quarter 2010 earnings release and filings with the Securities and Exchange Commission, for a more detailed discussion of important factors that could cause actual results to differ materially from those contained in the company's forward looking statements. The company disclaims any obligation to update its forward looking statement.

Also during the call today, the company may be discussing funds from operation, or FFO. FFO is adjusted for compatibility and cash available for distribution or CAD which are non-GAAP financial measures. Please view the company's press release for a reconciliation of FFO. FFO is adjusted for compatibility and CAD to net income the most direct comparable GAAP measure.

It is now my pleasure to turn the call over to CapLease's Chairman and Chief Executive Officer Mr. Paul McDowell. Paul.

Paul McDowell

Thank you very much, Brad, and good morning, everyone. With me on the call today, is our Chief Financial Officer and Partner Shawn Seale.

We have a very productive third quarter and continue to make significant progress towards our business goals for the year. We have completed our new $140 million 3-year term revolving line of credit with Wells Fargo in July. We continue to further reduce overall debt through a combination of discretionary pay downs and scheduled amortization but most importantly we have begun to grow the portfolio again.

During the third quarter we closed at a roughly $10 million build to suit warehouse facility with a 10-year net lease to the U.S. subsidiary of Michelin. The 150,000 square foot property is under construction and is being built by an experienced developer with whom we have entered into a project joint venture. CapLease will own the entire property upon completion which is scheduled for March of 2011.

The economics are attractive with a CapRate during the lease term of about 9.5% and an imbedded return during the construction period of 9% on capital deploy. We are continuing to evaluate a number of build to suit opportunities and we expect that we will be able to execute on additional transactions in this sector.

In addition during the quarter we acted as a fee adviser to a borrower with whom we have a direct relationship on a complex $45 million loan, in connection with the purchase and subsequent long term lease of a hospital. We assisted the borrower in all aspects of the structuring of the transaction and the arrangement and placement of the loan. The transaction closed last Friday and we ended up roughly quarter of a million dollar free.

Finally we expect to close on a roughly $30 million property purchase before year end at initial CapRate of around 8% and an average CapRate over the more than 10 years lease term slightly above 9%. We also continue to actively work on our pipeline and hope to have some additional transactions lined up before the end of the year.

Our team leveraged our market franchise and our deep relationships to directly source this high quality opportunity at attractive return. Once added to the portfolio the new properties will be (inaudible) to both FFO and cash flow.

The investment market remained challenging as supply remains constrained and the search for yield by the broader market has led to CapRate compression over the past several months. This CapRate compression however has been outpaced by the decline of the 10-year treasury rate and the associated decline in the cost of financing these assets for first mortgage debt. As a result the spread between where net lease asset trade as compared with either the corporate bond of the same credit or the risk free rate has rarely if ever been wider. While I cannot predict the future we believe this phenomenon is likely to continue and will give us a long window in which to profitably invest.

As we add assets an utilize our existing cash in hand we will continue to monitor the evolving opportunity set and our cost of capital in a concerted efforts to not only grow the portfolio, but to do sell in a manner beneficial to share owners over the long term. Our existing $2 billion dollar portfolio continues its outstanding long term performance.

As quarter ends the weighted average underlying Standard & Poors credit rating on our single tenant portfolio was a single A minus and our single tenant owned properties remained at single A. Our portfolio remains the highest credit quality of any portfolio within our sector.

We are aggressively managing this investment grade net lease portfolio of assets with our primary focus on the three properties in the portfolio where we have a material opportunity to replace existing vacancy in growth revenue.

With respect to the two properties we owned in Omaha. We continued to make significant progress on leasing in particular the suburban building on West Side Road is now 96% leased and with the new leases in place, we will produce an average yield for us of about 10%.

I will now turn the call over to Shawn.

Shawn Seale

Thanks Paul. Today we reported FFO for the second quarter of 2010 of 9.3 million or $0.16 per share. The net loss to common shareholders for the third quarter of 2010 was $2.8 million or $0.05 per share. CAD in the third quarter was $7.7 million or $0.13 per share. Total revenues for the third quarter were $41.4 million. Undepreciated book value stands at $8.95 per share.

Results during the quarter were impacted by the relatively large cash balances we continue to carry on the balance sheet and increase share capital in the first quarter. We continue to have strong financial flexibility including having significant cash on hand and capacity under our revolving credit line.

Although the $50 million of cash we have on the balance sheet will have a negative impact on FFO until deployed that provides us with flexibility to primarily pursue acquisition opportunities and secondarily further reduce debt. While we don’t have a definitive cash target we anticipate continuing to run the enterprise going forward with significant levels of cash on the balance sheet to be able to take advantage of opportunities as they arrive.

The key thing for the third quarter and the beginning of the fourth was the combination of renewed portfolio growth coupled with the continued strengthening of the balance sheet through both further debt reduction and maturity extension.

During the quarter we further reduced outstanding debt by an additional 27 million of that amount roughly 17 million went to further reductions in the outstanding balances both under our recourse obligations including our convertible nodes and our credit facility. As of September 30 the outstanding balance under our convertible nodes and the credit facility were 35 million and 93.1 million respectively. The remainder was scheduled amortization largely on our first mortgage debt that the owned property level are leveraged was approximately 67% at quarter end based on undepreciated book value and leverage continue to decline.

For the year we have reduced debt a quite significant 78 million of about a $1.35 per share. Addionally our scheduled amortization will continue for the next several years at the rate of about 25 to 30 million per year net principal collected on our debt investments which will further lower our leverage levels and build equity.

The property expenses line in the income statement merits a brief explanation. The increase in the 2010 period is due nearly entirely to our properties in Johnston, Rhode Island and Omaha, Nebraska. These expenses are expected in the expense associated form moving the properties from net lease to gross lease status will over time be offset by increased revenues from these properties.

Although the credit quality of our portfolio remains very strong overall and all the cash flows continue to be received as expected we continue to be impacted by the overall macro real estate environment. As we mentioned in last quarter’s call this is most pronounced in the roughly 19 million of our portfolio that is invested in generic non net lease fact CMBS from 2006. Although outcomes from the loans in these two pools are hard to predict it won’t be resolved quickly. We continue to monitor them carefully and we will take appropriate action and response if necessary.

I will turn the call over to Paul now for some final comments before we open it up for questions. Paul

Paul McDowell

Thanks, Shawn. We continue to methodically execute on our business plans. We have recommenced portfolio growth and expect our forward pipeline to continue to improve. Over the past 12 quarters we have markedly reduced recourse indebtedness, significantly increased cash liquidity, extended debt maturity and selectively sold long dated assets that were financed in our shorter term facility.

Our targeting capital rates in the first quarter gave us the ability to begin to grow the portfolio again and now that growth has started. The team at CapLease remain committed to the enterprise and I firmly believe that it's the strongest asset we have.

I will now open it up to questions. Operator.

Question-and-Answer Session

Operator

Thank you sir. We are now conducting a question-and-answer session. (Operator instructions) Our first question is coming from Jordan Sadler of KeyBanc Capital.

Jordan Sadler - KeyBanc Capital

Good morning.

Paul McDowell

Good morning Jordan

Jordan Sadler - KeyBanc Capital

First question regarding the acquisition or with the built to suit and then acquisition, I guess first maybe if you can provide some any additional color surrounding the $30 million purchase you have and generally surrounding these 2 initial investments. How do you expect to fund them? Would you use the cash or would you look to raise additional capital?

Paul McDowell

On $30 million investment Jordan, I am not going to give any more color because obviously that is a work in progess. So I am just going to leave that with the comments I made during my prepared remarks. With respect to how we would finance these investments we have a variety of options available to us. We have existing cash in the balance sheet of 50 million. We have close to $50 million available to us under our existing revolving credit facility with Wells Fargo and we may choose to permanently finance one or both of these properties at completion or when we finalize the purchase.

Jordan Sadler - KeyBanc Capital

But as of now these are unencumbered?

Paul McDowell

They are both unencumbered. Acquisition is not complete so they are both I guess by definition, unencumbered.

Jordan Sadler - KeyBanc Capital

Right. And what does the pipeline of activity look like? It sounds like you are pretty excited.

Paul McDowell

I am not sure I would characterize it necessarily as overly excited. I would say that we are pleased with the pace at which and the quality of the transactions in our pipeline that we are beginning to see in the latter half of the year. Transaction volumes are still low but they are starting to pick up. The mortgage market or financing property continues to tighten so that makes transactions possible to get done at attractive returns. So we are pretty pleased at what we are seeing in the marketplace and you hope that that momentum will continue through the remainder of the year into the beginning of next.

Jordan Sadler - KeyBanc Capital

Okay. And just coming back to the capital rate, I know you don’t have a cash target but is 50 on the higher side of where you would expect to be the 50 million you are currently at or?

Paul McDowell

Yeah I think so Jordan. It is certainly plenty of load operating capital and enough dry powder that it lets us be responsive quickly to good opportunities without being (inaudible) to the capital markets for any particular transactions.

Jordan Sadler - KeyBanc Capital

Just on the West Dodge building. Could you just give us a little bit more detail surrounding the lease up there? What were the rates on the leases? What is the expected timing?

Paul McDowell

We recently signed up the last sort of big lease in that property to bring it up to 96% occupied so we are functionally from a leasing perspective done or nearly done there. The tenants were doing some work on the building, tenants will move in through the remainder of this year and the beginning of next year. The average rent that we are getting is roughly 18 bucks per foot with s 3% escalation.

Shawn Seale

I think Jordan from a rent rate standpoint, second quarter next year you will see a kind of a full rent rate on that property and we think that is about a $1.4 million NOI.

Jordan Sadler - KeyBanc Capital

In total?

Shawn Seale

Yeah, for the Dodge property.

Jordan Sadler - KeyBanc Capital

Were versus where is it, what is the run rate in 3Q for instance?

Shawn Seale

It is a bit quite lower because most of those leases don’t actually kick-in in full form until the end of the first quarter next year.

Jordan Sadler - KeyBanc Capital

Okay.

Shawn Seale

I think in the first or in this quarter we got about 800 or 750,000 that are kind of revenues at that property. And it is still running at an operating loss currently maybe about 300k. Next we probably got some small positive benefit (inaudible), so it is getting to the point of profitability and as I said in the first quarter next year and certainly in the second quarter we expect it to be kind of full run rate.

Jordan Sadler - KeyBanc Capital

1.4 million as NOI?

Shawn Seale

That is correct, or at that is how I should say before depreciation. That is a yield we did go on our cost basis of about 10% which is we think very very good.

Jordan Sadler - KeyBanc Capital

Great. I think Craig has one, quick one.

Craig Mailman - Keybanc Capital Markets

Yeah hey Paul, are there any more opportunities to do that advisory business and clip a couple of small fees?

Paul McDowell

I think we mentioned it on the call just to remind people that we do have strong capabilities in-house and a variety of different things rather than just necessarily owning and operating that lease properties. We do have finance expertise here and from time to time opportunities presents themselves – they are not the type of opportunities where we would like to write the first mortgage ourselves. Coupons are too low and we are not particularly interested at that business at the moment. But on the other side we do have the expertise, that expertise is recognized in the marketplace and I think they will come up from time to time.

Craig Mailman - Keybanc Capital Markets

Just to clarify that’s going to book in the fourth quarter right?

Paul McDowell

Yeah. (inaudible)

Shawn Seale

It is the kind of thing that we would never project in terms of recurring. We certainly hope to be able to do some of it but we are not going to bake it into any kind of forward projection.

Craig Mailman - Keybanc Capital Markets

Great thanks guys.

Operator

Thank you. Our next question is coming from Gabe Poggi of FBR.

Gabriel Poggi - FBR

Two quick questions. I know you guys may have just given this, I may have missed it. Did you give the occupancy at the other Omaha building outside of Dodge? Kind of where we are sitting there. And the second question: Any commentary you guys could provide, I know you have given color in the past but about 2012 lease renewals would be helpful. Thanks.

Paul McDowell

I think with respect to the Landmark property Gabe, the property is now about 67% leased so we still got some work to do there. We have some people continuing to look at the property and maybe some expansion from existing tenants but we got about in the line now about $1.5 million run rate from the existing tenants in the building, which gives us an average yield on cost of the building now at about 5%. Obviously, if we continue to lease the building up that yield will continue to rise.

Shawn Seale

We think that once we get the other third of the building let up that the NOI there will be approaching 3 million.

Gabriel Poggi - FBR

Great that is helpful thank you.

Paul McDowell

As far as the lease renewals on 2012 we don’t really particularly have any comments at the moment.

Gabriel Poggi - FBR

Okay thanks guys.

Operator

Thank you. Our next question is coming from the line of Sheila Mcgrath of KBW.

Sheila Mcgrath - KBW

Yes good morning Paul. I was wondering if you could talk about sourcing of the build to suite development opportunities. Are these wildly marketed transactions? And also on the yield there the 9.5, is that a cash yield?

Paul McDowell

With respect to sourcing the transaction Shiela, we have been in the business for 15 years, so we got very, very deep contacts throughout the market that we know lots of (inaudible) including the in development community. The build to suit transaction that we announced today was directly sourced was not widely marketed. And so we always work hard to directly source transactions and hope to do some additional ones in the future. With respect to – at the 9.5 cap rate, that is the same cash yield if we do not finance the asset.

Shawn Seale

It is a flat rate transaction so it is a cash yield for the entire term. Shiela the build to suit are much more than a measure of the partnership they are kind of a widely marketed thing, it is just – it is not that kind of thing that can be widely marketed right because it is not completed. We see this as an opportunity for us to add value where it is more competitive, the completed projects. We think there is good opportunity here in the developer market where we can add value both to our shareholders and to the development partner.

Sheila Mcgrath - KBW

Okay. And in terms of funding acquisitions which were touched down earlier, are you considering asset disposition at this time?

Paul McDowell

I think we always consider asset disposition to the extent that we think that we can replace the earnings of that asset is producing with either higher quality earnings or greater earnings than the capital currently deployed and the using assets.

Sheila Mcgrath - KBW

Okay can you give us your thoughts on dividend and the outlook for dividend in 2011?

Paul McDowell

We know that dividend remain and continue to be very important component of investor’s decision making process, it is important to us as well. We will be considering that – the dividend in our next board meeting and we will have an announcement thereafter.

Sheila Mcgrath – KBW

And last question. Are there any tenants that are currently on your watch list?

Paul McDowell

Not particularly, other than what we mentioned during the call which is not so much as tenant driven thing but we do have some generic CMBS from 2006, $19 million so very small in a $2 billion portfolio but we are watching carefully.

Sheila Mcgrath – KBW

Okay thank you.

Operator

Our next question is coming from the line of Greg Schweitzer of Citigroup

Greg Schweitzer - Citigroup

Good morning guy it is a (inaudible). I was just wondering with respect to the built to suit, if there is a potential for any construction overruns or delays and who is responsible for that?

Paul McDowell

Yeah. The build to suit, by nature I guess is subject to potential delays. The property itself is about as simple as you can get. It is underway now. The contract itself is worth (inaudible), subject to guaranteed fixed price. We do not expect any kind of issue with that at all. One of the strengths of the industrial market is that the lead time for this things once you get the go ahead and get them underway, the build period is relatively brief.

Greg Schweitzer - Citigroup

Okay. Just to be clear, if it does go on delay?

Paul McDowell

Yeah. The developers are on the hook for the over run.

Greg Schweitzer - Citigroup

That is great. And then, do you ever sense on the magnitude for what you like to get done by next year?

Paul McDowell

Not really, I mean I think if we continue to see opportunities in this return range, I think we like to do as much we possibly could fund. These transactions are creative to both ethical and cash flow and our free cash flow. And we think that the market will be pleased with the levels of returns we are able to turn up for these type of transaction.

Greg Schweitzer - Citigroup

Okay. Thanks very much.

Operator

Thank you. Our next question is coming from the line of Joshua Barber of Stifel Nicolaus.

Joshua Barber – Stifel Nicolaus & Company Inc.

Hi, good morning. Most of my questions have been answered. Just a quick one, touching on the 2011 dividend, could you give us a sense on what is your taxable income might look like relative to this year taxable income?

Paul McDowell

Not yet Josh. The 2011 income is virtually zero from a tax standpoint. Clearly – rather 2010 rather, next year will be kind of a more back to normal levels but I have not done any detailed projections that are ready to disclose to the market right now.

Joshua Barber – Stifel Nicolaus & Company, Inc.

Okay. Regarding the new FASB proposal about consolidating leases on balance sheet and everything, do you guys think it will have any meaningful impact or have you seen any tenants maybe shying away from doing longer, triple their deal because of that impending legislation?

Paul McDowell

The legislation obviously where there are new fancy rules are not yet in affect so there are a lot of discussions around that and what the potential impact may be on tenants. But so far, we have not seen any impact whatsoever. This property we are looking at today has 10 to 15 years leases. We are not hearing a lot of tenants telling us that “Well jeez this new (inaudible) rule will really impact in our decision.” because we think at the end of the day it is still primarily an economic decision, dollar decision whether or not venture into a lease versus no.

Joshua Barber – Stifel Nicolaus & Company, Inc.

Great. Thanks very much.

Operator

Thank you. Our next question is coming from the line of (inaudible) of Wells Fargo Securities.

Phil DeFelice – Wells Fargo Securities

Thanks for taking my question. Given your 9 months FFO result of $0.50 and your reaffirmed guidance of 63 to 65 implies Q4 guidance is $0.13 to $0.15 which compares to your Q3 run rate is $0.16. Can you just help us to understand the difference there?

Shawn Seale

We think we are in target to meet our guidance. There is always potentially – factors that come in that you are not projecting. We certainly don’t want to plan for a quarter of perfection. As an example, we are in a very low interest rate environment. Interest rate could certainly pick up and have some impact on our interest cost from our secured line, G&A items, the legal fees that kind of thing. We have been running very tightly from a G&A standpoint. It was slightly below budget. We are pleased about that but things come up that you don’t always anticipate so I would expect that next quarter is going to be as projected and will be in the range of our guidance.

Phil DeFelice – Wells Fargo Securities

Okay, thanks. That is helpful. That is all that I had.

Shawn Seale

Thank you.

Operator

Thank you. We have a follow up question coming up from the line from Jordan Saddler.

Jordan Sadler - KeyBanc Capital

I just had a follow up on the dividend question. Paul you are the Chairman of the Board. Just curious what – and obviously Shawn, you have got input as well, just curious what your recommendations would be. I know that you are going to bring it up to a vote but what are your thought on the dividend these days.

Paul McDowell

I am not going to – really particularly Jordan expand on my earlier comment which is, we know the dividend yield is important, we know that rising dividend yields are – rising dividends are important but we need to discuss with the board at our next scheduled board meeting in light of all of the fact there – in play. Obviously we have independent board members and I don’t want to foreclose their point of view.

Jordan Sadler - KeyBanc Capital

Just on capital raising opportunities. I know debt is pretty available and expensive these days but obviously asset deal could come to fruition as well, as we discussed but what about the preferred and sort of common sources of equity.

Paul McDowell

We have seen – we have seen continued flow of capital available to public reach in both the common and preferred market place. We did a preferred transaction at 9% in the first quarter. That transaction had created reasonably well. We think that that market remains open to us so I think once we decide that we need – if we need additional capital we will take a look at how much capital we need and then where is the lowest cost of – where can we act as the lowest cost of capital that will best benefit our common shareholders over the long term.

Jordan Sadler - KeyBanc Capital

Okay, I think Craig has one.

Craig Mailman - Keybanc Capital Markets

Shawn. On the debt reduction what was the timing of those during the quarter, is are any pick up on interest expense going on 4Q or more color on that will be helpful.

Shawn Seale

Well, we made the debt kind of gets paid down during the quarter. (inaudible) like most of our mortgages are monthly paid mortgages. We did make a small payment. I think there is 2.5 million on our (inaudible) line or Wells Fargo line right at the end of the quarter, so there wasn’t really any interest savings here from that pay down per se in the number; continuously interest expense drop a little bit each quarter as that amortizes. We also bought back a small bit of our convert from a calendar stand point. That was pretty early in the quarter by Michelin.

Craig Mailman - Keybanc Capital Markets

Okay. So most of that basically baked in, so obviously you might have a little bit to pick up but really not much.

Shawn Seale

Right.

Craig Mailman - Keybanc Capital Markets

Okay, then there is another question. How much capital do you acted out so far to the Delta suit? You said you get a 9% on capital out the door. Is that correct?

Shawn Seale

You got about 1.5 million out. We won’t really earn anything on that it is completed but because it is our development property so it is like you are not going put any revenue on that until March when it is actually done.

Craig Mailman - Keybanc Capital Markets

Okay, I guess because I think Paul made a comment that you guys are going to earn 9% in the capital and then the stabilized yield for 9.5. So just trying to figure out is there any take up prior to the completion of the asset.

Shawn Seale

No there is not. The return is embedded in our purchase price at the end of the contract.

Craig Mailman - Keybanc Capital Markets

Okay, thanks guys.

Operator

Gentlemen there seem to be no further questions and comments at this time. I would like to turn this over back to you.

Paul McDowell

Thank you all very much for joining us on our third quarter conference call. I am going to look forward to updating you at the conclusion of the fourth.

Operator

Thank you and that concludes today’s teleconference. You may disconnect your lines at this time and thank you for your participation.

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