Alexandria Real Estate Equities' (ARE) CEO Joel Marcus on Q2 2014 Results - Earnings Call Transcript

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Alexandria Real Estate Equities, Inc. (NYSE:ARE)

Q2 2014 Results Earnings Conference Call

July 29, 2014 03:00 PM ET

Executives

Rhonda Chiger - Investor Relations

Joel Marcus - Chairman, CEO and Founder

Peter Moglia - Chief Investment Officer

Steve Richardson - COO and Regional Market Director (San Francisco Bay Area)

Dean Shigenaga - EVP, CFO and Treasurer

Analysts

Emmanuel Korchman - Citi

Jamie Feldman - Bank of America Merrill Lynch

Gabriel Hilmoe - ISI Group

David Rodgers - Robert W. Baird

Michael Knott - Green Street Advisors

Sheila McGrath - Evercore

Michael Carroll - RBC Capital Markets

Michael Bilerman - Citi

Jim Sullivan - Cowen and Company

Operator

Welcome to the Alexandria Real Estate Equities Incorporated Second Quarter 2014 Earnings Conference Call. My name is Jessica and I will be your operator for today’s call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. Please note today's conference is being recorded.

And I will now turn the conference over to Rhonda Chiger. Ms. Chiger, you may begin.

Rhonda Chiger

Thank you and good afternoon. This conference call contains forward-looking statements within the meaning of the federal securities laws. Actual results may differ materially from those projected in the forward-looking statements. Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements is contained in the Company's Form 10-K, Annual Report and other periodic reports filed with the Securities and Exchange Commission.

And now, I would like to turn the call over to Mr. Joel Marcus. Please go ahead.

Joel Marcus

Thanks, Rhonda, and welcome everybody this second quarter call. With me today are Peter Moglia, Steve Richardson, and Dean Shigenaga. As all of you have seen from the press release we are pleased to have reported our second quarter FFO at 1.19 a share an increased in the mid point of our narrow 2014 guidance range $4.74 to $4.80. In the second quarter we have witnessed the very positive conversions of really more a key cyclical as well as structural factors which have resulted in exceptionally strong environment for our unique collaborative science and technology campuses in our great urban innovation clusters.

And point we actually see exceptional opportunities, very strong tenant demand, increasing rents and occupancy and Alexandria is able to drive earnings and NAV growth therefore. We will at Investor Day in December set expectations for growth and 2015, as well as how our value added growth pipeline should evolve over the next two to three years. We will also detail our funding approach to our capital allocation in 2015 as the company continues to have the full range of capital sources available to it and if you look at -- take a glimpse of 2015 can be seen on page 50 of the supplement.

Other macro comments let me share with you. We see continuing strong improvement in the life science industry’s ecosystem participants to be urban core clusters, Peter will talk about this in a minute, presences, really tertiary cluster locations outside of the key core urban clusters are really declining even if you have got a second tier academic or university nearby and Pfizer sale of three facilities and they are moved to the heart of Cambridge which again Peter will comment on in detail in a moment, really are the prime example we have witnessed the strong biotech and pharma capital markets performance over the last many months and solid profitability and lots of cash. As you know, record high FDA approvals of new drugs are with us plus the FDA review time is down from about 23.8 months as the high and 20.08 to right now about 9.4 months in 2013. When combined with the new breakthrough therapies designation and the new way of precision targeted medicines to treat serious life threatening illnesses and diseases, it's pretty clear that we’ve got substantial improvement over existing therapies and better targeting of medicines with fewer side effects. And of the six breakthrough therapies approved by the FDA, four Alexandria tenants Roche, Gilead, Novartis and GlaxoSmithKline.

In the first half of 2014, in fact 143 digital health companies raised $2.3 billion or 168% growth over 2013, so another good factor.

If you look at July 25, Wall Street Journal, they did a feature article on Google Acts, an important tenant of ours in the San Francisco Bay region and Google's so called New Moonshot project to human body was kind of elucidated in that article and simply stated it’s focused on not being restricted to specific diseases, using new diagnostic tools to collect a broad range of samples using Google's massive computing power defined biomarkers and patterns and then using these biomarkers to detect diseases much earlier than we ever have. So we’re on the new frontier of some pretty dramatic breakthroughs.

We moved operations and internal growth and both Steve and Dean will talk about this. We’re certainly beating our occupancy and rental rate increase estimates and we’re in a strong environment given our urban locations. Leasing by region has been driving internal growth with 752,000 square feet lease this quarter, Greater Boston contributed 58%, San Francisco 13% and San Diego 12%.

On external growth, you’ve seen the disclosure on the acquisition of 500 Townsend Street in the SoMa district of San Francisco in April adjacent to our Mission Bay cluster and really over time we think integrated well will help driver our continued growth in the city of San Francisco where we’ve successfully developed over 1 million square feet.

I also direct your attention to page 27 of the supplement, our near term value add pipeline. It is the strongest it’s ever been in key multiple and innovation clusters and we’re very pleased about that. I'll leave the balance sheet comments this quarter to Dean and may be finish up on the dividend. The company will continue its policy to share increasingly strong cash flows with shareholders as we continue to maintain a low payout ratio, 61% this quarter.

So I’m going to turn it over to Peter for some comments.

Peter Moglia

Thanks Joel. Good afternoon. This quarter I would like to highlight one notable life science trade that provides some clarity on cap rates in Torrey Pines, San Diego, one of Alexandria's largest sub markets. Trades of office property in San Francisco and Manhattan that illustrate continuing cap rate compression in the core urban markets that Alexandria invests and operates in and then highlight the sale of life science portfolio by Pfizer in West Cambridge, not so much for its financial metrics but because it offers further support that the transition of large pharma and biotech companies from siloed research campuses to centers of innovation anchored by academic institutions is continuing.

First, I would like to discuss the sale of 11099 North Torrey Pines Road by Angelo Gordon to HCP. The asset is 93% occupied, 92,479 square foot multi tenant laboratory office building on the northern age of the Torrey Pines sub market. There are about a dozen tenants in the facility that are mix of large company or institutional credit with some early stage private biotech.

The sale price was $43,750,000 which would indicate a low 5% cap rate on in place income. But after allocating value to excess land, it was reported to be at 5.67%. So this is a solid building but we believe our portfolio in the submarket is of higher quality and therefore this comparable should support low 5% cap rates for our higher-end Torrey Pines properties such as our Nautilus and Spectrum projects.

There were no other life science trades to report this quarter, but we would like to note that last week an article in the registry noted that 405 Howard Street in San Francisco is being acquired by Norges Bank Investment Management and TIAA-CREF for $350 million, which is estimated to be $750 per square foot at a cap rate of between 3% to 4%. This asset is located within 1.5 miles of our 500 towns in project in the Northern edge of our Mission Bay Holdings. We believe the Mission Bay is on course to be every bidders of a desirable location at SoMa and Financial District as it moves towards full build-out aided most recently by the announcement of the development of the new Golden State Warrior Stadium and supporting on the east (inaudible). Because of this we believe that cap rates for our Mission Bay assets closely resemble those of assets trading in SoMa in the Financial District. Adding the Mission Bay’s terrific location and close SoMa and the Financial District is that our Mission Bay assets are relatively new within average age of 5.8 years and are leased to high quality tenants such as Pfizer, Celgene, UCSF, the VA and Baird under long-term leases.

We’d also like to note that both 5 Times Square and 920 Broadway traded in Manhattan at $1,361 and $1,091 per square foot respectively showing that investor appetite for New York City asset is not necessarily being governed by price per pound limitations. No cap rate was reported for 920 Broadway, but the 5 Times Square cap rate was reported at 4.35% and we’d like to note that it was a lease hold transfer.

Lastly, Pfizer the recently sold vacants asset 87 and 200 Cambridge Park Drive in West Cambridge total in 280,000 feet to King properties for a $192 per square foot. But what is really interesting about is that the sign a lease with MIT at 610 Main Street South in Kendall Square for 287 square feet and are rumored to be looking at taking another 140,000 square feet at MIT 610 Main Street North project.

A June 15th article on Boston Globe references that Pfizer will consolidate employees from West Cambridge 620 Memorial Drive and some employees relocated from Groton, Connecticut to 610 Main. Although only 4.5 miles away from their new location, Pfizer decided to sell fully improved owned research assets in West Cambridge and materially increase their occupancy costs by leasing space in the heart of Kendall Square because to close the article.

“While the company has historically deployed the standard pharmaceutical industry model of in-house, siloed drug discovery, the new research center here has stolen a page from the collaborative culture and open architecture of the entrepreneurial startups that dot Kendall Square.”

They obviously see that the value of the location will vastly out way the increase in operational costs. Mikael Dolsten, Pfizer’s President at Worldwide Research and Development was quoted saying that Pfizer’s decision in consolidate in the Kendall Square location “is a real recognition of our confidence in Cambridge, Mass., to become one of the leading hubs of biomedical research for us in the future”.

Examples like this continue to validate our cluster model and we expect more in the future as a result new product pipelines and lower overall cost of drug development.

So with that, I'll pass it over to Steve.

Steve Richardson

Good afternoon, everyone. At the outside, I'd like to first commend our best in class regional teams for truly exceptional operational performance year-to-date as we are hitting on all cylinders. The level of expertise and commitments excellence in all facet of the business is truly unique and unparalleled in the industry.

Today I will touch on two key aspects of our operations in my remarks. One the ongoing and sustainable solid performance of our core. And two as we forecasted earlier this year the increasing actual and immanent deliveries from our significant $1.1 billion current value creation development pipeline. First the core is performing very well as we reported cash and GAAP increases of 6.3% and 13.6% year-to-date and 3% and 9.9% respectively this past quarter for renewals and re-leasing of space. We were seeing now more broadly as a trend the clear and compelling sense of urgency towards Alexandria’s Class A facilities and operational teams and its irreplaceable cluster locations as tenants with 2015 and even in some cases with 2016 rollovers engaging our regional leadership teams to renew leases and lock down space.

This is a very noteworthy and powerful market dynamic that we really haven’t seen in decade or more. The stability provided by our Class A facilities and AAA, urban science and tech campuses populated by investment grade tenants with a high bar 96.9% occupancy rate for North American properties is also impressive as this is the second consecutive quarter we have been greater than 96.5% occupied. Probably no better metric for the return to stability seeing we outlined at our December 2013 investor meeting.

The rollovers remaining to resolve in ‘14 are very manageable 150,958 square feet or just 1% of our operating base. We'll take a closer look at each of Alexandria's urban science and technology innovation clusters and a very positive fundamentals for each.

In Cambridge we are seeing demand remaining very robust and increasing with more than 4.3 million square feet of demand from both life science and tech users. Our mark to market and rollovers for the balance of the year is targeted at 14% on a GAAP basis and the region has hit a high order mark of 98.5% occupancy.

The clear scarcity of both large blocks and smaller blocks of space is maintaining rents at the new level of high 50s, low 60s triple net for existing product and Binney Street build-to-suit prospects are anticipating rents in the low 70s triple net.

Direct office vacancy rates in East Cambridge remain very healthy at a low of 6.8% and lab vacancy rates remain unchanged at 10.7%. Although it's important to note that the bulk of this lab availability is really B quality leave behind space from Vertex and Pfizer and as such the desirable direct spaces are experiencing competition for multiple users creating a clear landlords market.

Moving over The San Francisco Bay, it's also continuing its strong demand cycle as we're maintaining our strong occupancy level at 98.4% in the operating and development asset base. We're tracking 750,000 square feet of life science demand and a pretty amazing 7.9 million square feet of tech office demand. We recently note Google's leased out approximately 250,000 square feet and purchased of an adjacent 90,000 square foot building in the Selmont further contributing to lease rates for new product now in the mid 50s tripe net.

The mark to market for 14 rollovers is anticipated to be nearly 14% with lease rates increasing again to the low 50s triple net Emission Bay mid 30s in South San Francisco which could pop if the Amgen's rumored plans to reoccupy space that they've had on the market for sub lease transpires and mid to upper 40s in the Stanford Cluster.

The market overall continues to tighten and vacancy rates dropped 50 basis points in the lab market from Emission Data Palo Alto to 6.3%. Its sense of urgency is clearly evident with a December 2015 and December 2016 tenant completing the early renewals.

Moving down to San Diego the core is performing very well with 97.2% occupancy, up 300 basis points from Q2, '13 and the market overall is similarly enjoying continued strong demand with 1.3 million square feet of life science requirement, up significantly from the 800,000 square feet earlier this year. A number of transactions along with Torrey Pines [Villas] had been recently completed in the range of $40 triple net for high quality product which is now becoming even more scarce as of the direct vacancies just 10% and our current negotiations are now reaching into the mid to upper 40s triple net.

ETC's direct vacancy rate has dropped 30 bps to 6.1% and although the remaining roll over is small, it's important to note that mark-to-market will be significant as legacy lease expires.

Finally Seattle will provide mark-to-market gains in the mid-teen range for the balance of 2014. Vacancy rates are also tight in the South Lake Union district to 4.9% and demand continues in Seattle with fresh requirements for nearly 500,000 square feet in the science and tech sector.

Finally our current value creation development pipeline remains on track with an additional 110,000 square feet delivered in place into service during this past quarter. We're on track to deliver and place in service significant fully leased facilities during the second half of 2014 and Q1 ‘15. These projects represent the highest quality Class A assets in core urban science and technology innovation clusters, Cambridge, Manhattan, San Diego and San Francisco and are another testament to the acumen of our fully integrated regional teams.

With that I’ll hand it off to Dean.

Dean Shigenaga

Thanks Steve, Dean Shigenaga here. Good afternoon, everyone. I have four important topics to cover. First, I want to provide an update on our balance sheet including our recently highly successful issuance of unsecured notes; second, I’ll provide a key update on land sales for the second half of this year; third, briefly touch on interest expense for the second quarter; and fourth, provide a summary of key drivers of growth and our guidance for 2014 FFO per share and confidence in our ability to deliver solid growth and cash flows, net asset value and FFO per share in 2014 and beyond from our Class A buildings and land parcels in AAA locations in urban innovation clusters.

Starting with our bond offering, mid-July, we completed our third highly successful unsecured bond offering and increased the strength and flexibility of our balance sheet and capital structure. Our $700 million dual tranche offering focused on three primary goals, first transitioning variable rate bank debt to longer-term fixed rate unsecured bonds; second, prudent laddering of debt maturities; considering our outstanding bonds with maturity dates in 2022 and 2023; and greatly increasing flexibility as we focus on several high value build-to-suite development projects.

Our bond offering consisted of $400 million of 2.75% 5.5 year unsecured notes due in 2020; $300 million of 4.5%, 15 year unsecured notes due in 2029; blending to a weighted average rate of 3.5% and a maturity of 9.6 years; and to put this pricing into context, a 10 year deal would probably have priced within interest rate around 4%.

This highly successful transaction also extended our average maturity of outstanding debt to 6.3 years, up from 5.1 years; increased our liquidity to 1.8 billion; and reduced our unhedged variable rate debt to 7% of total debt.

Briefly on a few other balance sheet matters. The high value projects that we have leased completed and delivered over the past several years along with delivery scheduled over the next few quarters really highlights the solid demand for our Class A assets urban innovation clusters.

Our target net debt-to-EBITDA for the fourth quarter of 14 annualized is on track with our plan at 6.8 times and is relatively consistent with leverage at the beginning of the year of 6.6 times. Additionally, our target net debt-to-EBITDA of 6.5 times is expected to occur by the fourth quarter of ‘15.

Non-income producing assets will decline to 15% by year-end and to 12% by March 31, 2015, primarily through the completion and delivery of pre-leased Class A development and redevelopment projects. These forecasts include a very conservative assumption for construction spend related to new projects and includes the land sales targeted for 2014. We also anticipate significant EBITDA growth for 2015 when compared to 2014 plus solid cash flows from operating activities after dividends, which in aggregate will provide funding for growth of approximately $500 million to $600 million in 2015.

Briefly on our second topic on land sales for the second half of the year, we remain comfortable with our range of guidance for land sales of $145 million to $245 million for the full year ‘14 and approximately $115 million to $215 million to complete for the remainder of the year.

Moving on to our third topic, I briefly want to touch on interest expense for the second quarter. Interest expense declined approximately $1.7 million, driven by a $2.4 million reduction in gross interest expense offset by an approximate $700,000 reduction in capitalization of interest. Gross interest expense declined primarily due to the repayment in January of ‘14 of a $209 million secured loan with an interest rate of 5.6%. Additionally, we had $200 million of notional and swap contracts that ended on March 31, 2014 which fixed LIBOR under the contracts at about 5%.

Capitalization of interest was lower this quarter, primarily as a result of the weighted average interest rate required for capitalization at 3.41%, down from 3.88% as of the first quarter. This temporary dip in the interest rate was caused by the higher proportion of variable rate debt outstanding under our line of credit which obviously has a lower interest rate. This temporary decline in the rate was reversed in July upon completion of our bond offering when we repaid almost all of our outstanding borrowings under the line of credit. We expect the weighted average interest rate for capitalization of interest to return to its prior run rate in the range from 3.8% to 4% for the second half of ‘14.

Lastly on guidance, our core operations continue to benefit from one of the REIT industry’s highest quality tenant basis with about 52% of our total ABR from investment grade rated tenants. Additionally high quality science and technology entities continue to drive strong demand for our Class A assets in urban innovation clusters, including build-to-suit opportunities on our land parcels.

This high quality demand drove continued improvement in our outlook for ‘14. Our guidance for FFO per share this year was increased $0.02 at the midpoint to a range from $4.74 to $4.80. We increased the range of our occupancy for year-end up to 97.2% after hitting the upper end of prior occupancy guidance well ahead of schedule. We also increased the range of guidance for same property NOI growth to a range from 3% to 5%, up 1% on both ends of the range. Additionally, we increased the ranges in rental rate increases on renewal and releasing a space to a range from 11% to 14% and a range for 4% to 6% on a cash basis, again both up 1% each on each end of the range. Most importantly, there is strong demand for our high quality buildings and urban innovation clusters will allow us to monetize several land parcels through development in the near term.

As we look back to the Investor Day in December of ‘13, our outlook at that point for 2014 was very solid. Now that we're seven months through the year, it's very clear that demand for space in our buildings has meaningfully improved. Again this demand and the strength in the performance of our core operations drove the aggregate $0.07 today in our mid-point guidance for 2014 FFO per share.

The key drivers of this $0.07 growth and $0.04 from core operations, $0.01 from value creation deliveries earlier than anticipated, $0.01 from acquisitions and $0.01 from other items including our recent bond offering.

In closing, we're very pleased to be in a solid position with our balance sheet, with continuing solid core operations and demand from high quality science and technology entities to drive stable growth in FFO per share and net asset value in 2014 and beyond.

With that, I will turn it back to Joel.

Joel Marcus

Operator, we are open for Q&A.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) And we'll go first to Emmanuel Korchman with Citi.

Emmanuel Korchman - Citi

Hey thanks guys. Dean, if we just look at your income statement there was no other income in the quarter typically you’ve had some amount in there attributable at least to marketable security sales, could you just tell us what's going on there?

Dean Shigenaga

Yes, I’d say we had a onetime decline in other income, typically you see other income in the $3 million to $4 million range and that's our outlook for the remainder of the year. In the quarter, we did have a lower amount of investment income. In fact there was a small loss in aggregate during the quarter. So that was the driver there.

Emmanuel Korchman - Citi

And then given the strength you spoke about in terms of assets sort of next you're already selling it good cap rates have you thought about selling more core assets into that type of market rather than just the non-income producing ones?

Dean Shigenaga

We did go through recycling of assets that we wanted to lighten up the uncertain sub market in latter '12 and part of '13 and I think that was completed at the moment. We're reviewing things constantly and you may see us do some of that but at the moment we don’t have anything particularly to target.

Emmanuel Korchman - Citi

And then in terms of the non-core sales the 50, 60, 100 JV do you still plan to have them this year?

Dean Shigenaga

We’re certainly on target to do that, yes.

Emmanuel Korchman - Citi

Great. Thanks guys.

Dean Shigenaga

Yes. Thank you.

Operator

Our next question comes from Jamie Feldman with Bank of America Merrill Lynch.

Jamie Feldman - Bank of America Merrill Lynch

Great, thank you and good afternoon. So I guess sticking with the acquisition or the disposition market, can you talk a little bit more about the types of buyers you guys are seeing for your asset class?

Peter Moglia

Hey Jamie, it’s Peter Moglia. We’ve seen a lot of domestic and foreign capital private equity, we’ve had a lot of pension funds interested in both buying our product and in joint venturing with us. So I would say that pretty much every class of investor has looked or purchased life science product now, maybe that wasn’t the case seven years ago but it is now.

Joel Marcus

Yes and I think that’s a good thing because it’s become more mainstream and certainly cap rates have reflected that.

Jamie Feldman - Bank of America Merrill Lynch

And then in terms of operating, I mean a little bit of a differentiated asset class today operated in-house or there is just specialized third-parties or do you guys maybe more retain more today?

Dean Shigenaga

I think most of the things that that have traded to those types of buyers have been long-term leases that they’ll likely probably be distil maybe within 3 years or 4 years of those leases bring up. We haven’t got to that point where someone needed to operate something yet.

Jamie Feldman - Bank of America Merrill Lynch

Okay, all right. And then shifting to the development pipeline. Can you talk a little bit more about your leasing prospects at 3013 Science Park Road and then New York?

Dean Shigenaga

Yes, I’ll speak to New York, you want to talk about 3013.

Joel Marcus

3013, we’ve got the existing building that we’re saving the steel frame where we’ve got that 25% lease to a top tier life science company in that market and then for the other project we actually have a letter of intent for the entire 65,000 or so square feet for a long-term lease there. So all we have left would be about three floors on building that development.

Unidentified Company Representative

And then in New York we have four floors left and we have some reasonable activity on some of those floors, we don't have anything that’s moved to the stage or LOI, but we're very active and we think that over the coming couple of months we'll have some news ahead of our internal projection. So I'd say stay tuned for that.

Unidentified Company Representative

Yes and Jamie, let me just add from a modeling perspective or guidance only assumes we deliver about 60% of the project by the end of this year for the West Tower.

Jamie Feldman - Bank of America Merrill Lynch

Okay. So I guess just thinking about leasing and just kind of interest in New York. I mean is there anything that’s changed or is it just a bit, is just lower than expected. I guess that’s an expected could you stay your environmental guidance but just how tenants are reacting to the market into those assets?

Joel Marcus

Yes. I think we're ahead of our own internal expectations, so I think that's reflected I the model that Dean just referred to. But I think you have to look at New York, again always in New York we are building a cluster there and so there is not, if not like Cambridge or San Francisco. But I'm very comfortable, we've got a number of tenants book big pharma and one very interesting entity that a non-profit that are looking that good blocks of space and we'll see. But a great market and I say rental rates are exceeding what we hope to get. So we are I think feeling pretty good about that.

Jamie Feldman - Bank of America Merrill Lynch

Okay. And then finally can you talk about your largest expirations in the bank half of the year and then in 2015?

Steve Richardson

Jamie its Steve. The expirations in ‘14 are really marginal as I was saying it’s a 150,000 feet total just 1% of the asset base. I think the largest block is potentially in Maryland and it’s probably about a third of that, otherwise it’s pretty well distributed in either Cambridge, San Francisco really.

Joel Marcus

And then for 2015, it’s really split among quite a number of regions, it’s about 1.1 million square feet which generally takes us about two quarters lease or sometimes in even one quarter, the largest is a suburban property in out in Route 128 and we are well on our way to working on a retenanting plan, we have got one or two tenants already until. So we feel pretty good about that there is a some phase that could be significantly up in tech square and kind of varied by region. I don’t know Steve any other color.

Steve Richardson

Yes, no. I think that’s right, I mean as you look at these rolls that were in the core markets, tech square, San Francisco piece and UTC in town center, so the larger blocks in ‘15 are all in good core locations.

Jamie Feldman - Bank of America Merrill Lynch

Okay. And do have a sense to the mark to market on your expirations?

Steve Richardson

Yes certainly in ‘14 as we touched on as we closed the year out those are all on a GAAP basis in the mid-teens so I think that will continue to support the guidance we had at the beginning of the year.

Dean Shigenaga

Yes. And I would expect directionally on the rental rate steps on our leasing activity for ‘15. I think generally speaking we're going to be in the general ranges of both GAAP and cash steps. So I think the performance we have this year or at least our expectation for 14 should continue in the ‘15.

Jamie Feldman - Bank of America Merrill Lynch

You are saying the leasing spread should be about the same [you read box]?

Dean Shigenaga

Yes.

Joel Marcus

Yes, the leasing spreads.

Jamie Feldman - Bank of America Merrill Lynch

Leasing spread. Okay.

Joel Marcus

So, the rental rate increases.

Jamie Feldman - Bank of America Merrill Lynch

Alright, great. I appreciate it.

Operator

Our next question comes from Gabriel Hilmoe with ISI Group.

Gabriel Hilmoe - ISI Group

Thanks. Just maybe following up on the last question little bit, but just on the expansion on the leasing spread guidance. Steve you talked a little bit about the current mark to market in a portfolio. But can you talk a little bit about where things are may tracking ahead of where you thought they would be maybe three or six months ago by market I guess?

Steve Richardson

Yes Gabe, it's probably certainly Cambridge, San Francisco and San Diego. I think overall we just see demand has not only continued, but it's strengthened in those areas. People are locking down space, so that's enabling us to drive rents in those kind of key core market more so.

So, it's probably those three markets that are driving it primarily.

Gabriel Hilmoe - ISI Group

Okay. And then I realize this is still strong number, but it looks like the occupancy dipped a little bit in San Fran, anything in terms of the progress and back selling some of those smaller move ups in the quarter?

Steve Richardson

Yes, we did have one legacy tenant at one of our mid Peninsula properties that ultimately rolled out, we're actually working with the Group right now. So, temporary dip from 99.9% occupancy there.

Gabriel Hilmoe - ISI Group

Okay. And then maybe lastly for Joel, I may have missed this, but any update on the plans or progress for the North parcel in New York or is the West Tower still kind of the priority for the time being?

Joel Marcus

Well both, the West Tower is still the priority with four floors left and some under active discussions but no paper trading yet and then we are in discussions with the city on North parcel also.

Gabriel Hilmoe - ISI Group

Any idea of any type of timing around that North parcel?

Joel Marcus

Too early to say at the moment.

Gabriel Hilmoe - ISI Group

Okay, thank you.

Joel Marcus

Yes, thank you.

Operator

We’ll go next to Dave Rodgers with Robert W. Baird.

David Rodgers - Robert W. Baird

Yes, hey Joel. You’re 97% leased, I think in the operating portfolio 77% leased or negotiated in the development portfolio. What should we expect to see coming out of the ground in terms of new development? I mean obviously you want to get more product out there. So may be give us a sense on starts may be over the next 6 months to 12 months and then also where those starts might be located, where do you feel the best about kind of getting new projects coming out of the ground?

Joel Marcus

Yes. I think in my prepared remarks I mentioned, if you go to page 27 of the supplement, this is kind of the best way to visualize it. And if you go to the second half, the bottom half of that spread sheet, if you will, we find a LOI with alumina working on finalizing the lease that will kick off here pretty quickly and that will be delivered next year.

We're in active discussions with two significant tenants in 6 Davis Drive. And my guess is that will probably kick off here in the second half of the year. Townsend, Steve can give you a quick update on that.

Steve Richardson

Yes, we’re making a real good progress. The team on the ground with advancing the entitlements there and perfecting the entitlements we’re engaging tenants in the market in a series of serious conversation, so we’re encouraged there as well.

Joel Marcus

On Campus Point, we have a letter of intent with an existing tenant to take most of the new buildings and we expect that will move forward here over the next few months. Lake Union, we’ve got two parcels in play with multiple users, don’t know how that’s going to go but we think we have a shot, so I’ll reserve judgment on kind of the starts there. And then on 50, 60 and 100 Binney we’ve got a lot of activity on those parcels.

David Rodgers - Robert W. Baird

Would you feel comfortable going just back on any of those or pre-leasing continues to be the focus?

Joel Marcus

When you say any of those meaning any of these on the whole list or any…

David Rodgers - Robert W. Baird

Yes, the bottom assets that don’t have that pre-leasing component or the negotiating component already underway.

Joel Marcus

It’s possible. I think the strength of the Cambridge market might move us to go forward, we’re already -- we're doing site work right now. So I’d say stay tuned there.

David Rodgers - Robert W. Baird

Okay. And I guess with 50, 60, and 100 Binney, maybe -- I don’t know how much you can talk about this under your negotiations but talk about maybe the cost and return terms to you as you think about maybe what you might be giving up. And I guess the only reason I ask that is your cost of capital has come way down with the both of bond offering and where the stock is. And I think that returns continue to improve given where rents are going in those markets. So, you said you’re still on track with that and certainly understand the capital component of it, but maybe can you talk about the cost and return terms to ARE?

Joel Marcus

Yes, I don’t think we’re ready to talk about anything. But I would say in general that we feel that we’ve got as I used the term exceptional prospects. I don’t know that I’ve ever used that before in all the conference calls I’ve done. So I think that with that clearly we want to keep our balance sheet in great shape. I think Dean’s report on the balance sheet is very comforting. So for us to be able to look at exceptional prospects and have another major source of capital to do things that we want to do and are greater than clusters gives us I think a big advantage. And so I think that just stay tuned. But we don't we're -- I wouldn't characterize that as giving up anything, I think we're gaining something very valuable. And we can move a number of projects ahead much more quickly than maybe we could on our own. And we are focused on again keeping both the NAV growth moving and very importantly our earnings growth moving, not only this year but well into next year in ‘16.

David Rodgers - Robert W. Baird

Great. Thank you.

Joel Marcus

Yes.

Operator

We'll go next to Michael Knott with Green Street Advisors.

Michael Knott - Green Street Advisors

Hi guys, good afternoon. Question for you, and this has been asked a little bit, but I just want to take a slightly different tack. Your ‘15 releasing spread sounds like will be similar to ‘14, but just curious given the strength of the tenant demand you're seeing, if you think that you might see at some point the cycle re-leasing spreads exceed what look to be the peak from last cycle about 8% on a cash basis, on an annual basis just curious. Yes, sorry go ahead.

Dean Shigenaga

Michael, Dean Shigenaga here. Yes, I gave you some baseline assumptions to think about for ‘15, but no doubt the strength of our core markets and demand in the marketplace for quality space that exist in our asset base or space like the quality of our asset base I think is going to provide opportunities, both in capturing new requirements but also as we work through early renewals, I think we have an opportunity on both sides. But I guess I want to give you some baseline assumptions as we think well ahead of Investor Day six months from now or five months from now.

Michael Knott - Green Street Advisors

Okay, that’s helpful. And do you guys think about where your overall portfolio is on a mark to market basis today, sounded like the ‘15 expiries are in pretty good markets and is sort of inline with spreads you are seeing this year but just curious if the overall portfolio is maybe a little better than that or sort of similar to that sort of up 5% on a cash basis.

Dean Shigenaga

Yes, I think on a cash basis, we are probably in that 2% to 3% and an 8% on a GAAP basis on a mark to market overall operating portfolio. Keep in mind, you have got long-term leases, you have annual cumulatively compounding increases with some pretty great tenants. So I think it’s important to really look at the GAAP metric as well.

Joel Marcus

And we are trying to be conservative so that it makes sense.

Michael Knott - Green Street Advisors

Got you. And then Joel or Dean, just curious how much development you are comfortable at carrying at any one time as a percent of total assets, just curious how you think about that? And obviously the list of projects you have going is pretty appealing at this but just curious how you think about it from an aggregate standpoint?

Joel Marcus

Yes I can ask Dean to comment from an aggregate. I think though the most important thing is that we try to cover the vast majority of our capital spend with both free cash flow and the generation of EBITDA from projects. And so to the extent that we can do that, Dean laid out I think a pretty nice slide on that.

Dean Shigenaga

Page 44 has a really nice depiction of…

Joel Marcus

So I think that’s how we think about that. At the same time, we are bringing down non-income producing assets as a percentage of total gross assets, funding our construction spend, really our spend on growth is really and this is just our own credit capital plan nothing is definitive yet till we give for sure guidance in December, but this is I think a handy way to think about it.

Michael Knott - Green Street Advisors

Okay. Thanks for pointing that out. And last one from me on that, debt to EBITDA target of 6.5 times. First, thanks for providing that, none other companies are thoughtful enough to do that, so thanks for that. But my question is, just curious is that your long-term target or is that more or just sort of where are you going to end up in the near term? And then also just curious how you arrived at that target as opposed to something else?

Dean Shigenaga

Well, I think 6.5 times has been a bogie for ours for some time. So it is near term by the end of ‘15. And I think we'll always look for opportunities as we grow our EBITDA to possibly improve that. But for now that's our bogie. And really most of our EBITDA growth is providing the opportunity to manage the growth of our business without moving leverage in the wrong direction.

Michael Knott - Green Street Advisors

Okay. Thank you.

Operator

We'll go next to Sheila McGrath with Evercore

Sheila McGrath - Evercore

Yes, good afternoon. Joel, I noticed that Longwood had a little bit of pickup in leasing in the quarter. I just wondered if the level of tenant interest is continuing there? And how the velocity of leasing you expect?

Joel Marcus

Yes, as I said. Thanks Sheila for the question. As I said last time and we've made comments on and maybe other places, of all the markets and the all the segments, this is the one that I think is most disappointing in a sense when we – they had the current vacancy rate in Longwood it's about 1%. But I think there has been this weird overhang of NIH not increasing the budget it was kind of little bit under the Budget Act from congress and then it got restore and it's kind of current run rate is about 30 plus billion dollars although I note that I think Tom Parkins I think Iowa just introduced the bill in Congress to raise it over, I think a five year period to 46 billion I don't know where that's going to go but that would be good.

But I think the institution has got a little bit frightened, they're also a little bit nervous about where Obama Care is headed, because nobody really has been through that process. So I think their operating spend has been more conservatively managed while their capital spend certainly is going forward. So we've had a lot of interest in buying floors for condominiums. We've kind of put that off for the moment. We may return to that at some point if we decide to. But we do have some -- we do have current demand for two floors which we hope to resolve over the coming may be quarter or so. And then beyond that we got active discussions with the bunch of people but nothing to show up on the scoreboard yet.

There is some pharma interest in Longwood although -- although the main pharma interest does tend to be as Peter pointed out Kendall Square. So we'll see what happens. But as they say that's the one area with such a low vacancy rate our view, back a couple of years ago when we proceeded on this process. We thought this would be much more efficiently leased than it is, but we're still comfortable. We don't deliver till the end of the year. And I think we'll be well over 50% at that point which will meet our internal projections. And we hope our rates stay at what they are pro forma wise which today have been the case. So we'll see where that goes keep in mind remind we have a 27.5% interest in that joint venture.

Sheila McGrath - Evercore

Then just on 50, 60, and 100 Binney it sounds like you’re seeing a lot of interest and given where you have the NOI coming online in 2016. Is the interest that you’re seeing more life science or is a mix of tax as well?

Joel Marcus

It tends to be very heavy life science at the moment.

Sheila McGrath - Evercore

Okay. And then last question Steve, you mentioned in your remarks that the Amgen submarkets base might come off the market. Could you just give a little more detail and how much space there is and maybe the impact on vacancy potentially?

Steve Richardson

Sure Sheila. The vacancy overall is probably right around 10% in the market although if you segment that and take smaller blocks of space you’re probably at just 3% to 4% so that’s why we’ve been able to be very successful with our projects there. In the smaller blocks over the past several quarters, these couple of blocks you’ve got probably roughly 0.25 million square feet and it looks like they may take back one if not both of those blocks of space there. So that’s been something they’ve talked about much more intently. I think as they look at 1000 Oaks recruiting versus South San Francisco.

So we’re hopeful that conversation is becoming more serious than we occupying that space. That would drop the overall vacancy rate, you probably down total that would cut it in half really be at 3%, 4%, 5%.

Dean Shigenaga

Yes, I’d make one footnote comment to that Amgen who I used to deal with pretty regularly and we have pretty close relationships with, approached us recently and we did a bit of a strategic planning session with them on innovation and it was pretty interesting because I think Amgen similar one or two of the big pharma is probably hasn't been historically as innovative as Genentech was. Genentech ended up spending out 75 to 100 companies over its lifespan, before it finally got acquire by Roche, Amgen is just starting to do that, but historically hasn't. So I think what Steve says make on the provision they really thinking about becoming a much more innovative company, they've been highly, highly successful. But it hasn't generate a lot of spin-off companies and out licensing of technology, which I think they are now under new leadership really beginning to examine pretty carefully.

Sheila McGrath - Evercore

Okay. Thank you.

Joel Marcus

Yes. Thank you.

Operator

We'll go next to Michael Carroll with RBC Capital Markets.

Michael Carroll - RBC Capital Markets

If you guys give us some color on monthly for 124 Terry Avenue and 9950 Medical Center Drive. It looks like you moved those two projects out of the near-term by accretion pipeline and moved them into the future one. Can you kind of explain what changed there?

Joel Marcus

Sure. Maryland I think the simple fact is we don't see the demand that would really push us to do development there. We think there is adequate available space there through we have some space obviously and others have a bunch space both local and national folks. So I think that was put down and then although we have been approached a number of times by the NIH, but we'll see where that goes up for some new space.

And then 124 Terry, we think that's probably likely to go resi and so that's probably something we wouldn't do ourselves. So stay tuned we might years sell the parcel or joint venture the parcel something like that.

Michael Carroll - RBC Capital Markets

Okay. How is I guess, how long does it take for 50 and 60, 100 Binney Street to do development how improved are those land sites and if you start the construction let’s say beginning of ‘15 were to get done by ‘16?

Joel Marcus

Yes there is several ready and there is something in the range of about…

Steve Richardson

30 months construction timeframes.

Joel Marcus

Yes.

Michael Carroll - RBC Capital Markets

Alright and then do you expect to start 50 and 60 before 100 or 100 just takes longer because it’s a bigger project?

Joel Marcus

At the moment although we have it in the disclosure but it looks like 100 would be started later it really depends on the demand the demand in Cambridge is as I said is pretty large and so it’s hard to say at the moment.

Michael Carroll - RBC Capital Markets

Okay, great thanks.

Joel Marcus

Yes.

Operator

(Operator Instructions). And we will go back to Emmanuel Korchman with Citi.

Michael Bilerman - Citi

Hey it’s Michael Bilerman. Good afternoon. I echo Michael (inaudible) thank you for the target debt disclosure as well as level of the commentary that you had in the release. And if I may I just had just a question sort of surrounding it. When you think about getting to 6.5 by the end of ‘15 from 7.2 today what else is sort of in that forecast in terms of capital spend and any asset sale. So we know what’s sort of happening in the back half of the year which I think you have about $380 million left to spend, you have about $16 million of free cash flow that’s coming in and then you have the asset sales you have targeted, but I am curious I didn’t know what was factored in to 2015 in order to get to that target?

Dean Shigenaga

Michael it’s Dean here. I think the best way to think about 2015 is that we have a number of items that bring clarity to what can unfold i.e. the retained cash flows after dividends and EBITDA growth. So we have tremendous capacity to fund growth for ‘15. Hopefully, everybody can appreciate it, it's a little difficult to predict the exact dollar amount of construction spending related to a number of projects that we've identified. And this goes back to page 27 on the pipeline of opportunities in the near term.

We have a number of negotiations ongoing, the exact starts will likely depend on the pace of those negotiations and leased executions on many of them.

So, I would say give us some time to come back to you, probably closer to Investor Day to give you better clarity on the exact mix of what will unfold for ‘15, because there is a lot of moving pieces at the moment.

Michael Bilerman - Citi

Maybe we talk it from a different level, there are some known factors that actually more embedded. One is you talked about that other income being very low, this quarter and you had a lot sales, investment sales, you had a loss. Just moving that back towards the average is about 0.2 times on debt to EBITDA. So, 7.2 goes to 7.

You have same store EBITDA growth. I assume next year. And so that's going to add some level, I don't know what are you going to forecast for next year, whether it'd be 3% or 4%, but probably somewhere within that range. That's going to add to it. And then you have this large redevelopment development platform that has delivered some assets that are not yet stabilized and that are going to be delivering over the course of the back half of this year and next year. Do you sort of have the buckets of that EBITDA from those activities. So at least we can get the EBITDA numbers that underly the forecast and then we can figure out what spend will be?

Dean Shigenaga

We'll provide that clarity in December Michael, at our Investor Day.

Michael Bilerman - Citi

How much of development, re-development pipeline is -- where is that number for what you want to be delivered in 4Q of next year, how of much that's been leased. So you do very highly leased development platform what is that number in terms of the projects that will be earning income 4Q ‘15?

Joel Marcus

Yes, I think if you look at page 28 of our supplemental which highlights the current development pipeline, it’s probably as simple as just to go top down on page 75/125 Binney Street, which is 99% released to ARIAD, will be delivered contractually here in late March and rent will commence in late March.

499 Illinois will be delivered over multiple quarters but I think we get to stabilization close to year-end, probably in 90% range with a little bit being delivered in the first quarter. And again, that’s 100% leased. 269 East Grand will be probably in October 1 delivery, 100 leased. Science Park, Peter ran through, 60% leased negotiating today; pretty good shape there. We talked about New York being about 60% delivered by the end of this year with upside on delivery through ‘15.

On the redevelopment front on page 30, 225 Second Avenue looks like 100% leased with an occupancy in the second quarter of ’15; Barnes Canyon 100% leased, delivery later this year in the third quarter. And then Rozelle, it's mix, 75% leased, 24,000 square feet has been delivered; we have another 17,000 to be delivered probably in second quarter of ‘15 with a little bit to resolve.

So big picture of your answer of your question Michael, the pipeline of active projects that will be delivered substantially through the first quarter is driving the tremendous amount of the EBITDA growth that’s been forecasted. And big picture I think same property performance on the cash side I think will be solid, given the occupancy growth in the portfolio over ‘14 which will contribute to ‘15 as well as nice steps on leasing activity and contractual rent steps embedded in the leases.

So, core should deliver strength into ‘15 and you’ve got tremendous value-add that’s highly pre-leased but driving a significant EBITDA growth. So, we’ve got a pretty good ability for internal funding which is what we’ve been trying to highlight and again I think we’ll provide more clarity to some of your questions on Investor Day Michael.

Michael Bilerman - Citi

And then just going back to Binney 50, 60, and 100, so you have about $300 million in the effective land today on your schedule pace 32, my understanding is that’s going to be where you’re going to raise some capital as part of this joint venture capital forecast you have of $110 million to $210 million, part of that’s going to be putting some of this land into a joint venture. How much of the project are you going to be putting into joint venture?

Joel Marcus

It will be a minority interest.

Michael Bilerman - Citi

So, 25%, to 30%?

Joel Marcus

Yes. I am not sure I am ready to announce any percentage but it will be a minority percent; it will be less than 50%.

Michael Bilerman - Citi

And as you think Joel, as you think about putting in land and obviously getting some mark-to-market on that piece of the value that’s been created in the value in Cambridge, how do you sort of evaluate that versus settling in 25% or 30% interest in a core stabilized asset versus putting a lot of money into Cambridge at arguably a very attractive yield relative to your plan basis. How have you sort of wrestled with being of current cash flow at attractive valuation given how where cap rates are versus developing to a higher yield and earning the NAV spreads on that?

Michael Bilerman - Citi

Yes, I mean that's always the historical challenge, but I think that, because Cambridge is so large and may move all together that having a capital makes a lot of sense and we look forward to having a more programmatic sense of other things that we have in more the medium term pipeline that aren’t necessarily reflected here as far as our thoughts and things that we're going to do we'd like to have that source of capital available to us to do things that we might otherwise can’t do.

I think if we go down the road of we are looking hard at a variety of assets that we haven't made any decision about, we have recycled assets as you know. But I think in recycling assets, we've got strong cash flows, we've got long-term tenants, we probably would not want to give up what we would consider to be really irreplaceable locations that are already cash flowing at very strong yields out there. But there are a host of assets that we might consider, so I think stay tuned on that score.

Michael Bilerman - Citi

Okay. Thanks for the color. Look forward to Investor Day.

Joel Marcus

Yes. Great questions as usual.

Operator

And we'll go to Jim Sullivan with Cowen and Company.

Jim Sullivan - Cowen and Company

Thank you. I just have one quick question. Digital houses a category has been attracting a lot of start-up funding as you were (inaudible) recent report from mid-year indicator a very, very significant uptick year-over-year in that category and I know that you've mentioned once or twice in connection with some of the land acquisitions and I wonder if you could talk to us a little bit about how you assess the potential for growth in digital health demand number one, number two whether or not there is any regional concentration in demand so far or anticipated? And I guess number three whether there is any specific physical demands in terms of space let’s say need i.e. can they take conventional office space or not and I guess finally is there any need for them to be and what you would think about is innovative cluster markets or approximate or adjacent to the innovative cluster markets?

Joel Marcus

Yes all good questions, I think it’s really an emerging sector broadly under the IT sector and under the life science sector my sense is over the next five to ten years it will be a very big sector and it will come into maybe some prominence that would be identified as a some category under/either both of those the growth is really pretty staggering, the opportunity is huge. But I think it’s too early to tell I think the main cluster where we are seeing activity is San Francisco at the moment there is some in New York and in the Boston Cambridge area, but I would say primarily in San Francisco and that’s due to the extremely heavy concentration of tech-oriented venture capital on San Hill Road et cetera. Most of those requirements can be accomplished with office kind of a creative tech office some might require some enhanced features, but we view that those people generally will want to be at least the ones that we identify now will want to be in kind of the urban innovation cluster markets primarily for recruitment and retention. So we're tracking that sector, emerging sector very closely. And I'd say we hope to see it growing in pretty substantial fashion over the coming years.

Jim Sullivan - Cowen and Company

Thank you.

Joel Marcus

Yes. Thank you.

Operator

And this does conclude our question-and-answer session. Mr. Marcus, I will turn the conference back to you for closing remarks.

Joel Marcus

Okay. Well, everybody thank you very much for busy time on one of the earnings day. Thank you for questions and attention and we look forward to talking to you on the third quarter call. Thanks.

Operator

This does conclude today's conference. Thank you for your participation.

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